Voluntary Carbon Credits - A Market Born Out of Necessity

The voluntary carbon credit market is coming of age. Next week, deliberation on Article 6 at the COP26 will be closely watched as the international community attempts to establish a framework for companies and countries to trade voluntary carbon credits.

Article 6 was drafted with the Paris Agreement and allows countries to achieve decarbonization goals via either a compliance instrument (a carbon tax or emission trading scheme) or exchanging carbon credits. The former has occurred (for example, the European Emission Trading Scheme), but the latter has not.

To date, governments have not been able to use credits to meet their domestic decarbonization goals in part because there is no international body that tracks where credits go to avoid double counting. [1]

Voluntary carbon credits are a financial tool issued by projects that avoid or remove greenhouse gas emissions (GHG) from the atmosphere. Each credit demonstrates the removal of 1 million tons of GHG emissions. As part of a more extensive suite of options, a country may choose to offset domestic emissions by purchasing carbon credits which provide capital to projects that generate those emission reductions.

While governments have yet to utilize voluntary carbon markets, they have been in existence in the private markets since the mid-2000s. Until 2015 the market was small but has grown at a compounded annual growth rate of 30% over the last six years. Despite this robust growth, voluntary credits cover less than 1% of global emissions, compared to 16% for compliance markets and carbon taxes set forth by governments.

A significant point of contention that will be deliberated next week at COP26 is whether private buyers should be part of the framework for international government accounting. For example, Shell is in the process of planting one million trees over the next five years in Scotland that will generate carbon credits that they will use to net against their emission profile. However, the Scottish Government is also planning on counting the same credits for emission removal as part of their national climate goals.

Can the same credit be used as part of two parallel schemes at the same time? Some suggest that yes, they can and that the debate is pointless as it is a discussion of two different markets; a compliance market set forth by the Paris Agreement and a voluntary market that individuals and companies can participate in, outside of any international mandate.

David Antonioli, the CEO of the largest certifiers of carbon credits, agrees with this perspective, noting that "host countries would lose the ability to claim the credits against their [nationally determined contribution], so the effect will be that they will be disincentivized to authorize projects in their jurisdictions, to the detriment of the need to solve the climate emergency, which requires accelerated and massively scaled-up actions. [2]

The counterpoint is rather apparent as well. It doesn't matter whether the use of credits is for the fulfillment of Paris Agreement obligations (countries) or private offsetting purposes (companies); double-counting credits undermines the total realized reduction of atmospheric emissions. In theory, it may also discourage a government from taking the initiative to reduce their emission profile if they happen to host a corporation that does the same.

Despite these wonkish issue that are still unresolved, I believe that carbon credit markets will grow dramatically over the next decade, in part as the rise of "net zero" promises meet the reality of economic and technical feasibility for many of the hard-to-abate sectors. The pace at which the market grows will be heavily influenced by Glasgow's outcomes (or lack thereof) next week.

Many argue that even absent an international framework (or a delayed international framework) for government participation, the demand from corporations alone is poised to expand the market significantly. Jonathan Goldberg, the CEO of Carbon Direct – a firm advising businesses on achieving net-zero goals – notes that corporate demand for high-quality carbon removal outstrips the supply of reliable options "by orders of magnitude." The CEO of Abaxx Technology recently pointed out that the market may grow from <$1 billion in 2019 to >$100 billion by 2030. A 100x increase over ten years, akin to creating the entire nickel, lead, and zinc market combined, from scratch, in a decade. Assuming a $50 per ton market-clearing price, this figure is consistent with estimates from recently released research by Shell and BCG that projects demand for carbon credits of upwards of 2,000 Mt of CO2, per year, by 2030.

I have two perspectives on this forecast. First, it is an incredible rate of change that will generate new businesses trading, tracking, and managing both the physical and financial side of the market.

While the market today for CO2 offsets and removal is immature and poor accounting plagues the current supply of credit, the expansion of the market – however imperfect – may be necessary to tackle environmental goals.

A key benefit of expanding the market is creating fungibility in a carbon price, allowing the market to provide price signals for productive investments across multiple geographic jurisdictions on a longer time horizon. There is an enormous pool of capital interested in going long the asset class, but sophisticated buyers today express frustration at the difficulty of finding high-quality carbon credits. A bankable price signal allows for increased market participation which importantly provides for longer lead time capital investments to get off the ground as more liquid forward curves and hedging products can be utilized to minimize risk.

This feeds into my second observation that we may be pushing for the securitization of a product that institutionalizes several critical problems in the market today. Retrospective studies have substantiated fears that voluntary carbon credit markets are not delivering on their claim.

"Questionable, wonky, and blatantly dishonest carbon accounting is rampant," writes Lauran Gifford, a researcher at the University of Arizona in an assessment of forest carbon programs. A 2019 analysis of forest-related carbon credits issued by the CAB (California Air Resource Boards) finds that "82% of the credits generated by projects likely do not represent true emission reductions". Consulting firm McKinsey & Co. concludes in early 2021: "The market is characterized by low liquidity, scarce financing, inadequate risk-management services, and limited data availability."

Can we let nature-based carbon removal set the market price if they are not reliable and permanent?

Two companies that have been very proactive about utilizing offset programs, Microsoft and Stripe, recently released an after-action report in collaboration with Carbon Direct. Microsoft received 189 proposals, offering a total of 152 Mt of CO2 emission offsets over the next several years. Only 55 Mt of CO2 were available for immediate implementation, and only 2 Mt of CO2 removal met Microsoft's high-quality removal criteria. What is Microsoft supposed to do? They are cash-rich, have clear intentions, yet only 1.3% of solutions presented work today. Stripe saw similar results: 47 carbon removal projects were pitched, amounting to 16 Mt of possible CO2 removal. Only 0.024 Mt met their criteria.

Part of the problem that both Stripe and Microsoft are running into is that they are looking to comply with the Science-Based Target Initiatives definition for claiming net-zero status, which is that offsets must be removals (not avoidance) and must exclusively constitute long-lived storage. This is also technically consistent with the IPCC definition as well. Today, systems for accounting for removal do not distinguish between short and long-term CO2 removal. Nature-based solutions (say planting trees) typically sequester carbon for <100 years and account for at least 95% of the projects available today. The alternative is to physically remove carbon from the atmosphere (think carbon capture and storage (CCS)) and bury it.

There are very few pure carbon removal options today, and most are from reforestation. Over 50% of the total credits available on the market generated for reductions come from Forestry and Land use. Close to 100% of the Forestry credits are generated by avoided deforestation, not reforestation. [3]

This means we have a credit trading system today where the vast majority of credits in circulation (and being generated) can be misused and whose value can easily be miscalculated. Returning to Shell as an example, the firm invested in a project in Indonesia to protect a particular tree from illegal logging. The project has been selling credits (accruing to Shell) since 2017 and falls under the broad category of "avoided" deforestation. In 2019 however, the Indonesian Government declared the land-protected area, theoretically lowering the risk of deforestation. Does Shell now need to re-work their calculations for carbon savings?

Generating credits based on "avoidance" leaves a wide gap for accounting gimmicks. There is hardly a concise way to measure a baseline and establish counter-factual conditions. Hypothetically, if a forestry project or investment did not occur, how much CO2 could that land area absorb? Well, it depends on whether the forest was preserved or whether it was logged. The project developer and purchaser of credits can try and claim either, depending on their strength of justification. If players in the market can reduce initial baseline estimates for "what would have happened," one can grossly over credit projects. Research organization Carbon Plan recently performed a comprehensive evaluation of California's forest offset programs - the largest in existence, worth roughly $2 billion - and found that 29% of all offset issues were over credited. 29% works out to approximately 30 million tCO2, worth roughly $410 million.

Carbon credit markets will be an important tool for governments and corporations as they tackle ambitious decarbonization goals. The market demand for a liquid and legitimate carbon price seems evident. The pace of growth may, in part, be dictated by events next week at COP26. Critically, however, the accounting concerns evident in the private sector today should not be dismissed. If the market is continually flooded with ill-legitimate financial claims on realized emission reductions, we may lose the opportunity to utilize market price signals on an externality that needs to be considered by global economies.

[1] COP26 will refer to this topic specifically as the “corresponding adjustment”.

[2] S&P Global Platts.

[3] Carbon Direct.