With renewed tailwinds — where is the carbon market heading?

TLDR Summary

The world is already facing the consequences of climate change. To avoid more dangerous and costly impacts, the IPCC reported that global emissions need to peak before 2025.

Current levels of greenhouse gas emissions (GHGs) must be slashed in half by 2030 and reach net zero by mid-century to keep this temperature target within reach. Since the Kyoto Protocol was signed in 1997, governments have tried to address the issue of carbon emissions via the Digital Carbon Market (DCM) to facilitate the trading of carbon credits and other forms of carbon offsets.

Encouraged by recent regulatory frameworks (particularly NFDR and CSRD), carbon accounting, ESG reporting, and other carbon offsetting solutions have experienced phenomenal traction between 2020 and 2022. Supported by sustained VC interest in climate tech companies, billions of dollars have been deployed to create new software businesses and models.

In this short market study, I’ve combined my views on the carbon software market and its potential transformation with market research conducted. As the decarbonisation of our modern society can’t happen without corporate transparency and these offsetting mechanisms, we believe this market still has room to grow and evolve. As this is still a nascent industry, we expect consolidation between existing players will shape a more mature ecosystem in the coming years.

In this article, we will give a high level overview of the “Carbon Software Market”. There are several ways to segmenting this market. Our view is that it can be divided into the following four categories: carbon accounting, ESG reporting, carbon credit trading, and carbon data analytics and rating.

Tailwinds

• Regulatory initiatives: The implementation of carbon pricing mechanisms and regulatory frameworks in various regions encourages businesses to measure and offset their carbon emissions. This provides a clear market signal and a financial incentive for companies to adopt carbon reduction measures.
• Corporate sustainability commitments: Many companies are adopting sustainability goals and committing to becoming “carbon-neutral” or achieving net-zero emissions. This creates a demand for carbon offsetting solutions and using carbon accounting solutions to build decarbonisation plans.
• The growth of DAC and CCS technologies: One big challenge of carbon offsetting projects is the difficulty in accurately measuring the offset. With Direct Air Capture (DAC) or Carbon Capture and Sequestration (CCS) technologies, the measurement should become more accurate.

Obstacles

• Lack of standardization: The lack of standardized methods for measuring and reporting carbon emissions makes it challenging to compare and verify the effectiveness of different carbon offset projects. Standardization is crucial for building trust and transparency in the market.
• Criticise for greenwashing concerns: There is a risk of greenwashing, where companies may exaggerate their environmental efforts or mislead consumers about the true impact of their carbon offset initiatives. This can erode trust and credibility in the market.
• Low carbon cap and prices: One of the main challenges of the carbon market is the fact that regulatory carbon caps are still limited and most importantly the price of credit is really low. This situation makes it easy for companies to buy their way out of emission reduction.

Key takeaway

The carbon software and ESG reporting market has seen strong traction in recent years, with a lot of venture capital flowing to new startups. Supported by regulatory frameworks and consumer demand, we see an exciting future for this new industry.

In this competitive environment, market dynamics may come down to sales capacity and geographical presence, but companies in this market are also maturing their business offering. Some solutions are now becoming more sophisticated and expanding their range of services. Others are focusing on a specific industry (such as financial services or entertainment market).

The world cannot decarbonise without carbon credit mechanisms and these reporting tools. Because of legal requirements, emission measurements and ESG reporting will likely become an essential part of corporate ERP systems. Growth in this market will come via M&A between existing players, as well as acquisitions by incumbents in the corporate software space (SAP, Salesforce, Microsoft, Oracle).

[The views and opinions expressed in this blog post are mine and do not necessarily reflect the position of White Star Capital.]

Carbon market dynamics

Over the last 10 years, approximately $2bn has been invested in solutions helping companies with their sustainability transition via ESG reporting or carbon accounting services.

As with many other tech sectors, investments culminated in 2022, before slowing in 2023. For a nascent market, we have already seen some notable exits, such as Planetly which was acquired in 2021 by OneTrust, and Metrio which was acquired by NASDAC in 2022.

If we include carbon credit and carbon offsetting solutions in this market sizing, we reach approximately $15 billion of cumulative investments in the space. Capital has been flowing due to new regulatory frameworks introduced around the world, that have imposed carbon caps and placed mandates on large companies to measure and report their emissions and other ESG activities.

Another driver is the demand from end users and consumers for more transparency. Thus, ESG software became a crucial instrument for improving stakeholder relations by satisfying rising demands for information. According to a 2021 Verdantix survey, a significant percentage of respondents identified GHG emissions management systems as their top priority.

As a result, the carbon software market has grown significantly, with actors ranging from emission measurement tools and reporting solutions, to trading credit platforms and voluntary carbon offsetting marketplaces.

Regulatory changes

• The Non-Financial Reporting Directive (NFRD), also known as Directive 2014/95/EU, imposes responsibilities on about 12,000 major firms in the EU. To verify the objectives of the European Green Deal and other regulations, there is, however, a strong regulatory momentum beyond this directive.
• The Corporate Sustainability Reporting Directive (CSRD), which will take effect in fiscal year 2024 and is expected to touch some 50,000 companies in the EU, including SMEs, was issued by the European Commission in November 2022, and will replace the NFRD while adding onto NFRD requirements. The CSRD adopts a dual materiality perspective, meaning that it requires businesses to record both the effects of business actions on sustainability aspects and the impact of sustainability aspects on the company’s financial status.
• In addition to European regulations, an increasing number of international organizations are setting sustainability standards. Companies often follow these voluntarily, as a way of informing key stakeholder groups such as investors, partners, and customers via sustainability reports based on international standards. Those standards include the PRI (Principles of Responsible Investment), TCFD (Task Force on Climate-related Financial Disclosure), ISSB (International Sustainability Standards Board), CDP (Carbon Disclosure Project), and SASB (Sustainability Accounting Standards Board).

Market overview

There are several ways to segment the “Carbon Software Market”. Our view is that this market can be divided into the following four categories: carbon accounting, ESG reporting, carbon credit trading, and carbon data analytics and rating.

As with many VC-backed sectors, a lot of players raised large rounds of funding at ambitious valuations in 2020–2022. For some, maintaining their revenue models in such a competitive environment may prove challenging (see examples), however for those companies that have found a niche, can strengthen their sales processes and rationalise their cost structure a promising few years await. It’s an exciting time for the space as market leaders begin to emerge and consolidate their positions.

Carbon Accounting

This area mainly includes data management software solutions. These are tools that help to collect and aggregate sustainability metrics for businesses and their supply chain. With these solutions, organisations can collect carbon data to meet reporting requirements and put in place carbon reduction plans.

Large companies with complex supply chains need sophisticated solutions to fully measure and manage their emissions to align with net zero commitments. The evaluation of scope 1 and scope 2 are generally easier to collect than scope 3 which encompasses emissions that are produced by the supply chain.

A few market leaders have emerged in this space such as Greenly, Sweep, or Persefoni. They all have expended their business offering providing additional more sophisticated measurement tools including systems to measure scope 3 emissions. Some also provide offsetting solutions to support emission reduction plans and other consulting services.

Carbon Credit and Offsetting Marketplace

The Digital Carbon Market (DCM) represents an ecosystem of digital platforms and marketplaces designed to facilitate the trading of carbon credits and other forms of carbon offsets. Today, offsets (also known as credits) are linked to projects ranging from forestry management and wetland conservation to carbon capture and renewable energy technologies. Carbon markets exist under both mandatory (compliance) schemes and voluntary programmes.

Compliance markets are created in response to legally binding emission reduction targets set by regional, national and international agreements, such as the 1997 Kyoto Protocol and the 2015 Paris Agreement.

Compliance markets usually function as cap and trade schemes, known as ETSs — Emission Trading Systems. They are regulated by national, regional, or international carbon reduction regimes. Initiatives such as the EU Emissions Trading System, California’s cap-and-trade programme and similar schemes in other countries from China to New Zealand cover jurisdictions representing 55 per cent of global gross domestic product.

Compliance carbon markets (ETS) and carbon taxes currently cover 22% of global greenhouse gas emissions. The global compliance carbon markets, on which carbon credits are traded and regulated by mandatory national/sub-national regimes, account for 75% of those total emissions covered and have an aggregate market value of approximately USD 270 billion.

This sector also includes platforms participating in the voluntary carbon market. These markets allow carbon emitters to offset their unavoidable emissions by purchasing carbon credits from offsetting programs. The current supply of voluntary carbon credits comes mostly from private entities that develop carbon projects, or governments that develop programs certified by carbon standards that generate emission reductions and/or removals.

By 2021, compliance markets had an annual trading value of more than $900bn, with the EU ETS by far the biggest, accounting for about 90 per cent of trading volume and value that year, according to LSEG Carbon Research. Much smaller, voluntary carbon markets, for their part, have seen the value of transactions rise sharply from $520mn in 2020 to $2bn in 2021, according to US non-profit Ecosystem Marketplace.

However, the carbon offsetting market is currently in turmoil. There has been a lot of negative press, such as this Guardian exposé into REDD+. According to this investigation, more than 90% of the rainforest offset credits of Verra, which provides carbon offset accreditations, did not represent genuine carbon reductions. Also, the EU pasted a regulation banning ‘climate-neutral’ claims that cannot be accurately backed As most voluntary offsetting initiatives were driven by marketing objectives, most businesses have lost interest in carbon credits.

Another issue is that the global weighted-average carbon price is still too low to incentivise tangible decarbonization activities. Carbon prices need to increase further to meet net-zero ambitions by 2050, according to the International Energy Agency. This also seems critical in advancing decarbonization technologies.

Data Analytics and Rating

ESG data and ratings encompass a wide range of services and products. Providers offer sets of publicly available and privately sourced data relating to non-financial performance of companies, such as greenhouse gas emissions and risk exposure data.

This sector is more relevant for large institutional investors, public market investors and large corporates. The market opportunity is big, but some consider that it is already well covered by actors such Bloomberg.

ESG ratings are very controversial due to lack of standardisation, data quality, or lack of oversight. But public investors have embraced them as an easy measure to allocate capital that has been earmarked as an “ESG” allocation. As ESG allocations grow, so does the demand for ratings.

ESG Reporting & Compliance

On the edge of this carbon market we find solutions tailored for reporting and disclosure of ESG corporate practises. The purpose of these platforms is to meet regulatory requirements and help with the reporting process.

These tools are particularly critical for financial players who are required by the EU taxonomy (NFDR) to report on their ESG activity. Other large companies (by number of employees or revenue) are now also under a legal mandate to report their ESG practices under EU CSRD.

As these regulations will only be fully enforced in 2024 we are only seeing the beginning of the adoption of these new tools. As companies will have no choice but comply, this sub-market will become part of the essential software suite, as they adapt to reporting on ESG matters in the same manner as standard financial reporting.

Market perspective

The carbon credit market credibility can be restored

The first learning from this market analysis is that the carbon credit market isn’t in great shape. While some carbon credit providers have been criticised for taking substantial margins (up to 80%) on the value of the offsetting project, other projects have been revealed as outright scams.

Beyond the bad press, the legal restriction on “climate neutral” claims that became the last nail in the coffin, putting a halt to the interest in the voluntary carbon credit market. With a significant decline in demand and an oversupply of offsetting projects, carbon credit values fell to an all-time low in June 2023.

The result of these backlashes is a consensus that the carbon market is not serving its primary purpose, which is a reduction in carbon emissions, and that cheap carbon credits turned into free passes to emit.

In May 2023, a new framework to better define high-quality carbon credits for market participants and buyers was finalised. Credits evaluated using the new Assessment Framework from the Integrity Council for the Voluntary Carbon Market (ICVCP) will begin selling by the end of this year.

The designation ensures that specific criteria (Core Carbon Principles) for programs and projects which create carbon credits are met. To qualify as a CCP credit, the carbon credit must go to projects that meet net-zero targets. It also must be a new credit, and it must be permanent.

Although the market has recovered since September 2023, we have yet to see whether the CCP label will restore investor’s confidence in carbon credits. Our view is that the world cannot decarbonise without these mechanisms. With better standards and oversight the reliability of the value of credits can be restored.

ESG reporting tools will be incorporated in corporate ERP systems

As explained above, the carbon accounting and ESG reporting market has seen substantial funding in recent years. This market excitement for these solutions created a very competitive ground. However we believe this is a nascent industry where there is room for further adoption.

Our view is that the world cannot decarbonise without carbon credit mechanisms and these reporting tools. With more regulatory requirements in place, these accounting and other ESG tools are becoming essential.

Pushed by recent regulations, in the EU (particularly NFDR, and CSRD) and other part of the world, carbon accounting and ESG reporting have become mandatory for many large companies and financial institutions. As time pass, we believe these legal requirements will extend to SMEs and more sectors. Further, these push for more corporate transparency will eventually become an essential part of the equity story for many businesses. With this trend in motion, we believe these businesses will likely be integrated with other corporate ERP systems.

Companies that will come on top will be those who dominate a regional market or control their niche. Given growth via M&A is very likely between existing players, we also believe that incumbents in the corporate software space (SAP, Salesforce, Microsoft, Oracle) will have a serious look at acquiring market winners.