Paying for quality: Early solutions that need to scale
Investors are ready to pay a premium for transparency. Faced with significant challenges in pricing and managing the risk of their carbon credits, voluntary carbon market participants are clearly seeking out and rewarding all areas of improved transparency and disclosure.
But buyers and market participants are not waiting for the structural and process challenges above to be resolved. Compelled by the core and immediate demand drivers that we set out in page 3 (above), participants are turning to a range of solutions that are available today and that can help them to mitigate their core transparency challenges.
Whilst valuable in the short term, the increased use of tactical solutions risks further exacerbating existing issues by adding to the market’s variability and complexity. In our short term approach, are we creating growing market complexity that could harm our progress, towards a coherent and scalable operating model?
“There are two paths for different types of carbon credits. Those that can be verified quantitatively will attract more financing at differentiated pricing. Those that can’t will face higher costs and, eventually, avoidance.”
(COO, Leading Carbon trading venue)
Growing use of exchanges for spot markets
A clear and proven source of transparency for all securities is exchange-trading – which is the preferred operating model for 43% of all voluntary carbon market participants today. With the growth of new exchange platforms such as Climate Impact X and Xpansiv – as well as the entry of major players such as CME and CBOE into the carbon credit markets - liquidity is quickly beginning to form to support organisations in their short term needs for carbon credits. Leveraging their strengths of product standardisation and their depth of consistent, automated market data and analytics, the growth of exchange-traded credits is both positive and unavoidable.
Yet the majority of this trading today remains concentrated on nascent, specialist and unregulated exchanges that lack the full weight of legal and regulatory oversight of traditional securities or derivatives exchanges and which many banks and financial investors require. Given their specialist role, they also remain fragile to significant market changes (as we saw with CCX). Fortunately these new exchange venues are receiving extensive support from governments, regulatory authorities and banks, meaning that many of the current limitations are likely to be short-lived.
“Ton years” and Engineered Carbon Removal
Transparency can be about much more than just data visibility. The increasing focus on carbon removal and permanence in 2023 is an excellent example of how people are taking innovative approaches to their carbon credit trading.
With a growing number of buyers and financiers now evaluating projects on the basis of “Carbon years” (i.e. CO2e x number of years), there is a growing distinction between (for example, forestry) projects that may only look set to last three to five years and (for example, engineered removal) projects where carbon may be removed for tens of thousands of years.
The growing role of engineered carbon removal projects is evidence that permanence is commanding a material premium today - trading at up to USD350 per CO2e. Permanence means certainty and hence offers a clear premium through the reduction in due diligence complexity and for lower ongoing monitoring and verification costs. Whilst only 15% of our respondents are trading in engineered carbon removals today, those that do see the market integrity as a core driver.
Yet it is too early to call engineered carbon removal a success. As we have seen during the recent COP28 discussions, the space remains highly divisive – with some hailing it as a huge potential market and others seeing it as an unproven and capital-intensive distraction. Amongst the former are the US Government, who have announced extensive plans not only to buy CDRs (Carbon Dioxide Removals) directly but also to offer significant tax incentives around them and to allocate USD3.5 billion to create 4 direct air capture hubs.
Regardless of the future of engineered removals specifically, the ability of projects to offer transparency through permanence is clearly a growing differentiator in today’s voluntary carbon markets.
“In the midst of their work researching a new global carbon trading system, the United Nations Framework Convention on Climate Change (UNFCCC) group seemed to rule out a role for technologies such as direct air capture (DAC) and bioenergy with carbon capture and storage (BECCS) labelling them as: “Technologically and economically unproven, especially at scale, and pose unknown environmental and social risks.”
(Reuters, October 2023)
“There is an increasing purism emerging – where only engineered carbon removals can work, because no one wants to wear the risk”
(Head of Investor Relations, Mid-cap Canadian corporate)
Traditional carbon credits: Evolving fast
Traditional carbon credits remain the mainstay of the voluntary carbon markets today, with over 55% of our respondents trading in this space due to the relatively higher levels of supply and belief around the market’s long term growth potential.
Fortunately however this market is not standing still. Echoing the growing premiums derived from improved transparency in engineered carbon removals, there is a growing distinction even in the traditional credits space between newer credits and their older counterparts.
As registries have continued to update their methodologies (to mitigate more risks and improve transparency), newer credits have become increasingly desirable, meaning that over 64% of commercial banks, corporates and financial investors now see credits for new projects (i.e. Year 0 credits) as preferable in tenor to those for existing projects. As methodologies have evolved to manage and mitigate more risks, buyers have seen both a net transfer of project risk and greater transparency around the risks that they need to track and monitor.
The fact that CORSIA-eligible credits have seen a 126% price rise in 2022/2023 is clear evidence of the growing value of quality and transparency.
The market is acting to improve risk and transparency – and buyers appear to be rewarding these efforts.
Beyond carbon: Additional certification
A further area where transparency is commanding a premium (albeit at a cost) is in the area of additionalities or social co-benefits. As a key area of distinguishing value in credits, the wider impact of carbon projects is often hard to quantify. Yet projects that have external certification of their co-benefits are today attracting a 78% price premium. There is clear value in evidencing these benefits but to do so means enlisting the support of more parties in the chain. Data evidence is becoming an industry in its own right.
Buyers taking matters into their own hands
In an effort to boost confidence, the industry is seeking out improved transparency wherever possible today. Yet the challenge with many of the above developments is that they are all nascent and future-dated. They are cause for optimism but they are not addressing the central, confidence-linked challenges that buyers face in the voluntary carbon credit markets.
To really solve these problems today, investors are taking matters into their own hands. Rather than rely on manual and unreliable information from many parts of the investment chain, major corporates and financial investors are disintermediating brokers and commercial banks to take up direct relationships with project owners. Buyers are setting their own sourcing rules, finding their own projects and conducting their own (onsite) due diligence – in a major increase in project investment and resourcing.
This benefits buyers in two ways. First it gives them direct access to the information they need straight away – “it is easier to standardise when you are the one asking the questions.” Second it gives investors greater say and influence in the future strategy and evolution of the projects that they invest in. Visibility today, control tomorrow – both of which mean greater confidence.
The problem is that this cannot scale. In another echo of the private equity model mentioned above, more time spent on each project inevitably means that fewer transactions can be managed across the industry. And higher onboarding costs per project can only mean that smaller projects become unviable – simply due to the due diligence costs.
“Developers have told us over the past couple of years of a greater interest in buyers to have direct carbon credit procurement relationships with them.”
(Ecosystem marketplace, November 2023)
