Countdown for carbon

Businesses can afford to be idealistic in the long term, yet in the short term, we all have to wrestle with the practicalities of daily life.  It’s very much the ‘art of the possible’ rather than the ideal. 

Take the rapid transition to net zero, as outlined in the Paris Agreement targets and affirmed at COP26.  Every industry is, to some degree, dependent upon fossil fuels and has been for decades.  Changing this – and achieving net zero carbon emissions – is a necessity, and one I strongly believe in.  But it cannot be done at the flick of a switch. It is a process that requires strategic investment in sustainable technologies, not all of which are sufficiently mature, or affordable, to be deployed at scale right now.

Carbon credits offer a pragmatic half-way house, a stopgap that effectively buys time for companies to address some of the difficulties that meeting the net zero target raises.  Buying carbon credits is a way for businesses to mitigate those emissions they are unable to totally eliminate . . .   until, I hope, they can.  

What is a ‘carbon credit’?

Carbon credits are certificates that represent quantities of greenhouse gas (GHG) emissions that have been avoided or removed from the air.  So, when a company buys a carbon credit for one ton of CO₂, for example, it effectively gains permission to generate an amount of CO₂ equivalent to that credit.

The carbon credits themselves come from certified climate action projects that reduce, remove or avoid GHGs in ways that can be measured and verified.  Common examples include establishing tree plantations or providing communities with more energy efficient means of heating their homes and cooking.

In late October 2022, I represented Abdul Latif Jameel at the Saudi Arabian Public Investment Fund (PIF)’s Voluntary Carbon Credit Auction at the Future Investment Initiative conference in Riyadh, the first-ever carbon offset auction to be held in the Middle East.  Altogether 1.4 million tons of carbon credits were sold, making it the largest-ever carbon credit sale.   Abdul Latif Jameel was among the 15 Saudi and regional entities taking part, representing every part of the country’s economy, from the Gulf International Bank to Saudia airlines, from Aramco to the Yanbu Cement Company.

How do carbon credits work?

To meet our net-zero targets, every business needs to reduce their own emissions as much as they can.   But for some organizations, it is prohibitively expensive to reduce emissions using today’s technologies, though the costs of those technologies might become cheaper in time.  For others, some sources of emissions cannot be fully eliminated at all based on current alternatives.

For example, making cement at an industrial scale typically involves a chemical reaction, calcination, that accounts for a large share of the cement sector’s carbon emissions.  Based on current cement-making technologies, for many cement producers it is not financially viable to make cement any other way.  These emissions are, in effect, unavoidable today.  Instead, the company can buy carbon credits to offset the emissions it is unable to eliminate.

It is important to note that carbon credits are voluntary.  As the title suggests, none of the companies taking part in the PIF’s Voluntary Carbon Credit Auction were under any legal obligation to do so, unlike some states and regions that have mandatory schemes for carbon credits.

The European Union, Australia, New Zealand, South Korea, California, and Quebec, Canada, for example, all have what are known as ‘cap-and-trade’ schemes, also called emissions trading schemes (ETS).  Cap-and-trade programs were first used to control pollution in the 1980s and 1990s when the United States brought them in to phase out lead in petrol and reduce certain emissions to combat acid rain.  The success of these programs laid the basis for their use in cutting carbon and GHG emissions[1].

The principle is simple: To incentivize firms to reduce their emissions, a government sets a cap on the maximum level of emissions and creates permits, so-called ‘ carbon credits’, for each unit of emissions allowed under the cap.  Emitting firms must obtain and surrender a permit for each unit of their emissions.   They can obtain permits from the government or through trading with other firms.   The government may choose to give the permits away for free or to auction them.  

This has created a massive market for carbon credits.  According to Refinitiv, the total market size is US$ 261 billion, representing 10.3Gt CO₂ equivalent traded on the compliance markets in 2020[2].

Businesses that do not have enough permits for the level of emissions have two options: they can either reduce their emissions, or they can buy additional permits from another business to cover their additional emissions.  For a given permit price, some firms will find it easier, or cheaper, to reduce emissions than others and so will sell their permits.  This process of trading ensures there is a unique price for all firms coordinating their activities and drives down emissions to the level allowed under the cap cost-effectively.

Of course, there is no reason to expect that a permit price that clears the market at a point in time will continue to do so in the future.  As economic conditions and emitting firms’ circumstances change, permit prices will fluctuate.  Permits will become more expensive when demand is high relative to supply, for example when the economy is expanding strongly.  Prices will, accordingly, drop when demand is lower, such as when ample renewable electricity reduces the requirement for thermal generation firms.

Mandatory and voluntary markets

Mandatory carbon markets are an important part of the effort to meet the Paris Agreement target of limiting global warming to 2^oC above pre-industrial levels – ideally 1.5^oC, even though some of these markets predate the Paris commitments.  

Examples include the Clean Development Mechanism under the Kyoto Protocol, the European Union Emissions Trading Scheme (EU-ETS) and the California Carbon Market.  Yet most mandatory markets are restricted to specific industry sectors and sources of emissions.  Businesses that operate in other sectors, such as Abdul Latif Jameel, can still offset their GHG emissions, however, by participating in carbon markets voluntarily.

Under the forward looking Saudi Vision 2030, Saudi Arabia is determined to support this.  To this end, it has established the Regional Voluntary Carbon Market Company, a joint venture between the Public Investment Fund (PIF) and Saudi Tadawul Group, the holding company that operates the country’s stock exchange.  The recent auction of carbon credits – that I attended on behalf of Abdul Latif Jameel – demonstrates its role in supporting regional businesses as they contribute to the global transition towards net zero.  

The PIF sees its support for voluntary carbon credits as a key part of its own drive to tackle the impacts of climate change and achieve net zero by 2060.

“We are passionate about the potential for voluntary carbon markets to deliver additional carbon reduction benefits throughout the region, thereby ensuring the MENA region is at the forefront of climate action and that Saudi Arabia is a leading force in solving the climate challenge,” said Yazeed Al Humied, Deputy Governor and Head of Middle East and North Africa Investments at PIF[3].

Courting controversy

Although there is a broad international consensus that carbon credits are an important step forward, they remain controversial in some quarters.  Critics put forward a number of objections: carbon credits do not actually reduce CO₂ emissions; they can be used for ‘greenwashing’; not all carbon offset projects get realized; and there are not enough carbon offsets for all CO₂ emissions.  Critics point out that the COVID-19 pandemic triggered the largest decrease in energy-related carbon emissions since World War II, a decrease of 2 billion tons.  But emissions rebounded quickly at the end of 2020, with levels in December 2020 ending 60 million tons higher than those in December 2019.  This indicates that the earth is still warming at an accelerated rate, and not enough is being done to implement clean energy practices[4].

It is undeniable that carbon credit schemes are not the ultimate solution.  And there is evidence that some programs are not quite what they should be.  For instance, the Oddar Meanchey Offset Program issued carbon credits for protecting forests in Cambodia until 2017, when it was discovered that the forests in question were in fact being systematically cleared by the Cambodian military.

This does not mean that the principle of carbon credits should be abandoned, however.  It just means they need to be monitored and managed effectively and transparently.  Without them, there would be no other credible means of directing private finance to climate action projects.

Good governance essential

Voluntary carbon offsets rely on there being a demonstrable link between the activity undertaken and the positive environmental impact.  Sometimes that link is obvious – companies that use carbon capture technology to remove CO₂ emissions and lock them away can produce data to show the reduction in emissions.  But other programs, like offsets schemes that promote green tourism or seek to offset the damage of international travel, can be more difficult to measure.  The reputation of the organization issuing the credit determines the value of  the offset. 

Reputable carbon offset organizations choose carbon projects carefully and report on them meticulously, and third-party auditors can help ensure such projects measure up to strict standards, like those established by UN’s Clean Development Mechanism.  Once properly vetted, “high-quality” carbon offset programs represent tangible, measurable amounts of reductions in CO₂ emissions that companies can use like they reduced their own greenhouse gas emissions themselves.  

Though the company has not actually reduced its own emissions, the result is materially the same. In effect, the company has bought itself more time to make its operations more environmentally friendly, while as far as the atmosphere is concerned, the level of CO₂ has been reduced.

Take the carbon credits auctioned at the FI conference in October 2022.  These were registered under Verra and comply with CORSIA, the gold standards for accreditation and compliance.  Verra is the non-profit organization that oversees the Verified Carbon Standard (VCS) Program, the world’s most widely used greenhouse gas (GHG) crediting program.  

It drives finance toward activities that reduce and remove emissions, improve livelihoods, and protect nature.  VCS projects have reduced or removed nearly one billion tons of carbon and other GHG emissions from the atmosphere.  The VCS Program is seen as a critical and evolving component in the ongoing effort to protect our shared environment[5].

CORSIA[6] was developed by the International Civil Aviation Organization (ICAO) and stands for “Carbon Offsetting and Reduction Scheme for International Aviation”.  It is the first global market-based solution that entities – not just private sector companies – can use as a major step to reach their climate goals.  

Only projects that have been accredited by a respected third party such as Verra are eligible for CORSIA, providing reassurance that these carbon credits are genuine.

Verra is just one of several carbon offset standards, each of which has a particular set of rules or ‘protocols’ that set out how carbon credits will be assigned to different types of projects based on various criteria.  These standards differ according to whether it is a mandatory market, in which they are usually set by government agencies, or voluntary, which use non-profit organizations such as the Climate Action Reserve, and the American Carbon Registry (managed by Winrock).

The organizations behind the standards generate fees from managing the certifications of projects as well as handling the logistics of issuing and retiring credits.  All high-quality projects are subject to review by third-party auditing firms.  These firms validate projects up front, then check that they operate in accordance with the protocol.  This ensures participating organizations avoid falling victim to unverified projects such as Oddar Meanchey.

This oversight or governance is vital.  

The voluntary carbon credit market is like any other: you pay for quality.  In current carbon markets, the price of one carbon credit can vary from a few cents per metric ton of CO₂ emissions to US$ 15/mtCO₂e for afforestation or reforestation projects, or even up to US$ 300/mtCO²e for tech-based removal projects[7].

Complex pricing

Pricing carbon credits, though, is still complex.  There is a wide range of credits on the market and several factors influence the price.  One of the most important of these is the nature of the underlying project, which generally fall in to one of two categories: avoidance and removal.  Avoidance projects prevent greenhouse gas (GHG) emissions, while removal projects collect and remove GHGs from the atmosphere.

Renewable energy projects, for instance, are in the avoidance category, as are forestry and farming emissions avoidance projects, which are also known as REDD+.  These stop deforestation or wetland destruction or promote agricultural and soil management practices that limit GHG emissions – for example, projects to reduce the amount of methane that cattle emit by feeding them different diets.  Other examples are projects that improve fuel efficiency, build energy-efficient buildings or that capture and destroy industrial pollutants.

The removal category includes projects that capture and store carbon from the atmosphere.  Often, they are based on nature, using trees or soil, for example, to remove and capture carbon in projects such as reforestation, afforestation, and wetland management.  Others employ technologies such as direct air capture or carbon capture and storage.

All this is reflected in the price, as removal credits attract a premium, partly because the underlying project requires more money, but also because there is a greater demand: investors believe they are a more effective tool in the fight against climate change.

When the underlying carbon project also helps to meet some of the UN’s Sustainable Development Goals (SDGs) then the value of a credit from that project can be higher.  So, for example, if the project provides clean water and also tackles poverty – two of the SDGs – then the carbon credit it generates may trade at a premium to other types of projects.

This is why the credits emitted by community-based projects that meet SDGs often trade at a premium to projects that don’t, such as industrial projects.  This is despite the fact that industrial projects are typically larger-scale and can often produce large volumes of credits with more easily verified GHG offset potential than community-based projects.  These, by comparison, tend to be very localized, designed and managed by local groups or NGOs, produce smaller volumes of carbon credits and are often more expensive to certify.

Other factors affecting price are those to be found in any market – demand and supply, where the project is, the delivery time and how old it is.  The older a project is, the cheaper its carbon credits.

Stepping-stone to a sustainable future

This is a market that is both growing quickly.  The Taskforce on Scaling Voluntary Carbon Markets (TSVCM) estimates that demand for carbon credits could increase by a factor of 15 or more by 2030 and by a factor of up to 100 by 2050.  Overall, the market for carbon credits could be worth upward of US$ 50 billion in 2030.[8]

Achieving these growth predictions is critical.  The carbon credit market has created a channel for private finance to reach climate-positive projects that otherwise would fail or not even happen.  It also has the governance that provides integrity and transparency in a way that foreign aid often cannot.  Carbon credits might not be the ultimate solution to our planet’s climate crisis, but for now, it is one of the most promising tools we’ve got.

[1] https://www.lse.ac.uk/granthaminstitute/explainers/how-do-emissions-trading-systems-work/#:~:text=Emissions%20trading%2C%20also%20known%20as,emissions%20allowed%20under%20the%20cap.

[2] https://carboncredits.com/the-ultimate-guide-to-understanding-carbon-credits/#9

[3] https://carboncredits.com/saudi-pif-largest-corsia-compliant-carbon-credits-auction/

[4] https://impactful.ninja/reasons-that-make-carbon-offsetting-a-bad-idea/#:~:text=Carbon%20offsetting%20is%20not%20economically,world’s%20poor%20is%20highly%20disproportionate.

[5] https://verra.org/programs/verified-carbon-standard/#how-it-works

[6] https://www.iata.org/en/iata-repository/pressroom/fact-sheets/fact-sheet—corsia/

[7] https://www.spglobal.com/commodityinsights/en/market-insights/blogs/energy-transition/061021-voluntary-carbon-markets-pricing-participants-trading-corsia-credits

[8] https://www.mckinsey.com/capabilities/sustainability/our-insights/a-blueprint-for-scaling-voluntary-carbon-markets-to-meet-the-climate-challenge