Assessing the evolution of carbon credits as an asset class
Over the last decades, there has been a gradually growing consensus about climate change: CO2 emissions are causing – and will continue to cause – global warming. Countries and governments, businesses and individuals have altered their operations, consumption, and production in attempt to minimize CO2 emissions in the atmosphere. By 2022 over 1500 businesses, 137 countries, and 1000 towns have pledged to become carbon neutral . However, many see this as not being enough and that bolder steps are urgently needed.
In this article, we look at carbon markets, a crucial tool for the transition to carbon-neutral economies that has its roots in the Paris Agreement and is increasingly producing a new asset class: Carbon Credits. Before we do that, we should understand what triggers the urgency to introduce effective carbon markets.
Are we missing the 2-degree goal?
Are we missing the 2-degree goal?
Our world is on course to warm by 3 degrees Celsius by the end of the century that would result in catastrophic disasters.  To mitigate the worst, consensus has evolved around the need to keep global warming below 2 degrees compared to pre-industrial level, with many calling for the need to keep it below 1.5 degrees. A 2-degree target may appear ambitious but consider the effects of such warming: eight of the world's ten major cities are coastal and would endure significant flooding and storms, Europe would face a 59 percent likelihood of high summer heat, and the oceans would warm to the point where marine wildlife species would become extinct. According to NASA, even despite the world putting its operations on pause for the pandemic, a substantial 5.4% reduction in emissions was not enough to slow down global warming. End-of-the-century forecasts demonstrate that our current policies and actions are putting us on course for a warming of 2.9 degrees Celsius, which would have disastrous effects.
|Graph 1: 2100 warming projections. |
How is it that, despite such solid framework, we are failing to fulfil the two-degree target? Many countries commit to climate policies, but few follow through, from some that do not back up their promises with concrete action to some that try to game the system. Carbon markets and trading schemes, however, are among the mechanisms that are becoming more established and increasingly embraced by the financial community.
Carbon markets – a key solution
The backdrop for market-based carbon trading mechanisms is the Emission Trading System (ETS) , which was first established in 1997, when the Kyoto Protocol came into force. ETS are a cap-and-trade system in which businesses may purchase and sell the right to emit carbon. The Kyoto Protocol has laid the groundwork for the UN's fundamental pillar of modern climate policy - a framework for global large-scale ETS. In 2015, Article 6 of the Paris Agreement established first worldwide carbon markets, providing nations with the foundations to develop national and regional climate policies.
How do carbon markets function? Companies that are struggling to meet their emissions-reduction targets under their national climate plans, and those that want to pursue less expensive emission cuts, can purchase emissions reductions from other companies that have already reduced their emissions more than the amount pledged.  In principle, this gives a clear financial incentive for those who want to reduce their emissions faster, as well as help direct investment to the cheapest and quickest emission-cutting initiatives.
There are 25 established ETS in the world with European Union ETS and Chinese ETS leading the market with over 90% market share.   Overall, the value of traded global markets for carbon permits grew by 164% to a record $851 billion last year.  In comparison, the voluntary carbon market where individuals and companies purchase carbon offsets on a voluntary basis with no intended use for compliance purposes, has reached a turnover of $1 billion. 
As with any new asset class, not only adoption is an important indicator for investors, but also the development of the underlying infrastructure as a pointer to the sustainable growth of the asset class. Certain pillars are needed for the emissions trading system to function efficiently, namely emissions measurement and reporting, verification of carbon credits, and market mechanisms. Let us take a closer look.
Pillar 1: Measuring and accounting for emissions (demand-side)
The most difficult aspect of ETS is calculating an organisation’s carbon footprint. Reporting on sustainable practices is mostly voluntary and it is at company’s discretion which picture they want to paint by choosing to present or omit certain data in their report. Some emissions are easier to quantify and manage than others. These are Scope 1 emissions, which are created directly by the firm, for example, by production and company vehicles, and Scope 2 emissions, which are generated through heating, electricity, and other sources.  The challenging part lies in the indirect emissions, Scope 3, which include emissions along the supply chain such as supplier emissions, water and paper used, business travel etc. Scope 3 emissions can account for 80-90% of the total company’s emissions and to quantify those the company must set up proper due diligence processes and tracking system in place. For example, 99% of emissions of Apple, which committed to being carbon-neutral, are Scope 3. 
|Graph 2: Carbon footprint emission categories. |
Carbon management software (CMS) is a system that help measure and account for all the emissions, including Scope 3, and make the reporting transparent and reliable. Companies like Plan A, Planetly and Watershed help companies to navigate societal and regulatory pressure in sustainability reporting, provide automation tools for leveraging the company data towards meeting sustainability goals. Plan A, for example, has created a SaaS platform for detailed corporate carbon footprint accounting and AI-driven decarbonisation planning. Plan A alone has 400,000t of carbon under management and developed over 450 solutions to decarbonise the economy such as Carbon Emissions Calculator, Automated Annual Emissions Report and Automated Decarbonization Plan. These companies are part of a larger emerging CMS market that is projected to be worth $19.8 billion by 2026. 
Pillar 2: Generating and verifying carbon credits (supply-side)
Calculating an organization's carbon footprint is the important first step in reducing or offsetting emissions. Knowing how much an organization is emitting provides the basis to plan and implement measures, voluntarily or driven by regulators, to reduce its carbon footprint. While reducing emissions is the responsibility of the organization, offsetting them requires a broader ecosystem approach. Namely, opportunities to purchase carbon credits. This means that for each ton of CO2, the emitter purchases a credit from another organization that reduces or eliminates the equivalent of those emissions by selling such credits. As a result, it requires organisations that conceive projects that reduce or remove emissions and issue and sell corresponding credits.
Many of such projects are part of REDD+, or written out in full Reducing Emissions from Deforestation and Forest Degradation. This UN programme provides a framework through which countries or private sector may pay to not cut down forests, either through direct payments or in exchange for “carbon credits” that are traded under ETS. 
We must distinguish between regulated (or compliance) and voluntary carbon credit markets. The difference is in who determines the emission cap. In the regulated market, it is the government and its national policy; in the voluntary market, it is driven by companies and individuals based on corporate responsibility, ethics, or supply chain concerns. The latter marketplaces are self-regulated, they are prone to fraud, misrepresenting emissions reductions, and mispricing.
The demand for offsetting has been soaring. McKinsey estimates that demand for carbon credits could increase by a factor of 15 or more by 2030 and by a factor of up to 100 by 2050.  Given the demand for carbon credits and the flawed functionality, many non-profit organizations were established to provide the global standard for carbon credits. ’Verra’, one of the leading providers for carbon standards and frameworks, has certified over 1806 projects that have collectively reduced more than 928 million tonnes of carbon and other emissions from the atmosphere. The ‘Gold Standard’, established by WWF and other international NGOs, aims to create $100 billion in shared value for climate actions and sustainable development by 2030. Alongside them, there are many more companies that aim to accelerate progress toward the Paris Agreement, such as Social Carbon, CCBA, and UN Clean Development Mechanism. 
|Graph 3: Carbon Credits standards overview.    |
Pillar 3: Transparent and efficient Carbon marketplaces (transaction infrastructure)
We have so far covered two pain points of carbon trading, yet the main inefficiency arises in trading itself. Nowadays, most transactions are made Over the Counter (OTC), which refers to private trades outside public markets, making price and seller discovery extremely difficult. There are numerous ways to obtain the offset credit this way: directly from the offset project, as a one-time purchase from an ongoing project, or through a broker or retailer.  In any case, all the solutions are inconsistent, often require third parties to take care of the transaction and lack transparency in credit pricing.
As a result, most offset credits on voluntary markets are sold for far less than the cost of reducing a ton of carbon (regularly for the price as low as $5).  If we are to fulfil the Paris Agreement's temperature objectives, the global carbon offset price should be between €100 and €150 per ton CO2 by 2030.  Carbon costs are higher in the compliance or regulated market, with the highest being temporarily over €90 under the European ETS scheme, due to credits experiencing commodity pricing. The lack of a clear framework introducing is impeding efforts to combat global warming through voluntary markets, which are a powerful instrument in this cause. This calls for public marketplaces that focus on this new asset class.
Many companies and initiatives are developing carbon offset marketplaces and exchanges, with the aim to improve access to the carbon credit market and contribute to appropriate pricing mechanisms. For example, SGX, the Singapore based exchange plans to scale the voluntary carbon market via its upcoming CIX exchange. Others are Xpansiv’s CBL, an up-and-running exchange for ESG-inclusive commodities or CTX, the Carbon TradeXchange.  From an European perspective, trading of future contracts on ICE is still the most prominent type of access to carbon-related assets.
Some initiatives have turned to distributed ledger technologies like Toucan, an infrastructure built to support the direct purchasing of carbon credits on-chain in the form of tokens. The tokens are held openly and securely before being exchanged like any other crypto asset with the goal of persuading prospective buyers who were previously uninterested in the carbon credit market.
Another streamlined platform is the AirCarbon Exchange (ACX), or since October 2019, Klima DAO, one of the flagship initiatives for carbon trading on blockchain, which facilitated the migration of over 17 million tons of carbon credits on-chain.  Klima’s purpose was to create the demand for the tokenized credits and push their prices up to incentivize companies to develop sustainable ways to reduce CO2 emissions rather than purchasing offsets.
|Graph 4: Carbon Exchanges using Distributed Ledger Technologies.  |
It is already clear that much will happen in the future regarding all pillars around carbon-related assets.
The three pillars described above lay the foundation for carbon as an asset class. How well the pillars of measuring and verifying the supply, and bringing it together with demand on transactional platforms for carbon credits are working, however, is not only evident from individual executions, but also from the level of engagement of all possible parties involved. Just as in other commodity markets it’s crucial that these assets are made broadly accessible by structuring products that meet all kinds of risk profiles of investors. The first products that are accessible to a broad public are already emerging. Vontobel is one example. The Swiss bank has issued a tracker certificate that allows investors to participate in the price performance of CO2 emission rights futures contract (based on the European ETS) traded on the ICE futures exchange. 
But while we have come a long way in creating efficient and effective marketplaces, the entire ecosystem still suffers from a high degree of fragmentation. The consolidation of these measurement systems, the verification of carbon credits, and the development of public marketplaces should serve as yardsticks for investors to assess the asset class of carbon credits. Therefore, we consider it essential to currently broaden the view on investment opportunities upstream or downstream of the carbon market.
Digital Waves is creating such an opportunity. Together with partners in Switzerland and Paraguay, we are preparing a certificate that will provide investors with exposure to a new investment scheme for rainforest in Paraguay. Instead of cutting down the forest, owners are paid by governments to preserve it in the interest of fighting climate change. This not only contributes to the environment, but also creates an attractive and collateralized investment opportunity, which Digital Waves and its partners will make accessible through an investment vehicle with Swiss-ISIN.
Stay tuned or contact us to learn more about how you can integrate this ESG-related project into your portfolio.