Carbon Credits, Explained 🪙
Are carbon markets the next big thing?
Our story begins in United States, more specifically at the White House on November 15, 1990 when then president George H. W. Bush signed the Clean Air Act.
At the turn of the century, United States was facing a big environment problem - that of acid rains. Acid rain occurs when sulfur dioxide content in atmosphere exceeds a certain permissible limit. The rapid industrialization of US during the 1900s meant that the country was burning more fossil fuel than it did ever before. Without a strict emission control policy, this increased burning of fossil fuel led to very high content of sulphur and nitrogen in the atmosphere which in turn, led to frequent acid rains.
The Clean Air Act of 1990 aimed to systematically reduce the amount of sulphur and nitrogen in US atmosphere. The act in itself though wasn’t anything extraordinary, but the mechanism of ‘cap and trade’, through which the act proposed to regulate and reduce the sulphur levels, was a new invention.
This is how ‘cap and trade’ worked ⤵️
US EPA (Environment Protection Agency) would set a limit on permissible yearly sulphur emissions for each industry. All the participants within the industry were allowed a maximum emission limit based on the size of their business.
This is the cap part of the ‘cap and trade’.
If a company within the industry required a larger emission allowance than allotted, they had to buy it from the quota of another company who may not be using it.
This is the trade part of the ‘cap and trade’.
US EPA would yearly reduce the allowed permissible sulphur emission limit, thus requiring all companies within the industry to work on long term plans to reduce their respective yearly emissions.
Companies which were successful in reducing emissions beyond their yearly quota, could sell their unused emission credits to other companies within the industry and generate income.
The price of the emission credit itself was decided based on the demand and supply of credits within the market. The higher the price, more the incentive for industry participants to reduce emissions.
This cap and trade policy worked wonders for the US. Since its implementation in 1990, sulphur di oxide levels in US atmosphere are down by ~95% (see chart above) and acid rains are a thing of the past.
In 1997, United Nations Framework Convention for Climate Change (UNFCCC) met in Kyoto, Japan to discuss binding emission reduction targets for 37 industrialized countries and the European Union.
To enforce these emission targets, the Kyoto Protocol policy was adopted. This led to the establishment of the first international carbon market system and ‘cap and trade’ was at the heart of it.
Kyoto Protocol also made it mandatory for signatories to set up their own regulated domestic carbon markets.
Shortly after the Kyoto Protocol, China opened its first environmental market exchange, followed by US and most other developed countries.
The modern day carbon markets in the last two decades have exploded in value, with majority of the growth coming in 2021.
Global carbon markets today are valued at ~750 Billion USD and have grown every year for the last five years. 2021 was a banner year with trading value increasing 2.5x compared to previous year.
The main reason behind this growth were the pledges made by several governments, in the run up to COP26, to cap respective carbon emissions by 2050. The largest growth was seen in the European Union market, which also happens to be the biggest carbon market in the world as well as the most regulated.
This article aims to serve as a primer for carbon markets. We will explore everything from the basics of how carbon markets work, to the scope and future of such markets in India as well as globally.
The structure of the article is as follows:
Part One: Types of Carbon Markets
Part Two: The Carbon Credit Lifecycle
Part Three: Current Demand & Supply Dynamics
Part Four: Problems with Carbon Markets
Part Five: How to Invest in Carbon Credits
Part Six: Carbon Markets in India
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Part One: Types of Carbon Markets
There are two types of carbon markets
Compliance Carbon Market
Voluntary Carbon Market
Compliance carbon markets are the ones set up by a government regulatory authority. This is the same type of market that was set up for reducing the sulphur emissions by United States in 1990 via the Clean Air Act. The buyers and sellers tend to be businesses operating within the industry and are bound to reduce emissions by law.
Voluntary carbon markets on the other hand are set up by independent certification bodies and have no direct regulation from the government. The buyers in these markets tend to be large organizations that want to voluntarily offset their carbon emissions. Example of this would be Google buying carbon credits to offset its yearly carbon emissions.
Over 99% of all carbon market transactions in 2021 (about ~750 Billion USD in value) took place in compliance carbon markets. Compare that to voluntary carbon market, which managed less than 1% of all transactions in 2021, with a combined value of less than ~1 Billion USD.
There are also two types of trading systems,
Cap and Trade
Baseline and Credit
We have already explored cap and trade at the beginning of this article. Lets now understand what is a Baseline and Credit system.
What is a Baseline and Credit System?
Baseline and credit system assumes the current emission growth rate of a company in line with its yearly growth and extrapolates it into the future. This serves as a baseline for the company’s carbon emissions.
If in a particular year the company emits more than its baseline, it has to buy carbon offsets to reduce its emissions. Similarly, if the company emits less than its baseline, it can sell the ‘extra unused emissions’ as carbon credits.
The important part to note here is that both cap and trade as well as baseline and credit systems work for only compliance credit markets. Each country’s regulatory authority that sets up and governs these markets decide whether the trading system will be based on a cap and trade system or a baseline and credit system.
For example, European Unions Emission Trading System (EU ETS), the largest carbon market in the world, is a cap and trade system. Whereas, China’s latest carbon market, the National Carbon Trading Market, is a baseline and credit system.
Since voluntary carbon markets are not regulated by a Government authority, their trading involve an entire lifecycle and several participants, which we will explore in the next part.
Part Two: The Carbon Credit Lifecycle
Voluntary carbon markets are not regulated and as such require several third party agencies to verify the origination of the carbon offsets.
A typical voluntary carbon market will include the following participants:
Project Developer
Carbon Offset Standard Agencies
Third Party Auditors and Consultants
Project Investors
Carbon Brokers
Carbon Exchanges
Credit Buyers
Project Developers: can be any organization (public, government or private) that wants to set up a carbon offset project. There are about 170 types of carbon credits ranging from renewable energy projects like biomass cookstoves to reforestation projects to energy efficiency projects. Basically anything that can help reduce carbon from the atmosphere.
A project developer has to build these carbon offset project in accordance to the detailed standards set by the carbon offset standard agencies like Verra. If a project developer fails to adhere to these standards, they will not be able to sell carbon credits generated from the project.
Carbon Offset Standard Agencies: These are usually not for profit organizations that run a registry / database of very high value verified carbon offset projects. The agencies are responsible for setting the standards required for a carbon offset project to meet a certain quality and qualify as authentic.
There are several of these around the world but by far the biggest of them all are Verra and Gold Standard.
A stamp of approval from any of these mean that the carbon offset generated from the project are of the highest standards of quality and have been verified by independent third party auditors.
Each of these standards are several hundred pages long and require compliance with complex criteria to qualify. The details of each standard are out of scope of this article but at a very high level, all of them require compliance with four key pillars - Real, Additional, Verifiable and Permanent (explained below).
Third Party Auditors and Consultants: These are companies that help project developers understand the standards set by agencies like Verra and ensure the entire process from project development to registration of project, third party audits, listing of project and finally sale of carbon credits is done in a smooth fashion.
Companies like EKI Energy Services fall under this category of the value chain.
Carbon Exchanges: These are similar to financial exchanges like Nasdaq, NYSE, NSE and BSE, but are oriented towards carbon markets instead of traditional finance. Unfortunately, not many of these exist yet but we are witnessing some fast developments in this space globally.
One of the oldest carbon exchange is CTX Global and more recently Salesforce announced that it will launch a new carbon exchange called ‘Net Zero Marketplace.’
Closer to home, in India, we have companies like IEX working with the Government and various agencies to launch India’s own carbon market.
In the next part, we will explore the demand and supply dynamics of both compliance as well as voluntary carbon markets.
Part Three: Current Demand and Supply Dynamics
The Demand Side
Almost entirety of demand today for carbon credits is top down regulatory driven with the European Union representing over 90% of the global turnover. Carbon markets in EU are much more advanced, liquid and mature than their global counterparts.
Overall, there are about 17 existing and operational regional carbon markets, concentrated across North America, European Union, China, South Korea and New Zealand. Post COP26 and Paris Accords, several new carbon markets are under development across the world.
India has proposed to launch its own compliance carbon market by as early as 2023.
Apart from government mandated demand, there is demand for carbon credits in compliance markets from industry organizations as well.
The global aviation industry adopted a policy on reducing carbon emissions via a cap and trade program known as CORSIA. CORSIA was meant to help international flights cap and gradually reduce their emissions starting 2016. What was perceived as a big tailwind for carbon credit industry, ended up being a dud as international air travel witnessed massive decline due to global pandemic and has since yet to return to pre-pandemic levels.
As countries and global industry organizations commit further to cap and reduce their carbon emissions, expect higher demand for carbon credits in these markets.
The shipping industry, which accounts for 2.5% of global carbon emissions, is already exploring a compliance program to regulate and reduce its carbon footprint.
Demand in voluntary carbon markets though small today is growing at a rapid pace. Innovations in allowing individuals to offset emissions for their flights, meals etc. coupled with already existing demand from organizations willing to voluntarily reduce their emissions, is enabling the demand for carbon credits in voluntary markets to grow by leaps and bounds.
According to a McKinsey study, voluntary carbon markets can witness a 15x growth in by 2030 and a 100x growth by 2050.
The Supply Side
In compliance markets, supply of carbon credits is via the governing regulatory body. Its under the voluntary markets where supply of carbon credits gets complicated.
As we have discussed earlier in this article, there are about 170 types of carbon credits differentiated based on their origination, quality as well as verifiability. High impact verifiable and permanent projects like direct air carbon capture are priced the highest as demand for these exceeds the supply. Whereas low impact non verifiable and less permanent solutions like reforestation programs tend to get valued at the lowest end of the price spectrum.
The below table provides a detailed overview of metric tonnes of CO2 offset sold at various price points for each type of carbon credit.
Each carbon credit type traded on the market has a project backing it. Most of these projects are based in India, Brazil, Africa, Thailand and China. Majority of these projects, however, suffer from the biggest problem currently ailing the carbon credit market - that of permanence and verifiability.
Lets dwell a bit deeper into these issues.
Part Four: Problems with Carbon Markets
The key problem that ails the carbon market today is of verifiability. How does a carbon credit buyer know for certain that a project actually removed the amount of carbon from atmosphere as it claims to do.
In most cases, carbon projects usually either double count the emission offsets or end up overestimating their impact.
To add problems further, the current market structure is designed to help the cheapest solution for carbon offset. However, these cheap solutions usually are the least verifiable projects and generally do not live up to their claims.
The problem is so extensive, that even large credible institutions like Disney and JP Morgan Chase, have fallen victims to these unverifiable and dubious carbon offset claims.
The below video summarizes these key points well.
In the next segment, we will look at ways through which one can invest in carbon markets today.
Part Five: How to Invest in Carbon Markets?
The easiest way to get exposure to carbon market is to buy an ETF that hold futures contracts for most liquid carbon markets globally. As of writing this article, there are 6 ETFs available that invest directly into carbon credit markets.
Each ETF has its own methodology and as a retail investor this is the least cost path to get exposure to carbon credit market in your portfolio.
Other than ETFs, an investor can get exposure to carbon markets by investing directly into companies that are associated with this value chain.
The Indian bourse listed EKI Energy Services is a third party consultant that helps project developers traverse through the lifecycle of a carbon credit.
If instead of a middleman, an investor wants to get exposure to carbon credit project developers, then Toronto listed Carbon Streaming Corporation is a worthy option.
Carbon Streaming Corp (Tickr: NETZ.NEO) is a financier of several different carbon credit projects. The companies business model (as shown below) is to provide upfront payments in the form of financing to a project developer. Once the project is developed, Carbon Streaming Corp receives a certain portion of carbon credits from the project as payment.
Finally, there are carbon exchanges like the ones from Salesforce and India listed IEX, both of which we discussed in Part Two of this article.
The carbon credit market is small, non standardized and still at very early stages. As such the choices to invest are limited, but I do expect the market to grow very fast in the coming years.
Speaking of fast developments, lets now explore the scope of carbon markets in India.
Part Six: Carbon Markets in India
On August 08, 2022 India passed an amendment to the Energy Conservation Act, which among many other things aims to establish both compliance as well as voluntary carbon markets in India.
As per the draft blueprint by Department of Energy, India plans to consolidate its existing Energy Saving Certs as well as Renewable Certs into a larger carbon credit program while establishing a national carbon market in a phased manner.
If implemented in its existing form, India would be able to standardize the issuance, monitoring as well as trading of its carbon credits. This would be the first step in a long road, to create a highly liquid and mature voluntary carbon market like that of the EU. In such a scenario, companies like IEX which already facilitate trading of ECerts and RCerts, stand to benefit the most.
So that was the detailed primer on carbon credits. I hope through this article, you were able to learn more about this niche area of investing.
Are you excited about carbon markets? Do you have any exposure in your portfolio?
Let me know in the comments 👇
Thank you for reading, see you in the next one.
Peace,
Tar
Thank you so much for this well researched article. Every time I read such interesting stuffs, feels like am little more knowledge person today than I was yesterday. Kudos !!!
The information is rich, thank you I really enjoyed it.