The pros and cons of carbon credit 'streaming'
The voluntary carbon market has borrowed a concept from the gold mining sector known as ‘streaming’.
Companies that are active in the nascent carbon streaming industry suggest that they offer investors a way to get exposure to the underlying value of carbon credits, while also reducing the carbon credit generation risks to investors, since they are involved in a broad portfolio of carbon offset projects.
So first off, what are ‘streaming’ contracts?
Streaming contracts seek to monetise expected future production and assets from a venture. The best way to think of it is an agreement to provide finance but the capital and interest is paid in the underlying product generated, e.g. gold. This gives project financiers flexibility as they can then either sell the gold or store it to speculate on the price going up.1
Streaming can in theory be applied to anything that generates a predictable flow of assets. Although typically applied to commodities, it could equally be applied to carbon credits generated by offset projects, or intellectual property assets such as music rights.
The origin of streaming
Gold mining companies have turned to streaming contracts as an alternative source of finance. Banks and other financial institutions are often cautious about lending to the gold mining sector. Poor returns in the past and concerns over ESG issues has meant that many traditional forms of finance are not always available, especially to junior and mid-tier mining companies.
In the mining sector a streaming contract is an agreement to purchase all or part of a mine’s future production at a predetermined price, usually well below market value at the time of the contract. Streaming deals typically start off being well protected. Contracts are based on the streaming company paying only between 20% and 30% of the prevailing commodity price for the ‘stream’ as it is delivered – so that their product ‘cash cost’ provides a very large profit margin when re-sold to recoup their loan. However, any subsequent reduction in the commodity price will reduce the absolute value of that margin.
Streaming contracts were originally used against the by-products of a mine (e.g. gold is often a by-product from copper mining) but which tends to be undervalued by traditional sources of finance. Initially focused on the precious metals markets, streaming has expanded into base metals like copper, nickel and zinc; energy opportunities including oil, gas and coal; and even rare earth metals and diamonds.
Streams have traditionally been negotiated for the life of a mine, with the terms of the deal based on a mine’s proven reserves. That means streamers get a windfall when companies successfully develop new reserves. As competition in the market has heated up mining companies have had mor room for negotiation. Increasingly, mining companies are adding buyback options on the streams or caps on the metal deliverable to streamers. This helps the mining company preserve more of the upside potential.2
What is the value of streaming contracts?
For the mining company, a streaming contract has both pros and cons. The upside is that the mining company has cash upfront which can mean the difference between the project being successful or not. The drawback is that the contract limits the potential upside in the commodity price, and it could reduce the perceived value of the mine to a prospective buyer somewhere down the line.
Afterall, the streaming contract reduces the incentive for the mine operator to invest in exploration since every additional ounce goes to the streaming company under strict conditions. Meanwhile the very nature of ‘streaming’ is that it only tends to be used by junior miners without access to better forms of financing. Otherwise they would not be using it.
The value to investors is that they get exposure to the underlying commodity but without the risks of developing and operating a single mine. Cost overruns hurt investors in precious metal miners. Cost overruns are irrelevant for stream holders; as long as the mine is producing then the streamers get their income stream.
What does this mean for the voluntary carbon market (VCM)?
In the same way that a gold streaming contract is an agreement to provide finance with the capital and interest paid in gold, a carbon streaming contract provides funds to a project develop in return for payment via a stream of carbon credits generated by a project.
These carbon credits can then be sold, or stored in anticipation of higher prices in the future. Nevertheless, there is a tension though in the storage of carbon credits that doesn’t exist in gold, and other commodities.
First, a carbon credit can only be said to have achieved its aim (see box below) once that credit has been retired, and can no longer be traded. In the meantime, the credit could be traded multiple times between various parties. An ounce of gold doesn’t need to do anything to provide value to the holder.
Second, the value of carbon credits tends to decay over time. Older vintages do not command the same value as credits generated today. In contrast, an ounce of gold extracted from a mine 100 years ago has the same value as one pulled out of the ground today.
Part of the reason for this decay relates to concerns over the quality of older offset projects. To go back to basics carbon offset projects, the value of a carbon credit depends on whether the carbon offset project is real, measurable, additional and its permanence. Older offsets may have been carried out under less rigorous accounting standards.
The carbon credits sector is also still going through a very early period of price discovery, much like other commodity markets evolved. For example, it took many years for the oil industry to accurately price various grades of crude oil following the breakup of the “Seven Sisters” oil company oligopoly which dominated global oil until the mid-1970’s.
Investors may also be getting the wrong idea that carbon credit prices can only go up. Back in February I highlighted the scenario analysis carried out by BNEF and published in their inaugural Long-Term Carbon Offset Outlook 2022. According to BNEF the quality of carbon credits eligible to meet corporate net-zero goals will be the most important factor influencing future price evolution.
Their voluntary market scenario (🟪 in the chart), assumes that all types of carbon offset supply are permitted, including offsets that avoid emissions rather than removing them. In that scenario the price of carbon offsets could remain anchored to current levels (of around $10 per tonne) throughout till 2040.
Carbon streaming companies are not without risk. They are competing against other project developers, often with little in the way of carbon offset project experience, and in jurisdictions where there is significant geopolitical risk. Depending on the terms of a deal the streamer may not have any significant influence over the management of the carbon offset project. It may take several years for an offset project to deliver carbon credits. In an extreme scenario the project might fail. No carbon abatement, no carbon credit stream, and no revenue.
Unlike ordinary companies with a stream of near-term revenue from what are usually predictable businesses and stable customers, carbon streaming companies own the future revenue from highly unpredictable activities and highly volatile carbon credit prices, both now and into the future. It is crucial for investors to understand how they have been valued on the balance sheet. For example, what carbon credit price has been assumed going forward, and why.
One of the few publicly traded carbon streaming companies, Carbon Streaming Corp. (NETZ) floated on the Canadian NEO exchange in July 2021 at around C$7.50. In the second half of 2021 it soared to a peak of near C$17 in mid-December, but has since dropped almost 50% to C$9 in mid-March. The boom and bust mirroring the trend in nature based carbon credit prices.
Carbon streaming contracts are an innovative way to provide financing to offset projects. However, the future value of carbon credits underpins the entire value proposition. In short, carbon streaming companies looks like a very risky way of investing in future demand for carbon offsets.
What are carbon credits?
A carbon credit is issued by carbon crediting body and represents a unit of emission reduction or removal of greenhouse gases. The purchase of a carbon credit should offset a tonne of carbon emissions by the emitter. These credits are tagged and tracked and the holder or purchaser of the carbon credit can surrender it or retire it to meet carbon neutrality or their emission reduction goal. Verification bodies act to ensure that the carbon credits meet strict standards.
Projects approved for carbon offsets under the VCM can be grouped into the following four categories:
- Avoided nature loss in which forests, grasslands, wetlands, peatlands, and other natural carbon sinks are protected.
- Technology-based avoidance/reduction, for example, transition to renewable energy in jurisdictions where renewable energy is not yet mandated, capturing methane from landfills and dairy operations, deployment of efficient cookstoves in rural households, and recovery and destruction of fluorochemical refrigerants.
- Nature-based removal which restores natural carbon sinks via, for example, reforestation, regenerative agriculture, and mangrove restoration.
- Technology-based removal and sequestration in which CO2 is separated from industrial stack emissions and either injected into secure geologic formations or used in manufacture of durable materials such as carbon fibre and concrete.
In contrast, a royalty contract usually just gives holders a simple cut of the revenues from a mining operation. The royalty company never takes delivery of the gold but receives the proceeds from its sale.
In 2004 the first streaming deal created the streaming company Silver Wheaton, now known as Wheaton Precious Metals. Wheaton and Franco Nevada are focused on silver and gold projects in North and South America. The other three major streaming companies are Royal Gold, Osisko Gold Royalties and Sandstorm Gold. These large streaming companies hold a portfolio of different streaming opportunities so the risk of any particular mine not performing is mitigated.