As Carbon is Financialised, a new Frontier Opens up in Fintech

The financialisation of carbon — meaning its treatment as a priced liability or asset in a company’s balance sheet — is an ongoing transition whose origins can be traced back to the establishment of the first carbon markets in the 1990s. It is only more recently however, in the last couple of years, that this process has gained real momentum, driven by increasing awareness of the negative impacts of climate change on the environment, the economy and society at large.

Carbon as a liability

Let’s look at carbon as a liability first: governments around the world are setting net zero targets and implementing a range of policies aimed at reducing emissions, including carbon taxes, climate transition investments and subsidies. All of this means that for any company, there is an increasing cost associated with emitting carbon. An example of government intervention that makes this cost very real is what is known as “compliance markets”. Compliance markets — such as the EU’s Emissions Trading Scheme (ETS) — are cap and trade schemes where companies are given credits that represent emissions budgets they’re allowed to use. These credits are subsequently traded between companies: those who emit less than predicted can sell to those that need to emit more, so that the total of emissions in the EU remains as planned. Companies that are in scope of these schemes have historically belonged to sectors where emissions are easy to keep track of, such as the energy sector. But now, these schemes are being expanded to the rest of the economy and might potentially apply even to non-EU companies exporting to the single market.

The EU’s compliance market’s carbon price has been on the rise; source: FT

Carbon as an asset

Now, let’s look at carbon as an asset: companies can pay for activities that reduce or offset emissions, such as reforesting a degraded area or using a direct air capture plant for carbon removal. Companies that do this receive “carbon credits” in what is known as “voluntary markets”. Unlike with compliance markets, companies are not yet mandated by governments to participate in these, yet many are doing so more and more to demonstrate goodwill and as part of their Net Zero strategies. In these strategies, offsets are used as assets to “net off” carbon emissions. Like compliance markets, the scope of voluntary markets is also evolving, with new types of companies entering these markets in the past 2–3 years.

Scenarios of scaling demand in the voluntary carbon markets; source: McKinsey

The opportunity set for tech and fintech

Growth in the financialisation of carbon comes with a wide set of problems, and there is an immense need — and opportunity — for technology to address these. The opportunity is compounded by the urgency with which carbon markets need to scale in order to meaningfully mitigate climate change.

1- Establishing trust

The biggest problem facing carbon markets today is trust. The methods we have traditionally relied on for measuring carbon are often inaccurate.

• “Emission factors” that companies often use to calculate their emissions can be based on wrong assumptions, total calculations can fail to even add up for companies and even entire countries, and scope 3 emissions calculations (those that arise from a company’s indirect activities, i.e. from its supply chain) can be off by as much as 50%.
• The situation is even worse on the asset side: recent analyses of projects that issue carbon credits have shown that a majority fail to deliver on their carbon targets despite being certified and traded. As such, the risk of buying an offset today might outweigh the benefit — at least reputationally — for a company.

The need for accurately measuring and offsetting carbon emissions, as well as carbon offsets, has brought about a wave of new climate tech startups, with the goal of making carbon markets more robust. These include carbon accounting and reporting tools, tech-enabled project design and certification players, and carbon ratings providers. At LocalGlobe, we’ve been lucky to invest in some of these innovations, with companies like Supercritical, ERS and Sylvera.

2- Managing complexity

Other opportunities will arise from the complexity of carbon markets. The voluntary markets for example can today be accessed using complex infrastructure such as provided by Xpansiv. Exchanges of this type are often complex and can be difficult for non-experts to navigate. What’s more, we expect the complexity of carbon markets to increase rather than decrease:

• For example, if regulators admit a certain type of offset (e.g. REDD+) to be used by companies to net off surplus emissions as part of a compliance scheme, that will inevitably increase the price of credits associated with such projects.
• Likewise, if a carbon project successfully produces additional benefits beyond carbon, such as increased biodiversity or social benefits to local communities, it might also see the price of its credits rise.

As such, companies will need to navigate not only buying projects of differing quality and price, but also managing their carbon liabilities on an ongoing basis, including price fluctuations. New tools might serve this need in a similar way to modern treasury management systems.

3- Tech-enabled carbon finance

In a world where carbon markets are trustworthy and accessible despite their complexity, we see even more opportunity at the intersection of finance and carbon. For example:

• Climate lenders, who link instruments such as green bonds (already used by a wide range of borrowers — from Prada to Camden Council) to the price of carbon or use climate data and AI to adjust interest; or — like Enduring Planet — who tweak models such as revenue-based financing for the needs of climate companies.
• New infrastructure to fund carbon removal, such as Stripe Climate and again Supercritical, and new instruments, such as OTC contracts for forward carbon to fund capex-heavy investments in tech-based carbon removal solutions such as direct air capture plants.
• Regenerative Finance, or ReFi, players. Whilst still in their infancy, carbon tokens might come to play a role in helping both large and small buyers to engage with carbon, with lower barriers to entry and more transparency.
• Tools that help assess and price carbon or climate risk, such as Cervest or ClimateX, to help companies become more resilient.
• New Insurtechs, such as Kita and Oka, to help protect offset buyers against the risk of projects not delivering on their reduction targets.

We believe the financialisation of carbon is now inevitable, and signals of its momentum — from the SEC saying it will require emissions disclosures from public companies, to Bank of England former governor Mark Carney championing carbon markets — are compounding. With this transition, an exciting new area of opportunity in Fintech is born.