The Carbon Story: Credits, Offsets, and Sinks

IN THIS PUBLICATION:

• Carbon credits are mechanisms to impose caps on emissions from certain industries.

• Carbon offsets and sinks exist to help individuals and businesses balance out their impact.

• Profitability and sustainability are becoming more aligned.

Why Do Carbon Efforts Matter?

• The Paris Agreement, set in 2015, is the legally binding target of attempting to limit global warming to 1.5 to 2 degrees Celsius above pre-industrial levels.

• The agreement was adopted by 197 countries and aims to achieve carbon neutrality by mid-century as a way to achieve this long-term temperature target.

• The strategies in place to reach carbon neutrality combine carbon efficiency efforts from polluting industries (i.e. the reduction of pollution) with carbon sequestration techniques.Combining these two strategies has led to the concept of carbon neutral commitments, where corporations and governments define a date by which it commits to reach a net zero emission stance – where it either does not produce any greenhouse gas emissions, or the emissions it does are offset by some form of emission sequestration.Carbon commitments are broadly adopted:

• One-fifth of the world’s largest 2,000 companies have already committed to carbon neutrality.

• Countries covering as much as 70% of the global CO2 emissions have also made net-zero pledges.

As with most things environmentally related, this is easier said than done. Committing to carbon neutrality involves a combination of:

(a) ambitious emission optimisation efforts, and

(b) balancing of emissions with offsets, credits or sinks.

What products are already available to polluters?

Carbon Credits

Carbon credits are a cap, set by regulatory bodies, to the total amount of CO2 emissions generated by polluting industries. The purpose of carbon credits is to limit how much environmental impact economic activity has on the environment.

There are a few credit systems in place around the world – the EU Emissions Trading System (EU ETS), the zero-emissions vehicles (ZEVs) credits in the U.S., and the Chinese nationwide credit trading system.

These trading systems work on the basis of credits supplied and controlled by the government or a similar managing authority, which are then distributed to polluters either for free or at a certain price.

The managing authority typically sets a limit to how many credits are issued every year (in order to contain pollution) and allocates them through the different players via grants (for free) or auctions (at a cost to the polluter). Once issued, the emissions credits can then be traded between players who need more emissions credits (heavily polluting players) and players who have more credits than emissions. Emissions credits have a market price in a similar way to stocks and bonds.

There are different forms of granting these credits. Some systems will award a set number of credits per player in the system (e.g. the EU ETS), while others will provide more credits to the good-doers and less to the bad-doers (e.g. the ZEV credits in the US). Either way, businesses underperforming in the environmental targets will be forced to acquire credits from the best-performers to meet the minimum required number of credits associated with their carbon intensity.

Carbon credits are sometimes confused with carbon taxes. Whilst the target is to reduce emissions through both mechanisms, carbon taxes give polluters price certainty (i.e. the regulator sets a fixed cost to each unit of pollution, but companies can pollute as much as they want) whilst carbon credits set quantity certainty (there is a capped amount of credits, and the price is set by the market), which is a materially better way to lead countries to comply with emission targets.

Carbon credits work as a subsidy to the good-doers (i.e. businesses generating little greenhouse gases, or businesses engaging actively in a transition to a greener economy) and as a fine to the bad-doers, but through a market efficient mechanism.

This is how Tesla came into the news recently by being a large recipient of ZEVs credits and selling these at a 100% profit to other carmakers in need of credits to meet the minimum threshold. In Europe the system is similar, though it targets a limited group of power plants and production industries (about 11,000 companies), allowing them to trade credits and auctioning and granting credits periodically.

Currently, there are no widely recognized fundamentals around how to value these credits, and the majority of the market is dominated by actual businesses that need to hedge their "pollution risk" rather than trying to speculate on the price of carbon credits. That said, there have been several high-profile investors (Andurand, Ek, or Lansdowne) that have been raising funds to allocate to the space. Hedge Funds own around 3%-6% of the carbon credits market, with the expectation of hoarding credits (in Europe they do not have an expiry date) to sell them at higher prices in the future.

Carbon Sinks

Reducing carbon emissions is essential to balance the carbon cycle. But looking at it from the other side of the equation – increasing the carbon sequestration on earth – is equally important.

Carbon sinks (or carbon capture certificates) are similar donation mechanisms as carbon offsets but target mostly projects (frequently associated with disruptive technologies) finding ways to sequester carbon rather than reduce its emission.

The tenure of the carbon capture projects usually impacts its price, with longer projects ending up being more costly.

See some examples:

• Climeworks, a direct air capture technology, is estimated to cost almost $1,000 per tonne of CO2 sink, which is expected to sink those emissions perpetually.

• Carbonfuture sells biochar sinks for about $100-120 per tonne, which is estimated to sink its emissions at least for 100 years.

• Earthly or Pachama sell reforestation projects for as little as $10-20 per tonne, which are expected to have a limited carbon sequestration time horizon, given the long time gap for forest consolidation and the complex forest management system for long time horizons. The UN also has a portal to sell these – UN Carbon Offset Platform.

These new products have not yet hit massive market – unlike carbon credits, which have become an increasingly more liquid market, and carbon offsets, which can be easily found at e-commerce checkouts or flight booking platforms.

Carbon sinks are top of mind in the start-up world and leading businesses within the carbon transition space are making carbon sinking part of their CSR efforts. A clear leader being Stripe, which is creating yearly portfolios of carbon removal projects (total committed to date $9m, so not very significant) – from the simplest to the more complex – to drive corporate support into these disruptive scalable technologies.

All of this means that the carbon story is only starting and will become an ever more important thematic for investors, businesses, politicians, and entrepreneurs in the coming years. To us, the positive side of this is that governments are using open market mechanisms with financial implications to drive compliance of an environmental goal. The question of profitability and sustainability is, as a consequence, a touch more aligned.

Let's hope to continue to see progress on this in the future.