In a highly constrained market, pricing confidence is the central issue
All market participants are looking to drive market maturity especially corporates
The nascent market structure of the voluntary carbon markets is clearly an obstacle for all profiles of market participants. Our survey indicated that 18% of all respondents are blocked from participating in today’s voluntary carbon markets due to issues in the listing, verification, trading and retirement processes, with a further 11% seeing their volumes capped at less than half of their target volumes, due to the same issues.
And who is struggling the most? Ostensibly almost every market participant is facing artificial or avoidable limitations on their ability to issue, transact or manage voluntary carbon credits – most of all the corporates for whom the market is designed to serve.
Challenges in listing and reporting mean that 49% of project owners are facing serious constraints in their ability to bring their projects to the market – with 39% of the banks that finance them equally handicapped. At the deal level, 40% of brokers are facing limitations in their credit trading – as are 27% of their investor clients.
Nowhere are the market’s current shortcomings more evident though than amongst corporates, 56% of whom would like to double their carbon activity if the market were to become more efficient. The same clients that are meant to fuel the carbon markets over the coming years are the ones who are most challenged by the market’s current form.
By comparison, only 6% of market operators (including exchanges and registries) see the same degrees of constraints that their corporate end-clients do. Those that are responsible for the current state and near-term evolution of the market appear worryingly comfortable with the its current form, in direct contrast to their clients and members.
With almost one in three firms meaningfully challenged in dealing with the current voluntary carbon markets today, there is a clear need for fundamental change, if we are to unlock the growing investment volumes and diversity that are on the horizon.
“It’s not that all carbon credits are inherently low quality. It’s just that it takes us too long to find out”
(Head of Commercial Banking, Asia. Tier 1 International Bank)
Confidence in market pricing: the central issue
Underpinning these issues across the trade cycle is a single core problem – that 30% of the market has little or no confidence in the price of carbon credits today. In comparison with the 25% of respondents who see core issues in overall market efficiency, the inability to trust market pricing (and the consequences of that limitation in risk management and financing) is the central challenge that we face today in scaling the voluntary carbon markets.
This issue is felt across all buyers and financiers of voluntary carbon credits. 66% of commercial banks, 25% of intermediaries and 33% of buyers (including corporates and financial investors) have low or no confidence in the price of the credits that they are transacting.
And if you cant trust the price then a myriad of issues quickly present themselves. Poor pricing means inaccurate risk management, over-conservativism and limitations in liquidity. Banks won’t fund a market where they can not accurately model risk. Brokers won’t trade and investors won’t hold – and volumes remain capped at artificially low levels.
“No project is entirely good or bad – unless you can’t manage the risk”
(CIO, Tier 1 Commercial Bank)
What is undermining our confidence? Lack of standardisation
Digging deeper, concerns around pricing confidence are clearly grounded in the structure of the voluntary carbon markets today. They are simply too manual and too fragmented.
At a project level, 35% of project owners struggle with the unavailability of automated reporting mechanisms for their projects and a further 21% struggle with the lack of standardised reporting mechanisms across different registries. In contrast to more evolved securities markets, project owners are currently compelled to provide a myriad of reports, in a wide range of formats to a large (and growing) number of registries.
Given this highly manual starting point in the chain, it is no surprise then that firms struggle with project verification. 50% of firms struggle to access project data in a cost efficient way; 49% struggle with the inconsistency of data and lack of comparability between projects; and 42% struggle with the consequentially high cost of verification. In the absence of standardised, automated reporting across registries and auditors, it is costing firms too much resources and time to manually source, consolidate and review vast quantities of manual reports (sometimes even hand-written). Add to that the significant risks inherent in this level of manual processing and you have a trade cycle that is bound to cause concern for Compliance and Risk departments across the industry. In the end, the data we are receiving is so disparate, so hard to source and so prone to manual errors that it is extremely hard for market participants to trust it – leaving us either with a confidence problem or with a host of expensive third parties who can deliver the needed transparency.
The absence of standardisation is not just an issue at a data level – it is also causing issues at a product level. Without standardised product definitions, 50% of respondents struggle in price discovery as they are unable to model or benchmark specific credits against any kind of market reference contracts. That this issue stands ahead of market liquidity limitations as a concern in price discovery highlights how this issue can unlock liquidity – not the other way round.
Today’s reporting, verification and price discovery for voluntary carbon credits is manual, variable and highly qualitative – all factors which inspire little confidence in pricing.
“Market fragmentation is leaving us with a growing number of liquidity puddles – none of them deep enough to be a pool and all of them sub-scale in terms of costs and connectivity”
Fragmentation is compounding the problem
If it is already hard and expensive to interact with each individual registry, then the challenges and concerns around pricing only multiply in the face of significant market fragmentation at a registry level.
Given their historic roots, registries today are often highly concentrated in specific project types or geographies (96% of agricultural projects are in Verra / VCS, for example). And with little or no standardisation or interoperability across registries, each of these minor concentrations is today a “puddle of liquidity” – each sub-scale, each entirely isolated from each other and each requiring entirely bespoke, manual resources to manage.
Today, the average voluntary carbon market participant faces between six and eight different registries – with the levels of fragmentation highest for commercial banks and for financial investors (52% and 44% of whom face more than four registries on a daily basis, respectively). These very organisations, whose role it is to provide financing or funding to a wide range of projects, are the most exposed to multiple registries and hence to the exponentially higher costs, risks and processing limitations of facing each registry manually for due diligence, trading and risk management. The more deals they do, the faster these manual costs escalate.
“If you can’t price carbon (credits) then everything else is academic”
(Chief Sustainability Officer, Leading Global Bank)
This combination of disparate, fragmented and manual interactions across the trade cycle is fundamentally undermining the industry’s ability to price and risk manage voluntary carbon credits in a scalable and accessible way.
Without consistent and statistical data, project due diligence becomes almost entirely qualitative – not quantitative – which few financial institutions are happy to accept without the promise of significant returns. Equally, being qualitative, carbon project evaluations rely on specialist expertise to identify and manage risks, which some firms may not have. In both cases, we face significant barriers to entry from key liquidity and financing providers.
There is also a question of scale. If each bank or buyer has to conduct extensive, paper-based due diligence on each project then there is an obvious limitation on the number of projects that they can evaluate in any given period. In contrast to (standardised and regulated) commodities markets, for example, today’s carbon markets mean that even the most aggressive investors can only fund or finance a handful of projects at any one time.
“If one project has 30 due diligence forms (in multiple languages and some even hand-written), there’s no way our volumes could scale to handle anything more than a few contracts at any one moment”
“Due diligence on carbon credits is all qualitative – and banks don’t like that”
(Head of Commercial Banking, Asia. Leading International Bank)
Keeping it local
Scale and barriers to entry aside, one additional consequence of this operating model is that it is keeping voluntary carbon credit liquidity very local. Across the global markets, over 42% of voluntary carbon credits are traded locally today – most often owing to confidence issues in being able manage the different levels of risk inherent in carbon credits from across the other side of the world.
At a contract level, the lack of standardisation and the highly customised nature of voluntary carbon credit trades is a natural obstacle to global reach – as is the wide variety in local legal and accounting frameworks across different markets. It is time consuming and manually intensive for investors to fully understand the true impacts of holding credits in distant jurisdictions.
At a project level, investors face a host of challenges from basic problems in having to read hand-written due diligence documents in multiple foreign languages, to a lack of standardisation in monitoring, reporting and verification standards across different markets. In the absence of easily comprehensible (let alone machine-readable) information on projects, half of investors opt simply to stay close to home.
Finally, at a country level, the fast changing and politicised context of voluntary carbon credits adds further risk – particularly when little has yet been codified or enacted into national laws. One respondent cited challenges where, in the absence of legal code, key decisions on the future of a particular forest (and the associated credits that it generates) can depend on a single politician to attribute responsibility to the forestry or to the environment departments – creating a risk for investors that is hard to quantify or manage.
Put together, these challenges (many of which stem from the same standardisation issue above) make holding voluntary carbon credits in distant regions highly unappealing for just under half of the market today. And without the ability for investor liquidity to scale across regions, we risk further reinforcing the fragmentation barriers that restrict today’s carbon trading to localised puddles of liquidity.
“We look to source credits as locally as possible – mainly because we can track and see their credibility more easily”
(Head of Sales, European Investment Manager)
Today’s voluntary carbon markets: A critical juncture
In light of the above challenges, today’s voluntary carbon markets resemble less the commodities or listed securities markets that we aspire to – and more the private equity or venture capital markets (where diverse, paper-based documentation, backed by paper-based agreements for every project is standard and where liquidity is highly fragmented).
To continue in this direction would be a major mis-step for the voluntary carbon markets – which need to scale rapidly to sustain massive growth in volumes and number of participants in the coming years.
Far from facilitating growth, the continuing need to perform manual due diligence and pricing for each project and credit will remain a significant barrier to entry. If only those with the specialism and appetite to assume the significant risks of voluntary carbon credit trading are able to enter the voluntary carbon markets, then we will continue to see industry liquidity running at a fraction of its true potential.
For those that do enter the market, higher due diligence costs per project will inevitably drive commercial banks, corporates and investors to seek out or entertain only larger deals – disenfranchising smaller project owners and smaller banks. The market will concentrate rather than diversify – reinforcing the consolidation of liquidity that we are already seeing take place today.
