Part Two – Offset credits: welcome to Dodge City
Alongside the regulated cap-and-trade market, there is a parallel market in offset carbon credits, currently smaller in terms of capitalisation, but faster-growing and encompassing a much wider variety of participants. This market has the potential to dwarf the cap-and-trade system in the future, though major structural hurdles exist. This is often referred to as the ‘voluntary’ CC market, but this description can be misleading.
In contrast to cap-and-trade credits, offset CCs fundamentally represent capture or amelioration of carbon emissions. They are fundamentally decentralised in nature, issued by a diversity of participants, and are produced by a variety of activities. In addition, regulation and validation of these credits is carried out by a range of quasi-autonomous regulatory and supervisory bodies, each with a more-or-less similar, but also more-or-less different set of parameters by which to test and verify the value of credits.
Who are the buyers for such credits, why are they buying them, and who are they buying them from? There is a huge diversity of participants on the buy side of this market, with diverse motivations and agendas to be satisfied. At one end of the spectrum are large emitters in cap-and-trade regulated industries who (depending on the regulatory environment in which they operate) may be able to use offset CCs to minimise their assessable emissions. Next, there are other large businesses outside the scope of most emissions regulations (e.g. the services sector, FMCG, retailers) looking to demonstrate green credentials and carbon neutrality in order to gain a competitive advantage. Finally, there are also individuals looking to offset their personal carbon footprint – usually purchasing CCs bundled with a flight or other polluting activity at the point of sale.
In between, a growing number of SMEs are facing downward pressure from their larger business clients to carry the burden of carbon neutrality (or negativity). This inevitably cascades down the supply chain as suppliers and partners are obliged to contribute to this reduction in net emissions. For those who have no meaningful ways to cut their direct carbon footprint, nor the resources to finance independent offsetting projects, offset CCs are an increasingly attractive solution.
What is the exact nature of the CCs which supply this demand? Again, the answer is not simple. Two distinct subcategories of offset CC can be defined: those which involve carbon capture on the one hand, and those predicated on avoided emissions on the other. Examples of the former include reforestation, peat bog renewal, CO2 gas capture and storage, etc.; in the latter category are electrification, renewable energy projects and efficiency drives.
CCs in both the above categories can be further divided by their term: either ‘permanent’ or ‘expiring’. ‘Permanent’ implies a legal foundation for a project, guaranteeing that captured carbon will not be re-released (e.g. a forest is planted and a binding commitment made that it will remain in perpetuity). The credibility of this clearly depends on the perceived reliability, both of the issuer and the regulator overseeing the credits, as well as the legal and political framework in which the credit generating project exists. ‘Expiring’ implies that the carbon will be captured for a defined period of time (e.g. a forest that is planted and will be harvested in a set number of years). Many of the considerations applying to permanent credits will apply to expiring credits, though the impact of long-term legal and political uncertainties is lessened. The utility of expiring credits will be discussed further in later articles.
In the absence of widespread governmental regulation of these credits, a host of independent bodies have emerged to fulfil this regulatory role. Each produces its own perspective on what makes a ‘good’ carbon credit, and takes different measures to ensure the compliance of producers. While these bodies all claim independence, just as much as any governmental regulator, these may be prey to conflicting agendas and value systems. Most troubling is the overlap of their roles as regulators and marketers of carbon credits which inevitably leads to conflict of interest. When valuing credits on the voluntary market, these regulators play a large role, as it is their marketing of the credits (and of their own standards) that help to convince buyers who are otherwise unable to make meaningful price comparison.
Conclusion
In summary, cap-and-trade CCs represent permissions to emit and have a centrally determined value, while offset CCs represent carbon capture or direct emissions avoidance and have a price set entirely by the market.
The essential value of any offset CC must be a product of:
- The type of generating activity
- The term of the CC
- The perceived reliability of the issuer
- The perceived strength of the regulatory body overseeing it
But standing between the current CC market and an accurate pricing for carbon is a minefield of complexity, as we have discussed. This results in wildly divergent CC pricing with no clear way to determine ‘fair’ values, compounded by an almost complete lack of price visibility. The next article will begin to plot a path through some of the confusion in valuing credits, and how other asset classes might help us address some of these challenges.
This piece was originally published in the Oxford Business Review