According to the International Energy Agency, the world’s CO2 emissions are expected to fall by 8% this year due to the effect of the coronavirus crisis. Estimations are obviously subject to change, but such a drop would be six times greater than the one after the subprime crisis. It sounds like an unprecedented drop, but it is actually the annual pace required for the next decade to stay below the 1.5C limit set by the Paris Agreement.
As you may have understood, lowering our carbon footprint is not an option anymore. Structural changes are needed to reach our objectives as the decrease following the coronavirus crisis is very likely to be temporary. Various mechanisms have emerged to do so, such as carbon offsetting solutions. At Daphni, we’ve been looking at the topic for a while and had a few question marks. So we deep dived into it and tried to get a clearer picture of what carbon offsetting is. Here’s what we found.
Carbon offsetting: /ˌkɑːbən ˈɒfsɛtɪŋ/
“The action or process of compensating for carbon dioxide emissions arising from industrial or other human activity, by participating in schemes designed to make equivalent reductions of carbon dioxide in the atmosphere.”
This article will distinguish the compliance carbon markets, which were defined by the Kyoto Protocol, and are regulated by the United Nations, from the voluntary one that has grown in the past few years. I will further discuss the differences between the two markets below.
I — The compliance carbon markets
Let’s go back to where it all began. In December 1997, Kyoto hosted the third Conference of the Parties (COP 3). The Parties are the countries which joined the United Nations Framework Convention on Climate Change (UNFCCC) in 1994, with the ambitious goal to reduce worldwide greenhouse gases emissions. The awareness around climate change started to rise earlier on, but tangible, international measures were only taken with the Kyoto Protocol.
Adopted in 1997, it only came into effect 8 years later when 55 Parties, representing 55% of industrialized countries’ greenhouse gases emissions, ratified it. One important point to note is that, though developing countries ratified the protocol, it was only binding for developed countries because they were recognized as largely responsible for the level of greenhouse gases emissions. Therefore, the aim of this protocol was for these countries (called Annex B countries) to decrease by 5% their GHGs (=greenhouse gases) emissions between 2008 to 2012, compared to their emissions level of 1990. The commitment period was then renewed until 2020 for most of the countries with the Doha Amendment in 2013, after countries failed to reach a new agreement during COP15 in Copenhagen (2009).
Though all countries were invited to meet their targets through national measures, the Kyoto Protocol allowed for flexibility by letting the Parties trade emissions permits through three market-based mechanisms:
- International Emissions Trading
Emissions trading markets have been set all around the world. In Europe, the EU ETS (European Union Emissions Trading Scheme) was the first one to be created in 2005. It allows companies that have performed better than expected in terms of emissions to sell their unused credits to the ones that did not reach their target, while ensuring that the global objective is respected.
To allow even more flexibility to this mechanism, the Kyoto protocol allows Parties to lead projects in other countries to reach their own objective. Indeed, when fighting climate change, CO2 emissions have the same impact wherever they are emitted:
- Clean Development Mechanism (CDM)
In exchange for the implementation of a carbon offsetting project in a developing country, an Annex B country (i.e. industrialized country) can be given Certified Emissions Reduction (CER) credits that he can sell. Each credit is equivalent to 1 ton of CO2.
- Joint Implementation (JI)
Joint implementation refers to one Annex B country undertaking a carbon emission reduction project in another industrialized country. For that matter, the investing country will earn Emission Reduction Units (ERU) that he can sell.
But how does it work in practice?
As mentioned above, various carbon markets have emerged all over the world (in Korea, California, Canada) but this article will focus on the European one, the EU ETS, which is the biggest and most dynamic one.
Each year, the European Commission allocates emissions quotas to companies from the following sectors, reducing the amount of quotas delivered by 1,74% every year:
- Electricity generation
- Steel industry
- Chemical industry
- Paper pulp
The compliance carbon markets only cover the above-mentioned sectors because they are considered as the biggest contributors of greenhouse gases emissions.
- Though pretty appealing at first glance, the carbon credit trading system has been widely criticized, rightly. Indeed, big industrial groups, which have a great bargaining power, managed to be allocated more quotas than they actually needed, and therefore made tremendous amount of money without even reducing their emissions. A french industrial group even made money by selling the quotas they were given for a factory that they had closed, because it had therefore emitted 0 ton of CO2.
NB: Industrial groups’ lobbying is not the only reason why too much quotas were circulating: the subprime crisis also slowed down factories’ activity and therefore their carbon footprint.
- Also, between 2008 and 2009, carbon markets have led to a massive VAT fraud considered as the fraud of the century, costing 1.7 billion euros to France. If you want to know more about it, I highly recommend the movie “Carbone”, directed by Olivier Marchal.
NB: VAT fraud is very often associated with carbon markets but it is important to clarify that it is very common on all types of markets, (in the food and beverage industry for instance) and it is rather reductive to only associate it with carbon markets.
- Some people also say that the price per ton is too low to encourage industrial groups to improve the performance of their facilities. But the EU ETS is being increasingly regulated to solve that issue (i.e. the amount of quotas available for sale is limited in order to increase the price per ton).
But to stay under the 2 degrees limit, the english website Carbon Brief said that people born in 2020 will have to reduce their carbon emissions three to eight times compared to the ones born in 1950 in order to reach the Paris Agreement’s objectives. The Kyoto Protocol was only the beginning of a massive global awareness on climate change. National actions aren’t sufficient by themselves, and individuals and service companies are growingly concerned about their personal carbon footprint and how they can take action. We are gradually moving from a top-down approach to a bottom-up one. Whether it is because of an environmental consciousness or to be better perceived by customers, individuals and enterprises are increasingly offsetting their carbon footprint: this is what we call, the voluntary carbon market.
II — The voluntary carbon market
It has emerged alongside the 3 flexibility mechanisms of the Kyoto protocol and is now rapidly growing. But unlike the compliance carbon markets, the voluntary one is not regulated, and nobody is compelled to use it. It is still very fragmented and practices are unequal. However, multiple certification labels exist and the trend goes towards more and more transparency in the value chain. Indeed the ICROA (International Carbon Reduction & Offset Alliance) has defined a Code of Best Practices encouraging the use of the highest quality standards.
Below is a diagram showing the different stakeholders and how they interact with one another.
#1 As always, companies offers various services and diversify as they grow. Therefore, some of the companies listed below can belong to more than just one category.
#2 There are obviously more players than the one listed below.
Now, let me explain to you what kind of services each group offers and give you some examples of incumbents or emerging startups in the field.
They are at the very start of the value chain and are the ones concretely setting up the project. It can either be a farmers’ cooperative, an NGO or a conventional company. But what exactly is a project? Well, it can be either the replacement of a fossil fuel power plant by a wind or solar power one, or an improved forest management system (these are just a few examples out of many). Some developers are only operating on a single vertical, agroforestry for instance, and some are operating on various ones. Examples of developers include: Terrapass, Pur Projet, NewForest.
NB: some projects are avoiding future emissions compared to baseline scenario (replacement of a fossil fuel plant with solar panels for instance), and some operate carbon sequestration (agroforestry and coastal or marine ecosystems). Only the oceans, trees and soils have the ability to sequestrate carbon dioxide. Some initiatives to capture carbon with machines have arisen around the world (Carbon Engineering, Global Thermostat in the US or ClimeWorks in Switzerland) but such technologies could disrupt ecosystems and for now, the amount they can capture is still marginal.
Also, developers cannot operate by themselves, they are working conjointly with consultants, auditors and certification labels.
Whether it is in industrialized or developing countries, developers sometimes have no idea they can earn money by selling carbon credits and how, and therefore request help from consultants in setting up their projects. For instance, EcoAct, a sustainable development consulting company develops low-carbon projects internally in addition to partnering with external project developers.
- Certification labels:
There are many different standards certifying the quality of a project, each of them has its own criteria. The most recognised certification labels are the Gold Standard, developed by WWF, and the VCS (also called VERRA) whose standards are inspired by the requirements of the Kyoto Protocol.
They are the people accredited by the certification labels to perform the audit. There are very few of them since it is a very complex sector, for instance, the Gold Standard only lists around 20 companies entitled to audit carbon reduction or sequestration projects. Examples of auditors include: TUV, Ecocert, Bureau Veritas.
This category is probably the most interesting from an investor perspective as it is where the largest number of start-ups are arising from. Indeed, as individuals and companies are increasingly asking for a quick and simple solution to offset their carbon emissions, startups have emerged in order to make this process smoother and faster. They are the link between project developers and final clients. Some are operating in B2B, others in B2C and some are addressing both segments. The startups we are talking about are providing a simple online interface where anyone can in a few clicks both calculate and compensate its emissions. Some players are focusing on a single vertical (i.e. transport, e-commerce purchases, …) and other are more horizontal (i.e. they will look into your general carbon footprint and encourage you to finance a clean project to offset it).
Important clarification: Some of the players listed below do not enter their credits into certified carbon registers and there is no ownership transfer from the initial owner to the final client. They usually do provide a certificate saying how much an individual or organisation has offsetted but without any credit transfer, it is not correct to use the term “carbon offsetting”, since there is no certified methodology used to calculate the reduction, nor carbon standard recognised by the ICROA, nor traceability of the credit since there is no credit. Therefore, if you are a company, remember you cannot claim yourself carbon neutral if you do not own the carbon credits.
Here are a few examples of players in each category:
The following two categories can be included is the “Horizontal” one as they are looking at people’s general carbon footprint, but rather than calculating it using a questionnaire, they will directly connect either to your bank or email account in order to analyse your purchases and calculate your approximate carbon footprint.
Mail API: FreshOffset
If you are starting a business in the field or your startups isn’t listed above, please reach out to us, we will be happy to have a chat!
3. Carbon brokers:
Carbon brokers usually work with industrial groups regulated under the Kyoto protocol to assist them in the selling and purchase process of their quotas. But voluntary actors can also buy regulated credits, whether it is by environmental consciousness or as a financial asset, and carbon brokers assist them in this process.
4. Final clients:
Final clients are either service companies (i.e. not industrial groups), individuals or local authorities (i.e. a metropolis wanting to become carbon neutral). Such actors are becoming more and more concerned about their carbon footprint and are increasingly willing to offset what they are not able to reduce, as we need to keep in mind that carbon offsetting has to occur only after all the possible measures to reduce an organization’s footprint have been taken. However, when the remaining emissions cannot be cut off, offsetting them is a better solution than doing nothing. This is why, as awareness is growing, so does the market. Still, the voluntary carbon market is much smaller than the compliance one, with 62 million tons of CO2 equivalent credits issued in 2017 (it has doubled compared to 2016), which in value is around 300 million dollars worldwide if we take an average price of 5 dollars per ton. However, these figures only encompass carbon credits that are certified, so in reality it is much bigger. Also, this is just the current state of the market and carbon offsetting will most likely be popularized in the coming years. Indeed, offsetting your online purchases or your flights is becoming more and more common, and another way of estimating the future size of the market is by taking a 1% cut on a country’s GDP, as this is approximately what operators offering you to compensate your purchases take from the final price of the good.
- Though widely criticized, the carbon credit trading system is an efficient financial tool to incentivize industrial groups to reduce their emissions. The trend is going towards an international carbon market and a wider sectors’ coverage.
- Carbon offsetting is often seen as a way to bury the problem. Indeed, it has to occur after reducing an organization or individual’s emissions. However, in a consumer society, we are not going to stop producing and buying, therefore it is better to compensate than doing nothing.
- Finally, from an investor’s perspective, we believe that even though the current market is relatively small and the operators’ landscape is competitive, climate change is a global concern, and carbon offsetting will most likely become a very common practice.
Thank you very much for reading, I hope that this article made the topic easier to understand. If you have any questions or comment, feel free to contact me on LinkedIn! A huge thanks to all the people from Geres, EcoAct, Forêt Sphère, EcoTree and the daphni team for your precious contribution to this article!