Voluntary carbon markets and carbon offsetting: what investors should know

We outline the importance of carbon offset markets, why they need to be improved, and related investment considerations.

Key points

• Achieving net zero and limiting global warming to 1.5 degrees Celsius are not the same, and reaching the former does not guarantee the latter.
• Realistically, it will take time for the technological breakthroughs required for holistic environmental management and for the financial transformation required to deliver longer-term change, and so offsets can prevent the emissions gap from increasing in the meantime.
• As investors assessing companies’ path to net zero, we engage with them to evaluate their policy around the use of offsets, as well as guide them appropriately if necessary.

What are carbon offsets and why do they matter?

A carbon offset broadly refers to avoidance of greenhouse gas emissions (e.g. via a renewable energy project), or a removal of emissions (e.g. by planting trees). It is used to compensate for emissions that occur elsewhere.

As environmental, social and governance (ESG) considerations continue to move up the investment agenda, companies are expanding their sustainability commitments, with the most common environmental targets focused on reducing emissions. Businesses are pivoting towards sustainable products and services, clean energy procurement and circular economy practices, for instance, but for those with net-zero targets, these actions might not abate all emissions, which provides a role for carbon offsets. In addition, for sectors such as oil and gas, heavy manufacturing, aviation and shipping, and transport, the emergence and implementation of cleaner technologies will take more time. The voluntary carbon market serves as a tool for companies in these sectors to invest in projects that avoid or remove emissions, thereby indirectly offsetting emissions from their own operations while they continue to invest in green technologies. The latest report by the Intergovernmental Panel on Climate Change (IPCC) on climate mitigation indicates that the deployment of carbon dioxide removals to counterbalance hard-to-abate residual emissions is unavoidable if net-zero emissions are to be achieved.¹

There are also separate country-level climate commitments, and most nations have endorsed the Paris Climate Agreement. In order to meet their Nationally Determined Contributions² (NDCs) under the Paris Agreement, many countries are developing their own carbon markets (essentially putting a price on local carbon emissions), but the majority have also included the use of international cooperation through carbon markets to reach their emission-reduction targets. The key benefit of this international cooperation is earlier emission abatement at a lower cost. In this regard, the climate talks at the 2021 United Nations Climate Change Conference (COP26) in Glasgow reached a major agreement on a framework that allows countries to cooperate on achieving their NDCs (surplus carbon-credit countries to be able to sell to those that would need them to achieve their NDCs) and for a global carbon market to be established. While it is too early to predict what shape and form the global carbon market might take, this is a positive development as it could improve the supply-demand dynamics in global offset markets, as well as lead to improvements in the overall quality and credibility of offsets in the voluntary carbon markets.

Carbon offset markets saw rapid growth until 2021. However, in 2022, that growth began to slow. The quality of offsets generated by forestry projects came under scrutiny over their additionality claims, in terms of the extent to which an offset project is capturing carbon above and beyond what would be happening naturally. Companies are wary of the criticism and reputational risk that comes with purchasing such offsets, and this is reflected in the weaker demand numbers for 2022.

Problems with the carbon offset market

Voluntary carbon markets (VCMs), however, are currently marred by a number of issues, including the absence of overarching regulatory oversight, lack of clear definitions around quality and the resulting poor quality of offsets, low offset prices (not offering meaningful incentives to attract more capital in carbon offset projects), lack of transparency, and high transaction costs. VCMs have lately also come under severe media scrutiny, especially over the permanence and over-crediting of nature-based avoidance projects. For example, there are allegations that there are credits for the protection of trees that are not in danger of being harvested, leading to misleading claims of emissions reductions. Weak regulation has created the incentive to develop offset projects that do little to mitigate climate change, potentially resulting in many existing offsets being ineffective or fraudulent.

In addition, on the demand side, a large proportion of offset purchases is currently done by consumer-facing companies to differentiate their products and offer customers the option to reduce their carbon footprint for an additional cost (such as airlines giving their customers the opportunity to offset the carbon emissions caused by their flight). Conscious of not charging their consumers too much, these companies at times resort to buying low-quality offsets that may not result in any emissions reduction. These problems, along with many others, raise questions about the legitimacy of the voluntary carbon markets, and pose a major hurdle for their growth.

Efforts to improve the carbon offset market

Improving the carbon offset market will require collaboration and partnership between a range of stakeholders, including governments, businesses, non-governmental organisations and customers. Some initiatives are working to foster collaboration in the carbon offset market. For example, the Taskforce on Scaling Voluntary Carbon Markets (TSVCM) created by the International Institute of Finance (IIF), is bringing together stakeholders from across the carbon offset market to develop a roadmap for scaling up the market and ensuring that it delivers real emissions reductions.

The Integrity Council for the Voluntary Carbon Market (ICVCM) launched by the TSVCM has recently launched its Core Carbon Principles (CCPs), intended to serve as a global benchmark for ‘high-integrity’ carbon credits. The fact that the Science Based Targets initiative (SBTi) and the Task Force on Climate-related Financial Disclosures (TCFD) framework have been widely accepted and adopted shows that market-led voluntary initiatives have the potential to become mandatory regulations. The ICVCM’s next iteration of the Assessment Framework (expected in the second quarter of 2023), which will include details on specific categories of mitigation activity, could become a crucial development providing the direction that the offsets market needs.

Third-party rating agencies such as BeZero and Sylvera rate projects based on their quality, giving buyers and brokers decision-useful data when trading offsets. The rating agencies use advanced technologies to assess the quality of offsets and offer an additional level of scrutiny (over carbon offset registries) for buyers and could come to play a bigger role in the offset market.

Technology is playing a crucial role and is being increasingly used to assess the efficiency, transparency and credibility of offsets. There is growing use of drones, lidar (light detection and ranging) and satellite imagery to track emission reductions from forestry and agricultural projects, making measurement more robust. Furthermore, artificial intelligence algorithms are being used to analyse data from sensors, satellite imagery and other sources to identify and quantify carbon emissions more correctly.

In addition, carbon crediting providers are cracking down on energy offset issuance, with some focusing on the least-developed countries (LDCs). Organisations are also making efforts to make trading easier and more accessible for investors, with some exchanges starting to offer physically settled, exchange-traded voluntary carbon offsets.

Investment implications

Achieving net zero and limiting global warming to 1.5 degrees Celsius are not the same, and reaching the former does not guarantee the latter. In fact, whether we can prevent irreversible climate change is likely to be more dependent on the path we take to reach net zero than on reaching it at the targeted dates. It is therefore essential to ensure that offsets generated equate to genuine environmental benefit. It is critical to note that offsetting emissions through carbon credits is not a substitute for, but a supplement to, the rigorous decarbonisation actions that are needed. Realistically, it will take time for the technological breakthroughs required for holistic environmental management to be achieved and for the financial transformation required to deliver longer-term change to be realised. Offsets can prevent the emissions gap increasing in the meantime.

There are considerable opportunities stemming from carbon offsetting that we think investors should consider. For example, carbon offsets can provide an avenue to bring capital to high-cost technologies (like direct air capture) that need scaling up. According to the International Energy Agency (IEA), a sevenfold increase in clean-energy investment is required by 2030 in developing countries,³ where significant expansions in the energy sector are needed to support accelerating economic growth. For instance, just 20% of Africa’s population has access to clean cooking, meaning cookstove offsets could prove essential in that transition. Reducing offsetting activities in developing regions will have major implications for decarbonisation efforts.

We believe that as regulations develop, and as the definition of ‘quality’ around offsets becomes clear, companies may have no option but to buy high-quality offsets owing to increasing scrutiny. This may lead to higher prices for these offsets, and if companies are not prepared for such changes, this might lead to them missing their emission-reduction targets.

As investors assessing companies’ path to net zero, we engage with them to evaluate their policy around the use of offsets, as well as guide them appropriately if necessary.

Notes:

¹ Source: Intergovernmental Panel on Climate Change (IPCC), April 2022

² NDCs submitted by countries under the Paris Agreement represent pledges on climate action that seek to limit global warming to well below 2 degrees Celsius, preferably to 1.5 degrees Celsius, over pre-industrial levels.

³ Source: IEA.org, It’s time to make clean energy investment in emerging and developing economies a top global priority, 9 June 2021.

Authors

Amit Khandelwal

Responsible investment analyst