Want To Understand Carbon Credits? Read This

You know from my first article in this series that forestry and land-use innovations represent a uniquely efficient way to sequester atmospheric carbon dioxide. After reading through my second article in this series, you know about compliance and voluntary carbon offset markets and the basic mechanics of cap-and-trade.

By the time you finish this article, you will understand how carbon offset credits (a/k/a “carbon offsets”, “carbon credits”) work and see examples of how credits are generated in both the compliance and voluntary markets. Along the way, you’ll learn about some of the innovative business opportunities in this emerging field — a field that has the mother of all tailwinds supporting future demand.

The Compliance Market at Work

The compliance markets start with interactions between large institutions – industrial manufacturers and other enterprises.

Let’s continue with our example from the last article and further assume that the business allotted 100 units of greenhouse gas (GHG) emissions in one year is a cement manufacturer.

Under a business-as-usual scenario, the cement company could expect to emit 120 units of GHGs. In the long-term, the goal is for the manufacturer to find ways of producing cement without emitting as many GHGs; to meet its regulatory burden in the short-term, it will need to buy carbon offsets to bring its emissions down to its mandate of 100 units.

At the same time a large landowner – International Paper IP, a timberland investment management organization (TIMO) like Weyerhaeuser WY, or even an educational institution like Middlebury College – owns timberland that has the potential to be monetized by harvesting for homebuilding or the pulp and paper industry.

If the landowner agrees to forgo aggressive timber harvesting on a certain track of land in perpetuity, it can receive an offset credit that it can sell to the cement manufacturer. The landowner can generate cold, hard cash; the cement manufacturer can meet its regulatory mandate.

The landowner must jump through some regulatory hoops to make that offset process happen. It also probably needs help in planning the timber conservation project so it generates the maximum amount of credits possible.

To get this very specialized help, our landowner would turn to an adviser with deep experience in carbon offset regulations and markets.

One of the most important companies in this advisory niche is Bluesource, which operates a full-service environmental markets firm from offices in the U.S. and Canada. Bluesource is the largest environmental projects developer in the U.S. and also finds buyers for the emission credits generated by smaller developers’ projects.

Bluesource derives a fee for advising clients and developing projects, and also takes a cut of revenues generated in the sale of others’ credits. They say that there are riches in niches, and Bluesource’s niche is one with the mother of all tailwinds as politicians and businessmen begin to wake themselves to the necessity of taking action to mitigate the effects of climate change.

The landowner in our example works with Bluesource to develop a project and register it as adhering to one of several carbon offset Standards. Each Standard has a particular set of rules or “protocols” that sets out how carbon credits will be assigned to different types of projects based on various criteria.

Standards can be government agencies (in the case of compliance markets) or non-profit organizations (which provide services for both compliance and voluntary markets).

Some examples of private Standards are the Climate Action Reserve, American Carbon Registry (managed by Winrock), and the Verified Carbon Standard (managed by Verra). 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, a list of which you can find on Climate Action Reserve’s website, validate projects up front, then verify that the validated projects continue to operate in accordance with the protocol on an ongoing basis.

Once the landowner’s conservation project is independently verified, the appropriate regulatory agency (such as the California Air Standards Board) reviews the project, makes sure it adheres to its regulatory requirements, and checks that the verification was done by approved providers. Once these checks are made, the Standards organization issues it serial-numbered carbon credits which can be sold to the cement manufacturer to allow the latter to meet its regulatory requirements in the short-term.

As an aside, when an end user like you or I rent a car and choose to spend $4.99 per day on carbon offsets, we’re actually buying carbon offsets from a retailer. For-profit carbon credit retailers (e.g., TerraPass and atmosfair) make money just the same way Wal-Mart does – they buy credits in the wholesale market from a developer like Bluesource, packages them into bite-sized portions, and offers them to consumers at a mark-up.

(Cool Effect is another company acting as a carbon credit retailer, but operates on a non-profit basis — charging fees just sufficient to offset its operating costs.)

The EU ETS and the Californian compliance markets are hugely important in driving down carbon emissions and have spurred a trend to rethink the way timberlands are managed and agricultural assets are operated.

Haters will say that the entire framework for carbon credits is flawed and point to obvious historical problems in the carbon markets.

It is true that mistakes were made in the early markets. Clever people exploited loopholes before they could be closed. Fraudsters sold the same credits twice and charged EU Value Added Tax (VAT) on both the buyer and seller leg. Oversupply of credits from ex-Soviet Bloc countries that far outstripped demand from Western Europe caused the prices of certain credits to crash.

However, the thing that has impressed me about these markets is how well the organizers learned from these mistakes and adroitly adapted to make the markets more effective as time went on. They closed the gaps and succeeded in building a framework that has allowed for the growth of a vibrant new set of business opportunities.

Voluntary Markets Add “Co-Benefit” Advantages into the Mix

Voluntary markets function in a similar way to compliance markets with a few notable exceptions. First, as the name implies, the institutions participating in this market are doing so voluntarily, not as a means to comply with some regulatory mandate.

Recently, you have read about commitments made by such giants as Microsoft, Amazon, L’Oreal, and others to transition their operations to some form of carbon neutrality (i.e., emitting zero net GHGs) or carbon negativity (i.e., sequestering more net GHGs than they produce) in the near future.

The cynic might say that these commitments are mere PR stunts enacted during the longest, strongest economic expansion in modern times by managers who can afford to make such plans when their companies’ profitability is at historic highs.

However, from the perspective of your realist correspondent, while public relations certainly does play some role in these companies’ strategic planning processes, the managers at these firms also realize that profits and stock prices are an outgrowth of a stable, wealthy population able to pay taxes for modern infrastructure projects as well as buy consumer products. This type of stable operating environment is placed into doubt when one considers the worst-case climate possibilities, so managers understand that it is in their own best interest to mitigate worst-case scenarios.

This attitude has historical precedence – Henry Ford, for all his faults, knew that if everyone in society were to be able to afford an automobile, workers’ wages would have to rise. Ford Motor doubled daily wages to its employees compared to contemporary averages and, in so doing, bootstrapped not only a new industry, but a new economic model based on mass consumerism.

Another important role that voluntary markets serve is to offer credit purchasers what is known as “co-benefits”.

An untouched stand of trees in Oregon – as in our compliance market example above – generates one big benefit – the carbon sequestered in the living trees themselves. However, voluntary development projects may offer other social or environmental benefits in addition to lowering GHG emissions, such as poverty reduction, habitat preservation, and increases to local living standards.

These are all benefits that support U.N. Sustainable Development Goals, so a company able to tout participation in programs with co-benefits scores valuable PR wins for its shareholders.

For example, one of Bluesource’s founders helped start a venture named the Paradigm Project to subsidize highly efficient wood-burning stoves and easy to use water filtration units to rural families in Kenya. In Kenya, as is true for other less developed rural areas, a lot of deforestation is brought about by families cutting wood to boil water and cook.

Through projects developed by the Paradigm Project, organizations are able to invest in carbon credits generated by verified emission reductions from rural households’ reduced burning of wood for fuel.

Proceeds from the sale of those carbon credits are plowed into to the operations of a company that employs local people to build stoves and filters and distributes these products to their rural neighbors. The filters help cut the amount of firewood needed for boiling water and the stoves are much more efficient at converting wood fuel into usable energy.

One co-benefit of this program is that the purchasers of the carbon offsets end up improving the health conditions and economic situations of rural Kenyans – through a reduction in indoor air pollution and freeing up time and / or money that would otherwise go to collecting or purchasing firewood.

As an additional co-benefit, the project helps support women’s empowerment as women make up the bulk of the workforce that sells and distributes the cook stoves. Again, what company looking to expand its reputation and global reach would not jump at a project like this?

Everyone in this voluntary credit value chain is doing well by doing good. Further proof, if proof were needed, that the economic manifestation of the human species’ wonderful adaptability – capitalism – offers a path to increased well-being at the local and the global level.

Courtesy of Forbs