Carbon Credits – Will they Oxygenize our Road to Achieving NetZero?
Climate Change. Are there two words which have sparked more debate, uncertainty and misunderstanding over the past 10 years? Maybe, but without a doubt the growing interest and understanding to the actions everyone must take in a coordinated, large scale manner to combat the effects of climate change is now becoming a lot more evident. A tacit understanding has arisen to how we all need to contribute to mitigating the global temperature rise by restricting it to 1.5°C, placing it at the centre of attention and discussion amongst global citizens.
Popular television shows, such as Netflix’s David Attenborough: A Life on Our Planet, which recounts the life of the British Natural Historian, has only helped in reaffirming the perilous position the earth finds itself in and has supported in expanding awareness to this plight. This, amongst other initiatives, have galvanized many to rethink the role they need to play to improve the health of our planet.
The statistics are striking and stark. Many are aware to the fact that there has been a 2° degree increase in the global average surface temperature since the pre-industrial era (1880-1900) but what is less known, and worrying, is that for last year (2020) every month, except December, was in the top four warmest on record for each month. These indicators have only stiffened the desire and public commitment from the global community to achieve a ‘NetZero’ target by 2050. To support this pathway, many businesses have vowed that by 2030 they will ensure a 50% annual net-emission reduction to around 23 gigatons of carbon dioxide from 2019 levels is achieved as a first step.
How will we stop the growing concentration of green house gases (GHG) in our atmosphere? Investing in nature-based solutions presents one, currently undervalued, solution to this issue. Whilst investments in nature represent just 3% of global finance currently, the recent growth and interest in carbon credits provides a viable answer with the scalability potential to support these emission reducing strategies under the nature-based solutions umbrella. With various commitments of leading blue-chip organisations, such as Amazon and Apple, pledging substantial amounts of capital to climate focused initiatives, there will be increased importance to carbon credits being a key component to the Net-Zero strategies of corporates, governments and even individuals alike.
Mark Carney, former Governor of the Bank of England and a current Special Envoy for Climate Action and Finance for the United Nations, points to this growth suggesting that a unified market for carbon offsets could be worth $100 billion by the end of the decade, up in value from the approximately $300 million in 2018. This clearly articulates the promise to the important role the carbon credit market will play in our quest to negate the effects of climate change. Yet what needs to happen for carbon credits to reach this number and how will they impact those countries which, many argue, are on the frontline of the battle against climate change: those ‘least developed countries’ (LDCs) in the Global South?
What are Carbon Credits?
Before we delve into assessing the increased potential for carbon credits, let us contextualise the current state of the market and break down what a carbon credit actually is. At its core, carbon credits are measurable, verifiable emission reductions from certified climate action projects – these projects will reduce, remove or avoid CO2 and GHG emissions entirely. In essence, if a company’s emissions end up being above its commitments, it can seek to purchase these credits from approved and certified projects.
The projects themselves tend to fall into 3 distinct buckets: those which reduce emissions (typically energy efficiency measures); those that remove emissions (carbon capture and planting forests); and those that avoid emissions entirely (such as not cutting down forests). In practice these projects can range from a company switching its energy sources to renewable energy instead of fossil fuels or to a business directly investing into certified forestry projects in Latin America.
Image 2: What is a Carbon Credit? Source: Antenna Foundation via ‘sswm.info’
The actual transaction around a carbon credit is theoretically simple as well. Once a project developer has raised the funding for its project it must adhere to a rigorous set of criteria from a third party to pass verification for its credits (the premier certifications include Gold Standard, Verra's Verified Carbon Standard (VCS), Social Carbon and Climate, Community and Biodiversity Standards (CCBS), or standards verified by the UNFCCC). The project can then issue carbon credits to potential purchasers and the wider market. Once a buyer has committed to a credit, it is retired preventing double counting and the money is transferred to the specific project in question.
Currently, there are two types of carbon markets for where these transactions can take place: voluntary or compliance schemes. The latter, the compliance markets, are the creation of national, regional or international carbon reduction schemes such as the Clean Development Mechanism which is regulated by the Kyoto Protocol (which will be touched upon later). Within the compliance schemes companies, governments as well as other entities purchase carbon credits to comply with the legal caps which have been put in place for carbon dioxide emissions. These caps are usually national or regional targets that entities must comply with. The Clean Development Mechanism is the main offset programme for issuing products on the compliant market.
Alternatively, voluntary markets function outside of the compliance markets and allow corporates or individuals to purchase credits on a voluntary basis. Throughout 2021 there has been increased entrants to the voluntary market including a number of oil and gas players, hedge funds as well as banks who are looking for ways to off-set their carbon emissions. The voluntary market allows these emitters to offset their unavoidable emissions by purchasing approved credits from projects which remove or reduce GHG from the atmosphere.
Whilst carbon credits are an attractive mechanism to encouraging decarbonisation through incentivising businesses to reduce emissions and allowing those emitters who have been over excessive on their emission to ‘balance their books’, a number of questions remain to the viability and state of play in today’s markets.
Standardized Pricing?
One of the challenges the carbon credit industry, particularly within the voluntary market, is the question of transparency. Today, there is no standardisation to the purchasing of credits. If a business, or an individual, wants to acquire a credit it can go directly to the project or use other sources such as a broker or one of the nascent exchanges which are developing quickly. The former, or ‘off-exchange’ purchases, are where most transactions occur making price discovery difficult and creating an opaque market where prices can range from US$1 to well over US$40.
There are retailers, such as TerraPass and atmosfair, which provide a retail approach to the selling of credits, as well as recent innovations around the development of carbon-credit trading funds. These ETFs have proved very popular with both retail and professional investors, which in theory should help drive increased liquidity to the carbon market.
Other new initiatives are underway, as positioned by Mark Carney and Standard Chartered’s CEO Bill Winters, who are looking to create a scalable voluntary market which will be governed by a set of high-level global standards to prevent carbon credits from being ‘undermined’. China, the country responsible for emitting 27% of global GHGs, recently launched the world’s largest carbon market to much consternation. This followed a recent new UK system, closely modelled on the EU’s carbon market EU ETS. All these initiatives send further positive indicators to the growing health of the carbon market which, when coupled with government-led commitments around regulation, will only catalyse the development in the standardization of the market.
Image 3: The Rising Price of Carbon Source: Refinitiv via FT
The ecosystem is also looking to learn from history too. The EU’s Emissions Trading Systems (ETS) – the cornerstone of the EU’s policy to combat climate change which seeks to limit emissions from around 10,000 installations in the power sector and manufacturing industry, as well as airlines operating between European countries - failed to garner the prices it promised when it was created 16 years ago, but a recent report demonstrates that the EU ETS, which initially regulated roughly 50% of EU carbon emissions from mainly energy production and large industrial polluters, saved more than 1 billion tons of CO2 between 2008 and 2016. This translates to reductions of 3.8% of total EU-wide emissions compared to a world without the EU ETS. This not only showcases the impact a well-run and regulated market can have but highlights that the learnings from the past will allow the industry to be better suited to meet the increased demand which is supposedly on the near horizon.
A growing market to meet stratospheric demand
One of the limited silver linings from the Covid-19 pandemic has been the surge in commitments and realignment in focus from corporates and governments alike to their NetZero promises. 2021 has been characterized by near daily statements from the global community committing their intent to be even more aggressive in achieving their publicly committed emissions targets.
The likes of Amazon, Boston Consulting Group, McKinsey, Unilever, Salesforce, Airbnb and GSK collectively came together in April of this year to throw their support behind a US$ 1 billion scheme aimed to tackle deforestation. This Lowering Emissions by Accelerating Forest Finance (LEAF) venture was launched to explicitly tackle the increasing GHG emissions following new data which showed that the loss of previously untouched tropical forests had exceeded the combined emissions from Europe’s five-largest economies. LEAF goes as far as proposing voluntary contributions of at least $10 per tonne of CO2 emissions avoided, or almost double what is presently offered in the voluntary carbon market.
Market dynamics around corporate commitments to NetZero are escalating so quickly that a recent judicial court ruling has reiterated the urgency businesses need to take in their climate actions, whilst simultaneously demonstrating the evolution of wider society’ expectations to what businesses need to do. Energy giant Shell’s seminal loss against the courts in The Hague earlier this year, which stipulated that the company’s current emissions cutting policy is inadequate to meet the requisite standard of care under Dutch law, resulted in the company being ordered to reduce carbon emissions for the group’s global activities by 45% by 2030 relative to 2019. To many this ruling will be a watershed moment and will only accelerate the divestment of other ‘Big Oil’ companies from their carbon intense assets.
What we can estimate from this verdict is that, like recent trends have shown, many corporates will look to increase reaching their targets by wholly owning and investing into projects, such as forestry assets. Not only does this provide clarity to the actual projects a company is investing in but it also hedges against the ever-increasing global demand for carbon credits as well as any future price increases. The development of a robust and transparent market will support this demand, particularly in enabling high-impact and verified projects in connecting with off-takers.
What needs to happen in the Market?
To put it into context, the original voluntary carbon markets were born out of the 1997 Kyoto Protocol and enabled organisations which wanted to voluntarily participate in carbon emissions reductions to do so. With the increased interest in the market, it is a must that we will need to see increased regulation of the market as well as price and transaction transparency. Given the current variety in how emitters can purchase credits – either directly ‘over the counter’ with the project, through a broker, or on a retail platform – means there will never be a consistent base rate and will create a big discrepancy in the market. There is also a potential that those projects present in nations globally considered ‘Least Developed Countries’ run the risk of being classified as a sub-prime credit options as well.
The new voluntary market being proposed by the ‘Working Group on Expanding Voluntary Carbon Markets’ believes this new market will negotiate a reference contract that, with enough buyers and sellers, can improve price discovery for offsets. The development of such a market should also enable better reporting to the state of carbon credits and monitoring whether businesses are meeting their NetZero commitments through cross referencing the liquidity of the market against those corporates’ public statements.
The Role of Emerging Markets
Many of the considered ‘Emerging Markets’ or ‘LDCs’ can play a critical role in developing and scaling verified carbon credit opportunities for the market. Given the fact that many countries within this category are the ones in line to suffer the most from the effects of climate change, it is imperative that innovative projects from these regions can receive funding directly into their projects. It is also important to consider the social and economic impact these credits can have to the communities where these projects are located.
The role of deforestation in driving emissions is well known. The reality is that in many LDCs a number of agricultural practices centre around the concept of small-scaling shifting cultivation, more commonly known as ‘slash and burn’ techniques. A study by the Global Forests Watch has demonstrated that in the Democratic Republic of the Congo (DRC) 92.2 percent of tree cover is lost to these very techniques.
Without engaging the farmers (who primarily tend to farm less than 2 acres) or others within these rural communities, and educating them to the value of natural capital means deforestation rates will only increase placing more tension on our ecosystems. This process can also support in creating potential future revenue streams for rural communities as well.
On the other side though, there have been some exciting success stories around the implementation of innovative solutions in the Global South. Costa Rica for example manages to generate US$ 30mn a year for forest conservation through the sale of carbon credits whilst conserving more than 2.5 million acres of its forests to date.
Another area where Emerging Markets can play a key role is around ‘Charismatic Carbon’. This is where the development of carbon credit projects creates a significant social, economic and/or environmental benefit to the communities associated to the project as well. These projects would certainly provide additionality to the credits emitters purchase and could subsequently improve the desirability of these credits from LDCs, increasing their demand on the market.
This does prompt questions which need to be addressed around the topic, such as the increased standardisation to how credits are rated. Whilst initiatives are underway to support the development of credits in this regards, such as the recent raise of seed capital by Sylvera – UK based start-up which utilises satellite, radar and lidar data-fuelled machine learning to bolster transparency around carbon offsetting projects - to do exactly this, more needs to be done. With the development of standardised ratings, where additionality benefits could be easily extrapolated, a route to promoting key carbon off-set projects within these LDCs that produce highly sought after credits could be implemented.
All of this clearly shows that there is a much-needed requirement for leaders within our industry, such as those from multinational corporates, need to take increased agency in increasing their role in reducing emissions.
Contributing to a Robust NetZero Strategy
Needless to say, all of this demonstrates the importance for corporates and governments to incorporate carbon credits into their NetZero strategies.
Whilst carbon offsets are not a silver bullet given they are no substitute for the massive reduction in fossil fuel emissions required, they do provide a valuable tool in the interim to supporting the wider NetZero Strategy. Today, natural capital solutions attract very little public investment, even though it is estimated that these projects can help deliver around one-third of the net emission reductions needed by 2030.
For one, there is the psychological impact as well to actively pursuing an offset strategy. The CDP Climate Change Report 2016 found that companies that bought voluntary carbon credits also made more ambitious emissions cuts compared to those organisations that did not.
However, much still needs to be done to scale up the potential of the carbon credit market. Not only will we need to see a standardization in the process of certifying credits and creating universally accepted regulations, but we will also need to see the implementation of transparent exchange systems highlighting transaction prices. Nonetheless we also will need to see increased commitments from all businesses, investors, governments and relevant stakeholders to create robust strategies which support the roadmap everyone needs to follow.
This is where ThirdWay has provided support to our partners. We have worked with clients and businesses from start-ups in Colombia to decades-established multinational corporates operating across West and North Africa in developing and scaling their sustainability agendas. As part of this work, it is critical we collaboratively create solutions which have a net positive impact on the environment. Through our work we have enabled businesses to structure innovative solutions which not only provide answers to supporting these endeavours but also allow their employees and stakeholders to be proud of what their organisations are leading on.
The Bottom Line? Whilst Carbon Credits will remain an important tool to support humanity’s quest to reduce emissions considering the negative effects of climate change, much still needs to happen to scale the industry. Certainly, we need to see increased standardisation and transparency within the industry, but the potential for promoting credits which create additionality, such as projects focused on charismatic carbon, would provide a route to scalability for those projects located in markets which have the most to lose from climate change, the LDCs. What is imperative and cannot be forgotten is the fact that we are quickly racing towards the precipice and will need to leverage innovative solutions which preserve our environment whilst enabling the global population to access the benefits of sustainable economic development and growth.
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