Carbon Markets Volume 2: Credits and Offsets
Following on from our Volume 1 article on carbon accounting, we bring to you a deep dive into the carbon credit and offset market, and its crucial role in shaping the way that the climate industry will evolve, in terms of i) commitments to net zero; ii) offsetting carbon emissions; and iii) the advent of technology such as blockchain and tokenization to bring about speed, standardization, and liquidity into the marketplace.
History of Carbon Credits or ‘Allowances’: The Compulsory Market
The carbon credits market is not a new concept. Trade in carbon credits began as part of the 1997 UN Kyoto Protocol, the first international agreement to cut CO2 emissions. Its Clean Development Mechanism (CDM) allowed industrialized countries to reduce emissions abroad where that might be cheaper than at home, such as by reforestation in developing countries. China and India have accounted for over 70% of the registered projects. A carbon allowance (also known as a carbon credit) permits a company to emit 1-ton CO2e into the atmosphere. It is generally given to ‘hard-to-abate’ sectors such as oil and gas, cement, chemicals, and steel producers.
The compulsory market is used by companies and governments that are legally mandated to offset their emissions.
The CDM serves as one of the main carbon reduction schemes which are government-administered, for the compulsory markets, along with the European Union Emissions Trading Scheme (EU-ETS) and the California Carbon Market. At present, there are 31 compulsory carbon markets in operation. A compliance ETS (Emissions Trading Scheme) is a region that sets emissions reduction targets that reduces on an annual basis. In order to reach emission targets, they allocate carbon allowances (credits) to companies in certain industries in their region. The countries that have joined these markets are those that have accepted and adopted the emission limits established in the Framework of the United Nations Convention on Climate Change (UNFCCC). Each ton of CO2 is measured in carbon credits or CERs (Certified Emission Reductions), and these credits (unused allowances) or CERs are generated in the implementation phase of the project and are issued once the reduction has been credited.
Over the years, concerns have been raised about the CDM, including the quality of the emission reductions approved under it, demand-supply mismatch, lack of transparency, lack of clarity on how the offset projects were being developed, and the unwillingness of governments to engage.
The Rise of the Voluntary Carbon Markets and Carbon Offsets
But the view on carbon markets is changing and maturing. The Paris Agreement was adopted as part of COP21 in 2015, as part of Article 6, validated the application of carbon offsets, and approved further facilitation of markets at the COP26 conference last year, leading to the rise of the voluntary carbon markets (VCM).
The VCM are not regulated and use carbon offsets rather than carbon credits (unused allowances). They allow for private companies and individuals to purchase carbon offsets on a voluntary basis towards climate action projects and technologies that are yet to take off.
Carbon offsets are project backed, for example, project developers build a reforestation project, plant trees to sequester carbon from the atmosphere, allow it to be independently certified by adhering to particular standards, and then issue offsets that companies can buy voluntarily.
These organizations would be in industries that are not regulated by cap-and-trade systems like the EU-ETS. Typically, these would include companies in technology, financial services, utilities, FMCG, and industrial sectors. Voluntary carbon markets today are 5% of the compliance market but the capital flowing into the VCM provides stimulus to achieve the scale required to make these projects feasible. Moreover, these projects have many additional social and economic benefits such as biodiversity protection and conservation, job creation, public health improvements, and job creation. 400+ global companies are using carbon offsets today, and there is tremendous potential for carbon offset markets to grow as companies increasingly set more ambitious emission targets.
Types of Carbon Offset Projects
Carbon offset projects can be segregated into two major types:
Avoidance: Avoid carbon from being released by capturing these emissions from industrial factories, storing and reutilizing this energy into useful, greener fuels, as well as preventing deforestation.
Removal: Remove carbon emissions that are already present in the atmosphere Include projects that sequester carbon, through man-made processes such as direct air carbon capture, or nature-based such as reforestation and ocean algae cultivation.
At their best, carbon avoidance projects may have a positive social impact, but the amount of carbon they actually offset is difficult to quantify. At their worst, these projects could have the risk of being perceived as ‘greenwashing’ – designed to give the appearance of environmental impact without proof of impact – and ideally should not be a significant part of a responsible company’s offset portfolio. Companies such as Microsoft, for example, have laid out a plan to be carbon negative by 2030, including a shift away from carbon avoidance and a $1 billion investment in carbon removal technology.
Specifically, on carbon removal, man-made solutions such as Direct Air Capture with Carbon Storage (DACCS) – technologies that use chemical processes to capture and separate CO2 directly from ambient air – and Bioenergy with Carbon Capture and Storage (BECCS) - capture and permanent sequestration of biogenic CO2 – remain expensive, espouse long lead times, and are championed mainly by the large oil majors, such as Shell, BP, and Aramco.
By contrast, nature-based solutions have been tested for millions of years, are less uncertain and less expensive, and involve conserving, restoring, or better managing existing ecosystems. These ‘carbon sink’ solutions are often colorfully referred to as green (carbon sequestered by land ecosystems such as natural forests and soil), brown (carbon sequestered by industrial forests), blue (carbon sequestered by ocean ecosystems), and teal carbon (carbon stored in inland freshwater wetlands).
India is well-positioned to harness nature-based solutions for the voluntary carbon markets – 25% of India is covered in forests, India has the second most cultivable, arable land in the world at 169 million hectares which is well-positioned for regenerative agriculture, and India’s coastal regions boast access to algae, coral and other marine biodiversity reserves.
While much of the recent focus has been on green carbon, there have been concerns arising from forests being susceptible to wildfires and other external forces. Blue carbon, by contrast, has drawn a lot of interest because of its huge untapped potential.
The ocean is the largest natural carbon sink on the planet, mainly due to phytoplankton (microalgae) which undertake the most photosynthesis in the world.
Mangroves or ocean credits sequester 10 times the carbon sequestered on a similarly sized plot of land in a forest. Verra, a standard for certifying carbon reduction emissions, has issued 970,000 credits to blue carbon projects. Over the past year, companies such as Gucci, Apple, and Procter & Gamble, have announced mangrove protection and ocean restoration projects to as part of their carbon removal offsets.
For carbon offsetting to be effective, it should be seen as a means to complement the company’s greenhouse gas emissions at the source. Sylvera, a company working on offset standardization aims to rigorously rate carbon offset projects to define the quality of offset projects, providing a source of transparency to carbon markets. This would allow high-quality offset projects to be priced inaccurately at a premium, prompting companies into action – either reduce the emissions organically or offset them at a higher price.
Challenges and Opportunities for Innovation
Today’s carbon market is fragmented, complex, and has limited pricing data for buyers to know whether they are paying a fair price, it creates uncertainty for project developers to manage risks that come with financing without knowing how much buyers would be ready to pay. Overall, the market is characterized by low liquidity, scarce financing, inadequate risk-management services, and limited data availability.
Challenge #1: Limited Pricing Data
The lack of pricing data can be addressed by the creation of a base reference contract that would include the core attributes of emissions reduction, with the additional benefits added to it and prices separately.
Solution:
The creation of a reference contract would help companies in buying large quantities that meet criteria and suppliers would aggregate smaller quantities to meet their bids. A resilient flexible market infrastructure would enable VCMs to function effectively, to accommodate high-volume listing and the trading of reference contracts. Marketplaces such as Pachama and NCX help aggregate demand from individuals and corporates to match them with projects. Moreover, academic institutions such as the Cambridge Centre for Carbon Credits are creating a decentralized marketplace where purchasers of carbon credits can confidently and directly fund nature-based solution projects.
In addition, transparency in reference and market data would benefit buyers and suppliers and would lead to clearer demand signals, which would help give suppliers more confidence in their project plans and encourage investors and lenders to provide financing. Platforms such as Patch and Cloverly help aggregate the demand of large corporates and individuals to provide accurate demand signals. These demand signals would help project developers in the development process of projects - to develop projects that are in demand and would help developers position and market their projects to produce a certain type and quality of offset.
Blockchain technology provides an open and inclusive platform, characterized by the immutable cryptographically-secured distributed ledger, allows for reliable issuance and tracking of carbon credits.
Public blockchains can help improve transparency and integrity so they can scale carbon credit markets in an effective way. Companies such as Toucan have built a 'carbon bridge' which has helped to create a publicly accessible carbon credit that helps to bring transparency to the market and unlock better financing for climate projects.
Challenge #2: Low Liquidity
Carbon markets lack liquidity mainly because of the heterogeneous nature of credits, as each credit has various attributes such as the type of project or the region it is implemented. These attributes affect the price of the credits because the additional or different attributes are valued differently. These inconsistencies mean that matching an individual buyer with a corresponding seller is inefficient and time-consuming to transact over the counter.
Solution:
Making the rating process more uniform would consolidate trading activity around a few types and would promote liquidity on exchanges. For example, the pooling of tokens (carbon credits) can create deep liquidity for carbon markets. Verra (one of the well-known certifiers) and the resulting Verified Carbon Units (VCUs) are now recognized as leading tokens in voluntary carbon markets. Pooled carbon reference tokens like Name Change Tokens (NCTs), can be traded at centralized and decentralized exchanges or used as green building blocks for green Decentralized Finance (Defi), Non-Fungible Tokens (NFTs), or the metaverse. Each token is representative of a real carbon offset that has been verified by the producers or standards body.
Challenge #3: Lack of Standardization
High-quality carbon credits are scarce because accounting and verification methodologies vary and because credits’ co-benefits (such as social and economic development and biodiversity protection) are seldom well defined. Verifying the quality of new credits takes time, and the heterogeneity of credits leads to lower volumes, unpredictable demand for project suppliers, and therefore lower prices.
Solution:
One corrective measure would be establishing a digital process by which projects are registered and credits are verified and issued, tracking performance at regular intervals.
A digital process can help lower issuance costs, shorten payment terms, accelerate credit issuance and cash flow for project developers, allow credits to be traced, and improve the credibility of corporate claims related to the use of offsets.
Globally accredited players such as Verra and Gold Standard have been monitoring carbon offset projects for years, and form part of the International Carbon Reduction and Offset Alliance (ICROA), which adheres to a strict code of practice that ensures that carbon credits purchased represent real emission reductions that business and consumers can trust.
In addition, on the blockchain, everything is transparent. Specialist platforms are creating buckets of credits with similar attributes, which buyers can specify which specific traits and methodologies can go in. If something is vetted and standardized, there is less risk. For example, a pool of credits or tokens will have a certain level of quality, and this is guaranteed. Carbon can become a multichain asset, integrated across multiple systems.
Where do we go from here?
As more companies are making pledges towards net zero, many businesses will find it challenging to reduce their emissions through their own operations. For many, carbon credits and trading would play an important role in meeting these net zero goals. The recent US climate legislation passed this month, allowing for an unprecedented $370bn invested in cutting US emissions by 40% by 2030, will provide a wider launchpad for green investment and will kickstart a transition towards renewable energy in the world’s largest greenhouse gas emitter.
By 2030, McKinsey claims the demand for carbon credits would increase by a factor of 15 than it is today to $50 billion, and has the potential to remove 5 gigatons of CO2 per year.
Countries such as India have a great potential to satisfy a large percentage of this by developing economical nature-based emissions reduction projects. The 2022 Bill to launch a carbon trading market in India is a promising step toward India’s commitment to net zero, building on the success of the OTC markets for renewable energy trading (RTM and GTAM) which will facilitate market-based instruments to lower emissions and potentially interlink with the global carbon markets.
We at Theia are excited to meet founders building innovative blockchain solutions through Web 3.0 technology, for digital carbon credit trading and smart contracts. We look forward to hearing from you!