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Highlighting Key Concepts - Offsets, Credits and Avoidance

September 6, 2021

Rina Cerrato & Chris Searle

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Highlighting Key Concepts - Offsets, Credits and Avoidance

By Rina Cerrato & Chris Searle

We Agree On the Goal Being Less Carbon In The Atmosphere

Investment strategies based on carbon markets and potential avoided emissions (PAE) have the same goal; achieving value whilst reducing carbon in the atmosphere. Despite the similarity in goal, the approaches are quite distinct, and the reduction and offsetting associated with the former can have very different outcomes to the avoidance of the latter. As we race towards 2030 we hear constant discussions around decarbonization and net-zero. In many cases terminology is being used interchangeably and creating confusion amongst the investment community.

We believe that the best way to reduce carbon in the atmosphere is by not emitting in the first place. In this article, iClima Earth will explain carbon markets and carbon pricing with a focus on the definition of offsets, credits, and avoidances. Although carbon markets are an important tool in fighting climate change, we will show that their impact potential is limited, and if communicated poorly they can obscure more robust solutions such as PAE.

Our investment strategy at iClima.Earth is built around the Potential Avoided Emissions framework. Rather than rewarding companies for emitting less, we look instead to the providers of alternative low-emission solutions to Business-as-usual. For the providers of these solutions, decarbonisation is their raison d’être. We believe that such a realignment of investment priorities is a more relevant way for finance to stimulate a transition to Net-Zero in the time that we have. The use here of the Avoided Emissions framework should not be confused with the term ‘avoided emissions’ to describe offsetting within an investment portfolio in order to claim carbon neutrality (see here for example). For more on the Avoided Emissions framework and our use of it see here.

A sentence epitomises our belief: The best way to reduce carbon in the atmosphere is by not emitting in the first place. The delta between the current high emissions products & services and the low or zero emissions new ones is their Avoided Emissions. Please do not be confused with the ambiguous use of “avoided emissions” to describe offsetting schemes.

Putting a Price on Carbon

The IPCC’s most recent report was as stark as any:

Human influence on the climate system is clear… Continued emissions of GHGs will cause further warming and long-lasting changes in all components of the climate systems… Limiting climate change would require substantial and sustained reductions in GHGs, which together with adaptation, can limit climate change risk”. IPCC, 2021

2020 witnessed a proliferation of companies and countries pledging emissions reductions through the setting of net-zero targets. According to the World Bank, as of December 2020, 127 countries, 823 cities, 101 regions, and 1,541 companies have committed to reaching Net-Zero by 2050. The term ‘net’-zero is important for our discussion here. It is used because many sectors will not be able to reach absolute zero, meaning technology will be needed to actively remove carbon from the atmosphere to counterbalance continued emissions. Hold that thought...

As capitalism evolved in the late 20th century and became more neoliberal, markets became the dominant way to manage environmental problems. This became known as third wave environmentalism. In order to stimulate the reduction of emissions towards the goal of mitigating climate change; therefore, the idea of assigning a price to carbon emerged. This price acts as a signal to incentivize GHG emission reductions through investment in emissions reductions or the avoidance of high emission projects or actions. The two primary methods of carbon pricing are emissions trading systems like cap-and-trade, and carbon taxes. The figure below is a representation of the different carbon pricing systems globally – implemented and under consideration.

                                          Countries & Carbon Pricing Systems

Source: World Bank, 2021

                                              

                                                                                                                         

Trading Carbon – the Kyoto Protocol

In line with iClima’s activities, this article focuses on emissions trading systems rather than carbon taxes. Carbon taxes are a powerful way to instigate emissions reductions but are not without political complications. As discussed, third wave environmentalism sought to provide an economic incentive for industry to undertake emission reduction activities, thereby letting the markets set a price on carbon. Carbon markets were created under the Kyoto Protocol (UNFCCC) to establish a flow of funds for climate change mitigation, primarily from advanced economies to less advanced economies. It engaged governments and the private sector and, in addition to a flow of funds, created a transfer of technologies.

Under the Kyoto Protocol, signatory countries from advanced economies undertook commitments to limit or reduce their GHG emissions. This is akin to the ‘cap’ part of modern schemes. Additionally, the Kyoto Protocol introduced three market-market based mechanisms to allow countries to meet their commitments. In subtly different ways, these mirror the ‘trade’ aspect of modern schemes:

  • Emissions Trading
  • Clean Development Mechanisms (CDM)
  • Joint Implementation (JI)

Emissions trading was made possible by the creation of assigned amount units (AAUs) which quantified national commitments during the first Kyoto commitment period of 2008-2012. This was effectively the first iteration of a carbon budget, with countries committing to keeping emissions under a certain level. Going over this allowance would equal using up the budget, thus requiring the purchase of AAUs from countries that had left over emissions if binding Kyoto commitments were to be met.

CDM and JI facilitate the funding of emissions reductions projects primarily in less advanced economies. In return for funding, more advanced countries would receive certified emission reduction credits (CERs), emission reduction units (ERUs) or, in the case of reforestation activities, removal units (RMU).

The selling and buying of instruments (CERs, ERUs, RMUs, AAUs) under the Kyoto protocol as described above laid the foundations for carbon markets as we know them today.

It is the first global, environmental investment and credit scheme of its kind, providing a standardized emissions offset instrument, CERs.” UNFCCC

Carbon Markets Today

Carbon markets today can be categorized as

  1. Compliance markets
  2. Voluntary markets

Compliance Markets

These are known commonly as cap-and-trade markets. In a cap-and-trade market, large emitters or other obligated parties must keep their emissions below a cap - the maximum number of emissions allowed to be emitted on an annual basis. Reporting annually to the regulatory authority, parties within the market must pay a fine if their emissions per facility are over their stipulated cap. Parties have three compliance options to remain under their cap; direct emissions reductions actions, allowances, and offsets, the latter two being forms of tradeable unit.

  • Direct emissions reductions should be the first point of action. These make the greatest material contribution to reaching net-zero.
  • Allowances are permits to emit up to the designated cap. Allowances are allocated to a facility or can be bought at auction. The number of allowances allocated to a facility or available for auction is determined by the regulating entity based on the cap. The cap reduces on an annual basis, which means that the number of allowances also reduces. Revenue generated through the auction of allowances may be earmarked for spending in climate adaptation and mitigation programs.
  • Offsets can be bought to meet a portion of the obligation. Some markets, like the California Cap and Trade system, set a limit on the use of offsets for compliance – only 8% of a facility obligation can be met with offsets. Offset issuance is controlled by the regulatory framework under which they may be used.

Voluntary Markets

Independent markets not covering regulated facilities, and not governed by a regulatory framework to meet a set cap or reduction goal are known as voluntary markets. Participation in the creation of offsets and credits, and their use is voluntary. Companies that want to claim carbon neutrality may choose to participate in voluntary carbon markets in order to offset their carbon emissions without undertaking direct emissions reduction actions. The same oversight applied to offset creation in compliance markets applies to voluntary markets – offsets are generated on a project basis, and issuance is managed under a registry. They must be audited by a third party so there is a level of assurance of the reductions being real. These markets are gaining momentum, with some of the independent crediting mechanisms gaining approval for use some regional, national, or subnational mechanisms such as the International Civil Aviation Organization (ICAO) Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).

The Positive Potential of Carbon Markets

“A liquid voluntary carbon market at scale could allow billions of dollars of capital to flow from those making net-zero commitments into the hands of those with the ability to reduce and remove carbon, significantly contributing in the transition to net zero”. TSVCM, 2021

Allowances may be instigating action by setting a base price for carbon. In the EU ETS, as offsets quotas have been reduced, allowances have gained greater trading value. For 2021, the cap is 1,572 MtCO2e (not taking into consideration the aviation cap), with a linear reduction of 2.2% per year. Therefore, by 2030 the cap will be at approximately 1,287 MtCO2e – a total reduction of approximately 18% over the ten-year period of the trading phase. The linear 2.2% reduction means a linear reduction of the cap by 43 million allowances per year. Combined with net-zero commitments, the value of allowances increases, in turn making it more expensive to continue to emit.

To effectively achieve targets of net-zero, the cost of emitting must be high enough to incentivize emissions reductions. It has been estimated that carbon prices must be in the range of USD 40-80 per tCO2e to do this. The World Bank estimates only 3.76% of global emissions are covered by a carbon price above this range. With the cost of allowances (see below) going up, there is a path to incentivize the transition to avoidance.

Source: Bloomberg, 2021

The Refinitiv Carbon Market Survey 2021 provided further evidence that higher carbon prices incentivize companies to reduce emissions. It found in particular that the EU ETS provides a price signal for investment decisions. The survey also found that non-compliance trading (financial investors) is starting to drive an increase in allowance price.

As well as incentives, the financial flows unlocked through carbon pricing generates revenue that can be used to deploy decarbonization technologies in the form of rebates and other programs for consumers or into demonstration projects for innovative low-carbon technologies. For example, in the Phase 4 of the EU ETS two new funds have been set up to this purpose: the Innovation Fund for funding demonstration projects of innovative low carbon technologies (including energy storage and carbon capture and storage CCS); and the Modernisation Fund for supporting 10 lower-income EU Member States to help modernize their energy systems and improve energy efficiency (no funding for CCS). In California, proceeds from the Cap and Trade Program are deposited into the Greenhouse Gas Reduction Fund and used to fund the California Climate Investments program to support GHG reduction and economic projects and programs that benefit low-income communities, low-income households, and disadvantaged communities. There is a legal requirement for at least 35% of the funds to go to disadvantaged communities, and low-income households or communities.

 

Limited Coverage Is Holding Back This Potential

We have seen how voluntary markets create incentives and innovation. However, according to the Task force on Scaling Voluntary Carbon Markets (TSCVM), for voluntary markets to have a meaningful impact in supporting the global goal to limit temperature increase to 1.5 degrees Celsius, they will have to grow more than 15x by 2030. This growth is limited by supply in demand, in that the current demand is less than the supply and its growth trend.

‘Demand is short to support net zero, while supply is growing by 31%’ TSVCM, 2021

Looking at a case study, the EU’s overall emissions by 2018 were 3,893.1 MtCO2e and the cap at that time was approximately 1,909 MtCO2e. The breakdown of overall emissions by sector is shown in the image below. Considering that the cap applies to covered facilities only, the cap is only addressing 40% of the EU emissions, leaving and achieving less than 10% of the overall goal of cutting global emissions in half by 2030.

Source: ICAP, 2021

Zooming out, the graph below shows the share of global GHG covered by carbon pricing, based on data from 1990-2015 (most recent data available). In 2021 there are 64 different carbon pricing mechanisms in operation, globally, covering less than 25% of the global emissions, or 21.7% as the World Bank estimates. If global emissions are trending to reach 56 GtCO2e by 2030, then these carbon pricing mechanisms are only addressing 12 GtCO2e of the 26 GtCO2e reduction required by 2030.

Source: World Bank, 2021

Deep-diving Carbon Offsets

Offsetting is the act of displacing or reducing emissions at their source. Within a carbon market, offsetting activities are rewarded with tradeable carbon credits. Offsetting is used within compliance or voluntary markets for activities that reduce emissions compared to the business-as-usual scenario.

The process of offsetting is more than just planting trees. Crucially, offsets must be real, additional, quantifiable, permanent, verifiable, and enforceable, and canonly be issued through a closed registry following a registration and verification process. The reductions must be quantified using an approved quantification methodology or protocol, recognized by the registry and verified (usually) annually. This means no random claims from someone that says, “hey I have a forest and can generate x number of offsets”. Third party auditor sundergo a rigorous approval process to become recognised as validation and verification entities.

Each offset issued has a serial number, which is used to track the offset through the transfer in the registry. An offset can be transferred within the registry between the seller and the buyer, as long as it is not “retired” or used for compliance or used for a carbon neutrality claim. An offset can only be used once. The transfer of offsets is done under purchase agreements between a buyer and a seller, and the trade is done within the registry. Anything done outside of a registry should not be considered a credible investment that has undergone the proper due diligence to demonstrate the reduction is real, additional, quantifiable, permanent, verifiable, and enforceable. Anything outside of a registry suggests the validity of the offset has not been verified by the overseen standard.

Greta Said Offsetting Was Bad?

This is an ongoing debate. We at iClima Earth believe that off setting has a very defined role to play in the decarbonisation of the economy. Remember net-zero versus absolute zero? There will be sectors of the economy which simply cannot be decarbonised by 2050. Aviation, for example, will most likely fit under this umbrella. Here, offsetting will be necessary, hence us returning to the term ‘net’-zero. Additionally, and less widely appreciated, offsetting is an important way to help companies achieve compliance with carbon pricing mechanisms. Just as offsetting can provide the final flourish for our journey to net-zero, as it can provide the initial impetus, getting reluctant or hard to abate companies to begin reducing their emissions and participate in carbon markets whilst buying them time to plan their decarbonisation strategy.

Offsetting can become dangerous when it disincentivizes real carbon reduction activities, but carbon markets are increasingly integrating ratchets into their structure that mean actors cannot rely on offsets forever. Here again, the EU ETS provides an illustrative case study:

The EU ETS is designed to limit emissions from around 10,000 installations in the power and manufacturing sectors, as well as aviation between Member States; it is now in its fourth trading phase (2021-2030). In its first phase (2005-2007), offsets were supplied from the CDM and JI mechanisms from the Kyoto Protocol and there was no limit to their use.  In the second and third phase (2008-2012 and 2013-2020, respectively), the use of offsets was capped to 50% of the overall reduction. For these periods the cap on offset usage permitted only 1.6 GtCO2e were used for compliance (ICAP). Assuming an equal number of offsets surrendered annually for those 13 years, then the demand for offsets was only 133 MtCO2e (million tonnes). 1.6 GtCO2e is only 5% of the annual emissions decline needed to cut emissions in half by 2030. In the fourth trading phase, offsets can no longer be used in EU ETS.

Offsetting, then, is useful in a defined role, at the start and the end of a journey to net-zero:

“Offsetting can play a useful role in catalyzing action, but this should not come at the expense or delay of emissions reductions and investments in low-carbon, zero-carbon, or net-negative technologies.” World Bank, 2021.

The role of offsetting should clearly not be overstated. For the voluntary market, the TSVCM Report states “in 2017, some 44 MtCO2e worth of carbon credits were retired, allowing the purchaser of these carbon credits to claim to have offset emissions by financing emission reductions elsewhere. Over twice as much volume of credits, 95 MtCO2e, have been retired in 2020”. That is approximately 0.4% of the required 26 GtCO2e reduction of the global emissions trend by 2030. As voluntary markets gain momentum for use in aviation or in the path to net-zero, their role will be complementary to real avoidance. Net-zero requires no new emissions to be released to the atmosphere, which suggest the role of voluntary markets will be limited to sequestration and removal type projects. In other words, companies making net-zero commitments cannot use offsets to avoid the direct emissions it generates; thus limiting the impact of voluntary market offsets.

“Offsetting by it’s nature involves redistributing responsibility for emissions reductions across sectors or borders, its role is necessarily limited where deep decarbonization is required across the board.” World Bank, 2021

 

Conclusions

According to the International Emissions Trading Association (IETA),carbon markets are a strong policy instrument:

“It is the most economically efficient means of reaching a given emissions reduction target. It is specifically designed to deliver the environmental objective; and, it delivers a clear price signal against which to measure abatement investments.”

Voluntary markets fill in the gap for those sectors, industries and companies that are not mandated to reduce under regional, national, or international regulatory frameworks. An increasing number of companies have committed to net-zero targets, which will require a mix of direct emission reductions and carbon credits generated by high-integrity voluntary projects that avoid, reduce, or remove carbon.

There are several initiatives evaluating the role of carbon offsets on the path to net-zero and there seems to be greater consensus that offsets should be limited to removals of unavoidable emissions if they are to count towards net-zero commitments. This would likely limit offset eligibility to forestry and carbon capture storage (CCS) project types.

Forestry in the form of afforestation and reforestation is the most readily available form of sequestration, but the carbon reductions can be reversed intentionally (forest management) or unintentionally (forest fires). According to the International Carbon Action Partnership (ICAP), the potential reductions from forestry are limited to 3.6 GtCO2e per year by 2050. This is approximately 6% or less of projected emissions levels of 56 GtCO2e by 2030. Therefore, for forestry to be truly impactful, more is needed and there remains the threat of carbon release through forest fires, a threat which is heightened with climate change.

Overall, the carbon pricing mechanisms and policies in place have the potential to cut 25% off the GHGs expected in 2030 (UN Emissions Gap Report). If we assume the World Bank finding of 21.7% of global emissions covered by carbon pricing, we can deduce falling short of the required reductions to achieve net-zero by 2050. Similarly, the Emissions Trading Worldwide: ICAP Status Report shows that ETS cover only a small portion of overall global emissions. Greater impact, therefore, may be achieved through the adoption of decarbonizing technologies and solutions that, rather than simply reducing, avoid the release of GHGs.