The Voluntary Carbon Market: New Report by BMO Equity Research
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In this special episode from BMO’s IN Tune Podcast, host Camilla Sutton is joined by Rachel Walsh to discuss The Voluntary Carbon Markets research report.
IN Tune features Equity Research analysts from BMO Capital Markets and explores key emerging themes, trends, and important issues to our institutional clients globally.
In this episode:
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Why this market is currently in its “carpe diem” moment and has arrived at an important crossroad
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While this market is slated for impressive growth, its potential is predicated on an ability to deliver high-integrity products
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The certain nuanced aspects of the market, including differences with compliance and voluntary markets, credit-quality criteria, and the implication of Article 6 of the Paris Agreement
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Michael Torrance:
Welcome to Sustainability Leaders. I'm Michael Torrance, chief sustainability officer with BMO Financial Group. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic, and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment business practices and our world.
Disclosure:
The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates, or subsidiaries.
Camilla Sutton:
The Voluntary Carbon markets are complex growing and receiving a lot of attention. On today's INTune podcast, we explore why they are important, what they are used for, how pricing works, and everything else that is critical for investors to understand. I am Camilla Sutton, MD and in Equity Research. And I'm joined by my colleague, Rachel Walsh, carbon innovation analyst speaking about her September report, which provides an in depth look at voluntary carbon markets. Rachel, I'm excited you're here. And I'm really curious where you're going to take us on today's conversation. Why don't we get started by setting the stage? Can you walk us through what the differences between voluntary and compliance carbon markets?
Rachel Walsh:
Thanks, Camilla. So, I think it's really important for listeners to understand that these are two very different markets that operate in parallel to one another, and that the credits between these markets are not interchangeable. First, on compliance markets, these markets are set up by government regulators to try and influence emissions reductions within their control. And participation in these markets is not optional. For these regulated entities who are typically very large stationary emitters - you can think of power generation facilities, chemical plants, refineries, just as some examples - I think it's also important to consider how credits are generated in the compliance market. They're created by emitters for outperforming whatever arbitrary cap or emissions intensity benchmark the regulator has set. And I think it's really important to note that there is no discernible difference between these credits as a result. You know, just to put that into context, a company might decide to dial back its operations during a time of economic hardship, which in turn could lower its emissions and allow that company to create compliance credits. Under this rules-based system, those credits would have the same economic value as a company that's actively investing in emissions mitigation technologies, assuming they were monetized at the same time. Now, this is a key differentiator between voluntary and the compliance markets. In addition to that compliance markets are quite exclusive. And participation is often restricted to regulated emitters and the financial intermediaries that help facilitate trades for them. And looking at the voluntary market. This market facilitates exactly what its title suggests it does, it's for the voluntary purchase of credits for those that wish to offset their emissions. That could include large corporations, foundations, governments or even individuals. You know, for corporations, specifically, the ability to voluntarily offset their emissions is becoming increasingly popular with the explosion in net zero targets. And credits in this market represent projects that have direct climate benefit, including those that reduce greenhouse gas emissions through mitigation activities are those that remove carbon dioxide from the atmosphere. And there is great pricing differentiation within this market based on the project type that these credits represent. In addition to that, there's no limit on participation in the voluntary market, unlike compliance markets. And then I think the only other major difference to note is the market size here, compliance markets have totaled roughly over $100 billion US and traded volume in 2021, while the voluntary market has reached just over a few billion dollars.
Camilla Sutton:
Rachel, I love the way you sum that up, you answered so many of my questions you touched briefly here on pricing. So can you walk us through and help us understand a little bit better about carbon pricing in the voluntary market?
Rachel Walsh:
Yeah, I think it's really important for listeners to understand the degree of pricing variance within the voluntary market. While a credit is meant to reflect the reduction or removal of one metric ton of carbon dioxide, each credit doesn't reflect an equivalent outcome. No, that disparity is largely driven from the quality of credit. So just as an example, take two removable credits. For instance, let's say one comes from planting of trees, and the other comes from direct air carbon capture, where carbon dioxide is removed from the atmosphere and then stored in a geologic formation. Now while the credit from both of these project types represents a single ton of carbon dioxide removed from the atmosphere, the tree may only live for 100 years, at which point the stored co2 is likely reverted back into the atmosphere. In the meantime, the co2 stored underground remains there. So how does the market handle that disparity in quality? Well, it does this through pricing with the longer duration credit trading at a premium. And I think the other key thing I would mention about pricing is that transparency in this market is generally lacking at the moment. Most credits, especially high-quality credits, trade through private over the counter transactions. And as a result, price discovery is generally challenged in the market as a whole at the moment, but we expect that to improve as the market matures.
Camilla Sutton:
So maybe shift course a little bit - Can you talk a bit about core carbon principles in the voluntary market?
Rachel Walsh:
The core carbon principles were coined by an integrity initiative group that aims to improve credibility in the market. And they are a set of attributes that help define the overall quality of a credit. And our report, we took an in depth look at these principles, including the concepts of additionality, permanence, robust quantification, verification, net negativity, and trade-offs. Now, in our minds, the more aligned a credit is with each of these principles, the greater it should be valued. And that is largely because these principles help a buyer determine whether or not a credit is creating a meaningful positive impact. And in our minds, a buyer is going to be more willing to pay up for credit that has clear benefit.
Camilla Sutton:
That's interesting. Can you walk us through a little bit what some of these concepts are like? Maybe start with additionality, permanence, and net negativity?
Rachel Walsh: Yeah, absolutely. First on additionality, this is the most critical aspect of a carbon credit, in our minds. And it's the determination of whether or not the creation of a monetizable credit is needed for a project to go ahead, or in other words, would the mitigation activity had been pursued without this carbon financing? Now, there are two ways to look at this first through a financial lens. And quite simply, that's just the determination of whether the sale of a credit was needed to push project economics over some investment hurdle rate. That rate is going to vary based on general project risk, jurisdictional risk, as well as, you know, a project developer’s access to capital. The other way to look at it would be from a regulatory lens. If an activity is legally required, then it would have happened regardless of the creation of voluntary carbon credits, and that would make it non additional. Now, in our view, any activity that is non additional should not be able to generate credits. It's really important for listeners to realize that additionality is not something that is static; Project economics can change over time, and so can regulations, the quality of a credit can change over time as a result, and that will largely be reflected in pricing. Now on permanence, this is really the quality of how long carbon is stored in some kind of medium, some of which is inherently risky. Think of biomass, for example, we kind of touched on this a bit earlier for reforestation project, a tree carbon is stored and may only live for 100 years. While there is a clear climate benefit to removing carbon from the atmosphere for that period of time. It's certainly not as beneficial as storing it underground for 1000s of years, we expect to credit from a project that stores carbon for a longer period of time to trade at a premium. And then on net negativity credits in this market represent a ton of emissions that are either avoided, reduced, or removed. Now to help listeners conceptualize this, we can think of emissions as being positive reductions as being neutral, and removals as being negative in terms of emissions flux with the atmosphere. If I am an emitter, and I am looking to truly offset my positive emissions, I would need to purchase something that represents negative emissions to do so, or in other words, removals. Now, the appropriateness of buying either reduction or removals credits will be dependent on what the offsetor is using them for specifically, you know, are they looking to use them to reach their emissions reduction targets? Okay, perhaps in that circumstance, only removals are appropriate? Or are they offsetting in excess of those targets than maybe reductions credits are appropriate? You know, in our opinion, negativity should be reflected in pricing. In other words, removals should trade at a significant premium to reduction credits. And that is something that we do see in the market today.
Camilla Sutton:
Those were great explanations. Thank you. One of the things that you highlight in your report is that there's over 170 types of carbon credits, Could you walk us through some of the most popular or maybe some of the ones that you find the most interesting?
Rachel Walsh:
Yeah, a lot of growth in the market lately has been from REDD plus projects, which stands for reduced emissions from deforestation and forest degradation. We are also finding that household device projects are becoming increasingly popular, and these projects would provide fuel efficient cookstoves or water filtration devices to households in developing parts of the world. Not only do they lower fuel use in those communities, they also reduce emissions and they burn a lot cleaner than the open pit fires that these families would otherwise be using, which can lead to significant health benefits in those communities as well. I think the most intriguing project types go forward are ones that represent removals. For reasons we touched on previously. Some removal projects that are active today include reforestation, a forestation and egg roof forestry, which are essentially the planting of trees in different environments. Now, direct air carbon capture and sequestration is something that is currently transitioning from a pilot stage to commercial development for a few companies. And it's something that's really intriguing to watch these projects capture carbon dioxide from the atmosphere, and inject it into geological formations for permanent storage. This represents the highest-quality project type that we looked at in our report, and development of these technologies have significant impacts on the market, in our minds. And then there's a lot of emerging removal technologies like enhanced mineralization, which essentially accelerates part of the carbon cycle and stores carbon permanently in mineral form, which while that's early days, we think that's really intriguing to watch.
Camilla Sutton:
You've talked a little bit about quality. Can I just push you on that a bit? Can you talk a bit more about how much quality of the offsets matter?
Rachel Walsh:
Yes, so quality is the most critical aspect of the market, in our minds. Ultimately, success for this market and its future growth are going to be dependent on its ability to deliver high integrity products. You know, going back to our discussion on core carbon principles, these attributes indicate that a credit represents a meaningful emissions outcome. If these credits don't represent that offsetting is not going to lead to neutralization of those related emissions, and total emissions will continue to rise as a result. Now that opens buyers in the market up to reputational risk, and that could deter them from accessing the market all together, in our minds.
Camilla Sutton:
Within Equity Research, BMO covers 930 companies, and one of the things that you've done is look at all of these with regards to corporate offsetting. Tell us a bit about what you learned.
Rachel Walsh:
I think the biggest takeaway was just how much inconsistency there was on offsetting disclosures across our coverage universe, some companies merely mentioned that they were using offsets, you know, some directly referenced using high-quality offsets, but then didn't speak to what that meant to them, exactly. And then interestingly, there were even a few companies that disclosed outright that they were using offsets that we would identify as being low quality. I think that speaks to just general lack of sophistication in offsetting, and also a lack of official guidelines in the space at the moment. Those things are currently being developed. We touched on a few of them in the report, which you know, kind of serve as a method of best practice. I think, as those things continue to be rolled out, and certain requirements come into play, advisory services are going to emerge, disclosure around the role of offsetting what volume is being purchased, and the level of quality that is being used are going to quickly improve.
Camilla Sutton:
Looking out into the future: What do you think is the most interesting area or the most interesting areas to watch when it comes to voluntary carbon markets?
Rachel Walsh:
I think for me, it's the implications that Article 6 is going to have on the market. You know, just quickly on Article 6, it's a provision in the Paris Agreement that sets guardrails for what are considered internationally transferred mitigation outcomes to help countries reach their reduction commitments, just as some industries can't decarbonize at the same cost countries run into the same problem. And this provision allows them to trade emissions outcomes. One really critical component of Article 6 is something called corresponding adjustment, which is an accounting measure that makes sure that double counting has not taken place. Imagine a credit is being generated in one country and is sold to a buyer and another corresponding adjustment would be required, where the country that is producing the credit would have to raise their emissions inventory, because the country that is purchasing the credit is now reducing their emissions inventory. So how does this impact the voluntary market? Well, it gives the exporting nation the authority to interrupt international trade of voluntary credits, essentially, those governments have to authorize export of those credits. Now, if you're a country with your own climate commitments, you wouldn't want to be exporting your credits in excess or it'd be difficult to reach those commitments. And you're already seeing the impacts of this India recently restricted export of voluntary credits until they're able to reach their own commitments under the Paris agreement. And Indonesia has also interfered with certain aspects of the market while it considers its own compliance market. So there's been a few other examples of this as well, but it's certainly already hitting news. Now, there are ways to mitigate risk of Article 6 for voluntary market players, and that could include trading credits domestically to avoid any implications from this. Now that would provide that emitters and these project developers are in the same jurisdiction. Either way, this adds a layer of complexity to this already complex market and investors need to be aware of it.
Camilla Sutton:
Rachel, I really appreciate you joining us today and sharing all of that knowledge. That was Rachel Walsh BMO carbon innovation analyst. BMO Capital Markets is proud to deliver a thoughtful analysis of upcoming Equity Research trends that will prove important to clients investment decisions for both its INTune podcast as well as our commodity specific metal matters hosted by Colin Hamilton. If you enjoyed today's INTune podcast, please do subscribe and rate it.
Michael Torrance:
Thanks for listening to Sustainability Leaders. This podcast is presented by BMO Financial Group. To access all the resources we discussed in today's episode and to see our other podcasts, visit us at bmo.com/sustainabilityleaders. You can listen and subscribe free to our show on Apple Podcasts or your favorite podcast provider and will greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO's marketing team and Puddle Creative. Until next time, I'm Michael Torrance. Have a great week.
Disclosure:
The views expressed here are those of the participants and not those at Bank of Montreal, its affiliates, or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy, or security. This presentation may contain forward-looking statements. Investors are caution not to place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only and does not constitute investment, legal, or tax advice, and is not intended as an endorsement of any specific investment, product, or service. Individual investors should consult with an investment tax and/or legal professional about their personal situation. Past performance is not indicative of future results.
