October 10, 2007 (Energy Risk) The market for over-the-counter (OTC) voluntary emissions offsets, which allow large companies and individuals to offset their carbon footprints, has recently experienced a sharp rise in transaction volumes after being long overshadowed by government-mandated compliance trading.Market participants, the media and the public are urging more transparency and standardisation in the market. Should such improvements be made, the potential for the market is vast, both in terms of benefits to participants and the environment itself.
Accurate data on the OTC voluntary offsets market is rare, but recent studies and industry consensus suggest huge growth in 2006. A joint study by information providers Ecosystem Marketplace and New Carbon Finance reports $91 million-worth of voluntary OTC transactions in 2006, resulting in the abatement of 13.4 million tons of carbon dioxide equivalent (MtCO2e). While this represents only 1% of the amount abated by the mandatory EU emissions trading scheme (EU ETS) in 2006, it is the growth trend of 200% that catches the eye: the market is embryonic but growing.
Some in the industry question the accuracy of such surveys, but none doubt that the figures reflect a real growth trend. For example, Climate Care, a UK-based organisation that delivers offsets to companies and individuals, has experienced a tenfold increase in sales between 2005 and 2006. In the past year it has offset the equivalent of 0.25% of the UK’s annual carbon emissions, and in the coming year it is aiming for 1%. Global carbon broker CantorCO2e has seen its voluntary business increase “phenomenally” in the same period. 3C Group, a German carbon asset management firm, has experienced a rapid increase in voluntary market turnover in the last two years, and expects 2008 turnover to be more than double that of 2007 (1MtCO2e).
Two types of project-based emissions credits are used for voluntary offsets:
• Certified emissions reductions (CERs) – verified by the United Nations and created under the Kyoto Protocol’s Clean Development Mechanism (CDM), which can also be used in compliance markets such as the EU ETS; and
• Verified emissions reductions (VERs) – like CERs, these represent the abatement of one tonne of carbon dioxide-equivalent emissions, but are not UN-verified, and so cannot be used for compliance. VERs can be generated by the early stages of a CDM offset project, before the certification process takes place, from projects in countries not covered by the Kyoto Protocol and, most significantly, from small projects that cannot afford costly UN certification.
This flexibility means that the VER market reaches the parts of the global carbon abatement effort that CERs cannot reach.
“The rationale for developing the VER market is that the less onerous verification process allows the development of smaller-scale projects, that wouldn’t be cost effective if they went through the certification process,” says Trevor Sikorski, a senior analyst at Point Carbon. The challenge of measuring emissions saved from community-scale projects, spread across a wide region, is a very different proposition from measuring emissions from industrial sites. “You need to take a different approach to establish the carbon saved,” says Climate Care’s spokesman Michael Buick. “VERs sensibly reflect the different methods of measuring emissions.”
The adaptability of VERs is also a crucial benefit. The CDM covers a limited number of greenhouse gasses (GHGs) and VERs can therefore encourage abatement of GHGs that are excluded from Kyoto for technical reasons. For example, chlorofluorocarbons (CFCs), which are harmful to the ozone layer, are dealt with internationally by the Montreal protocol. However, this only regulates their production and disposal. “There are millions of tons of CFCs already out there, and there is no mechanism to dispose of them,” says Buick. “There’s a clear opportunity for the voluntary market to provide a financial instrument to actually do that.” A further benefit is that VERs offer incentives to start up small abatement projects, which can often be highly innovative, acting as a testing ground for new approaches. VERs can be produced in the initial stages of such projects and once they have demonstrated their effectiveness, they can start to produce CERs.
There are also social benefits. “For community-scale projects with strong sustainable development aspects, VERs have been much more successful,” says Buick. “In terms of quality of life in Africa, the CDM framework has so far failed to deliver the methodology to measure the carbon savings from such projects.”
Carbon finance from VERs drives community-scale projects forward. “That’s absolutely crucial if we’re to get the carbon market to deal with sustainable development and to produce a market that doesn’t simply focus on large industries,” says Buick.
The fact VERs have a strong link to community-level sustainable development projects is key to understanding their soaring popularity. As awareness of climate change increases, so does pressure on companies to reduce their carbon footprint. So while CERs are usually purchased by institutional customers who don’t care where the credit originates from or what abatement technology lies behind it, VERs are bought by businesses that sell products with offsets, such as flights, to individuals.
“They want to be able to explain clearly to consumers how their money is tackling climate change and how the project producing the credits is bringing other benefits,” says Buick.
The Ecosystem Marketplace study suggests that the vast majority of VERs are sold to buyers in North America, the European Union and Australia, with very little demand coming from elsewhere. Industry sources suggest that the UK is leading the way in terms offsets purchased on a per capita basis, but consumer profiles vary by country. “US demand for VERs mainly comes from large consumer-facing corporations,” says Jasmine Haneef, emissions broker in TFS Energy’s global environmental products group. “At the moment, US utilities are offering offsets in response to their retail customer base, who are demanding a carbon-neutral product. The speculative side of the VER market to date has been much more limited. Interest here might come from private equity or a private developer with direct interest in projects.”
Testing existing markets
Haneef observes that a growing proportion of activity in the US comes from companies that are testing the existing emissions markets (including the voluntary, but legally binding cap-and-trade Chicago Climate Exchange) before a mandatory scheme is introduced. “The majority of people buying VERs are doing it for the here and now, but anything they learn in the markets in terms of trading mechanisms is a bonus. In the last six months we have seem increased calls from interested parties, and it’s building up.”
As demand grows on both sides of the Atlantic, and also from emerging markets such as Brazil and Australia, the spotlight has fallen on the standard of the credits. There is general consensus among all market participants, from project developers, credit wholesalers and retailers to individuals, that greater standardisation of VERs is necessary.
The voluntary offset market has received negative headlines in recent months, as doubts have been cast over market and project integrity. Claims that “carbon cowboys” are selling thin air for a fistful of dollars have caused a stampede of organisations rushing to establish better regulation. About 15 VER standards are now either in place or in development.
“There has been a rush to look at standardisation because it’s clearly the big issue for the market,” says Climate Care’s Buick. “There will be a process where the best standards, which encourage projects and satisfy transparency for customers, will come out on top.”
Until recently, the main standard applied to VER projects has been the Gold Standard, established in 2004 and backed by environmental group WWF and 43 non-governmental institutions. Another significant initiative is the Voluntary Carbon Standard (VCS), issued in draft form in March 2006. Backed by the International Emissions Trading Association, the Climate Group and the World Business Council for Sustainable Development, a finalised version is expected in the next two months.
“I think standards are very important, and so does the whole industry,” says Cantor CO2e managing director Steve Drummond. “The production of an independent standard that people have confidence in will help the market to move forward.” Drummond sits on the VCS steering committee, and believes the project will set the benchmark for voluntary standards. “The touchstone has always been environmental integrity,” he says. “If you stick with that it’s hard to go wrong, and the people coming together on the VCS, covering diverse aspects such as monitoring, verification and registries, all have that commitment. They’re all looking for environmental integrity.”
The VCS will look to offer a high standard of verification while still encouraging smaller projects outside the scope of the CDM. Gold Standard has had some criticism as it uses the same procedures applied in the CDM to verify a project’s abatement. These procedures can cost $10,000 or more.
“Current accreditation systems can be very expensive, especially for small projects,” says Nicola Steen, senior vice-president at global carbon broker CantorCO2e. “That means they may become discriminatory against some very good projects.” The VCS has special arrangements for small projects to help encourage local, small-scale sustainable VER projects.
“Demand for VERs is going to be enormous going forward, so we need good projects in place,” says Steen.
Meanwhile, the Voluntary Offset Standard (VOS), created by International Carbon Investors & Services, is another initiative that has garnered support from investment banks such as ABN Amro, Deutsche Bank and Morgan Stanley. “These three [Gold Standard, VCS and VOS] should gain more prominence among the many initiatives,” says Haneef. “The market definitely needs to raise quality control.”
There are great expectations for the voluntary offset market once that quality control is in place. As understanding and concern about climate change grows, emissions offsetting may well become standard practice across the globe.
“We’ve gone from the electorate saying that climate change is the government’s problem to individuals now being able to do something about the issue,” says Drummond. “That gives support to the political process to be more stringent with further reductions. The voluntary market is incredibly important, not because it replaces the compliance market but because it creates the political space to move the whole climate change issue forward.”
Buick agrees about the environmental importance of offsets. “It would be great if we can get people used to paying for offsets while the prices are low. As the ‘easy wins’ [projects that are easier to develop] are used up, the price will rise but people will accept they have to pay for carbon, and that might trigger behaviour change.”
Haneef is equally bullish. “There will always be a role for VERs, even when the US has a compliance market, for companies that do not fall under regulation, as they become increasingly aware of carbon neutrality,” she says. “It also allows for the development of some sideline sectors like forestry, which are not quite making it into the CDM.”
There are signs that, as fundamental issues such as standardisation are tackled, VER products could become more commoditised, with credits potentially being bundled together for trade on an exchange.
Further ahead, Buick sees convergence. “Do we need a market for voluntary reductions running along side a market for certified reductions? We believe the carbon markets will converge at some point in the future, around the foundation provided by Kyoto.”