I love travelling and I am not from the UK, so I probably fly more than the average person, to get home and to take a sun holiday (wet summer holidays in Kerry are not enough!). In our equity funds we are exposed to carbon intensive industries, such as energy and mining. This personal and professional position has prompted me to think about my carbon footprint and how I might continue to fly while assuaging my eco-guilt. It has also prompted me to understand better how our portfolio companies are addressing these issues. Welcome to the world of carbon offsets.
A Carbon offset refers to the reductions or removals that compensate for an organisation’s or individual’s own emissions expressed in terms of carbon dioxide equivalent (CO2e). Purchasers of offsets can ‘retire’ the credit and claim the reduction or removal towards meeting their own emission reduction goals. Where emissions cannot be completely reduced to zero, use of offsets offers a potential route to carbon neutrality. A carbon offset can be demanded by regulation, or it can be a voluntary act. There are a wide variety of offset projects including forestry and land use, renewable energy, waste disposal and greenhouse gas (GHG) capture.
Why so murky?
Carbon offsets have been the subject of lots of criticism; how they are used and the quality of the offset credit being the main focus. An offset credit “must represent at least one metric tonne of additional, permanent, and otherwise unclaimed CO2 emission reductions or removals”. GHG reductions are additional if they would not have occurred in the absence of a market for offset credits. If the reductions would have happened anyway – i.e., without any prospect for project owners to sell carbon offset credits – then they are not additional. This is not as simple as it sounds… ‘additionality’ can be elusive. Take a renewable project; unbundled renewable energy certificates (RECs) and environmental attribute certificates (EACs) in the US or guarantees of origin (GOs) in Europe allow the project developer to generate two sources of income, one from selling electricity and a second from selling its ‘greenness’. The buyer of the REC or GO, claims they use green electricity with this ‘overlay’ structure, even as their actual electricity continues to be generated from fossil fuels. However, from an ‘additionality’ perspective, this purchase of a REC or GO did little to spur additional removal of carbon because the revenue is close to immaterial to the success of the project. In 2020, it was estimated the cost of a GO added 2% to the cost of electricity (adding €0.75 to €0.85/MWh, versus €40/MWh for the actual electricity). A wind project would very likely happen without this small extra amount of revenue. RECs and GOs are falling out of favour, but other renewable projects continue to offer carbon credits.
Reducing deforestation provides another source of carbon offsets. The Amazon rainforest can be saved by paying locals not to cut down trees; protecting this essential natural carbon sink would be an amazing result for the planet. But how do you predict how much of the forest would have been lost in the absence of such payments, to avoid overstating the credits? Worse, might action to protect one area cause illegal loggers to deforest elsewhere, meaning no net benefit overall? This has led to strong criticism of such schemes. Further, local communities may not always be united in welcoming such schemes, as Disney have discovered at their flagship carbon offset project in Alto Mayo, Peru.
Taking a further example, JP Morgan is offsetting its emissions by buying carbon credits. Kudos JP Morgan. However, Bloomberg explains that one of the projects earning credits is the preservation of a ‘carbon-absorbing’ forest, with the twist being that the forest is part of a nature reserve, protected by the US Nature Conservancy, the world’s largest environmental group, i.e. the forest is already well preserved. This raises a serious question as to whether there is any meaningful ‘additionality’ and the extent to which JP Morgan are truly offsetting their own carbon emissions.
Measurement is a big challenge for such schemes; how to calculate the baseline (both past emissions and emissions that would have happened without the reduction strategy) and how to account for the carbon ‘leakage’ are two challenges. Leakage occurs when illegal loggers move their illegal activity elsewhere or a protected forest burns down. Do Disney, JP Morgan or other corporates lose their retired carbon credits if the forests on which they rely suffer a wildfire? What if they are illegally cut down in the future? Global Climate Insights (GCI) refer to an EU Emissions Trading System (ETS) study in 2016 that found that 73% of certificates issued were likely to have overestimated emission reductions.
There is also a question mark over the credibility of the acreage needed for carbon offsets. GCI estimates that Shell’s 2030 offset targets “required 240,000 square kilometres of land, approximately the size of the UK.” Plausible?
Not all carbon credits are equal
Illustrating the disparity in carbon credits is the variability in price between and within categories, all for removal of one tonne of CO2. Ecosystem Marketplace estimated the average price for all categories for 2021 (to end November) was $3.08/tCO2e. The average for a renewable energy project credit was $1.19, for a waste disposal project it was $20.67. Within the waste disposal category, the pricing spread between project credits was $45.40.
Consider further the price to emit one tonne of CO2 as represented by the EU ETS, averaging at $63.03 in 2021.
With such disparity in offset pricing, and disparity with the price to emit CO2, how can we have confidence in the outcome? Even equating quality to price is not a perfect solution, some projects will intrinsically be more expensive to develop, while others will have co-benefits outside of climate mitigation. While purchasers may lean on independent verifiers, bear in mind many verifiers are paid by project developers and therefore may be conflicted.
Why does it matter?
Carbon neutrality where we continue emitting greenhouse gases and think carbon offsets are enough, will not work. To keep global warming to 1.5°C we need to drastically reduce the amount of fossil fuels we burn. Carbon credits cannot become an excuse for avoiding the harder and more expensive steps we need to take.
However, there is some general agreement for offsets as an interim solution, particularly for hard to abate sectors. Outside of offsetting own emissions, they can illustrate added commitment by corporates to mitigate global warming and can have very positive co-benefits in local communities and developing countries, helping deliver a just transition.
Understanding offsets also matters to investors in assessing the risk profile of a company. If companies are forced to buy credits, either because regulation demands it or other stakeholders demand it, the impact on profitability may become material. S&P Global Platts estimated that CORSIA-eligible* carbon credit (CEC) prices increased by 944% from January to November last year. Mind those airline stocks.
What then?
It would be easy to write off carbon credits as too unreliable. However, we need to use every tool available to fight climate change. The good news is that these problems are well recognised and are being tackled. Mark Carney and Bill Winters are leading the Task Force on Scaling Voluntary Carbon Markets (TSVCM) to correct them because “a well-functioning voluntary carbon market with high integrity quality standards and robust governance is needed.” While those standards are being developed, investors need to stay alert; understand the quality of the offsets employed by companies and the motivation for using them. The Stockholm Environment Institute (SEI) and Greenhouse Gas Management Institute (GHGMI) Offset Guide is a great resource to help us to do that.
This is all incredibly hard. While some companies may be greenwashing, most I believe are genuine about reducing emissions, but find it difficult to do so. What we need are honest conversations about what is possible in the short-term and what needs to be done in the long-term.
* The Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) is a carbon offset and carbon reduction scheme to lower CO2 emissions for international flights
The information shown above is for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.
The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of Redwheel. This article does not constitute investment advice and the information shown is for illustrative purposes only.
Unless otherwise stated, all opinions within this document are those of the Redwheel UK Value & Income team, as at 8th February 2022.
