Why is there a market for carbon credits? What is it looking to solve? Carbon credit markets is humanity’s first attempt at putting a financial value on nature.
Two concepts before we jump into credits:
- “Tragedy of the Commons”. A group of people live by a small lake filled with fish, the lake is shared by the people. Each person has an incentive to take what they can from the lake. If you don’t take fish from the lake, then someone else will take it. The end result is that everyone frantically harvests the lake for fish and all of the fish disappear — hence the “tragedy of the commons”.
- “Negative externalities”. A negative externality is a negative impact generated out of a specific process (making toys, food, cars, sending electricity or mail) that does not impact the original parties. The negative externality directly affects a 3rd party. For example, a chemical plant upstream of your house might be dumping waste into the river at the end of their chemical creation process. The waste is a negative externality, directly affecting a party not involved in the creation of the original product. Earth is often the 3rd party affected by negative externalities, but it could also be people or animals living in a particular area where waste or dangerous chemicals are dumped or tested.
Carbon Dioxide (CO2) Emissions are a negative externality. Our planet suffers from the tragedy of the commons. Human processes pollute planet Earth and drives climate change. By pricing CO2 emissions in the form of carbon credits, emissions become a business variable creating an incentive for people and businesses notice and mitigate their emissions.
You can make the arguments that there is no such thing as a negative externality — if you are producing corn with mass use of pesticides and herbicides, you’re really poisoning your own land (not to mention aquifers, waterbeds, rivers, food supply etc.) and that it isn’t good for you long term. But as we’ve seen, if businesses can get by without short term consequences, harmful practices will continue.
So, we created the carbon credit market. It’s our first attempt to price nature, resulting in a cost for polluting Earth.
There are two carbon credit markets: compliance and voluntary.
The compliance market is regulated by a central governing body. The centralized registry says specific businesses have a budget of how much emissions they may emit. Going over those budgets results in fines, so companies are incentivized to optimize their processes to reduce emissions. When a company has done everything possible to reduce emissions, they are allowed to purchase carbon offsets. Carbon offsets are 3rd party programs or projects that sequester carbon and often have nothing to do with the company itself. Carbon offsets act as a funding mechanism for forest protection, reforestation, renewable energy, and other projects that otherwise wouldn’t receive funding. For example: Project A needs funding to protect a tropical forest. Company B needs to offset emissions from their business, so they fund Project A in exchange for the offsets. The compliance market size is well over $200B annually.
The voluntary market is not regulated by any central governing body, but there are multiple Carbon registries that evaluate, certify, and price carbon credits. Nobody is required to take part in the voluntary market, but there’s good traction — the voluntary market will reach $1B in size in 2021 and growing rapidly (up from ~$400m last year). Companies do this because they believe it will mitigate some kind of risk to their business, whether regulatory, supply chain, or consumer perception.
Growing voluntary carbon market from 2005 to 2021. Source.
How are carbon credits priced? There are centralized exchanges that specialize in carbon credits, but no true global exchange — for example you can’t go to one place to buy a carbon credit at market price like you can for say, stock in a company like Apple or Amazon. Most of the carbon credit transactions are done “over-the-counter”. This means a broker working to connect large institutional buyers with large scale projects. As a result, the prices of carbon credits are often opaque and fall within a wide range rather than a specific price. Adding to the confusion, carbon credit prices vary drastically between types of projects.
Variance of carbon credit prices, both between and within registries. Source.
Within the voluntary market, Verra.org is the dominant player, with over 75% share of the carbon credits. Other notable players include Gold Standard and American Carbon Registry. Multiple categories exist within carbon credits: renewable energy, forest carbon, waste, industrial gases, to name a few.
The range of carbon credit project categories by registry and region through 2019. Source.
I will dive into the specific category of carbon credits I’m most familiar with: forest carbon. Forest Carbon includes three sub-categories: Afforestation/Reforestation (R), Avoided Conversion (AC), and Improved Forest Management (IFM). The startup I work at, Terraformation, focuses on native reforestation projects to fight climate change and our projects fall in the Forest Carbon category.
While forest carbon seems like it should be dominated by forest growing projects, the dominant sub-category in forest carbon are avoided conversion and improved forest management. They are exactly as they sound: protecting an existing forest or improving how an existing forest is managed.
Why don’t we see more forest restoration projects? It comes down to the economics of a reforestation project: price of carbon credits and the cost associated with reforestation.
An example: The price of a carbon credit is about $10 per ton of CO2. A fully mature tropical forest sequesters about 700 tons of CO2 per year per hectare. A mature tropical forest is the biggest type of land based carbon sink — but it can take tens and hundreds of years for a forest to reach that level of maturity. On a per hectare basis, that’s $7,000 in carbon credit revenue. So if you’re looking at 1,000 hectares, that’s $7,000,000 a year. The costs includes the work required to acquire, manage, and maintain 1,000 hectares. Additionally, the carbon credit potential of $7,000,000 is due to decades, if not hundreds of years, of natural growth. These numbers are for a still-standing, untouched forest.
Compare this with a denuded piece of land — it sequesters no carbon to start, thus no carbon credits to claim. The land needs to be revived, requiring human labor and energy to fence and clear land, gather seeds, nurse seedlings, generate water, physically put the plant in the ground, water plants, and manage the forest growth through infancy — and infancy can mean 3 to 5 years, if not longer. During those first ~5 years, the land is not sequestering much carbon due to its infancy.
For any project, carbon credit verification with a registry is a fixed cost, costing about $100,000, sometimes more. In the case of forest protection projects: they perform their verification every 5 years with the registry. They allow carbon credits to aggregate over multiple years so the fixed cost is a smaller percentage of their total revenue. It doesn’t make sense to collect carbon credits every year given the cost associated with performing a carbon verification through a registry. If you apply that to a reforestation project that isn’t sequestering any carbon to begin with, the economics become nearly impossible.
So, working with an existing forest that is already capturing CO2 is easier than reforesting land that will take decades to reach the same level of carbon capture. This is a good reason why stopping deforestation today is critical: saving forests now means more carbon sequestration today.
While reforestation projects are difficult, the pay-off is growing to match the effort. Overall, carbon markets saw 4 times the demand in 2020 and there are predictions of carbon credit prices shooting up to $100 per ton of CO2 in the years to come. By starting the process of building forests now, we’re investing in an asset that is clearly valuable in the long term and as those forests come to maturity, carbon credit prices should reach more attractive prices for project owners.
In other categories like renewable energy, many of these projects were funded early on — but as the efficiency of solar has improved, certain types of renewable energy projects are no longer capable of earning carbon credits as determined by the governing body. The idea is that if the market has reached a point where renewable energy is cheaper to build than a coal plant, then capitalism will naturally move that market.
Carbon credits was a regulatory attempt to create a global market for emissions. This successfully used market dynamics to move financial resources to protect and revive our planet. As our first globally coordinated iteration at a free market for natural resources, I’m excited to see what we add in the future to account for biodiversity, native species, and large scale sequestration.