The commodification of carbon offsets

Voluntary carbon offsets, the next great commodity market

This analysis is from BloombergNEF. It appeared first on the Bloomberg Terminal.

On March 7, 2022, CME Group launched its CBL Core Global Emissions Offset (C-GEO) futures, creating a standardized, tradable voluntary carbon product that satisfies integrity criteria so desperately sought by market participants. The product is just one of dozens of efforts to standardize and boost liquidity in the voluntary carbon offset market, creating fertile ground for corporations to neutralize their emissions and traders to capitalize on growth.

The fruits of this labor cannot come soon enough: issuance and retirements of offsets increased by 86% and 54% from 2020 to 2021, respectively, while prices continue to rise. Standardization will be key to ensuring the sustainable growth of offsets and could fuel the creation of the next great commodity market, valued at hundreds of billions of dollars.

Heterogeneity fuels confusion today

Today’s voluntary carbon offset market, in which entities can buy and sell verified emission reductions to neutralize their own hard-to-abate emissions, is fraught with opacity. 

Every offset is valued, priced and exchanged in a unique way, meaning a certain level of due diligence is required when buying. Several interdependent factors drive stagnation:

• Quality: This is impacted by traits like an offset’s geography and vintage (age), but most importantly its sector. Offsets from an energy generation project, created by displacing carbon-intensive power generation with clean alternatives, made up 47% of supply in 2021 and were priced at just $1.1/ton on average. This is due to the already cheap cost for clean energy, meaning it does not need financial support from offsets. Conversely, offsets from nature-based solutions including reforestation and avoided deforestation, which made up 44% of supply in 2021, were priced at around $5 per ton. Emissions offsets, which typically come from any technology-based emissions avoidance or removal such as direct air capture projects, averaged $14 per ton in 2020.

 

Massive potential to be unlocked

Should these new initiatives, exchanges, products and technologies be successfully commercialized, stakeholders could be looking at a market valued at hundreds of billions of dollars, up from current estimates of $1 billion today. In January, BloombergNEF published its inaugural Long-Term Carbon Offsets Outlook, which forecasts supply, demand and prices for carbon offsets out to 2050 under various scenarios.

Under the Removal scenario from the report, in which companies can only use offsets that remove, store or sequester carbon in order to achieve net-zero targets – an outcome pushed by SBTI as part of its net zero standard – the market is valued at $190 billion as soon as 2030 and $546 billion in 2050. Even under more bearish outcomes like the Voluntary Market scenario, in which the types of eligible projects are not regulated and the market is flooded with supply – an undesirable outcome – the market is still valued at $245 billion in 2050.

While these scenarios have different outcomes and vary significantly in market value, they all hinge on carbon offsets becoming more of a homogenized commodity market. Efforts to standardize products, uphold integrity and increase liquidity are all central to this. If these efforts are successful, the voluntary carbon offset market will be more than just a household name – it will be a core component of every private sector player’s agenda in the transition to a low-carbon economy.

 

 

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• Contracting method: Most companies lock into long-term, bilateral contracts with developers for offsets or buy them through a broker. A small but growing group use exchanges. Many companies currently use more expensive and complicated contracting methods out of necessity.

• Measurability: Measuring carbon reductions for sectors is extremely complex and often results in developers under- or over-estimating a project’s potential. This has led to waning confidence in hard-to-measure sectors like forestry.

• Liquidity: Even if a developer can guarantee a project’s quality, the market is not yet sufficiently dynamic to always find customers or catalyze financing. This makes contracting for offsets a lengthy and cumbersome process.

While some companies value this heterogeneity of offsets, it is also what scares companies away and draws criticism from investors and the media.

Efforts to fix these issues

Most stakeholders acknowledge this heterogeneity as the biggest factor holding the offset market back and efforts are underway to address it, including:

• Integrity initiatives: Several initiatives have been created to standardize carbon offset buying, boosting quality and in some cases liquidity. The Integrity Council for Voluntary Carbon Markets (IC-VCM) is a governance body tasked with creating core carbon principles for the offset market.

 

 

These principles will be the baseline requirements – focused around areas like sector, geography and vintage that an offset must meet, in order to be deemed high quality. The separate Voluntary Carbon Markets Integrity Initiative (VCMI) is creating guidance on buying high-quality offsets that don’t interfere with country goals. Finally, the Science-Based Targets Initiative (SBTi) released its net-zero standard in November, which tells companies when they should buy offsets and what type.

• Commodity products: Companies such as CME Group are creating tradable products that combine an offset contract with additional attributes. Its new C-GEO futures product ensures that offsets are aligned with IC-VCM’s core carbon principles, giving buyers certainty on quality.

Separately, its Nature-Based Global Emissions Offset guarantees a forestry offset from a project listed on Verra, the biggest offset registry by volume, which has additional ‘co-benefits’ beyond decarbonization, like upholding biodiversity. Such homogenous products provide a buyer with the certainty required to contract for more offsets at a faster rate.

• Exchanges: Even with standardized products being created, infrastructure is needed to facilitate fast transactions. Exchanges like Xpansiv and CBL Markets (XCHG), as well as Carbon Trade Exchange, allow for high-frequency trading of carbon offsets. Buyers specify their needs such as volume or price and get access to listed offsets that meet criteria. New products like C-GEO are listed on exchanges like XCHG. Offsets of all qualities are permitted on these exchanges today, however.

Efforts to standardize the voluntary carbon offset market and the core challenges they will solve 

 

Source: BloombergNEF. Notes: Chart is not comprehensive. Colors apply to key focus of each initiative or company. 

• Technology: Dozens of companies are developing technology to address the problem of heterogeneity in the offset market. Pachama uses LIDAR, satellites and AI to better measure forest carbon and has created a marketplace that lists projects verified with its technology.

Nori has created its own currency for carbon removal to attract financing to agriculture projects. While it operates outside of the core voluntary market, with its projects not listed on any registry, it is helping to catalyze supply through new financing and offers buyers more insight into the offsets they purchase. 

• Standardized contracts: Even outside of exchanges, the purchasing of offsets is becoming more sophisticated. Groups like the LEAF Coalition – led by a consortium of companies including Amazon and BlackRock, are working to create blueprints for an emission reduction purchase agreement (ERPA) that can be easily applied to portfolios of projects for multiple companies at once. Under an ERPA, the buyer locks into a long-term, fixed price contract for offsets, allowing a developer to secure financing. While this does not necessarily help with liquidity, it provides buyers which value heterogeneity with a standardized way of buying high-quality, additional offsets.

• Article 6: The closing hours of COP26 saw parties reach an agreement on Article 6, which is the framework for international carbon market mechanisms. If Article 6.4 – the global market trading mechanism – became robust, transparent and efficient, the platform could also help to scale up and standardize offset markets. 

All of these efforts are underway concurrently, which should give stakeholders in the market a renewed sense of optimism.

Pioneers are transforming carbon offsets into a commodity

This analysis is from BloombergNEF. It appeared first on the Bloomberg Terminal.

Even as supply and demand grow for voluntary carbon offsets – verified emission reduction credits – today’s market is rife with heterogeneity.

Each credit is uniquely priced, determined by factors like age, sector and geography. The average price of an offset from a technology-based emissions project averaged $14/ton in 2020, compared to just $0.87/ton for an energy project. Such opacity scares many companies out of buying offsets.

But that may soon change; efforts are scaling to standardize offsets and create a more tradeable commodity. Initiatives like the Integrity Council on Voluntary Carbon Markets are working to enforce quality standards. Companies like CME Group are creating tradable offset products off these standards, working with exchanges like CBL Markets to facilitate more liquidity.

Technology start-ups like Pachama and Nori are supporting these efforts with artificial intelligence, satellites and blockchain to better quantify offsets. All of this will create a more homogenous product to build a market around.

Efforts to standardize the voluntary carbon offset market and the core challenges they will solve 

 

Source: BloombergNEF. Notes: Chart is not comprehensive. Colors apply to key focus of each initiative or company.