Voluntary carbon markets - generating a new asset class
The search for real impact, written by Sven Meyer
The Hague, The Netherlands - As a tech4good impact fund we are constantly looking for the most innovative digital technologies to drive impact in our focus verticals of environment, inclusion, and health & well-being. Recent heatwaves across the world have drawn public attention back to the climate crisis, but the facts have not changed: To maintain a livable planet, reducing greenhouse gasses such as carbon dioxide in our atmosphere is the key societal challenge of this century.
With the energy transition well underway, but far from completed, we need another way to complement and accelerate this transition. The challenge remains to bridge the gap between now and net-zero.
To address this challenge effectively, we need to accurately bake carbon dioxide (CO2) emissions into the cost of the things we buy, sell, and do.
Costing the carbon, crediting the carbon
Carbon markets offer a way of doing just that.
The first iteration of an emissions pricing and trading scheme was implemented with the U.S. Clean Air Act of 1990 to combat coal power plant emissions. Using a cap-and-trade mechanism, the initiative was successful in reducing sulfur dioxide emissions by 43% from 1990 to 2007 (even though overall electricity generation from coal power plants increased by 26% over that same period). The 1995 Kyoto Protocol, focused on CO2 reductions, then introduced this system on an international level and inspired subsequent cap-and-trade models like the Clean Development Mechanism and the EU Emissions Trading System (ETS).
These systems rely on a regulatory authority to determine an emissions cap, rules for trading emissions allowances, and fines for surpassing the cap. They are often encapsulated by the terms Compliance Carbon Market or Mandatory Carbon Market and are one mechanism of moving toward a net-zero state of the economy.
Until we reach this net-zero state, society can not function without producing residual emissions of around 1,000 GtCO2e until 2100, so we have to rely on offsetting mechanisms to cover these emissions. As compliance carbon markets only cover a part of total emissions (e.g. EU ETS covers 36% of total greenhouse gas emissions in EU), additional climate action can be taken through the voluntary carbon market (VCM).
(See here an in-depth introduction by impact fund AENU on carbon markets)
The VCM allows those who want to offset their emissions to finance climate-positive projects and claim the resulting avoided or removed emissions, thus putting a price on carbon emissions (i.e. the price of purchasing a carbon offset ton-equivalent) and establishing carbon that is reduced or removed from the atmosphere as a valued asset.
However, within VCM lies a critical distinction between these offsets: CO2 that is avoided from being emitted into the atmosphere (avoidance credits) versus CO2 that is actually removed from the atmosphere (removal credits).
The dichotomy between avoided and removed carbon is the symptom of an acute ailment of VCM going forward. As with any nascent asset class (Cryptocurrencies, NFTs) there are a variety of inefficiencies. One such inefficiency is the blending of avoidance and removals credits. These credits represent two very different things – both from a moral and environmental perspective – yet they are used almost interchangeably.
The difference between the two, however, is material. So is the impact potential.
Avoidance credits are linked to emissions that are prevented from happening in the first place. Examples include avoided deforestation, the replacement of charcoal cookstoves, or financing of renewable energy projects.
Reducing the carbon footprint through avoiding emissions is a crucial first step in any organization’s decarbonization journey, as per the Oxford Principles. However, avoiding further emissions – at best – does nothing to improve the state of our planet. At worst, monetizing any such reduction in the form of carbon credits may invite the buyer of that credit to emit an incremental ton of carbon dioxide, that otherwise may not have occurred, resulting in an increase in overall CO2 and therefore taking us backward in the challenge of climate change.
For example: A forest that has been present for centuries, and is now prevented from being cut down, should not entitle anyone to emit an equivalent amount of additional CO2, just because they are financing the preservation of this forest.
Sadly, avoided deforestation credits make up around 17% of the total VCM today. Stopping further emissions from happening is not going to save us. We need to reduce carbon dioxide in the atmosphere to make meaningful progress toward a better future.
Avoidance credits do not have an additional impact on carbon dioxide reductions.
Removal credits represent tons of CO2 that are actually removed from our atmosphere, are by definition additional, and result in a net reduction of CO2 in the atmosphere. Projects range from nature-based solutions like afforestation and soil carbon sequestration, to biochar applications and direct air capture technologies.
All projects have their pros and cons, but they all remove CO2 from our atmosphere. This is good!
Carbon removal credits do have an additional impact on carbon dioxide reductions.
While carbon removals attract increasing attention, credits based on carbon removal still comprise only around 7% of the VCM – 93% of credits are based on avoided emissions. The dominance of avoidance credits can be largely credited to availability: the cost of generating avoidance credits is lower than that of carbon removal credits. Those, in turn, are based on a variety of carbon dioxide removal (CDR) technologies at different stages of maturity.
Venture capital funding to the carbon sector has increased substantially in Q2’22. Direct investment in CDR technologies surged in the last few quarters. Comprehensive financing commitments by Temasek ($5B), Microsoft ($1B), Lowercarbon Capital ($350M), or the Alphabet, Stripe, Shopify, Meta, and McKinsey consortium (Frontier: $925M) have spurred projects that remove carbon dioxide from the atmosphere and generate carbon removal credits.
We expect the volume of CDR projects and CDR-backed carbon credits to continue to grow.
Pricing voluntary carbon credits
Demand for carbon credits, and increasingly for CDR credits, is being driven by front-running corporates, consumer activism, government regulation and a broader global understanding of the climate-related risks we face. Demand for carbon credits could thus increase 50-fold by 2030, while stricter regulation on the claims behind credits as well as more conscientious buyers drive up prices in an already supply-constrained market. The supply crunch may further be exacerbated by low-quality credits (such as avoidance credits) being invalidated by regulation and/or consumer standards, leaving high-quality removal credits in a favorable market position.
We expect CDR-backed carbon credit prices to continue to climb for the foreseeable future.
Where are the opportunities to invest?
We see legitimate and growing demand for carbon credits in the VCM, in particular for higher-quality removal credits, which is driving up prices and making CDR projects increasingly financially viable in this nascent market.
For any market to be successful requires homogeneity, liquidity, and transparency. We see the primary investment opportunity in establishing this market infrastructure and building the features which will enable the market for CDR. This remains a sector for pioneers, but one with substantial upside, especially for the planet.
This new market structure is being built by a variety of startups. Even those that have been around for a few years face potential for disruption by new entrants. VCM can be segmented in numerous of ways; we observe the following categories, with many startups active in more than one category: