Part Three – Diamonds are forever, pork bellies are for lunch, bitcoin is for the bros, but are carbon credits for the birds?
The previous articles in this series opened a window into the opaque world of the carbon credit market. Some readers may feel scales lifted from their eyes; while others may feel more confused than ever. Those in the latter category are probably assessing the situation more accurately. After all, an excess of confidence has led even big players to make major missteps…
Carbon credits as a concept are undeniably peculiar. Other commodities have a physical presence at the heart of what they are, whereas carbon credits express a non-existence or negativity – a removal or avoidance of something, rather than the creation of something. Moreover, while other activities attract the attention of environmentalists, no other asset class has an environmentalist function as its raison d’etre. From an activist viewpoint, carbon credits’ status as a store of monetary value, and the fact they are subject to speculation and exploitation by markets, may seem entirely incompatible with their function as a tool to combat global warming.
But, by stepping back and looking at carbon credits in comparison to a range of asset classes, many of the ‘oddities’ of carbon credits actually look familiar, and far from insurmountable, which is exactly the rabbit hole that we are going to dive down today
Fiat currency Cap-and-trade can be seen as analogous to fiat currency, with credits centrally issued and accepted by a polity which guarantees their value. In the same way that a rouble is always worth a rouble when it comes to paying taxes in Russia, so too is one cap-and-trade credit always worth one tonne of carbon in its issuing regulatory regime.
However, in the same way that printing money does not create wealth, issuance of cap-and trade credits does not create emissions reductions; it creates liquidity. Offset carbon credits can inherently represent an emission reduction, but in this analogy may suffer from a lack of credibility in their issuers – like the currency of a failing state. However, there are many examples of assets which do not rely on the direct authority of a state to underpin their value.
Gold Before fiat there was gold, which still retains its role as a store of value. That value comes in part from the process of extraction and concentration of a rare material into a pure metal. In this sense, there are parallels with the formation of carbon stores that underpin some carbon credits, with the concentration of a diffuse gas into a defined point.
However, for gold, the variability in the method of extraction does not affect the value of the end product, whereas for different methods of producing carbon, it does. This is a fundamental distinction between gold and carbon credits: a troy ounce of gold has the same value everywhere, while a carbon credit, although always representing a theoretical tonne of stored carbon, does not. The value of a carbon credit is a product of a complex combination of factors, including its utility (or otherwise) in a regulated scheme, the wider ESG values that may be attached to it, and the reliability of the issuer. But is this a fatal flaw?
Diamonds Like carbon credits, diamonds come in various varieties, and the value of each individual diamond is also the product of a complex combination of qualitative factors; provenance, aesthetic characteristics, novelty, size etc. However, this has not prevented the formation of a mature and varied market in diamonds, which has even withstood the arrival of synthetic diamonds.
What diamonds demonstrate is that the heterogeneity of carbon credits, and the myriad resulting ‘grades’ of final credit does not need to be a barrier; in a functional market many different grades can be accommodated.
Pork bellies A major objection often raised against offset credits is their inability to guarantee permanence. But is this a reasonable, or even necessary demand? While diamonds (and gold) are forever, pork bellies clearly are not. They have a temporal existence and must be consumed to realise their value (just as carbon credits must be ‘retired’ to realise an offset).
Again, this has not precluded the development of a mature, efficient and sophisticated trading markets, which allow investors to maintain permanent exposure to pork bellies by holding rolling contracts. So why should the temporal nature of many carbon credits be a barrier to their utility? Pork bellies may be an extreme example, but it is worth considering why carbon credits are expected to make guarantees on a timescale not demanded of other asset classes.
Cryptocurrencies In contrast to the previous examples, the market for cryptocurrencies is far from mature; in fact it is fragmented, volatile and, at times, illiquid. It also lacks regulation and standards of accountability common to conventional markets, with many cryptos lacking any form of collateralized or intrinsic value. All the more impressive then, that cryptocurrencies have become a huge store of value in a very short time.
At the same time, this rapid growth has prompted a difficult relationship with regulators. Authorities want to prevent outright fraud, but avoid inadvertently choking off innovation. This has led to an uneasy seesawing between the permissive and the reactionary.
These problems of regulation, valuation, and trustworthiness all clearly have parallels in the voluntary carbon market. In fact, the carbon market looks relatively benign in comparison. How is it that cryptocurrencies have mooned (and developed complex derivatives, spot, and futures pricing at such an early stage), while the voluntary carbon market has failed to launch?
There have been many calls from influential quarters for the establishment of an efficient offset credit market, though unhelpfully always in vague terms. What the carbon market needs, in addition to all that has been said elsewhere, is a compelling investment case; a shot in the arm of the same profit-seeking motive that has just jumpstarted the market in cryptocurrencies. In the next article we will attempt to lay out, if not a definitive roadmap, then a series of pointers towards this goal.
This piece was originally published in the Oxford Business Review