Market efficiency: A compounding effect
“The challenges in the [voluntary] carbon markets today are about market structure – not our own operating models”
(Head of Sustainability, Leading Corporate)
Whilst market confidence in pricing is the leading issue for voluntary carbon credit participants today, we can not overlook the fact that one in four respondents sees the market as highly inefficient.
Across the voluntary carbon credit trade cycle, 94% of processes are managed manually today (i.e. using phone calls and emails) – creating costs, risks and limitations on scale for participants at every step of the chain. Driven by these factors, tolerance thresholds for participating in the voluntary carbon markets are unnecessarily high - giving each firm reason to question whether or not to participate in the markets in their current form.
At a project owner and listing level, time is a core issue
57% of project owners see their businesses severely limited by the fact that new credit listings can take months to be onboarded at existing registries. In the absence of standardised (or regulated) onboarding requirements, registries’ long and bespoke onboarding processes not only generate costs in their own right but they also impede project owners’ access to capital, just when it is most needed. If financing through carbon credits is available only to projects that can withstand a several-month wait for funding, then a large number of projects will inevitably be disenfranchised and – with them – large amounts of carbon left in the atmosphere.
Faster listings by registries not only accelerate access to capital but also grow the market by expanding the number of projects available to market participants.
Commercial banks cite a range of due diligence problems
Legal certainty around credits is a central issue. Beyond the legal standing of the credit itself, the core challenge for commercial banks is how to manage the underlying risks that a credit entails, such as who carries the performance risk of projects, how reliable that party is and whether the project documentation is strong enough for banks to offer financing against. Often cited in this context as well is the significant challenge that firms face in evaluating counterparty risk – especially for those banks that do not have an established history in the agriculture and forestry sectors, for example. Given the huge regional variance of these factors around the world, the location-specific nature of projects and their constructs is an issue for 100% of commercial banks today – meaning that new entrant banks either stay out of the market or they severely limit their funding capacity whilst they build out the necessary competencies and expertise to safely manage these issues. And in an era of increasing risk management, it can take banks several years to build out entirely new credit risk frameworks.
Then comes the cost of manual reporting and oversight – an issue for two-thirds of commercial banks. Lack of automation in reporting means qualitative risk management, high project costs and lack of scalability for banks.
“As we’ve seen with many recent deals, the huge range of variables in carbon projects means a large volume of heavily bespoke contracts, with very little consistency at all”
(Head of Carbon, Leading Commercial Bank)
Intermediaries see only costs
All parties to a credit trade are sensitive to its costs – but no one more so than the broker who intermediates the trades. In this context, it is highly concerning that 100% of market participants see high settlement transaction costs (with registries) as an issue that is severely limiting their carbon credit trading volumes.
Across the capital markets, settlements are a scale activity. Over several decades, the world’s financial markets have driven settlement costs through standardised contracts, processes, connectivity and messaging formats – to the point where settlement instructions against almost any major securities depository in the world can use the same (Swift) network and format. As a result of this standardisation, organisations and depositories are able to settle millions of trades per day in major markets at a minimal unit cost and with automation levels of over 98%.
Few of these foundations to scale are present in today’s voluntary carbon markets. With disparate contracts being traded across disparate registries, using no clear standard of instruction format or processing rules, the levels of automation are minimal and hence the costs of settling voluntary carbon credits is unnecessarily high.
The cost of such massive variance across the voluntary carbon markets are felt by every market participant. But for brokers and intermediaries, these costs can be an existential issue – rather than a mere cost of doing business. If the costs of intermediating a trade are disproportionately high, they risk eating up all of the commission or margin that a broker may be making on a trade – putting the broker at a loss. And if brokers are losing money then their willingness and ability to provide valuable liquidity to the market will disappear.
Low market sophistication is causing a blockage for institutional investors
The world’s leading institutional investors (including the world’s largest sovereign wealth and pension funds) have evolved over recent decades to maintain investment risk oversight frameworks that are second-to-none. From account structures to counterparty risk monitoring, these investors’ demands of the markets and service providers in which they operate are stringent and exacting.
In this context, it is no surprise that 32% of these same investors are challenged when they come to invest in the voluntary carbon markets – most of all by the lack of regulatory frameworks and by a lack of clarity on how their investments should be classified.
In the absence of clearly established regulatory frameworks, the responsibility for risk management passes entirely to the investor and – in the case of large institutional investors – firms are only slowly beginning to know what considerations to focus on as they look to manage carbon credit risk. In contrast to established securities markets, the expertise to manage carbon investments is nascent at best, making firms reluctant to take on 100% of risks themselves.
If we want the world’s largest investors to enter the market then we need to both help them to grow their expertise and to make sure that the frameworks exist for their investments to be safely managed, within regulated and transparent frameworks.
“We’re not a grown up market yet. So far most volumes have come from impact investors or corporates - and the world’s major institutional investors are only now beginning to learn what questions to be asking”
(Global Head of Distribution, Carbon credit investment fund manager)
Corporates are diverse – but need to be ready to disclose
A common theme across all corporates is the need to provide the right levels of (sophisticated) disclosures to their shareholders – yet the corporate world is increasingly divided.
Amongst the 167 firms that make up 80% of emissions, carbon neutrality management is becoming a core competency that stretches well beyond the simple management of carbon credits. Having built out portfolio-based strategies across multiple projects (Microsoft has invested in 1.5m tons of CO2e across 17 projects), blue chips’ interactions with project owners now closely resemble those of commercial and funding banks – where information flows are constant and heavily tailored, all with the aim of being ready to provide deep and accurate disclosures to their sovereign-wealth and pension fund shareholders. In this context, the “Venture capital” problem highlighted above is manifest: if each corporate has to work extensively to ensure that it can receive the right levels of information, in the right format, from every project, then its appetite to entertain new project owners is inevitably low.
Smaller corporates are finding themselves under more acute pressures – stranded as they are between unstandardised processes at a project and registry level; and growing disclosure requirements from index providers and regulators. Too small to compel each project to adopt their own reporting standards, these companies nevertheless face constant pressure to support growing disclosures to index providers (such as S&P and MSCI) in order to remain desirable to investors. Add to that the ongoing variance on net-zero definitions and questions around measurability and the operating agenda for smaller corporates is highly complex. With these pressures most acutely felt from European shareholders today, smaller companies seeking global investors are having to invest to build the human expertise to bridge the gap between the needs of their shareholders and the providers of their carbon offsetting tools.
