2021 will probably be remembered as the year when carbon finance emerged as a talking point among a wide range of industries.
Among the 2021 new entrants in voluntary carbon markets, oil and gas majors, hedge funds and banks were heard as the most active players, resolutely taking positions in the market. But as the year unfolded, many other sectors of the economy joined the market following their pledges to reduce carbon footprints.
Many political entities like the EU, the UK or the state of California already have mandatory carbon markets covering specific industry sectors and gases. These form an important part of the effort to meet the Paris Agreement target of limiting global heating to 2 degrees Celsius above pre-industrial levels (with a more ambitious ideal of remaining within a 1.5 C increase), even though some of these markets predate the Paris commitments.
But other sectors have taken a cue from compliance schemes and pledged to offset their greenhouse gas emissions (GHG) by participating in carbon markets voluntarily.
Voluntary carbon markets allow carbon emitters to offset their unavoidable emissions by purchasing carbon credits emitted by projects targeted at removing or reducing GHG from the atmosphere.
Each credit – which corresponds to one metric ton of reduced, avoided or removed CO2 or equivalent GHG – can be used by a company or an individual to compensate for the emission of one ton of CO2 or equivalent gases. When a credit is used for this purpose, it becomes an offset. It is moved to a register for retired credits, or retirements, and it is no longer tradable.
Companies can participate in the voluntary carbon market either individually or as part of an industry-wide scheme, such as the Carbon Offsetting and Reduction Scheme for International Aviation, which was set up by the aviation sector to offset its greenhouse gas emissions. International airline operators taking part in CORSIA have pledged to offset all the CO2 emissions they produce above a baseline 2019 level.
While compliance markets are currently limited to specific regions, voluntary carbon credits are significantly more fluid, unrestrained by boundaries set by nation states or political unions. They also have the potential to be accessed by every sector of the economy instead of a limited number of industries.
The Taskforce on Scaling Voluntary Carbon Markets, sponsored by the Institute of International Finance with support from McKinsey, estimates that the market for carbon credits could be worth upward of $50 billion as soon as 2030.
Five main players make up the engine of carbon markets.
Project developers represent the upstream part of the market. They set up the projects issuing carbon credits, which can range from large-scale, industrial-style projects like a high-volume hydro plant, to smaller community-based ones like clean cookstoves.
There are projects aimed to destroy or manage the direct emissions resulting from industrial processes such as fugitive emissions management, ozone-capture or destruction of ozone-depleting substances, or wastewater treatment. Nature-based projects include REDD+ (avoided deforestation), soil sequestration or afforestation. Other types include tech carbon capture such as direct air capture while new categories are being added constantly.
Each credit has a specific vintage, which is the year in which it was issued, and a specific delivery date, which is when the credit will be available on the market. Together with their primary purpose of avoiding or removing GHGs from the atmosphere, credit projects can also generate additional 'co-benefits' and help meet some of the UN's Sustainable Development Goals (SDGs). For example, they may contribute to improved welfare for the local population, better water quality, or the reduction of economic inequality.
The downstream market is made up of end buyers: companies – or even individual consumers – that have committed to offset part or all of their GHG emissions.
Among the early buyers of carbon credits were tech companies such as Apple and Google, airlines, and oil and gas majors, but more industry sectors, including finance, are joining the market as they set their own net-zero targets or look for a way to hedge against the financial risks posed by the energy transition.
The implementation of Article 6 of the Paris Agreement on Nov 13 at the UN Climate Conference, or COP26, in Glasgow set the rules for a crediting mechanism to be used by the 193 parties to the Paris deal to reach their emission reduction targets or nationally determined contributions. The article implementation has made it possible for countries to buy voluntary carbon credits, as long as Article 6 rules are respected.
To link supply and demand, there are brokers and retail traders, just as in other commodity markets. Retail traders purchase large amounts of credits directly from the supplier, bundle those credits into portfolios, ranging from hundreds to thousands of equivalent tons of CO2, and sell those bundles to the end buyers, typically with some commission.
While most of the transactions are currently happening in private conversations and over-the-counter deals, some exchanges are also emerging. Among the largest exchanges for carbon credits at the moment are the New York-based Xpansiv CBL and Singapore based AirCarbon Exchange (ACX).
Exchanges have been trying to simplify and speed up the trade of carbon credits – which have a high level of complexity due to the high number of factors affecting their price – by creating standard products, which ensure some basic specifications are respected.
For example, both the Xpansiv CBL and ACX have set up standard products for nature-based credits, CBL's Nature-based Global Emission Offset (N-GEO), and the ACX Global Nature Token.
Credit trading under these labels are guaranteed to have set characteristics such as the type of underlying project, a fairly recent vintage, a certification from a restricted group of standards.
Exchanges' standardized products – especially those for forward delivery – are currently preferred by traders and financial players looking to buy and hold in anticipation of skyrocketing carbon credit demand.
End buyers that need to purchase credits to offset their emissions tend to prefer non-standardized products as this allows them to look into the specific characteristic of each underlying project, ensure the quality of the credit being purchased and therefore protect themselves from potential accusations of greenwashing.
Often, the exchanges are used to settle large bilateral deals that have been negotiated offscreen. In a market note shared in May, CBL said that an even larger number of bilateral deals negotiated offscreen were being brought by traders to be settled on the CBL platform.
These deals made up a significant portion of volumes transacted on CBL.
Brokers buy carbon credits from a retailer trader and market them to an end buyer, usually with some commission.
There is a fifth player unique to carbon markets. Standards are organizations, usually NGOs, which certify that a particular project meets its stated objectives and its stated volume of emissions.
Standards have a series of methodologies, or requirements, for each type of carbon project. For example, a reforestation project will follow specific rules when calculating the level of CO2 absorption of the planned forest and therefore the number of carbon credits it produces over time.
A renewable energy project will have a different set of specific rules to follow when calculating the benefit in terms of avoided CO2 emissions and carbon credits generated over time.
Standards' certifications also ensure certain core principles or requirements of carbon finance are respected:
- Additionality: The project should not be legally required, common practice, or financially attractive in the absence of credit revenues.
- No overestimation: CO2 emissions reduction should match the number of offset credits issued for the project and should take account for any unintended GHG emissions caused by the project.
- Permanence: The impact of the GHG emission reduction should not be at risk of reversal and should result in a permanent drop in emissions.
- Exclusive claim: Each metric ton of CO2 can only be claimed once and must include proof of the credit retirement upon project maturation. A credit becomes an offset at retirement.
- Provide additional social and environmental benefits: Projects must comply with all legal requirements of its jurisdiction and should provide additional co-benefits in line with the UN's SDGs.
Overlapping roles, bilateral trade
There is an overlapping of roles that is specific to carbon markets.
Many brokers act as traders, and many financiers have both brokering arms and project development arms.
End buyers can also finance their own carbon project and decide to keep all or part of the issued credits for their own offsetting needs.
All these groups may ultimately market credits to a buyer, or a developer may arrange to sell them direct. All these juxtapositions can have an impact on price, and ultimately affect market transparency.
Pricing a diverse supply
When a company turns to voluntary carbon markets as a potential way to compensate for its carbon emissions, one of the key pieces of information it looks for is the price of carbon credits. With this information, a company can decide how ambitious it can be when setting its emission reduction target and whether voluntary markets can really help in reaching it.
At the same time, a clear price signal for carbon allows players already involved in the market to make sure they are trading their credit at a price that reflects the real market value.
But putting a price on carbon credits is far from a straightforward operation, mostly because of the wide variety of credits in the market and the number of factors influencing the price.
Projects issuing carbon credits can be of many different types and sub-types. The nature of the underlying project is one of the main factors affecting the price of the credit.
Carbon credits can be grouped into two large categories or baskets: avoidance projects (which avoid emitting GHGs completely therefore reducing the volume of GHGs emitted into the atmosphere) and removal (which remove GHGs directly from the atmosphere).
The avoidance basket includes renewable energy projects but also forestry and farming emissions avoidance projects. The latter, which are also known as REDD+, prevent deforestation or wetland destruction, or use soil management practices in farming that limit GHG emissions – such as projects aiming to avoid emissions from dairy cows and beef cattle through different diets.
Cookstove projects, fuel efficiency or the development of energy-efficient buildings also fall under the avoidance basket and so do projects capturing and destroying industrial pollutants.
The removal category includes projects capturing carbon from the atmosphere and storing it. They can be nature-based, using trees or soil for example to remove and capture carbon. Examples include reforestation and afforestation projects, and wetland management (forestry and farming). They can also be tech-based and include technologies like direct air capture or carbon capture and storage.
Removal credits tend to trade at a premium to avoidance credits, not just because of the higher level of investment required by the underlying project but because of the high demand for this type of credits. They are also believed to be a more powerful tool in the fight against climate change.
Beyond the type of the underlying project, the price of carbon credits is also influenced by the volume of credits traded at a time (the higher the volume the lower the price, usually), the geography of the project, its vintage (typically, the older the vintage the cheaper the price), and the delivery time.
When the underlying carbon project also helps to meet some of the UN's SDGs, the value of a credit from that project to potential buyers may be higher, and the credit can trade at a premium to other types of projects.
For example, community-based projects – which are usually very localized and typically designed and managed by local groups or NGOs – tend to produce smaller volumes of carbon credits. It is also often more expensive to certify them. However, they usually generate more additional co-benefits and meet the UN's SDGs, contributing, for instance, to improved welfare for the local population, better water quality, or the reduction of economic inequality.
For this reason, credits emitted by community-based projects may trade at a premium to projects that don't meet SDGs, such as industrial projects, which are typically larger-scale and can often produce large volumes of credits with more easily verified GHG offset potential.
In current carbon markets, the price of one carbon credit can vary from a few cents per metric ton of CO2 emissions to $15/mtCO2e or even $20/mtCO2e for afforestation or reforestation projects to $100 or even $300/mtCO2e for tech-based removal projects such as CCS.
S&P Global Platts assesses the price of an array of carbon credits and currently produces 20 price assessments including both spot and forward (Year 1) prices. Each price assessment reflects the most competitive credit for each category, based on bids, offers trades reported in the brokered market, or on trading and exchange instruments.
Platts collects bid, offers and trades for carbon credits that have been certified by the following standards: The Gold Standard, Climate Action Reserve (CAR), Verified Carbon Standard (VCS), Architecture for REDD+ Transactions, and American Carbon Registry. Price indications are collected directly from market participants during every trading day.
Platts produces four standalone prices: the CEC (reflecting CORSIA-eligible prices), the CNC (reflecting nature-based solutions with a vintage of each of the past five years and including both avoidance and removal credits), the Renewable Energy Carbon credits price (vintage of each of the last three years), and Methane Collection price, which reflects credits generated by projects aimed at reducing methane emissions such as Landfill Gas Collection, Waste Gas, and Livestock Waste Management projects (vintage of each of the last three years).
There are then two baskets of prices: the avoidance prices and removal prices. The first basket includes the Platts Household Devices price, Platts Industrial Pollutants price, and Platts Nature-based Avoidance price. The second basket includes Platts Natural Carbon Capture and Platts Tech Carbon Capture.
As well as publishing the price of each assessment contained within the two baskets, Platts also assesses the price of the basket itself, producing a Carbon Avoidance Credits price and a Carbon Removal Credits price. These two basket assessments reflect the most competitive of the prices they contain.
Given the wide array of credits, Platts also reports price indications for each category of projects as they are traded in the broader voluntary market and not just as part of the CORSIA scheme, in an effort to increase transparency.
Although the rise of voluntary carbon markets dates back to the early 2000s, following the ratification of the Kyoto protocol, growth was stunted by the 2008 global economic crisis. The new wave of public and private commitments to curb carbon emissions over recent years is now triggering a resurgence of interest in voluntary carbon credits as one way to manage carbon footprints.
While there are no barriers to entry, the lack of transparency in transactions and insufficient understanding of how carbon finance works have kept many potentially interested players at bay.
However, the growing interest in understanding voluntary carbon markets, as well as the efforts of several players to scale and standardize operations, suggests that carbon finance will soon be able to attract new entrants and increase in size.
Additional reporting by Kanchan Yadav and editing by Paula Vanlaningham. A version of this article appeared in the October 2021 edition of Insight magazine.
UPDATE 1 – Adds detail on S&P Global Platts carbon credit assessments (June 23)
UPDATE 2 – Additional details throughout (Nov. 25)