Part Four: What next after COP26?
Whatever new promises emerge from COP26, major commitments have already been made on carbon. The exact cost of these is unknown, though huge, and debate still rages over how these ambitious goals can be achieved. Governments have various tools at their disposal, including prohibitions, taxes, and subsidies, but none are cost-free and any could be ruinous for the economy if applied too heavy-handedly. The political cost of restrictions on voters’ lifestyles may prove unbearable as a consequence.
Governments should support carbon credits – but need to tread carefully
An appealing option that is receiving more support is a more integrated carbon market allowing offset credits a greater role, while extending the benefits of agreed standards in existing regulated schemes. As this series of articles has discussed, there are also many criticisms of carbon credits, and offset credits in particular. These are often valid, but if we believe that we are in the midst of a climate emergency, carbon credits could at least buy us valuable time.
The automotive market stands as an example of both the benefits and drawbacks of government intervention. On one hand, legislation has accelerated the development and adoption of hybrid and fully electric vehicles. However, there are risks in over-specifying solutions; with all the focus having been on in-use emissions, thorny questions around the whole-life emissions of battery powered vehicles are only now being addressed.
The same risks apply to the carbon credit market. Overly restrictive or prescriptive regulation will have undesirable consequences – as can be seen in the experiences of the cap-and-trade market. Restricting the range of credit-generating activities could squeeze out innovative new technologies, while distorting the market and hampering price discovery, competition and organic market growth.
In terms of regulation, current financial markets may again provide a useful template. Quasi-autonomous bodies like the FCA and SEC provide oversight and compliance with a basic set of standards, while commercial actors are free to compete in providing (and defining) key services like index setting and credit rating, with a high degree of autonomy.
This approach has organically led to a separation of roles to prevent conflicts of interest. The current situation in the voluntary carbon market is almost a parody of this, with companies financing, certifying (to standards they have chosen or indeed invented themselves), and then selling credits. Disrupting these arrangements would not only prevent serious problems like double-selling (or outright fraud), but also promote confidence and efficient price discovery.
QE for Carbon?
Governments with a greater appetite for direct involvement have another potentially game-changing option. There has been much talk about the need to expand the carbon market to ‘critical mass’; government pump-priming could be the answer. By guaranteeing to buy a volume of carbon credits, governments would give confidence to investors and kick-start growth. Buying these credits in line with a public ‘soft standard’ would allot the government to prioritise its vision of high quality credits without precluding the production and sale of other forms of credit in the wider market.
A truly visionary government could go further, by linking such purchases to the cap and trade system. By predicating the issuance of cap-and-trade credits on the tonnage of government purchased ‘compliant’ credits, cap-and-trade credits would be transformed from ‘permissions to emit’ into actual emissions reductions. It would also create a disincentive to inflation of the cap-and-trade credit market, by adding a cost to such decisions.
Thus, while the existing voluntary market will continue to grow organically, largely on the basis of reputational gain for buyers of credits, in order to create the rapid expansion that governments should be targeting, huge inflows of capital will be required. However, without a coherent investment thesis, which private capital will follow into the market, no amount of government pump-priming will work.
The investment case for carbon
Just as (apocryphally at least) the real money of the gold rush was made by the sellers of picks, shovels and blue jeans, it may be those servicing the carbon industry who stand to benefit most from an expansion in the carbon market. Just as major financial institutions are dipping their toes into crypto, so established commodities brokers are starting to take carbon seriously. In addition, there is an increasing number of specialist brokers, ratings agencies, and research houses [sylvera] dedicated to carbon. For venture capitalists, followed by institutions, there will be opportunities here for exposure to growth in the carbon market. However, at present there is not the capacity to absorb huge injections of capital.
So where could large amounts of cash be deployed? Directly into the purchase of carbon credits might seem the obvious answer. There is a case that carbon prices will continue to rise, through increased demand, and the ‘low-hanging fruit’ thesis that the earliest carbon offset projects will be the most cost effective. The counter argument to the latter point is that novel, more efficient carbon capture technologies may emerge, driving down the price of credits – but this is likely to be beyond the average investment horizon. A stronger case against direct investment in credits is the nature of the current market, with its lack of visibility around price and quality. Smaller, specialist investors will be able to exploit this information asymmetry, but until these issues are addressed any large-scale influx of capital will likely achieve nothing but a glut of poor quality credits.
The best option might be direct investment into carbon capture activities and the ‘farming’ of carbon credits. This approach would allow investors to guarantee and control the type and quality of the credits produced, to benefit from the underlying assets (often land), and to fully leverage the intangible ESG value of such projects. This is particularly relevant to large, industrial corporations (like oil majors or miners) looking to make a green transition, and to institutional investors in those companies. Large carbon capture projects are, by their nature, massive in scale and capital intensity – well suited to absorbing large scale investment.
Conclusion
The birth pangs of this carbon rush will inevitably have their unpleasant side: greed, speculation, volatility, insolvency – and yes, one or two outright scams. But those who question the fundamental propriety of the market taking a central role in solving the climate emergency will have difficult questions to answer. An expansion of the carbon market buys time for the decarbonisation of the broader economy. The prize is the creation of a huge new asset class, with massive rewards for the leading centres.
This piece was originally published in the Oxford Business Review