Challenges in carbon markets

Challenges in carbon markets

Voluntary carbon markets (VCMs)—projected to grow to a $50B+ market by 2030—can be an essential tool to accelerate efforts to reverse climate change. Where emissions avoidances and allowances were once traded primarily under cap-and-trade schemes in mandatory markets, VCMs are growing as governments seek to combat the climate crisis and corporations respond to pressures from shareholders and customers. VCMs include private companies and governments; occasionally, governments agree to use credits from VCMs to help achieve the climate pledges they’ve made (e.g., under the Paris Agreement). Government participation in VCMs is a more recent development, buoyed by decisions made at COP26.

Despite high growth in the past decade, there are many open questions surrounding VCMs, ranging from concepts like additionality to leakage, verification, permanence, and more. At the same time, a new generation of startups is strengthening VCMs with high-quality accounting and durable carbon management solutions. This progress also presents additional challenges for VCMs. They must keep up with and adapt to a rapidly evolving landscape while addressing concerns like double-counting that have persisted for decades.

As corporations and governments attempt to fulfill net-zero pledges, they often focus on reducing emissions. These entities can power their operations with renewable energy rather than fossil fuels, transition their transportation fleets to electric vehicles, and use other mitigation solutions in their supply chains. Historically, VCMs have been used to offset the rest of the emissions that a company or government cannot or has not yet eliminated.

One significant evolution of the VCM is the introduction of CO2 removal credits, which are similar to but not the same as “offsets.” Whereas offsets ‘cancel out’ future emissions, carbon removal credits are relatively new and remove past emissions from the atmosphere. Carbon removal credits only represent about 5% of the current supply in VCMs.

The primary stakeholders in VCMs include:

Buyers: Buyers are individual consumers, businesses, or other entities, e.g., brokers, who purchase carbon credits from registries or other carbon credit marketplaces.

Marketplaces: Marketplaces like Nori’s, facilitate carbon credit transactions between buyers and sellers. Unlike registries, they do not necessarily verify credits or set methodological standards.

Registries: Registries are organizations that verify credits and set methodological standards. There have been four primary registries to date in VCMs: Verra, Climate Action Reserve, the American Carbon Registry, and Gold Standard.

More registries are joining the market as it grows, offering expanded carbon crediting options. Some registries are also marketplaces, though not all marketplaces function as registries.

Suppliers: Suppliers are the individuals and groups whose projects remove atmospheric carbon from the atmosphere or prevent future emissions.

The following sections now explore concepts and challenges in carbon markets, many of which historically complicated achieving greater market scale and impact.

Alignment

Alignment

There is significant disagreement over how carbon markets should function, what types of products should qualify for sale, and how and to whom suppliers should sell credits. Part of the reason for this misalignment is the wide range of stakeholders participating in carbon markets, all of whom have unique goals and interests.

Carbon market 'rules' are a topic of fierce debate at almost every international climate conference. Especially in compliance markets, governing bodies constantly manage disagreements and update policies, attempting to achieve greater consensus.

One consequence of these iterative updates is that they make carbon markets more complex. Making amendments and additions that appease all stakeholders is challenging. Further, as new additions and amendments are made, standards and best practices become more difficult for participants to navigate. These dynamics hamper greater market participation and growth.

Architecture

Another reason misalignment and confusion have grown in VCMs is that carbon credits now consist of removal credits and avoidance credits. As explored earlier, carbon removal is fundamentally different from emissions avoidance: Carbon emissions avoidances prevent future emissions from entering the atmosphere. Carbon removal removes past emissions from the atmosphere.

Though the above statements may seem obvious, the rules, infrastructure, and policy debates in VCMs don't reflect these differences. Carbon credits remain a single category of products. Early registries were built to address emission avoidances, not necessarily carbon removals.

Older systems and processes need to be rearchitected to allow crediting systems and marketplaces to reflect the unique approaches, challenges, and opportunities of carbon removal. For instance, definitions surrounding the additionality of carbon credits were tailored for avoidance credits and may need to be adapted or changed for certain types of removal credits, especially as they become more prevalent.

Another challenge with VCM's architecture is how transactions happen in carbon markets. At present, matching buyers and sellers isn't a seamless process. Buyers and sellers look for counterparties with whom they're aligned on the above mentioned topics. Even when alignment is achieved, parties must still negotiate deal terms across dimensions such as volume, price, duration, payment terms, and more.

To an extent, registries help alleviate these challenges, as they aggregate supply that meets various standards and conditions that the registries set. Considering the extent to which different registries' approaches differ, the average buyer may still have to conduct considerable diligence to make a decision. This becomes even more difficult for large-scale buyers, who must aggregate multiple projects to meet their offsetting goals.

Better infrastructure that aggregates supply that satisfies clear conditions and enables more seamless transactions between buyers and sellers would alleviate these issues and reduce barriers to entry, helping to scale carbon markets.

Supply-side market dynamics

Supply

Carbon markets are significantly supply-constrained. There are not enough carbon removal credits to satisfy current market demand, let alone future demand or the level of removal needed to satisfy climate objectives. For one, removing carbon from the atmosphere costs money. The demand side of the market is growing, but directing capital from buyers to suppliers often relies on bespoke agreements brokered by intermediaries and diligenced by internal teams or consultants. These cost money and time.

There are promising financing mechanisms for carbon removal start-ups to provide supply. Companies like Microsoft, Shopify, and Stripe are advancing the demand side by financing early-stage projects. Many of these companies also formed Advance Market Commitment (AMC) groups. These financing mechanisms use COVID-19 vaccine development as a model to accelerate carbon removal start-ups. The most well-known is Frontier, with $900M+ in funding. Additionally, funding from the philanthropic sector (e.g., the Chan-Zuckerberg Initiative) and various legislative efforts to drive government procurement will fuel further demand.

These funding mechanisms actually exacerbate short-term supply shortages, even if they're a big net benefit to the industry's long-term health. To an extent, they may monopolize early supply produced by new carbon removal entrants. More scalable, open models to direct capital to carbon removal suppliers are thus also needed to expand the VCM further.

Pricing

Carbon markets have a pricing problem. At present, there are no strong reference prices for carbon removal supply. Market participants rely on opaque, aggregate indexes or negotiate pricing with suppliers on a case-by-case basis. The absence of a sound reference price leads to significant pricing inefficiencies. Most importantly, the lack of a universal carbon reference price makes it hard for market participants to navigate and / or enter the VCM:

• How do you estimate financials from a carbon removal project if you're a prospective supplier?

• If you're a prospective buyer, how do you forecast how much capital to allocate to source sufficient supply in the future?

• In negotiations between both parties, how do you establish a fair price for a deal?

These questions divert time and resources from the essential work that needs to be done—removing CO2 and other GHGs from the atmosphere.

Barriers to entry

For them to move the needle on climate change, people, corporations, and governments must be able to participate in VCMs equally and fairly. Making climate-smart decisions needs to be accessible before any such practices become common. Carbon crediting is accessible only to sophisticated climate consumers—it favors companies, consultants, and nonprofits highly knowledgeable of the entire VCM value chain.

The value chain begins with organizations that interface with several stakeholders and must navigate sprawling bureaucracies. Listing a project on a registry requires third parties, for which said third parties collect fees, cutting into the value of the carbon credit to the supplier. Additionally, registries charge listing fees, taking more money away from suppliers. Carbon removal suppliers need access to funding to build viable income streams; if their margins are eroded by listing and consulting fees, continuing to produce credits or getting started in the first place becomes less tenable.

Even for established carbon removal techniques, like regenerative agriculture, the high level of expertise and financial margin required to access registries makes it difficult for suppliers to participate. Nor do registries make it easy for all types of buyers to participate – the cost of diligence is high, often requiring staff and consultants to validate which credits may be suitable. Most companies and individuals do not have the resources to engage in this work.

Unfortunately, many potential participants often view the mosaic of challenges in VCMs described here and decide not to get involved at all or to wait until more clarity exists.

Permanence

It's not enough to remove GHGs from the atmosphere. To reverse climate change, carbon removal processes must also keep them out of the atmosphere for some time or pair with other processes to sequester them.

Many technological approaches exist to sequester CO2 and other GHGs in sophisticated ways. These range from highly 'permanent' – i.e., the carbon will stay out of the atmosphere forever – to ones that offer hundreds of years of sequestration.

Other carbon removal methodologies feature shorter sequestration capabilities. Nature-based solutions like planting trees or increasing soil carbon can be less permanent than engineered solutions; said differently, they tend to sequester carbon for less long. These methodologies are often easier to scale.

Carbon sequestered in natural ecosystems, like forests or soil, may also be less 'durable,' i.e., it is more likely to be subject to reversals when CO2 escapes into the atmosphere. For example, a project developer might reforest a parcel of land to remove and sequester CO2 and estimate their own ability to maintain the forest for 100 years. If that forest burns down ten years into its maturation process—emitting carbon—that permanence hasn't been achieved.

Increasing permanence and durability often sacrifice scalability, a critical tradeoff and design consideration for carbon credits. This isn't just because of the technical sophistication required to achieve permanence; longer-duration permanence also requires longer-term measurement, verification, and reporting, which comes with costs.

Project developers and entities participating in carbon markets must make informed choices about which variables to emphasize over others. Depending on their goals, buyers may purchase 'shorter-term' or 'longer-term' carbon credits. What's important is that they understand what they are buying and are provided realistic permanence assessments to select carbon removals that satisfy their objectives.

Finally, saying something has 100 years of permanence does not guarantee that is true. What's essential is ongoing monitoring and developing methodologies with an increasingly low risk of reversal. Participants in carbon markets should be informed about the risks inherent to all carbon removal credits. Suppliers, registries, and marketplaces should provide information about relevant permanence factors and likelihoods of a reversal so buyers can more easily source credits that satisfy their preferences.

Additionality

One central question to consider when discussing carbon credits is under what circumstances credits qualify for exchange. One of the most critical factors is proving whether carbon credits are indeed 'additional;' non-additionality is one of the biggest challenges in carbon markets.

Many voluntary and compliance markets apply additionality tests to projects before listing credits for approval. While there are many types of additionality, all of which we will not cover in this whitepaper, two of the most important include:

• Emissions additionality: Avoidances or removals that are additional to what would have occurred if the project had not been carried out.

• Financial additionality: That a project would not have happened without the availability of carbon finance.

Emissions additionality

For a carbon credit to drive impact, project developers must demonstrate that they reduce or remove emissions above a certain baseline, i.e., what might have happened anyway. For instance, if a project claims it will prevent deforestation, it should prove that the trees it seeks to preserve are, in fact, in danger of being cut down or dying. Unfortunately, in practice, environmental organizations have taken credit for “preserving trees in no danger of destruction.” Many other examples exist from projects that produced carbon credits without driving impact.

Proving additionality is especially challenging for offsetting projects with hypothetical emissions avoidances. Recall that most carbon credits traded in voluntary carbon markets stem from renewable energy projects or avoided deforestation projects. In both cases, projects develop projections of the additional emissions that would enter the atmosphere or would not be removed from it if their project didn’t take place. Of course, the challenge with this approach is that these hypothetical emissions are never directly observable or measurable.

Proving additionality in carbon removal is much more straightforward, as carbon removal deals in removals of excess CO2 from the atmosphere that aren’t theoretical.

Financial additionality

Whether or not emissions are removed or avoided above a certain baseline is not where additionality tests for carbon credits end. In many carbon markets, financial additionality tests also apply. If a hypothetical renewable energy project is cost-competitive with fossil fuels on its own merits, it doesn’t necessarily require additional revenue from carbon credit sales to make financial sense. This is a scenario where financial additionality tests are often applied—is the additional revenue offered by carbon credits necessary for the viability of the project? Would the project fall through if it could not profit from carbon credits?

Determinations of financial additionality can be pretty complex. Whereas CO2 sequestration levels are often measurable or can be modeled, the hypothetical economics of a project is always speculative to some degree. That said, some carbon removal methodologies only stand to benefit by selling carbon removals, simplifying the financial additionality question.

Standardization of definitions around additionality, as well as establishing entirely new ones, would bring considerably more confidence to the voluntary markets. Setting new standards could be particularly pertinent as carbon removal credits enter marketplaces and registries:

• What does additionality mean for various types of carbon removal? Is there an automatic assumption of additionality when a direct air capture facility draws down carbon, regardless of whether capital from carbon credit sales was required to build the facility?

• For nature-based solutions, should only those projects that require financial support through carbon credits meet additionality criteria? This excludes profitable projects, or ones with other potential benefits to suppliers, limiting future carbon removal supply.

• Should the urgency of advancing a given climate situation not factor into consideration? If the priority is removing carbon from the atmosphere and storing it, how much does it matter if a project has other benefits to its developer? At what point are esoteric counterfactuals counterproductive?

Leakage

Similar questions continue with the concept of leakage. For emissions avoidance projects, leakage refers to an unintended increase in greenhouse gas emissions elsewhere, outside the bounds of the project. If demand shifts from a protected place to an unprotected one, leakage has occurred. Imagine, for instance, a prevented deforestation project that merely shifts deforestation from one parcel of land to another part of the same forest.

Is this a concept that exists in carbon removal? Can there be a comparable 'displacement' of legacy atmospheric CO2? The applicability of these definitions must be reevaluated in the context of carbon removal and used consistently to help buyers understand what they are purchasing. Plus, many more considerations ladder up to the broader 'additionality' umbrella. Those explored above are not intended to be exhaustive.

Accounting

One key component of Nori’s approach is that all of the carbon removals in its marketplace are retired immediately upon sale. Said differently, Nori’s carbon removals don’t trade hands more than once. When you buy a carbon removal on Nori’s marketplace, it’s yours forever.

The mechanisms by which carbon credits trade hands in other carbon markets can be more complicated. For one, carbon credits across compliance and voluntary markets are often traded many times. With each subsequent trade, there’s a risk that a lack of transparency and traceability, unsound accounting practices, fraud, or some combination of the above prevents proper accounting for those carbon credits.

In practice, each entity that trades a carbon credit may claim it as an offset for their emissions, whether or not they still hold the credit. Several entities might thus claim the same underlying carbon credits. This double-counting can also occur when project developers and the buyer of their carbon credit both count the credit as evidence of emissions reduction.

Double-counting reduces the impact of carbon markets, as fewer credits satisfy the same level of market demand. It also reduces the value of carbon market size estimates. If $1B of volume is traded in voluntary markets, but that volume numbers include the same credit being sold multiple times in secondary markets, the amount of emissions avoidances or removals can be far lower than headline numbers suggest. Such inaccuracies reduce the value that market size and trading volume statistics provide market participants.

Again, there are many other accounting considerations and principles within the realm of carbon accounting. This focus on double-counting isn’t an exhaustive assessment by any means, but it is most relevant to Nori’s work and marketplace.

Measurement, reporting, and verification ("MRV")

Establishing proof of additionality is just one of the first steps in the lifecycle of a carbon credit. Nori's definition of additionality—incremental and measurable changes in carbon removal, year-over-year—hints at the importance of measuring, reporting, and verifying carbon removals.

Carbon credit 'quality' is dependent on accurate MRV. But MRV for carbon offsetting and removal is a significant technical challenge, as amounts of carbon sequestered can be difficult to measure. There's a lot that remains uncertain scientifically across many carbon removal methodologies. For example, in ocean-based carbon removal, one tonne of CO2 drawn out of the ocean does not necessarily mean that one tonne of CO2 will be drawn out of the atmosphere. Even concerning a methodology, like soil carbon sequestration, that's directly measurable via soil samples on a micro level, there are many different ways to tackle it on a macro level.

Buyers should know that many methodologies require complex measuring and modeling techniques to estimate carbon accounting. Similarly, Suppliers, registries, and marketplaces should communicate the uncertainties inherent to measurement to Buyers.

Perfect measurement should also not be the enemy of sound measurement either. To help buyers make good decisions, companies should be transparent regarding measurement accuracy and reversal risks. Beginning to test processes allows companies to iterate and improve.

In carbon markets today, standards and methodologies for MRV are often set by carbon credit registries, such as Verra. If projects want to sell carbon offsets in a registry, they must meet its standards and adhere to its methodologies. Projects also typically must engage independent third parties to verify their data's accuracy.

The fact that there are many different registries with different standards, protocols, and methodologies for MRV complicates matters in carbon markets. Carbon offset and removal suppliers must make tradeoffs, choosing one registry's methodologies over another. Supply thus fractures across registries, reducing liquidity, efficiency, and transparency in the market.

Vintage

Another vital factor to consider regarding carbon credits is the vintage of each offset or removal, i.e., the year in which they were first created (similar to wine).

If you've read other pieces of this whitepaper section, one thing that may have stood out so far is that the VCM is still in its relative infancy and that a lot of standard-setting continues to happen in real-time. One open question is how vintages impact demand for carbon offsets.

Of late, buyers have started showing a preference for newer vintages, with part of the logic being that the more recently a credit was produced, the more likely it adheres to the evolving 'best practices.' Based on this logic, focusing on newer vintages lowers risk.

Many credits considered impaired are also old; there is often no market for them. As a result, many of the cheapest credits on registries are of older vintage. This isn't exclusively because they're old—they stem from a period in which standards in carbon markets differ from today. They are also more likely to stem from projects that failed to prove their additionality or were scrutinized for insufficient or faulty MRV practices.

Despite these nuances, vintage has become a stand-in proxy for 'quality' in the eyes of some buyers. This further exacerbates current supply constraints in VCMs; in an already supply-constrained market, many buyers only focus on the newest vintage credits, limiting the supply of 'desirable' credits available even further.

Insurance

There are additional issues with the current insurance mechanisms in VCMs. Buffer pools are credits reserved by projects to compensate for reversals. If a reversal occurs, credits are retired or canceled from the buffer pool on behalf of the project's buyers. The number of credits a project must contribute to the buffer reserve is usually based on assessing the project's risk for reversals. Theoretically, this approach can cover catastrophic losses affecting individual projects over defined periods, as long as the buffer reserve is sufficiently stocked with credits from projects across an entire program.

However, buffer pools often do not meet their stated goal. As seen with forestry credits, projects can be destroyed beyond the value of the buffer pools, leaving buyers with worthless credits and no net carbon removal. If a project is successful and there is no or limited use of the buffer pool, at the end of the project, a supplier is left with buffer pool credits that have no value, lowering the value of the overall project. These mechanisms neither benefit buyers, as they don't offer complete protection, nor suppliers, who lose out on some of their projects' value.

In closing, mind you that the challenges covered above are not an exhaustive list of those that face VCMs. They’re intended as an introduction and an overview specifically tailored to those that Nori also addresses in its marketplace.