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Responsible Investment Insights

Voluntary carbon markets: the need for scrutiny
19 May 2022
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    In a nutshell:

    • Over USD1 billion of voluntary carbon market credits were purchased in 2021.
    • Firms buying voluntary carbon market credits should do so as one element in a broad-based ‘net zero’ strategy.
    • Buyers of voluntary carbon credits should carefully scrutinise the projects that underpin the credits they purchase.

    The rise of a USD1 billion market

    At the end of last year, as many as one-fifth of the world’s largest 2,000 public companies had committed to ‘net zero’ targets by mid-2050 or sooner.1 As these firms pull together their overall net zero strategies, many are being attracted into the rapidly expanding voluntary carbon market; to buy carbon credits to stand against some of their greenhouse gas (‘GHG) emissions.

    This corporate rush to meet the goals of the 2015 Paris climate agreement triggered a significant rise in demand and pushed the voluntary carbon market over USD1 billion for the first time in 2021, with credits traded from projects located in 80 countries.2

    This market is likely to continue to grow rapidly, in part because translating ambitious emission reduction commitments into effective near term action can be challenging, especially in ‘harder to abate’3 sectors like aviation, cement and steel.

    Figure 1: Voluntary carbon market (January – November 2021)

    Voluntary carbon market (January – November 2021)

    Source: Forest Trends’ Ecosystem Marketplace initiative (2021)

    1. ‘Voluntary carbon markets poised for growth in 2022’, S&P Global, 4 January 2022
    2. ‘Voluntary carbon markets rocket in 2021, on track to break USD1billion for first time’, Ecosystem Marketplace, 15 September 2021
    3. ‘Consultation papers on harder to abate sectors’, Energy Transitions Commission, 11 December 2021.

    Past performance is not a guarantee of future performance. Any forecast, projection or target where provided is indicative only and not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecast, projection or target.

    Figure 2: The growth of voluntary carbon market (in millions tCO2e)

    The growth of voluntary carbon market (in millions tCO2e)

    Source: Forest Trends’ Ecosystem Marketplace initiative, (2021)

    Voluntary carbon markets; different to compliance markets

    Of course, we are talking here about the voluntary carbon market, not the compliance carbon market. Compliance markets – mandatory GHG emission trading systems (ETS) – exist in many parts of the world.4 In an ETS, firms in prescribed sectors like utilities or chemicals must surrender sufficient GHG permits to cover their emissions over a certain period. If they are likely to emit more GHG than they have permits, they must either reduce their GHG emissions, or buy carbon permits from other operators or programmes.

    In the voluntary carbon markets, participants are not obliged by law to surrender carbon credits to cover their business or supply chain GHG emissions. Rather, these companies choose to do so, offsetting their GHG emissions to reduce their carbon footprint. Such actions therefore sit outside of compliance markets, providing a complementary channel for companies to support the transition to net-zero.

    Net-zero: carbon credits are only one part of the solution

    So how should a firm entering the voluntary carbon market for the first time proceed? Fankhauser et al.5 present helpful guidance. They set out seven steps that firms can take in order to establish a successful net zero strategy. According to this framework, carbon trading is encouraged, but carbon capture projects should be used alongside company level emission reduction, and carbon offsetting should be effectively regulated.

    The Science Based Target initiative (SBTi) also has outlined guidance.6 Based on the ‘mitigation hierarchy’, carbon offsetting comes after firms have undertaken all other steps to reduce emissions. The SBTi states that ‘companies should commit to reducing value chain emissions and implement strategies to achieve these targets as a first order priority, ahead of actions or investments to mitigate emissions outside their value chains. Investing outside of the value chain is in addition to, and not instead of, emissions reductions.’

    4. Including a national level Chinese ETS launched in 2021, the European Union ETS, the US/Canada RGGI programme and the K-ETS in the Republic of Korea.
    5. ‘The meaning of net zero and how to get it right’, Nature Climate Change, Sam Fankhauser et al, Dec 2021.
    6. ‘Beyond value chain mitigation FAQ’, version 1.0’, Science Based Targets initiative, 28 October 2021. See also ‘Managing the carbon asset from investments in natural climate solutions; implications for investment strategy and portfolio decarbonisation’, NewForests, April 2020.

    Past performance is not a guarantee of future performance. Any forecast, projection or target where provided is indicative only and not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecast, projection or target.

    Rise of nature-based solutions that benefit people and planet

    Once a firm decides to enter the voluntary carbon market, it will need to decide what types of credits to buy. For example, what type of underlying climate solution is being deployed? Where in the world? And under what voluntary carbon credit standard?

    In relation to the type of solution, there is a wide range of options, from nature based solutions (forestry or land use projects) through to ‘waste disposal’ credits associated with landfill methane capture; or those generated via the use of clean cooking stoves that displace the burning of charcoal in homes.7

    Figure 3: The growth of voluntary carbon market (in millions tCO2e)

    The growth of voluntary carbon market (in millions tCO2e)

    Source: Forest Trends’ Ecosystem Marketplace initiative, (2021)

    A key trend in recent years has been the growth in firms seeking to buy credits associate with nature-based solutions – protecting, restoring or more sustainably managing terrestrial ecosystems. This may be because well managed nature based solution carbon projects can deliver multiple co-benefits including biodiversity enhancements, societal advancement and so forth. Given the momentum behind initiatives such as ending global deforestation and achieving a ‘nature positive’ stance by 2030, we expect support for nature-based solutions to continue to grow.

    In the absence of regulation, a number of voluntary standards have become established, such as the Gold Standard, VERRA and the CCB standards.8 These provide market participants with some surety over the providence of the carbon credits they are buying: indeed they play a central role in validating the quality of individual carbon projects; and verifying the actual carbon credits generated.

    7. ‘Voluntary carbon markets rocket in 2021’, Ecosystem Marketplace, 15 September 2021
    8. Verified Carbon Standard – Verra and Climate, Community & Biodiversity Standards - Verra

    Past performance is not a guarantee of future performance. Any forecast, projection or target where provided is indicative only and not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecast, projection or target.

    That said, we always recommend that buyers of voluntary carbon market credits, assure themselves of the environmental and social integrity of the projects that underlie the credits. This is partly because we expect much of the voluntary carbon market to develop somewhat like the art or the diamond market; where the multitude of defining features of the asset play a role in determining its monetary value. ‘High quality’ carbon credits are likely to be associated with greater local societal and biodiversity benefits and with projects that are successful in the long term. They may also retain their value better than credits associated with weaker underlying projects.

    Carbon projects can be examined using a four step approach. First comes the nuts and bolt of the project: how are permits derived and how strong and robust are the claimed climate mitigations? Second comes biodiversity: does the project bring benefits in terms of enhancing biodiversity; or conversely does the project generate carbon permits at the expense of biodiversity? Third comes social impact: to what extent is the local community involved, supportive and do they benefit from the project? This is important as local communities are guardians of the environment and it is only with their long-term buy-in that a project will be successful in the long term. At the very least some kind of ‘social safeguarding’ should be built into the project.9 Fourth comes governance of the project.

    Undertaking this level of review may be beyond the capacity or capability of many firms, so working with trusted partners can assist. Furthermore, there are a number of market-wide initiatives looking to deliver definitive guidance to firms on which attributes make a high quality carbon credit, and which types are likely to have these, such as the Integrity Council for the Voluntary Carbon Markets (IC VCM), which should release something later in 2022.

    Voluntary carbon market growth to continue

    The volume of voluntary carbon market credits generated and traded remains low compared to compliance markets. But the voluntary carbon markets is expected to grow rapidly. Indeed the IC VCM10 says that to meet the Paris Agreement’s target of 1.5 degree Celsius warming from pre-industrial levels, the voluntary carbon market will need to grow 15 fold by 2030 and 100 fold by 2050.

    Figure 4: Voluntary carbon market scenarios (in gigatons of CO2 per year)

    Voluntary carbon market scenarios (in gigatons of CO2 per year)

    Taskfore on Scaling Voluntary Carbon Markets (TSVCM). Projected credits demand envisioned by subject-matter experts within TSVCM. Source: McKinsey & Company (2021)

    9. The Climate, Community and Biodiversity (CCB) standards developed by the Climate, Community and Biodiversity Alliance (CCBA) can play a key role in documenting some of the co-benefits that derive from high quality carbon projects.
    10. https://icvcm.org/.

    Past performance is not a guarantee of future performance. Any forecast, projection or target where provided is indicative only and not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecast, projection or target.

    Historically, there has also been a lack of universal frameworks to guide the appropriate use of carbon credits by firms, making it hard for corporates to ensure they are offsetting with integrity. To fill this gap the UK Government and others helped establish the Voluntary Carbon Market Integrity Initiative (VCMII). With a US based secretariat at the Meridian Institute headquarters, and members from around the world, it is developing high integrity guidance for buyers of carbon credits, to be released later in 2022.

    A further boost was achieved at the international climate negotiations (COP26) in Glasgow at the end of 2021. After years of negotiations, a global agreement was reached on the final element of the Paris Climate Agreement, namely Article 6. This outlines modalities for, amongst other mechanisms, the trading of carbon emission units between governments. Whilst the text agreed on Article 6 does not directly regulate the voluntary carbon market, the political signal that its agreement sent should boost the momentum behind all carbon markets.11

    With all of this, it is perhaps no surprise that demand is running ahead of supply in the voluntary carbon markets, which in turn has contributed to recent price rises. With the development cycle from project concept to a sellable issued carbon credit taking two or more years (for some projects such as replanting forests this can be five or more years) this situation may continue for a while.

    Looking ahead, whilst overall market growth looks set to continue, it remains to be seen what market norms, best practice or regulation will actually emerge to more clearly guide how carbon credits are used. The voluntary carbon market is therefore sure to remain a highly debated topic during 2022.

    11. ‘Voluntary carbon markets poised for growth in 2022’, S&P Global, 4 January 2022; ‘Article 6 of the Paris agreement and implications for the voluntary carbon market’, ICROA, December 2021.