Background
As we strive to meet the Paris Agreement targets, the financing needs for the climate transition are daunting. Channeling more capital towards climate-related projects can be facilitated by further developing a market-based mechanism that already exists. Although voluntary carbon markets (VCMs) have been around for thirty years, current developments have the potential to unlock substantially more capital for projects that avoid or remove greenhouse gasses (GHGs). While these markets are currently small with a size of less than $2 billion, Bloomberg NEF estimates that this market could reach $1 trillion given the right conditions by 2037. Such an increase would benefit various types of climate projects that lack funding today especially those located in the Global South. Current and past policymakers such as Janet Yellen, Mark Carney, and John Kerry support growing this market with some guardrails. Recently, the U.S. Commodities Futures and Trading Commission has issued guidelines for some carbon offset financial products.
On the demand side, large number of corporates are making net-zero commitments resulting in greater demand for carbon offsets. Many corporates are making these commitments because of intense pressure from customers, investors, or their financial institutions. Policymakers caution that corporates should not use VCMs as a substitute for reducing their carbon footprint. According to the United Nations, more than 9,000 corporates and over 600 financial institutions have made net-zero commitments globally. The corporate demand in 2050 is expected to reach 5.4 billion tons CO2e (carbon dioxide equivalents) (Bloomberg NEF) which would be a dramatic increase from 164 million tons CO2e retired by corporates in 2023. Increasing corporate attention on offsetting scope 3 emissions, which are indirect emissions in a corporate’s upstream and downstream value chain, is a game changer in terms of unlocking greater amounts of capital for climate projects. Today, many corporates are facing scrutiny on the types of offsets purchased and their performance. When certain types of offsets do not perform as expected, corporates are often accused of greenwashing. Such uncertainty and accusations have negatively impacted corporate demand.
On the supply side, integrity issues continue to plague this market. For this market to thrive, offset quality and integrity must improve. Two key factors determine offset quality—additionality, measures the additional avoidance or removal of CO2e resulting from the project’s existence, and permanence, which measures the lasting nature of the avoidance or removal. Today, new types of offsets are being introduced that are of significantly higher quality in terms of additionality and permanence. For example, carbon dioxide removal (CDR) projects are growing although delivery of such offsets remains very low. A key characteristic of CDR is net removal of CO2, also referred to as carbon negative. Therefore, carbon capture and storage (CCS) where emissions are reduced from an industrialized process are not part of removal offsets. Additionally, according to Nordahl et al., CDR provides the best way to achieve net-negative emissions to address the warming effects of legacy emissions. However, prices of CDR offsets remain substantially higher than other offsets resulting in lower corporate demand. To meet our broader climate goals, investment in CDR technologies must occur today so that we can substantially increase the availability of CDR offsets in the future. Some ideas to increase funding for CDR are discussed below.
As with financial transactions broadly, intermediaries play an important role in matching buyers and sellers. Climate project managers use registries to issue offsets where 1 offset represents 1 ton of CO2e avoided or removed. Registries also retire these offsets when corporates use them to negate their residual emissions. Verification and validation bodies monitor whether climate projects meet certain standards and deliver on their emission avoidance or removal claims. Financial institutions and exchanges enable trading of offsets.
Recommendations
In a recent paper that I coauthored with Nick Cook, Emily DeAlto and Bertrand Rioux as part of an Alliance for Innovative Regulation climate project, we propose 16 policy recommendations to scale VCMs. I discuss and expand on four of those recommendations. First, corporates should calculate the climate impact of their business activities at the time that they make their business decisions. Furthermore, corporates should determine their carbon strategy at the time or even prior to when business decisions are made. For example, one corporate told us that prior to purchasing plane tickets for business travel, both financial and climate budgets must be considered.
Second, offset suppliers should adopt uniform reporting standards that allow offset purchasers and their advisors to compare different types of offsets in terms of function, quality, and performance. Each supplier should quantify the climate impact of its offsets at regular intervals. Furthermore, adoption of smart sensor and satellite imagery technologies would further improve the measurement, reporting, and verification (MRV) process of offsets. Such improvements would increase the confidence and trust of corporates and other types of buyers which is necessary for VCMs to scale.
Third, greater adoption of innovative financial products would generally improve risk mitigation, liquidity, market depth, and price discovery and would allow these markets to scale more rapidly. Greater use of forward contracts and pre-purchase agreements would help increase the availability of high-quality offsets. Corporates may prefer to invest in a portfolio of offsets to reduce the idiosyncratic risk of purchasing offsets from a single supplier. Also, improvements in financial infrastructure and adopting technologies such as blockchain may result in lower fees and more efficient information flows.
Fourth, for capital-intensive new technologies such as direct air carbon capture and storage (DACCS), a technology-based CDR method, to achieve scale, public sector financing may be required. In fact, such funding has started to be disbursed as part of the Inflation Reduction Act of 2022 in the United States. In addition, private-sector funding would also be beneficial. For example, venture capital could also provide funding based on the level of pre-purchase agreements that a CDR operator has entered into.
Innovative market-based solutions should be encouraged to promote effective climate policies. Given the growing demand for offsets, the time is ripe to improve the integrity of VCMs. These markets have the potential to unlock much needed capital for climate projects that will help save our planet.