Scottish land prices and natural capital investment

Dr. Craig Mackenzie is one of our new Commissioners. Craig has had a long career in investment management, with a focus on environmental, social and governance issues, including investing in natural capital.

Introduction

Many who want to see more land reform are also enthusiastic about planting new woodlands and restoring Scotland’s natural environment. At the same time, there is a concern that a wave of new 'natural capital' investors might be pushing up land prices, making it more difficult for communities and others to buy land and slowing progress on diversifying land ownership.

Over the last few years, the Scottish Land Commission's land market surveys have provided some justification for this concern, offering evidence that natural capital investors are playing a significant role in land price movements, particularly in more remote rural estates. However, our 2024 report suggests this pressure may have abated recently. Why is this? Is it a permanent shift or are we likely to see a renewed upward pressure on prices from natural capital buyers?

To answer these questions, it is helpful to understand how investors decide what price they are prepared to pay for land for natural capital projects.

Putting a price on land

The main tool investors use for assessing natural capital projects is called 'discounted cash flow' (DCF) analysis.  This approach is recommended by the Royal Institute of Chartered Surveyors for valuing forest projects and is widely considered to be the gold standard for valuation in the investment world.

The key message of DCF is that the price of a piece of land is driven by two things: the amount of income (net of costs) it is expected to generate over time; and the cost of financing, which is, roughly, the projected Bank of England interest rate, plus an adjustment to take account of risk.

The more income a piece of land is expected to generate, the higher the price it’s worth paying; while, conversely, the higher cost of risk-adjusted financing, the lower the price of land. 

These simple economic relationships help explain a lot that has happened to the prices of land in Scotland in recent years.

New income streams

Let’s take land income first. Government policy and corporate Net Zero targets have meant that three types of Scottish land have seen large upward shift in revenue potential.

• Peatland. Around 20% of Scotland is covered by peatland and around 80% of this is damaged by being drained, or due to erosion or herbivore damage. Scotland’s damage peat emits 2.5m tonnes per year, equivalent to over a third of the emissions from Scottish businesses.. Given government’s 2045 Net Zero target, this damaged peat will need to be repaired and, as a result, there are grants available for peat restoration. In addition, a voluntary framework called the Peatland Code has been set up to allow peat restoration projects to claim carbon 'credits' which can be sold to companies who wish to buy offsets to meet their Net Zero goals.

In the past, peatland generated only modest amounts of income, mainly related to rough grazing for sheep. The higher income from grants and carbon credits means this land commands a higher price.

• Native woodlands. Another kind of previously low value land that has seen a price shift is hard-to-access plantable land. Commercial timber forestry requires good access for log removal, so sites with poor access don’t work well. But native woodlands planted to sequester carbon and restore biodiversity do not require felling and so have much lower access requirements and can now generate income from Scottish Forestry grants and Woodland Carbon Code credits.

As with peatland, this land used to generate a small amount of income from rough grazing or sporting uses, but now investors see the potential for substantially increased income and so it commands a higher price.

• Commercial forests. While peat restoration and planting forests for carbon credits are new revenue generating activities, commercial forestry for timber is centuries old. But the story is similar: prices for forest land has been rising for the best part of 20 years, due to rising income from higher timber prices, greater availability of planting grants. Financing costs also fell significantly, which further boosted the value of commercial forest land.

Financing costs

Discounting uses the required rate of return for a project to convert future income into their present value. The starting point for thinking about required rates of return is the prevailing Bank of England base rate. During the 2008 financial crisis, the base rate collapsed to all-time historic lows near zero and remained there until 2022.

A near 5% reduction in discount rates is a very significant shift and resulted in substantial higher valuations for assets of all kinds, including commercial forestry.

The picture of rising income potential and falling financing costs does much to explain why prices of estates in Scotland have been trending upwards in recent years. They also help explain why prices have stalled or fallen in the last 18 months.

Financing costs have surged. In 2022, the return of inflation pushed the Bank of England base rate up to over 5% and long-term interest rates (yields on government bonds) rose from 0.5% to over 4%. This rise in financing costs has been a major drag on valuations. If higher interest rates prove to be persistent, this could reduce the value of some long-lived projects by 50% or more.

The other headwind for natural capital projects had been greater uncertainty about revenues. Timber prices have fallen; demand for carbon credits seems to have weakened, due to controversies about failed carbon credit projects and about corporate greenwashing; and the availability of grant funding for tree planting and peat restoration has become much less certain.

With rising financing costs and a weaker income outlook, it is no surprise that the price of bare land for commercial forestry fell 22% in 2022-23, after more than a decade of prices rises.

The future outlook

 In the immediate future higher interest rates may persist for longer; controversies in the voluntary carbon markets continue, so there is no obvious short-term relief there; and the tight fiscal position mean budgets for forest and peat subsidies are likely to remain under pressure. All this suggests prices for peat and forest land may remain subdued for a while.

The long-run picture is more positive for natural capital. Demand for timber is projected to grow, not least because it is a relatively climate-friendly building material and the UK consumes far more of it than it produces. Both the Scottish and UK governments have ambitious Net Zero and biodiversity targets and tree planting and peat restoration are important to the achievement of these goals. So there is likely to be government policy support for these activities in future.

On the current model, this means ongoing reliance on a mix of public subsidy and woodland and peatland carbon credits, and perhaps eventually integrating woodland and peatland carbon credits into the UK’s mandatory emissions trading scheme. There is considerable uncertainty about future policy direction, but as it clears, this could mean higher income streams for woodland and peatland projects, which would likely result in a resumption of the trend for higher land prices.

Policy is important

It is worth noting that the impact of natural capital on land prices is, at least partly, a policy choice. It would be technically possible to achieve the tree planting and peat restoration needed for climate and biodiversity targets though regulation and grant subsidy in ways that generate lower income streams and so, have a lower impact on land price.

The downside is that this may require significantly more public funding in a period when the fiscal outlook is becoming increasing constrained. Of course, this is why sharing the burden with private finance is attractive to policy makers. If incentivising private finance is necessary to achieve climate and biodiversity goals, greater consideration should be placed on the impact on land prices, and the options to mitigate this impact in policy design. 

To make the most of the natural capital opportunity for rural Scotland, we need a long-term policy framework which balances multiple objectives: sequestering carbon, restoring biodiversity, creating jobs, businesses, and affordable housing in rural Scotland, empowering local communities, and achieving more diversified ownership of land.  This is not just about nature markets policy, but about tax, fiscal support, economic and land policy. One thing our rural land market report makes clear is how responsive Scotland’s land market is to policy, so the positive impact of a more joined-up approach could be significant.