The voluntary carbon market (VCM): At the edge of the carbon market risk curve

At the edge of the carbon market risk curve you will find the voluntary carbon market (VCM).

Up until this point I have only discussed carbon markets from the perspective of the formal carbon compliance markets, such as the ones active in Europe and California.

Regulated. Legal. Transparent. The rules of the market are (mostly) clear. The voluntary carbon market (VCM) has none of those features.

The VCM enables corporations, organisations and individuals to purchase carbon offset credits from environmental projects located across the globe. The idea being that by outsourcing the carbon abatement it is achieved in the most efficient way possible, thereby reducing costs for the organisation (or indeed the individual) seeking to offset their carbon emissions.

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.

The first carbon offset project dates back to 1989. An American power company offset the emissions from a new coal-fired power plant by providing $2 million in finance to Guatemalan farmers. The project helped finance the implementation of agroforestry practices reducing the need to expand commercial agriculture into the forests.

Carbon credits or offsets should not be confused with the carbon emission allowances which are traded in the carbon compliance markets. In the latter, emission allowances must be purchased in order to comply with an imposed regulation or regulatory act. Unlike the formal compliance market the VCM is unregulated. There are no legal requirements for businesses to purchase carbon credits.

Some compliance markets, such as California’s allow carbon credits to help utilities and major energy users meet their formal carbon reduction commitments. Although, carbon offsets from the voluntary market must only be used in limited quantities, and only if they meet certain strict criteria.

What are the different type of carbon offset projects?

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.

Real, measurable, and additional

The voluntary carbon markets rely on an ecosystem of standards and certification organisations, project developers, and verifiers to only recognize emission reductions that are ‘real, measurable, and additional’. Conformance to these core principals and minimum quality thresholds depends on numerous factors including the quality and accuracy of monitoring data, credibility of the crediting baseline, whether impacts are accurately quantified using conservative, transparent methodologies, accounting for leakage, and the rigor of independent, accredited verifications.

Proving additionality requires a project proponent/developer to demonstrate that a given project would not otherwise occur under business as usual. For example, a technology based avoidance/reduction project in a jurisdiction with an existing renewable energy mandate or portfolio standard would not qualify for carbon offset credits under a properly administered program.

Uncertain permanence

The carbon offset market suffers from poor fungibility - one carbon offset is not the same as another carbon offset. To see why consider that climate change is a problem of cumulative greenhouse gases in the atmosphere. Many climate experts argue that the longer that carbon dioxide can be stored before seeping back into the atmosphere, the more valuable it should be.

Some offsets represent avoided GHG emissions that are inherently permanent. For technology-based removal and sequestration projects permanence will depend on how the CO2 is utilised. For example, is it embedded in durable materials such as concrete or is it being used as an intermediate feedstock in alternative fuel synthesis?

Nature-based offset projects are generally considered to provide multi-decade carbon sequestration. Nevertheless, there remains the risk of carbon being released back into the atmosphere (for example due to fire, disease, or illegal logging) that must be accounted for and managed.

Other environmental or social benefits

Carbon offset projects can have secondary benefits in addition to reductions in carbon emissions. For example, conserving forests, wetlands or other natural carbon sinks can enhance natural capital. The benefits of maintaining the stock of renewable and non-renewable natural resources are poorly valued by governments and companies, even though they yield a substantial flow of benefits to people.

Other projects may also provide social benefits. For example, the provision of efficient clean burning stoves lessen the risk of families breathing in noxious fumes, reducing the risk of adverse health impacts. This type of project also reduce the amount of water needed for boiling, which means that labour previously used to fetch water can now be used for more productive purposes.

Carbon credit demand

Net zero pledges have seen exponential growth in recent years.

The Net Zero Tracker, compiled by a group of four non-profit organisations and research firms, tracks the environmental commitments published by the largest 2,000 publicly-traded companies in the world by revenue. As of late 2021 the tracker shows that 682 of them, a little over one-third have technically committed to a net-zero strategy.

However, a more detailed breakdown reveals that many of these net zero pledge are unlikely to make any real difference to operations of the companies concerned. That’s partly because many organisations fail to account for the emissions produced by their own supply chains, despite being a significant source of carbon.

To see why consider the standard framework for measuring emissions, called the Greenhouse Gas Protocol. It defines three broad categories of emissions associated with business operations: Scope 1 covers direct emissions from owned or controlled sources. Scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating and cooling consumed by the reporting company. Scope 3 includes all other indirect emissions that occur in a company's value chain.

If a company does not include Scope 3 emissions in its carbon accounting, then any net zero pledge it’s management makes is essentially useless. For example, Saudi Aramco, the world’s largest oil exporter, and one of the biggest companies on the Net Zero Tracker, does not include Scope 3 emissions in its 2050 net-zero pledge. According to Aramco CEO Amin Nasser, “Scope 3 is the responsibility of end users, regulators, policymakers and governments around the world.” Nothing to do with us guv!

Many of these net zero pledges rely on the use of carbon credits to offset emissions included within the net zero pledge. In fact, almost half of the companies that have committed to net zero intend to rely on carbon offsets, but two-thirds fail to specify the conditions on their use.

The pent-up demand for carbon credits required to meet these net zero pledges is potentially enormous - more on that later.