Carbon Credit Markets 101

How they work to reduce climate change

There are a lot of misconceptions about carbon credits and how they work. Let’s tackle some of those head-on.

Myth: Carbon Credits are a “sin tax”. They’re just a license to pollute.

Firstly, no person or corporation can ever reduce their carbon footprint to zero. The fact that we eat and breath means we are emitting carbon dioxide. In fact, agriculture is one of the single largest sources of carbon emissions and produces more emissions than the entire global transport industry. So, without a credit to apply against the unavoidable carbon deficit, we will simply never reduce global carbon emissions.

Secondly, carbon credits are not a license to pollute. Carbon taxes are a license to pollute and therefore do not create a net reduction in carbon emissions. Carbon credits do create a net reduction in carbon emissions.

What’s the difference?

Carbon Taxes or Allowances

Under many regional and national “compliance” schemes (government mandated carbon regulations), governments issue “Allowance Certificates”. As the name suggests, these are an “allowance to pollute”. In theory, less allowances are issued than are needed in the market, which drives the price up through market competition, incentivizing companies to reduce emissions. That’s a great deal for the governments that issue them, but probably not such a great deal for the planet. Like so many “special purpose taxes”, the money seldom ends up going to the cause for which it was intended. The revenues from carbon taxes or the sale of carbon allowances often end up in a general fund to offset chronic government deficits. Even if some of those funds are actually dedicated for carbon emissions reductions, they’re often spent on feasibility studies handed out to an inner circle of government-approved contractors, or to academics in the form of grants to study the impacts of climate change, or to fund research and development on a new technology that might one day produce a carbon emissions reduction. Consequently, it’s a pretty low ROI; to the planet at least.

Carbon Credits

Carbon credits, on the other hand, are produced by private sector initiatives that quantifiably reduce carbon emissions. The most compelling aspect of carbon credits is that they use “ex-post” accounting. In other words, they are performance based (in arrears). So, a carbon credit is not issued until after the carbon emissions reduction has been created and verified by internationally approved auditors under internationally approved standards.

Carbon Credits can be produced by a number of activities, such as:

Renewable Energy: Replaces fossil fuel powered energy generation.

Replaces fossil fuel powered energy generation. Improved Land-Use Management: A farmer may switch from nitrogen-based fertilizers (nitrogen is a powerful greenhouse gas) to an organic fertilizer or may rotate crops less frequently.

A farmer may switch from nitrogen-based fertilizers (nitrogen is a powerful greenhouse gas) to an organic fertilizer or may rotate crops less frequently. Reforestation: Companies may plant trees, or even certain species of fast-growing tall grasses, in previously degraded areas. Trees and grasses absorb carbon dioxide.

Companies may plant trees, or even certain species of fast-growing tall grasses, in previously degraded areas. Trees and grasses absorb carbon dioxide. Avoided Deforestation: Agricultural conversion of forests (deforestation) creates emissions in four ways. First, it reduces the carbon absorption mechanism that trees provide. Second, it usually involves “slash and burn” techniques, which of course cause emissions. Third, it involves “tuning the soil”, which exposes the portion of organic (carbon-based) matter in mineral to oxygen, which then creates CO2 and methane. This can be a particularly large source of emissions in pure organic soils like “peat” soils. Lastly, the industrial agricultural plantation that replaces the forest uses nitrogen-based fertilizers, creating even more greenhouse gasses. Hence, projects that avoid deforestation and conversion of forests to agriculture (known as REDD+ projects) are a powerful tool in combatting climate change. These avoided deforestation projects, which most often involve tropical forests, have a massive collateral benefit of biodiversity conservation as well. And, in many cases, there is a strong social component to these projects since they support forest-dependent indigenous peoples.

The Rimba Raya Biodiversity Reserve in southern Borneo is an example of a REDD+ project

Projects like the above have to use internationally approved “carbon accounting methodologies” and adhere to internationally approved standards and undergo annual audits by a list of internationally approved independent auditors. These audits verify the actual number of metric tonnes of carbon that were “sequestered” (absorbed) or avoided (prevented) and a corresponding number of carbon credits. Each carbon credit created represents one metric tonne of carbon emissions reductions. The new carbon credit is then issued to the project developer, who may then sell those credits to companies with carbon deficits.

Additionally, these carbon credits are issued and tracked by yet another independent party such as the IHS Markit Registry and the APX Registry. These internationally recognized registries serialize each carbon credit and strictly control the chain of custody so that the provenance of every credit can be verified and tracked as it transfers from the carbon credit originator to a carbon credit broker or distributor and finally to a carbon credit end-user.

When an end-user (usually a corporation) of a carbon credit purchases a credit in order to offset a carbon liability on their balance sheet, the registry “retires” the credit and issues a certificate to the end-user in order to verify that the emissions reduction credit has been “consumed” and can never be sold again. This ensures an absolute carbon reduction or offset has occurred.

What is the origin of this carbon credit offset mechanism?

The carbon credit offset mechanism was conceived and brought into existence by the United Nations through a treaty called the Kyoto Protocol, which was signed in 2005. The treaty recognized the reality that we can not simply reduce our carbon impacts to zero and set forth a market-based mechanism called “Cap and Trade” that was designed to involve the private sector in the reduction of carbon emissions through “offsetting”.

The Cap & Trade mechanism of the protocol set a “cap” on global emissions at the 1995 level. This meant that, in 2005, the world was already in violation of the agreed emissions limits. Therefore, the protocol established a “compensation” or “offset” mechanism that allowed for the creation and trade of carbon emissions reduction credits (as previously described) in order to cancel out the deficit.

Additionally, the protocol established the “caps” for “developed/industrialized” countries and did not allow those countries to produce carbon credits. Conversely, the protocol imposed no caps on “developing/non-industrialized” countries since it was argued that this would place unfair burdens on countries that had not yet had their chance to grow their economies. However, in order to integrate those countries into the new “green economy”, it allowed for the credits to be produced in those countries.

By all accounts, it was a brilliantly conceived plan — save one fatal flaw. As I outlined in my previous post, the UN drew the world black and white and classified China and India, the world’s first and third largest polluters, as “developing/non-industrialized” nations. This meant they were allowed to produce an unlimited amount of credits and had no emissions caps.

The United States, who refused to sign the treaty, argued that: 1) these two countries could hardly be considered “non-industrialized” in the same category as Sudan or Bangladesh; 2) the treaty was hollow given that it could never hope to abate climate change if it failed to address the emissions of two of the top three emitters in the world; and 3) that it would lead to a collapse in carbon prices due to a supply and demand imbalance, which would eventually collapse the market by driving prices below the point where they were economically viable to produce.

And, that’s exactly what happened.

At first, demand exceeded supply and carbon prices rose sharply to trade as high as €30/tonne. But, by about 2012, just seven years into the program, Chinese factories with 50-year-old smoke stack technology were able to spend a couple hundred thousand dollars on 20-year-old scrubber (filter) technology and produce a million dollars of credits. European carbon credit prices collapsed to under €2/tonne and many private sector projects that were actively reducing emissions and creating credits in the developing world — died.

The California Cap and Trade initiative, which now includes several western states including British Columbia, learned some important lessons from this failure and established a “free floating range” with a hard price floor and ceiling for carbon prices, supported with more carefully balanced supply and demand controls. This has led to a stable and healthy regional emissions market.

The Future of a Global Agreement

It’s really anybody’s guess whether the world’s politicians will ever be able to agree on a global agreement. The much touted “Paris Agreement”, signed under the Obama Administration, had the same fatal flaws as the Kyoto Protocol — all due to political wrangling and “sovereign interests”. Unable to reach an agreement with any real substance, they simple served up a toothless one, no more effective than a placebo, but characterized it as “historic”. There was a lot of back-patting in the months that followed and as much hand-wringing when, in equally grand fashion, the Trump Administration announced it would pull out of the agreement. The fact is, neither of these grandstanding events made any difference to climate change.

UN officials and government leaders celebrated the adoption of the Paris Agreement in 2015

Private Sector Compliance Markets

What’s really moving the needle in terms of incentivizing corporate behavior and leading to real reductions in emissions is a band of unsung climate heroes. In the basement offices of the world’s largest institutional investment funds, pension funds in particular, Risk Managers are driving environmental responsibility more than any other force in the universe. Driven by fear, an even more powerful catalyst than greed, risk managers have figured out that, politics aside, climate change is a RISK they don’t understand — and that makes them nervous. It’s their job to quantify ALL risks, however remote or arcane, and then mitigate those risks. And so, for the past five years or so, “Environmental and Social Governance” (ESG) has become a thing. Risk managers now apply ESG ratings to the companies and management of their portfolio investments.

That has had a profound effect on corporate behavior. Environmental Responsibility has moved from the realm of public relations campaigns to serious measurements of the companies’ environmental and social impacts. Many companies have begun offsetting, even in the absence of a government mandate.

Growth of ESG as a part of Sustainable, Responsible and Impact (SRI) investing for entities in the U.S.

Stranded Assets

Beyond that, risk managers have begun to calculate the risk of “stranded assets”, which could result in an even deeper discount of a company’s share value. Stranded assets are assets that convert to liabilities due to an unforeseen or unavoidable event. Oil & Gas companies are particularly susceptible to write-downs of stranded assets since a significant portion of their “book value” is based not on last quarter’s profits, but rather on the “in-ground proven reserves” they hold on their books as assets. Those in-grounds reserves have a quantifiable value today in the form of “discounted future revenues”. The value of those reserves can be adversely affected by the threat of carbon regulation and escalating carbon prices. At current prices, those assets have X value but at the $50/tonne prices projected by the majority of market analysts, the value of those assets could turn negative, thus converting them to liabilities and resulting in huge, billion-dollar, write-downs and a resulting drop in stock price. Just ask ExxonMobil. After years of denying they had any risk of stranded-assets, their largest institutional shareholders forced them to recognize these liabilities, resulting in an $8 billion-dollar write-down.

So, can’t companies just hedge this risk, like they hedge oil price risks in the futures markets?

It seems obvious, right? However, despite the fact that carbon credits make up a multi-billion-dollar market, they lack the sophisticated tools used in other markets to mitigate future risk. Mainly that comes down to two inherent flaws in the two classes of offsets I wrote above — public-sector compliance market allowances and credits, and private-sector compliance credits or so called “voluntary” credits.

Public-sector compliance credits are liquid and can therefore be listed on a company’s books as an asset and loaned against. This is a major consideration for any CFO taking on a substantial size “long or forward position”. Companies could simply buy credits and hold them for the future as a “hedge” against the risk of price increases. The problem is, public-sector compliance credits and allowances typically expire in 2–3 years or 5 years maximum. So, that’s not a very good long-term future protection.

Private-sector compliance credits, or so-called voluntary credits, have very long expiration dates, exceeding 10 years or more, and they also often have broader environmental mitigation scopes (forestry and biodiversity conservation and positive social impact). That makes them a very attractive long-term hedge. But, they are not traded on public exchanges, but rather over-the-counter (OTC) or B2B, which means they can’t be “marked to market” (priced at a publicly published price index). That makes them hard to classify on the books as an asset and loaned against, making an investment in them very inefficient from a cash management point of view.

This is one of the principle problems Veridium is creating a solution for. By tokenizing the high-quality but illiquid credits, and by creating a credit that represents a diversified basket of credits, we can provide fund risk managers and corporate managers with the tools they need to mitigate future risks — and that could be a billion-dollar business.

We hope this write up helps you to understand the carbon credit markets better. If you’d like to learn more about Veridium, support our project, or join our community, we welcome all the help we can get. You can learn more here.

Image sources:

http://infinite-earth.com/rimba-raya-biodiversity-reserve/

https://www.eco-business.com/opinion/beyond-the-paris-climate-agreement/

https://www.forbes.com/sites/annefield/2017/01/31/more-evidence-impact-investing-growth-and-what-it-means-for-social-entrepeneurs/#5165e1ee7b7f