Voluntary carbon credits are above all an instrument to price-in the carbon footprint of open market operations. The problem that they aim to address is simple: for a long time, probably since the first industrial revolution, the free market has facilitated transactions with significant negative externalities that have yet to be fully accounted for. These externalities relate to public health, growth, and most importantly sustainability. While the term “sustainability” may have degraded in essence following its frequent use in context that is far removed from its original meaning, any forward-thinking stakeholder ought to remember what it is that we’re really talking about. Sustainability is not an optional goal or an item that may be lost in a long corporate public relations checklist. Sustainability is about the real impact that current economic activity has on the ability of future generations to meet their needs. It is about ensuring that any economic system that distributes resources today does not compromise economic systems 5, 10, or 50 years down the line. It is about protecting value from the effect of environmental risk, which directly translates into financial risk once we depart from short-term absolutism.
The driving forces of this risk are multi-faceted. For one, we are already experiencing the effect that environmental degradation has on assets around the world. Whether we’re talking about beachfront property that is on track to be underwater property, infrastructure that simply ceases to function under extreme temperatures, or land that is no longer arable due to water insecurity, empirical evidence on the effect of our polluting activities is all around us. At the same time, the vector of policy change that aims to assign a price tag to carbon emissions creates transitional risk, which is defined as the threat to the viability of any organization that is not anticipating and preparing for scrutiny and penalization in reference to its carbon footprint.
Of course, nobody expects economic activity to have no gross carbon footprint. Carbon emissions are inherent in any process that consumes energy, and are embedded in every unit of applied capital and labor. Rather, the objective is to establish a two-step process by which corporations are able to effectively neutralize their impact on environmental degradation and climate change, which is (reductively) summarized in the term “net zero” and all related pledges and strategies. Firstly, corporations need to undertake operational decarbonization to minimize their carbon footprint without compromising the fundamental role that they exist to fulfill. Oftentimes, this decarbonization is actually a worthwhile investment, with the main current holdbacks being capital availability and managerial shortsightedness.
Secondly, corporations need to participate in voluntary carbon markets to purchase VCCs that offset what carbon footprint remains; this is the carbon footprint that is inherent in their operations. The boundary between these two steps should be set in accordance with the marginal returns of investment in decarbonization and VCCs respectively. Once profitable and cost-efficient decarbonization methods are exhausted and corporations can get more bang for their buck by investing in carbon-negative projects through VCCs, they should switch. If new technologies enable better marginal returns in decarbonization once again, corporations need to be ready to adapt.
Following this model, the importance of VCC pricing becomes clear. The price of a VCC is a representation of the marginal cost of one ton of carbon emissions. If VCCs are overvalued or undervalued, the entire idea of using them to complement operational decarbonization breaks down very quickly. So how do we arrive at a fair price for a VCC? Currently, the answer might disappoint. The market for VCCs is oversaturated with offsets that serve more as a cheap public relations service than actual investment in carbon-negative projects. As such, prices may range from a few dollars to a couple of orders of magnitude more. While that is great for the expense forms filed by PR departments, it is a huge problem for the legitimacy and potential of VCCs and voluntary carbon markets.
This brings us to the billion-dollar question: what pricing mechanism should be used for VCCs? If you ask an economist, they might tell you that we should simply let the laws of supply and demand work a fair price out. If you ask an economist that knows the first thing about carbon mitigation or sequestration, the answer is quite different. Not all VCCs are born equal, and in fact treating them like a commodity would be a massive oversimplification. To understand why a more granular approach is required, we need to look at the specific factors that assign value to this instrument.
As a starting point, let’s look at a basic model for asset pricing: discounted cash flow. The idea is that the asset’s value is based on the present value of the series of payments it generates. For example, we could say that a flat is worth as much as the present value of the series of payments that the owner would receive by renting it out. In the case of VCCs, we are not interested in projects that generate a series of payments, but rather a series of carbon footprint reductions. For example, replacing incandescent bulbs with LED lighting in a hospital may result in a certain amount of carbon footprint savings per year. It follows that one way to price a VCC is by discounting these carbon footprint savings to find the present carbon footprint savings and then express that in money. This might sound easy, but figuring out the value of a carbon footprint reduction (i.e. the cost of carbon emissions) and the carbon discount factor is a tremendous task. More on that in a different post.
Furthermore, there are other factors that need to be taken into account. First, the marginality of the underlying project. For a VCC to be legitimate, it needs to be associated with carbon footprint reductions that would not have occurred should the VCC not have been issued. This is pretty intuitive; if the carbon footprint reduction would’ve happened anyway the VCC transaction is pointless. We can turn to this paper by the Grantham Research Institute on Climate Change and the Environment for a way to determine marginality. The paper addresses projects funded through the United Nations Clean Development Mechanism, a system through which purchased VCCs go towards carbon-negative projects as UN subsidies. Simply, if there are less profitable projects that were funded and launched despite the absence of subsidies, then that’s a surefire way to determine that the projects that did receive subsidies were not marginal. Thus, we can establish a frontier of sorts which describes at what level of profitability we are dealing with marginal projects.
Second, we need to distinguish between carbon mitigation and carbon sequestration projects. The former relate to preventing carbon emissions, while the latter relate to removing carbon from the atmosphere. The difference is vital in terms of climate impact. To be precise (and pedantic) climate change is not actually caused by the emission of greenhouse gasses, but rather their accumulation in the atmosphere. Carbon emissions are a flow variable that is important in its own right, but it’s the stock of carbon in the atmosphere that we’re really concerned with when it comes to climate change. One way to reduce this stock is by limiting our emissions and waiting for this carbon to dissipate on its own through the Earth’s natural carbon cycle. Don’t get your hopes up though. According to MIT Professor Daniel Rothman, it would take centuries for excess carbon to be absorbed into the oceans and around 10,000 years for the oceans to return to equilibrium. Another way to reduce this stock is by applying technologies that speed up this carbon removal process beyond its usual pace. Carbon capture projects have greater potential in addressing the urgent issue of climate change and reversing the effect of human activity on the atmosphere, and should therefore be valued higher than carbon mitigation projects when it comes to VCCs.
Third, local impact needs to be considered. An ecosystem of offsetting through VCCs and voluntary carbon markets should never come at the expense of populations local to the regions where the projects are based. Frankly, any project that causes displacement of local populations and disruption of local economic activity should not receive funding through VCCs. The point is to deal with a negative externality, not create new ones in the developing world. It’s that simple.
Finally, we need to consider confidence. Confidence comes into play in nearly all parts of the economic system. Credit ratings represent confidence in an individual or company in terms of fulfilling debt obligations (but not too soon, so the financing operation can actually turn a profit). Car insurance premiums represent confidence in a driver in terms of not ignoring stop signs and throwing it sideways every chance they get. Evaluations (estimates) of all of the aforementioned factors should come with transparent communication of the associated confidence levels. For example, let’s assume we’re dealing with a carbon-negative project that prevents deforestation through land purchase. Its added value in terms of carbon footprint is measured in comparison to a base rate of deforestation. While surely nobody would be petty and greedy enough to outright lie about the expected rate of deforestation (ahem) it is also important to price in the confidence interval of that expectation. We need to know how certain it is that the money that goes towards a VCC purchase will end up actualizing the promised carbon footprint benefit.
Now let’s return to the original question. How do we price a VCC? A portion of the process needs to be determined by what a higher authority estimates the social cost of carbon emissions to be. A laissez-faire voluntary carbon market cannot solve a market failure. Sure, market-based solutions such as cap-and-trade systems do exist, but implementing one based on a global emissions cap requires international cooperation on a level that is currently unrealistic. Further to this question, I believe that the best way to include the aforementioned factors in voluntary carbon markets would be through a rating system much like what is standard in corporate and sovereign debt markets. My idea is to assign each VCC a grade based on estimates on marginality, the type of carbon footprint impact, local impact, and the confidence level of these estimates. This workflow could be handled by built-for-purpose carbon rating houses or just be assigned to new divisions within existing audit and rating giants.
To conclude, VCCs and voluntary carbon markets have substantial potential in facilitating the global energy transition and meeting net zero pledges. They’re not the be-all and end-all of dealing with climate change, but rather a necessary piece of the puzzle. However, we need to harbor progress in terms of pricing this instrument correctly and embedding more transparency and verification in each VCC transaction. Should the voluntary carbon market move towards the right direction, it’s bound to grow in terms of volume, liquidity, and legitimacy. Policy makers will be more likely to take VCCs into account and corporate and sovereign actors more likely to be involved in the VCC ecosystem. This outcome would be preferable to a world where polluting activity is simply taxed and the money goes towards a largely mismanaged and inefficient pool.