Coming of age

The evolution of carbon credits fits a pattern of financial innovation

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Estimated reading time ~ 11 mins

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The first carbon project dates back to the late 1980’s.

Concerned about the climate impact of the coal plants his company was developing, the CEO of Applied Energy Services (AES) Roger Sant, sought the advice of the World Resource Institute (WRI). That conversation gave birth to the first avoided emissions carbon credit project. AES agreed to fund the planting of trees and the protection of forest in Guatemala, in return for offsetting the emissions of its coal plants in the United States.

It wasn’t for another decade that governments first entertained the idea that carbon credits could also be the most economical way of meeting national climate targets. Negotiators working on the Kyoto Protocol developed a scheme known as the Clean Development Mechanism (CDM), aping the early innovation employed by AES and its successors.

Barclays was one of the first financial institutions to secure a foothold with which to benefit from the growth in carbon markets. The bank launched its carbon trading business in 2004, prior to the ratification of the Kyoto Protocol (February 2005), and before the EU ETS began operating (January 2005). Other banks were quick to follow, attracted by the potential opportunities in financing, origination, and market making.

The first carbon panic

Global financial turbulence, coupled with political uncertainty, punctured the banks enthusiasm for the carbon trading business. First, EU carbon prices began to fall in May 2008, coinciding with the start of the Great Financial Crisis (GFC). After peaking near €30 per tonne, carbon prices declined to below €10 per tonne by mid-January 2009 as the market anticipated a deep recession would cut emissions, resulting in lower demand for EUAs.

The EU carbon price rebounded somewhat during 2010 and into early 2011, but it wasn’t long before it was under pressure once again as the European sovereign debt crisis erupted. From a high of almost €17 per tonne in May 2011, the carbon price fell to less than €5 per tonne by mid-2013 as carbon market participants feared an increase in the allowance surplus as economies suffering under the weight of austerity would inevitably slow.

The pressure wrought by the GFC and the subsequent Euro debt crisis were the main factors behind the collapse in the EU carbon price, but two other factors made the situation worse. First, the break down in negotiations at COP15, held in Copenhagen at the end of 2009, added to the poor sentiment in the carbon market.

Second, there was a enormous influx of cheap carbon credits (amounting to ~1.2 Gt of CO2) from the CDM and the UN’s Joint Implementation (JI) programme during the period 2008-2014. Japan’s retreat from its climate targets following the Fukushima nuclear accident added to the surplus. The price of certified emission reduction credits issued under the CDM gradually fell from €25 per tonne of CO2 in 2008 to €10 per tonne of CO2 in 2011 before crashing to €0.50 per tonne of CO2 in 2012. Unlike the situation now, EU ETS obligated entities were able to meet their compliance needs through international carbon credits.¹

Many financial market participants had seen enough and started to scale down their carbon trading operations or merged them with their power and gas trading operations (e.g., JP Morgan and Morgan Stanley), or simply got out of the business altogether (e.g., Barclays, Deutsche Bank and UBS).

In addition to the political and structural risks present in the nascent cap-and-trade market, new banking regulations and compliance requirements, introduced in the wake of the GFC, curbed banks ability to trade. Overall, the number of workers employed on the carbon desks of London’s financial centre fell from close to 1,000 in early 2010 to ~200 by the end of 2013.

“To da Moon”

It wasn’t until 2023, after a decade-long hiatus, that Barclays sought to rebuild its carbon trading desk. The bank’s outlook for the voluntary carbon market (VCM) has been particularly bullish, anticipating the opportunity for exponential growth as net zero targets draw near.

Barclays published a report at the time in which they predicted that the VCM would hit a “tipping point” in the near future, enabling it to grow from $0.5 billion currently, to $250 billion by 2030, before reaching $1.5 trillion by 2050. Other institutions were also bullish, albeit to a lesser extent, calling for it to be a mere $50-$100 billion market by 2030 (see Is the VCM a trillion dollar business opportunity?).

Nevertheless, 2023 was arguably the peak for the VCM.

Gartner’s 2023 Environmental Sustainability Hype Cycle, published in August 2023, revealed that ‘Voluntary Carbon Offsets’ were at the ‘Peak of Inflated Expectations’. Gartner uses a variety of market signals and proxy indicators for hype and maturity to assess where different innovations are on the hype cycle. Trove Research, a firm specialising in data and analytics on the VCM, timed the top of the market perfectly, being acquired by MSCI in October (see Divining reality from the hype).

Unfortunately, the race to hitch a ride on the VCM rocket may have resulted in banks and other financial institutions paying over the odds. As with any market where supply is highly price inelastic, a sudden increase in demand can quickly result in higher carbon prices.

But incentives being what they are, this can also result in lower quality carbon projects being bid up in value. In opaque markets in which prices are are being squeezed buyers are often unable or unwilling to carry out the appropriate due diligence. Instead, buyers might rely on rising prices as a signal of quality. This appears to have been the case for so-called REDD+, agroforestry projects that focus on preserving or developing forests in developing countries.

Back to Earth with “defunct assets”

In early 2023, UK newspaper The Guardian and German weekly magazine Die Zeit published the results of an investigation into rainforest carbon abatement credits. Analysing the performance of REDD+ credits issued by Verra, the largest verification body, they concluded that “more than 90% of rainforest carbon offsets by biggest certifier are worthless.” (see REDD+ and the common knowledge game).