Are carbon credits (offsets) investable?
I see the conversation on carbon trading Twitter has begun to include a lot of references to carbon credits, which I assume means carbon “offsets” as opposed to the carbon “allowances” that are traded in compliance markets like the EU, New Zealand, South Korea, RGGI, California and Quebec.
The offset market is orders of magnitude more complicated, fragmented and opaque than the relatively easy-to-understand compliance markets. So this post is by way of explaining how offsets are different.
To be absolutely clear, carbon offsets are not carbon allowances. Not by a long chalk. Explaining the difference between offsets and allowances has never been easy, but there’s a terrific article by Jan Ahrens which does the best job of explaining it that I’ve yet read.
(To be equally clear, some compliance markets do allow carbon offsets to be used for compliance – take a bow, California – but only under strict conditions and only specific types of offset can be used. But they are pretty much the exception to the rule.)
The key takeaway is that an allowance represents a legally-binding fraction of a legally-binding absolute cap on emissions, while an offset….literally doesn’t. Offsets represent the canceling out of emissions made elsewhere.
Before anyone from the offsets sector comes at me, rest assured that I *do* believe offsets have a significant role to play in getting to net zero, but to my mind offsets are the final piece of the puzzle, not the first, nor the second… the final piece.
(But first we need to reduce as much CO2 as we can reduce, and remove as much CO2 as we can remove. Then can we offset the rest.)
Offsets don’t really reduce emissions. They neutralise existing ones and help prevent future ones. An offset represents a reduction in emissions compared to a baseline in which the generating project doesn’t exist.
Let’s say you’re the Tanzanian power company. You have a growing population, you need more electricity. Your number one option is a coal-fired plant. It’s cheap, the technology is reliable and easy to maintain. But it’s very carbon-intensive.
But along comes a large Norwegian pension fund. They say they’ll invest in new solar parks that will generate the same power but with zero carbon emitted. Tanzania gets more electricity, while the pension fund gets a steady flow of reductions in emissions compared to what would have happened if that coal plant had been built. That flow is represented by offsets, which are created every time the reductions are verified and certified by an independent auditor.
Not a reduction under a legally-binding cap, and not a removal either. But it does prevent future emissions. Offsets are a great enabler of technology transfer, too.
So. What’s the offset business like? As I wrote above it’s complicated, fragmented and opaque. There is no single, global standard for offsets. There’s no single, global market for them either. So there is risk involved.
For a start, you need to have a standard. You need to know how offsets should be generated, how they should be verified and counted, how they should be represented and where they will be stored.
There are some pretty fine and upstanding companies that set rigorous and transparent standards – the Gold Standard and Verra are two well-known names. They maintain and update these standards, and ensure that offsets are issued only to those projects that meet every element of their standards.
Then you need a project developer. These are companies that understand the standards and their specific requirements, as well as the regulations in the host country. They'll corral the engineers who do the building as well.
Then you need an independent verifier. A company that will come in and ensure the project was build to the required standard, that all the conditions (sustainable development etc) are being met, and that the methodology for counting reductions is sound.
And finally you'll need a buyer for those offsets. Until recently buyers would spent a lot of time looking over offsets and making sure that they matched their own goals and needs – for large buyers with varied portfolios that's still the case.
And there are some fine and upstanding companies who buy these offsets to neutralise their carbon footprint. You’ve probably heard of a few of them: Microsoft and Apple, for example. They don't play fast and loose with their reputation, so they do a lot of due diligence before they buy.
Strictly speaking, simply offsetting 100% of your entire Scope 1, 2 and 3 emissions might allow you to claim that you’re a net zero company, but unless you’ve first reduced and removed as much as you can, I don’t really think that claim holds water. Others will disagree.
The single biggest offset market is probably the aviation sector. The global aviation industry, represented by the International Civil Aviation Organisation, has set up a carbon offset market to allow its members the airlines to do their part to help drive down emissions.
This market, called CORSIA for short, doesn’t actually reduce emissions. It sets a baseline of airline emissions at 2019 levels, and then require airlines to offset any growth above that baseline. So it locks in 2019 level emissions, unabated. It’s net zero growth, rather than net zero.
Now, the brains behind CORSIA selected a list of offsets that are eligible to be used in that market. They picked good standards, they rejected some project technologies that aren’t environmentally sound, and they set a cut-off date, by which offsets that were generated before a set date are ineligible.
So in order to trade in CORSIA, you have to know which standard, project type and “vintages” are eligible.
Of course, you can take the easier route by trading one of the new exchange-based instruments (see below) that guarantee you’re buying or selling CORSIA-eligible offsets, and because it’s backed by an exchange you have a degree of security. This part of the offsets market is growing – and fast.
And CORSIA is the only legally structured compliance-level market for offsets (so far). Yes, I’ve also mentioned California above, so very quickly: compliance entities (factories, power stations etc) can use offsets to cover a very limited share of their total emissions, as long as they come from approved project types in approved jurisdictions.
So if you’re not in CORSIA or California, which are nice and regulated and pretty clear, you’re in the jungle. And what does that jungle look like?
There are in excess of 20 different standards – that is, entities who have written rules governing how to reduce emissions from clean-tech projects. How to measure reductions, how to ensure that the projects are properly monitored, how to ensure that local populations are able to participate, how to…. the standards are very long and very technical.
There are literally hundreds of different project types that reduce emissions (and not all of them are approved by every standard). A small run-of-river hydro plant that replaces an oil-fired generator. Restoring a mangrove swamp. Converting municipal buses from gasoline or diesel to run on natural gas. Protecting a forest from being harvested, or burned in a wildfire. Changing to no-till farming.
And the buyers come from every different kind of business. Large multinationals. Taxi companies. Airlines. Office buildings. Department store chains. Logistics companies. You name it.
Because there are so many different kinds of offsets, generated in every corner of the world, buyers can afford to pick offsets that align with their goals and their image. So a company that makes paper products may want to be associated with a forestry project. A company that makes cosmetics may want to find offsets from a project that reduces CO2 but also empowers women.
And that brings me to the other element of offsets. It’s not just about the CO2 any more.
The goal of the Paris Agreement (the treaty that’s driving everything climate-related) calls for action on climate to also drive sustainable development, to make sure that economic growth doesn’t come at the cost of the planet. These Sustainable Development Goals are listed by the United Nations, and offset developers are increasingly tailoring their projects to meet one or more of them, in addition to offsetting CO2 emissions.
So who’s involved in this market? It’s not (yet) what you’d call a transparent marketplace. Part of the problem is the sheer complexity: there are so many standards and project types. A company that’s looking after its ESG or CSR will want to look hard at the offsets before it makes a decision to buy. Equally, a company that doesn’t care so much can look for the cheapest-priced offsets and hope that nobody examines them too closely.
Trying to wrangle all those standards and project types into a small number of investable instruments is a huge task. As I alluded to earlier, some efforts have already started. The Xpansiv CBL market offers spot contracts for CORSIA-eligible offsets, and CME has built a futures contract around them. Now both CBL and CME have developed contracts for nature-based offsets.
The problem for potential investors is that the exchanges are setting themselves up as gatekeepers. In an effort to drive their own growth, they’re picking the standards and projects that they want to enjoy the market’s support, while consigning more specialised or perhaps environmentally impactful projects to the sidelines.
Note that when you're buying an Xpansiv CBL GEO contract or a CME GEO future, you're buying CORSIA eligibility, and not necessarily a specific offset type or vintage: you're specifically not buying any attributes other than eligibility. All that you're guaranteed is that if you are an airline and try to surrender the offsets packaged under this GEO contract, they won't be rejected.
This is, to me, the main problem with developing a liquid market for offsets. Because they can encompass so many attributes at the same time, it isn't easy to standardise them.
And big offset buyers may not like to put all their eggs in one exchange-traded basket. The airlines will, because their market has dictated what they should use, and exchanges offer that very same product.
This reminds me of something that’s I’ve been watching for a few months now. I wrote about the efforts to standardise the offsets market a while back, and how what’s going on today isn’t especially new: the market went through this when the UNFCCC started an offsets market in 2005.
But in that post I also highlighted some efforts to use AI to develop a matrix of prices for offsets according to their various sustainable development attributes, and I think this may well be the way forward. Exchanges won’t like it, since it won’t give them a single point of entry into the market, but offsets aren’t really a market that invites a single point of entry.
But for investors who want to get involved in carbon offsets and who want to be careful about what they’re buying, this may eventually be the answer. But remember: it’s still only an offset.