Milestone 05


The Wyre Catchment Natural Flood Management Project


Develop Business Case and Financial Model


Project Summary

The Wyre Catchment Natural Flood Management Project is the first example in the UK of the use of repayable private investment enabling the delivery of natural flood management. The project will deliver more than 1,000 targeted measures to store, slow and intercept flood water and prevent peak flow in a catchment in England, with the interventions hosted by local farmers. Beneficiaries of the reduced flood risk are paying for the interventions through an extendable nine-year contract, and the Project’s Community Interest Company (CIC) has successfully raised a nine-year £850k private loan facility to help fund the up-front capital cost of the interventions.

Milestone 1: Initial Project Scoping

Often the initial task is to understand the site(s) you want to use and the land use change needed for nature restoration or creation. This includes considering the goals of the land managers involved, the vision within the wider catchment or neighbouring area, and whether there are permits or planning consent needed for any proposed changes.

At this stage, you can also conduct a high-level assessment to determine which revenue streams can be generated from ecosystem services , e.g. carbon credits, flood reduction cost savings, or biodiversity units, which will be crucial for identifying buyer interest.

Finally, it is useful to have an idea of the costs of the project and potential grant funding that may be available to support initial development.

Milestone 2: Identify and Work with Sellers

Initial ownership of the ecosystem services will belong to the landowners or, in some cases, the tenants of the sites that the project is using. However, these can be passed onto others, such as third-party project developers, with appropriate legal arrangements and compensation. In some cases, there may be a sole seller of the ecosystem services, where the site or landholding is large enough that it delivers the volume of ecosystem services needed to cover the costs of the project and attract buyers.

However, in order to achieve scale and impact, a project will likely involve multiple sellers, such as neighbouring farmers and estate managers. Scale of land is often needed to deliver significant environmental outcomes, and also to attract private finance. Project developers must plan how they initially contact and engage with these sellers going forward, building their wants and needs into the project.

Milestone 3: Baseline and Estimate Ecosystem Services

At this point, you will have understood the vision for the project and identified a particular ecosystem service or set of services to be sold. The next step will be to carry out detailed analysis – baselining each ecosystem service and quantifying what will be able to be delivered from the interventions, as well as planning how to monitor and maintain these interventions. You will need to rely heavily on ecological expertise for this more scientific Milestone.

At this step, standards, verification and accreditation methods will be considered in more depth.

Milestone 4: Identify and Work with Buyers

Based on your earlier market analysis in initial project scoping, you will have identified one or more groups of beneficiaries who may be willing to ‘buy’ or pay for the ecosystem service(s) to be created, restored or maintained. Buyers vary – as do their requirements – but at this step, greater buyer engagement is now needed to develop a deal that channels money towards the nature-positive outcomes that your project wants to deliver.

 

 

Milestone 5: Develop Business Case and Financial Model

You’ll have started building your business case and financial model in earlier steps – laying out your vision, the market proposition and estimating costs and income. This step offers a review, in addition to providing details on information needed to build out the financial model and business case more fully. Both of these key documents will be iterated throughout project development, and may be altered during project delivery as new information emerges. These documents are interlinked and, if developed correctly, will ensure your project’s viability and also help you with discussions with stakeholders including sellers, buyers and future investors.

The financial model will also enable you to better understand the type of structure your project may take to attract investment (i.e., an environmental bond, a loan, an equity investment) and what sort of returns you can afford to pay/offer.

Milestone 6: Develop a Governance Structure

A governance structure will inform the way in which the project is run when fully operational and for what purpose. It identifies appropriate decision making processes, who is responsible for what actions, and what controls are in place to make sure that the project is meeting its stated goals, all while abiding by the risk appetite of its engaged stakeholders. The legal entity to host the project will be a key driver in this, and the appropriate choice of entity will be dependent on several factors that are outlined below.

Your governance structure should align with and underpin your business case, as a necessary component of how the project will deliver its environmental outcomes and other strategic targets.

Milestone 7: Identify and Work with Investors

It is important to note that not all projects will need up-front investment, but for those that do, this section provides a framework for thinking around the development of the investment model. This does not constitute financial advice – as the GFI is not licensed to do so. However these considerations are based on the insight offered by project developers and other market stakeholders.

An investor will be a new core stakeholder in your project, and it’s just as important to think of what you require from investors, as much as what they require from you – so that you can build a positive and collaborative relationship with them.

This entails defining the investment ask (in line with the financial model), the strategy for approaching the right investors, and the negotiation of terms that can then be formalised in contract development (Milestone 8).

 

Milestone 8: Establish Legal Contracts and Closing

When all relevant stakeholders have been engaged and their terms of engagement are clarified as much as possible, this is the time to develop the legal contracts and close the deal. This stage is last because legal fees are expensive, and it is generally advised to determine as much as possible in previous stages before

Note: The information in this Milestone does not constitute any form of legal advice but instead serves as practical advice on how to manage engagement with lawyers and the process of contract development.

The Green Finance Institute is not a firm of solicitors or connected in any way with the courts. The information and opinions we provide in this section and across the Toolkit do not address your individual requirements and are for informational purposes only. They do not constitute any form of legal advice. We recommend that appropriate legal advice should be taken from a qualified solicitor before taking or refraining from taking any action.

Community Engagement

Community engagement is highly advisable for any project that aims to sell ecosystem services, to ensure fair outcomes for local communities and the long-term success of the project. Project developers can build connections with local stakeholder groups early on to spot both risks and opportunities.

Policy and Regulation

Project developers and enterprises will need to keep a continuous check on how current and future policy may affect the project, and also opportunities for the project to inform policy. The role of private finance for nature across the UK is being encouraged by the UK government and its devolved administrations, and new rules, standards and markets are being developed.

 
Acknowledgements 

 

With many thanks for their time and insight on this case study:

Dan Turner, Technical Lead, Land Management and Market Creation, The Rivers Trust

 

The Rivers Trust - Wildlife and Countryside Link

 

Dan Hird, Principle and Founder, Nature Finance

 

 

Date published: 08/12/2022

Next Milestone

Introduction to the financial model

Work to develop an outline financial model and business case for the Wyre Natural Flood Management project (the project) began almost immediately. Triodos Bank UK, which was formally engaged on the project as investment readiness and commercial advisor in 2019, led this work. Input was sought from other project partners including the Wyre Rivers Trust, the Rivers Trust, the Woodland Trust and representatives of the buyer group. The project also received legal advice from Hogan Lovells and tax advice from PKR Francis Clark.

The financial model was built in Excel and covers a 50-year period to align with the project’s own lifespan. The model includes quarterly time periods for the first nine years and then moves to annual time periods.

This structure corresponds to the contracting and financing structure of the project as a whole – the initial contract period with land managers and buyers of ecosystem services was nine years, and the project sought to secure a nine year repayable loan from investors. The initial nine year contract was potentially extendable to 50 years by the buyer group once the external investment had been repaid.

The financial model itself incorporated a number of worksheet tabs including input assumptions, revenue, land manager payments, investment structure, integrated financial projections (profit and loss account, cashflows and balance sheets for the CIC), outputs, visual projections and sensitivity analysis. The outputs worksheet included various tables and graphics that could be lifted and pasted into presentations and the business plan.

As with its hydrological modelling work (See Milestone 3), the Wyre project team used an open book approach to develop the financial model and business case amongst project partners and did not use Non-Disclosure Agreements. In theory therefore, any project partner could access the financial model from the data-room or request a meeting with the Rivers Trust and Triodos teams to run through and understand how the financial model worked.

 

 

Approach to financial modelling

Dan Turner, Technical Lead of the Rivers Trust and member of the project team, says that a ‘reverse-engineered’ approach to creation of an investable financial model and business case was taken. This approach meant that the project team started by carefully thinking through and  costing up the full scope of planned environmental interventions required to deliver the project’s targeted environmental outcomes. This approach, Turner says, was important in making sure that the environmental outcomes were embedded as the starting point for the project.

The “reverse engineering” approach to the financial modelling took the following broadly sequential five point process:

  • Prepare and input the CAPEX (capital expenditure) budget for the project as described above. This includes a scheduling of the interventions over the planned delivery period – in the case of the Wyre project over three years.
  • Calculate and input the planned revenue payments to land managers over the life of the project. In the case of the Wyre, these payments were based on a premium to Countryside Stewardship, Retail Priced Index linked and for an initial period of nine years – potentially extendable to 50 years.
  • Incorporate the cost of delivering the project through a Special Purpose Vehicle (SPV). This included project delivery and ongoing management costs (provided by Wyre Rivers Trust as main contractor) and SPV running costs (legal, financial, administration, insurance, data monitoring etc).
  • Include a repayable finance structure. In the case of the Wyre, this was a nine year loan at 6% drawn down over three years and repayable in Years Four to Nine. Some grants from Woodland Trust were also included within the model to fund the tree planting element of the project.
  • The final step of this “reverse engineering” approach is to identify what annual revenue stream is required by the SPV to ensure it can deliver the project, pay its suppliers and land managers, repay its loans and generate a modest retained profit by the end of the initial nine year contract period.

 

Scoping Costs

Some more detail on each of these steps is provided below:

The main capital costs identified in the model were the installation of the interventions themselves, which included the creation of woodlands and ponds, earth bunds, leaky dams, bunded hedges and the restoration of rivers. These interventions took place over c.70 hectares of land cover.

The Wyre Rivers Trust, as a core member in the project that would also install these interventions, was able to estimate the up-front costs with a relatively high degree of confidence once these interventions were identified (See Milestone 3). The Wyre Rivers Trust was also able to estimate how quickly it could install these interventions over the first three years of the project. This three-year timeframe itself was driven by a number of factors including; delivery capacity, seasonal timings for installing these interventions (such as tree planting) and the likely phased take-up from land managers in the catchment.

Less easy to predict were the subsequent maintenance and replacement costs of these interventions over several years. Maintenance of interventions was contractually the responsibility of the land managers, and this is funded out of the annual land manager payment. Replacement of interventions due to end of life or force majeure events was the responsibility of the CIC. The financial model therefore incorporates planned capital replacement costs plus an additional contingency budget of £100k (broadly 10% of total CAPEX) for replacement and adaptive management costs. The latter is an important provision, because the interventions may need to be optimised to ensure they meet key sub-catchment performance indicators agreed with the buyer group (See Milestone 3).

The Wyre Rivers Trust was able to estimate the replacement cost of interventions such as fences, gates and earthworks, however there was naturally less data available for some other interventions, such as river restoration. The project generally took a conservative estimate around replacement costs and ensured it effectively “over-raised” on its initial investment to provide financial headroom for uncertainties. This is a new business model and so erring on the cautious side was a sensible approach agreed by all stakeholders.

The project team sought formal accounting and tax advice from PKR Francis Clark to help with two specific elements of the Wyre business model: a) VAT and b) the tax treatment of intangible fixed assets. On the first point, the CIC registered for VAT because it was providing VATable services (i.e. ecosystem services) to its customers (the buyer group) and could therefore reclaim input VAT on all capital and operating expenditure. The second point was interesting in that, through its investment in NFM interventions on third-party land, the CIC was creating an intangible fixed asset (i.e. an asset which enabled it to derive revenue but not a moveable fixed asset under its control) on its own balance sheet. .

The CIC’s operating costs included annual revenue payments (which were loosely called Hosting and Maintenance payments) to the land managers (See Milestone 2), contracted project delivery and management fees to the Wyre Rivers Trust, which would be installing the interventions, contracted asset management fees to the Rivers Trust for managing the finance, administration and company secretarial requirements of the CIC, plus a small annual cost provision for insurance, travel costs associated with Board and site meetings (all board members are unpaid) and data monitoring and evaluation costs. As with the capital intervention costs, the project team set an overhead contingency as a percentage of these costs.

One-off costs included success fees paid to Triodos on completion of the transaction in March 2022, and a small onboarding fee paid to the Rivers Trust for setting up finance and company secretarial systems for the purpose of managing the CIC. The investors in the project did not charge an arrangement fee.

The development costs of the overall project were covered by a grant from Esmée Fairbairn Foundation (supported by Defra and EA) as this project was effectively a pilot before the launch of the £10m Natural Environment Investment Readiness Fund (NEIRF). Valuable pro bono legal advice was secured from Hogan Lovells.

The financial model incorporated an estimate for inflation throughout based on the Retail Price Index (RPI) forecasts. This was important because both the buyer and land manager contracts are index linked.

 

 

Developing the revenue stream

The key success factor in this project is the creation of a consortium of five buyers of NFM ecosystem services. Without a revenue stream, there is no potential to raise external investment or deliver the project and so this became the number one priority of the project team, once the other elements of the “reverse engineering” process had been worked through at a high level.

The development of this consortium and negotiation of commercial terms took a significant amount of time, and work as each buyer had their own particular commercial and non-commercial drivers for engaging. Initial exploratory conversations with buyers led to more detailed discussions and finally commercial negotiations leading to MoU and ultimately contract. In keeping with the open-book nature of the project, all buyers knew they would signing an identical contract in the end – but there was a great deal of work involved in agreeing how the annual total revenue stream target should be split between the five buyers.

Through discussion, the buyer group recognised the benefits of bringing in external financial investment to fund the up-front capital interventions. This meant that some of the construction and development risk in the project could be transferred from the buyers to the external investors. In addition, the buyer group negotiated a performance metric that also shifted risk away from themselves to the investors (see below).

The buyer contracts were structured in such a way that during the first three years of the project (the implementation period), buyer payments to the CIC are directly linked to the percentage of the target NFM interventions that are delivered on the ground. The buyer contracts also stipulate that at least 80% of the agreed NFM interventions must be installed in the ground by the end of three years. If this percentage is not met by the end of Year Three, the buyers have the option of exiting the project. It is expected that 100% of the interventions will be delivered by Years Four and Five.

The percentage of agreed NFM interventions delivered in the ground is therefore a key performance indicator in the first three years of the project and something that the CIC board will be very focused on.

A second key element in the buyer contracts concerns performance risk and the CIC has a contractual commitment to monitor and measure NFM intervention performance in two sub-catchments of the Wyre as an effective proxy for the whole catchment (see Milestone 3).

During the first five years, the data from this sub-catchment will be collected and shared with the CIC having the ability to undertake adaptive management works using its reserve adaptive management budget.

From Year Six however, the buyer contract provides for the start of what effectively becomes ‘outcomes-based payments’ in that a failure in performance in the sub-catchment monitoring stations can lead to a significant reduction in the annual revenue payments made by buyers in the remaining term of their contracts. A reduction on annual revenue payments in this event would mean that the external investors would not get repaid in full – and so this is a second example of risk transfer from buyers to investors in the project.

Turner says that the development of a five year adaptive management phase and inclusion of a £100k adaptive management budget was crucial in attracting private finance to meet the project’s needs and took several months to construct.

There also was further debate on how the contracts for these payments would be renewed over the 50-year period. This took time to negotiate, as the project team needed an initial nine year contract to cover the complete repayment of any upfront investment (see below), whereas both buyers and sellers were less inclined to sign long-term contracts due to the associated uncertainty. After some iterations of the financial model, it was shown that an initial nine-year contract with both buyers and sellers would allow the project to fully repay the investment. The buyers then agreed to a contract renewal process that would set the ongoing contract price as a much lower percentage of the initial nine-year period, reflecting that the CIC would be debt free from this point onwards. In the event of an agreed extension beyond nine years, all buyer payments would reduce to around 25% of the initial contract and would remain index linked. These lower payments would still be sufficient to pay land managers an index linked revenue payment for hosting and maintaining the interventions and running the CIC.

 

 

Identifying the investment need

The Wyre project had a capital requirement of around £1.5 million. This was ultimately funded through a “blended finance” mechanism comprising £627k of tree planting and hedgerow creation grants from the Woodland Trust and  £850,000 of external repayable investment. The project team did not note any issues with blending these two sources of capital funding, other than keeping the Woodland Trust team updated with the project design and showing how the grant funding was directly attributable to the costs of the woodland and hedgerow planting.

Testing the need for and ability to raise upfront repayable investment was one of the main ambitions of this pilot project. The inclusion of external repayable investment was therefore included in early iterations of the financial model and was a central feature of discussions and negotiations with buyers.

The financial model indicated that the £850,000 of external investment would need to be drawn down over the first three years of the project as the capital interventions were installed. The project team decided very early on that repayable debt was more appropriate for the project than equity, because the team wanted to use a CIC limited by guarantee as the project vehicle rather than an SPV with shares (See Milestone 6). Triodos assessed that a headline interest rate of 6% would be a reasonable starting point for discussions with potential impact investors given the risk profile of the project (see Milestone 7 ).

The investors in the project were provided with the business plan, financial model and access to the virtual data-room and meetings with the project team for the purposes of assessing the transaction and due diligence.

Investors inevitably focused heavily on risks to capital and these were very clearly laid out in both the business plan and in a range of sensitivity scenarios within the financial model.

 

 

Testing Assumptions and Scenario Modelling

Triodos listed out all of the key assumptions in the financial model. These were extensive and included the estimated delivery and maintenance costs of each type of intervention, the timings of delivery, investment interest rates and drawdown dates, inflation, annual revenue from buyers, overhead spend and many others.

Overall, Triodos modelled five scenarios where the key assumptions of the project would fail, in addition to the ‘base case’ with all assumptions proving accurate. These included an ‘upside’ scenario, where 5% fewer costs for maintenance would be needed to keep the interventions to standard, a ‘downside’ scenario where adaptive management costs increased by 50%, and three scenarios across Years Five, Six and Seven where the performance metric of the interventions would fail, leaving the project with reduced revenues from buyers with which to repay investment.

Under each of these five sensitivity scenarios, the financial model was able to generate a table of outputs  relevant to investor return on capital – including potential capital loss under some of the worst case scenarios..

Triodos and the project team used this financial model and transparent approach to disclosing risks and downside sensitivity to support negotiations and project planning with investors.

 

Photo credit: The Wyre Rivers Trust