2021 will probably be remembered as the year carbon finance emerged as an important topic for discussion among various industries.
Among the 2021 new entrants to carbon markets with a voluntary approach the oil and gas majors, hedge funds and banks were deemed to be the most active players, who were determined to enter the market. However, as the year progressed various different sectors of the economy have joined the market in line with their commitments to reduce carbon footprints.
A number of political bodies, including the EU, the UK or even the United States of California already have mandatory carbon markets for specific industries segments and gases. These are a crucial element of the efforts to reach the Paris Agreement goal of limiting global heating at 2° Celsius above preindustrial levels (with an even more ambitious goal of keeping within 1.5 C). 1.5 C increase), even though some of these markets are older than the Paris commitments.
However, other industries have also taken a cue from compliance programs and have agreed to reduce the greenhouse gases they emit (GHG) by taking part in carbon markets voluntarily.
Carbon markets that are voluntary allow producers of carbon to reduce their unavoidable emissions through the purchase of carbon credits produced through projects aimed at eliminating or decreasing GHG from the atmosphere.
Each credit, which equates to a metric tons of reduced, avoided or removed CO2 or a comparable GHG can be utilized by a corporation or an individual to compensate for the emission of a ton of CO2 or other equivalent gases. When a credit is used to offset the emission of gases, it becomes an offset. It is then transferred to a registry of retired credits, or retirements, and it is no longer tradable.
Companies can join the carbon market that is voluntary on their own or as part an overall industry-wide plan including that of the Carbon Offsetting and Reduction Scheme for International Aviation, which was set up by the aviation sector in order to reduce CO2 emissions. International airlines that participate in CORSIA have committed to offset all the CO2 emissions they emit above a baseline 2019 level.
While compliance markets are currently limited to certain regions the voluntary carbon credits are significantly more fluid, without restrictions imposed by the nation states as well as political unions. They also have the potential to be used by any industry instead of a limited number of industries.
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The Taskforce for Scaling Voluntary Carbon Markets that is run by the Institute of International Finance with the support of McKinsey, estimates that the market for carbon credits could reach upwards of $50 billion as early as 2030.
The participants
Five main players constitute the core of carbon markets.
PROJECT DEVELOPERS
Project developers form the upstream portion of the market. They design and build the projects that issue carbon credits. These can be large-scale industrial projects such as a huge-volume hydro power plant to smaller community-based ones such as cooking stoves that are clean.
There are several projects that aim to eliminate or control directly emitted emissions resulting of industrial processes, for example Ozone-capture, fugitive emission management or removal of ozone-depleting chemicals or wastewater treatment. The projects that are based on nature include REDD+ (avoided deforestation), soil sequestration or afforestation. Other forms include carbon capture by technology such as direct air capture. new categories are being introduced every day.
Each credit comes with a particular vintage that is the year when it was issued, and the specific date of delivery and the time at which the credit will be made available for sale. Alongside their primary objective of avoiding or eliminating GHGs from the air, credit projects can also generate additional ‘co-benefits’ and contribute to the achievement of some of the United Nations’ Sustainable Development Goals (SDGs). For instance, they can aid in improving the welfare of the local population, better the quality of drinking water and the improvement of the economic inequalities.
The END BUYERS
The downstream market is comprised of end buyers: companies or even consumers – that have committed to offset some or all the GHG emissions.
Some of the first purchasers of carbon credits was tech companies such as Apple and Google airlines, as well as oil and gas companies, however, other industries like finance are joining the market in the process of setting their own net-zero targets or look for a way to protect themselves from the financial risks that come with the energy transition.
The introduction of Article 6 of the Paris Agreement on 13 November the UN Climate Conference, or COP26, in Glasgow established the guidelines for a crediting mechanism that could be utilized by all 193 parties to Paris deal to reach their emission reduction goals or nationally determined contributions. The implementation of Article 6 has made it possible for nations to purchase voluntary carbon credits, so provided that Article 6 rules are respected.
RETAIL TRADERS
To connect demand and supply, there are brokers and retail traders, as in other commodities markets. Retail traders purchase huge quantities of credits directly from suppliers and then bundle them into portfolios ranging from many hundreds of tonnes equivalent of CO2, and sell those bundles to end-users typically with a small commission.
Although the majority of transactions are happening now in private conversations or over the counter transactions, a few exchanges are beginning to emerge. Some of the most significant carbon credits exchanges right now are new York-based Xpansiv CBL and Singapore based AirCarbon Exchange (ACX).
Exchanges have been trying to make it easier and faster carbon credits trading with an extremely complex structure due to the high number of variables that affect their value by developing standard products, which ensure that the basic requirements are met.
For instance, both The Xpansiv CBL in addition to ACX have developed standard products for nature-based credit CBL’s Nature-based global Emission Offset (N-GEO), and the ACX Global Nature Token.
Credit transactions that are conducted under these labels are certain to be regulated by specific characteristics like the nature of the underlying project, relatively recent date, and a certification from a specialized group of standards.
Exchanges’ standardized products – especially those designed for forward delivery – are currently preferred by traders and financial players who want to buy and hold in anticipation of increasing demand for carbon credits.
End buyers that need to buy credits in order to reduce their emissions tend to prefer non-standardized products because they allow them to look into the specific characteristic of each underlying project, verify the validity of the credit they purchase and therefore be protected from possible accusations of greenwashing.
The exchanges are often used to settle huge bilateral contracts that have been done offscreen. In a market note shared during May CBL declared that an even greater amount of bilateral agreements negotiated offscreen were brought in by traders for settlement through the CBL platform.
These deals made up substantial portions of the volumes transacted on CBL.
BROKERS
Brokers purchase carbon credits at the expense of a trader and sell them on to an end buyer typically with a commission.
STANDARDS
There is a fifth party that is unique to carbon markets. Standards are organizations, usually non-governmental organizations, that certify that a certain project has met its stated objectives and its declared emissions levels.
Standards contain a range of methods, or guidelines that are applicable to every kind of carbon-related project. For example the reforestation plan will be guided by specific guidelines when calculating the amount of CO2 absorption of the forest planned and thus the amount of carbon credits that it earns over time.
Renewable energy projects has a set of rules that must follow when calculating the benefit in terms of avoiding carbon emissions and carbon credits generated over time.
Certifications of standards also guarantee that certain basic principles or rules of carbon finance are adhered to:
Additionality: The project must not be legally required or common practice. It should not be financially attractive in the absence of credit revenues.
The CO2 emissions reductions must be equal to the number of offset credits that are issued for the project. It should also account of any unintended GHG emissions caused by the project.
Permanence: The effects of the GHG reductions should not be in danger of reversal and should result in a permanent reduction in emissions.
Unique claim: Every metric tons of CO2 can only be claimed one time and must be accompanied by proof of the credit retirement at the time of project completion. Credits are offsets at the time of retirement.
Offer additional environmental and social benefits: Projects should comply with all legal requirements of its jurisdiction. They should also provide additional co-benefits in line in line with UN’s SDGs.
The overlap of roles, bilateral trade
There is a commonality of roles that are specific to carbon markets.
Many brokers operate as traders and some financiers have brokering arms as well as project development arms.
End buyers may also invest in their own carbon project and decide to keep all or some of the credits they receive for their own offset needs.
All these groups may ultimately sell their credits to a buyer, or a developer may decide to sell them directly. All of these events can affect the price, and ultimately impact transparency in the market.
Pricing a diverse supply
If a business decides to use voluntary carbon markets as a option to offset carbon emissions one of the primary items it searches at is the cost of carbon credits. With this information an organization can make a decision on what level of ambition to set in setting its emission reduction targets and whether voluntary markets can assist in achieving it.
However it is important to have a clear price signal for carbon enables those already involved in the market to be sure that they’re trading their credit at a cost that is in line with the actual market value.
However, determining the price of carbon credits isn’t an easy process, in large part because of the wide variety of credits on the market and the multitude of variables which influence the price.
Carbon credits issued by projects could be of different types and sub-types. How the project is among major factors that determine the cost for the credits.
Carbon credits can be classified into two large categories, or baskets: avoidance projects (which stop emitting GHGs completely therefore reducing the quantity of GHGs released into the atmosphere) and removal (which take away GHGs completely from the air).
The avoidance basket is comprised of renewable energy projects, but also forest and farming emissions prevention projects. These, commonly referred to REDD+, stop destruction of wetland and deforestation or employ soil management techniques in agriculture that reduce GHG emissions, such as initiatives aiming to limit the emission of dairy cattle as well as beef cattle by varying their diets.
Cookstove projects that focus on fuel efficiency or development of energy-efficient buildings also belong to the avoidance basket as do projects for capturing and destroying industrial pollutants.
The removal section includes projects to capture carbon from the air and storing it. They can be nature-based that use trees or soil as an example, to eliminate carbon and store it. Examples include afforestation and reforestation projects, as well as management of wetlands (forestry and agriculture). They can also be tech-based and may include technologies such as direct air capture, or carbon capture and storage.
Removal credits are usually traded at a higher price than avoidance credits, not only because of the larger amount of investment required by the base project but because of the demand for these kinds of credit. They are also considered to be a stronger tool in the fight against climate change.
Beyond the kind of project itself, the price of carbon credits is also affected by the amount of credits traded at a time (the higher the volume the cheaper the price typically), the geography of the project, its date of birth (typically, the older the model, the less expensive) and timing of delivery.
If the carbon project also helps to attain some of the United Nations’ SDGs The value of the credit from the project to prospective buyers may be higher and the credit could be traded at a higher price than other types of projects.
For instance, community-based projects tend to be localized and are typically managed and designed by local NGOs or local groups tend to create smaller volumes of carbon credits. Additionally, it is often more expensive to certify them. However, they usually generate more co-benefits, and they meet the UN’s SDGs which contribute to, for example, an improvement in the quality of life for the local population, better water quality or reduction of economic inequality.
In this way, credits generated by community-based organizations may trade at a premium to projects that don’t meet SDGs like industrial ventures, because they are typically more extensive and may produce massive amounts of credits that have greater, more easily verified GHG offset possibilities.
In the present carbon market, the price of one carbon credit can vary by a fraction of a cent for each million metric tons of CO2 emissions to $15/mtCO2e or even $20/mtCO2e in afforestation or reforestation initiatives up to $300 or $100 for mtCO2e for tech-based removal projects like CCS.
S&P Global Platts assesses the cost of a variety of carbon credits. It currently provides 20 price evaluations, including the spot and forward (Year 1.) prices. Each price assessment represents the most competitive credit available for each type, based on the trades and bids that are reported on the brokered market or on exchanges and trading instruments.
Platts collects bid trades, offers and offers for carbon credits that have been certified by the following standards: The Gold Standard, Climate Action Reserve (CAR), Verified Carbon Standard (VCS), The Architecture of REDD+ Transactions, and American Carbon Registry. Prices are gathered direct from participants in the market on every trading day.
Platts creates four separate prices which include The CEC (reflecting price that is eligible for CORSIA), the CNC (reflecting nature-based solutions with the vintage of each of the past five years and comprising both avoidance and removal credits), the Renewable Energy Carbon credits price (vintage of the past three years), and Methane Collection price, which includes credits generated by projects focused on reducing methane emissions, such as Landfill Gas Collection, Waste Gas, and Livestock Waste Management projects (vintage of each of the previous three years).
There are then two price baskets which are the avoidance price and removal prices. The first basket includes the Platts Household Devices price, Platts Industrial Pollutants price and Platts Nature-based price for Avoidance. The second basket consists of Platts Organic Carbon Capture and Platts tech Carbon Capture.
Along with publishing the cost of each evaluation contained in the two baskets Platts analyzes the value of the basket itself, producing an Carbon Avoidance Credits cost and Carbon Avoidance Credits price and Carbon Removal Credits price. These assessments of the two baskets reflect the most competitive of the prices they contain.
Due to the variety of credits, Platts provides price indications for each project category when they are traded on the wider market of voluntary markets and not just as part of CORSIA. CORSIA scheme, in an effort to increase transparency.
Although the rise of voluntary carbon markets dates back to the early 2000s following the ratification process of the Kyoto protocol, their growth was stunted by the 2008 economic crisis. The new wave of public and private commitments to reduce carbon emissions in recent times is now triggering a resurgence of demand for carbon credits on a voluntary basis as a way of reducing carbon footprints.
While there aren’t any barriers in the entry process, lack transparency in transaction transactions and lack of understanding of how carbon finance works has kept potential players from taking part.
However, the growing interest in the understanding of voluntary carbon markets as well as the efforts by several actors to scale and standardize processes, suggests that carbon finance is likely to be able to lure new participants and expand in size.