What should buyers of carbon credits expect from projects?

The last couple of years has seen development firmly in one direction.   More requirements and expectations for carbon credit generating projects.  This is evident by looking at the standards/methodologies for generating credits, the ICVCM overlay and the increasing number of questions and due diligence from buyers.

No doubt we are today in a better place than years ago but ultimately increasing requirements come with increased cost to project developers and a balance need to be found.   This article offers a view on where that balance may be by offering analogies to other products. I also acknowledge the crudeness of the analysis and that each product class is not homogeneous. Yet the intention is to provide a framework for discussing the balance of regulation / transparency with cost rather than to offer an extensive analysis which is beyond this article.

Similar issues has been highlighted by Illuminem (Renat Heuberger and Steve Zwick) in the paradoxes issued each day in December 2024.  This article is also in response to these paradoxes.

Specially I will address the amount of transparency into a project buyers should be able to require (paradox 21 and the control over the use of funds (from carbon credits) buyers should be able to have (paradox 16).  In answering this I will indirectly look at the increasing requirements from standards (paradox 15) and refer to the characteristics that may require it to be regulated (paradox 23).

Executive Summary

• The carbon market has benefited from more regulation and transparency.  Yet there is a limit to how much burden can be placed on project developers.   Given the high price elasticity for carbon credits, it is often not possible for project developers to recover the increased cost that goes with increased regulations and disclosures.  I make a distinction between the regulation imposed on project developers and that imposed on intermediaries.

• When exploring the right balance between cost and additional regulation and transparency it is helpful to look to other products to gauge the balance.  I draw analogies to four products Books, Cars, Food and Medicine that differ in terms of attributes such as criticality of the output, homogeneity of buyer preference, complexity of the process, requirement for ongoing maintenance and price elasticity.  In doing so I recognise that carbon credits arguably are a policy tool as much as a product or service.  Yet the analogy helps think through the regulation and requirement implemented in more mature markets.

• I observe that products with high profitability and where the correct outcome of the project is critical (e.g. medicine) generally is subject to higher requirement for regulation and transparency than other products although it naturally varies by jurisdiction.

• I evaluate the attributes of carbon credits projects as a product and conclude that whilst it has similarities to several products the closest analogy is that of a car. I then look at the regulation for the car industry to deduce what are reasonable requirements for carbon credits. 

• I conclude that:

1.  Buyers of carbon credits (as oppose to investors) should not be able to mandate the use of funds or the process for producing the credits as long as they meet the requirements of standards and methodologies. It would seem odd to say at least if a buyer could tell the car producer whether money is better spent on machinery, R&D or bonuses.  The product is evaluated based on meeting the stated output (for carbon credit generating projects the core output sequestering emissions) and are within the applicable laws and regulation.

2. Compared to the closest analogy carbon credits have similar or higher level of transparency and regulations (or for carbon credits that is methodologies).

3. I would welcome further transparency into the financial position of the project developer, not mainly to determine the permanence of the project, but primarily for buyers to gauge if the developers get an equitable share of the profits and loss from a project.

4. I would welcome minimum prices for carbon credits to ensure they remain profitable but in a voluntary free market with an over-supply of credits this is hard to effectuate. Signs of governments requiring minimum prices for projects with Corresponding Adjustments is a sign of change.  Subsidies for projects may be valuable for project developers but could create issues with additionality if too high. 

5. I would also advocate stronger requirements in the carbon standards to ensure the upholding of safe working conditions and minimum wages.

6. I am in favour of the increasing regulation of carbon market intermediaries to transform the carbon market infrastructure into a trusted and transparent market.

 Regulation vs Industry Standards

Before getting started it may be useful to recognise that regulation can come in many forms.  It can be mandated by law by competing standard setters (e.g. Verra and Gold Standard) or self-imposed industry norms.  These are obviously different but for the purpose of this article I chose to equate them to simplify the argument.

Requirements Equals Cost

In a World free of constraints, we could put in place all kinds of regulation and requirements for disclosures about everything imaginable.  However, project developers, like entities in all other industries, are certainly not free of economic constraints.  Normally an increase in cost from compliance regulation and disclosures are levied onto consumers of the products but for carbon markets that has not been the case.  This is evident by looking at the correlation between regulation and prices.  Increasing regulation and requirements but generally lower prices (for the same credit).  This means that that project developers and local communities absorb this cost.  As mentioned in an earlier post (link), the current price for REDD+ is multiple times lower than the cost to produce a quality project.  That is not to say that regulation is necessarily an evil.  An appropriately designed set of regulation is certainly useful for the market, but it comes at a cost and the balance must be right.

Also, buyers may wish to control how projects are run and how money is spent.  This too may seem reasonable, but it too comes as a resource requirement for the project developer.  It is not free to service the disparate and changing requirements of buyers.

This is to say that we must be careful in finding the right balance before requiring more disclosures and imposing more regulation.

Introducing Analogies

When analysing the issue of control and transparency it can be helpful to think about how these are met in other products.   I have chosen to analogise to four different products: (fictional) Books, Cars, Food (for general consumption) and Medicine.    In drawing the analogy, I recognise that carbon credits arguably are a policy tool as much as a product or service.  Yet the analogy helps think through the regulation and requirement implemented in more mature markets.  I also acknowledge the crudeness of the analysis and that each product class is not homogeneous. Yet the intention is to provide a framework for discussing the balance of regulation / transparency with cost rather than to offer an extensive analysis which is beyond this article.  

The four products differ in terms the attributes also relevant to carbon credits and have increasing amount of regulation and transparency imposed on them.  These attributes are:

• The criticality of the output.  It is far more critical the medicine delivers the output intended than a book.  The consequence of the former can be fatal whilst for the later at worst that may happen is that we spend a couple hours bored.

• The homogeneity of buyer preferences.   For the majority of people is generally easier to define what we want in car (speed, comfort etc) than it is from our food (nutrition, allergies etc.) although connoisseurs in any product class will have the unique features that matters to them (car collectors and foodies).  Another way to think of this is in terms of utility (i.e. does the product serve its intended primary purpose).  For a car that may be getting from point A to B, for food (nutritional value), and for carbon credit sequestering a ton co2e. Car buyers arguably have a high expectation that the car meets its utility purpose, as opposed to a book, which can be more subjective. 

• The complexity of the process.  Building a car requires a complex value chain as does producing food.  A book conversely requires an author and a computer (and a bit more).  It has far fewer people and processes involved.

• The requirement for ongoing maintenance.   When you consume a Mars Bar (if you call that food) you don’t need anything afterwards.  It would maybe be nice if you could buy the Mars Bar again but if you couldn’t, surely you would find other chocolate bars.   For purchasing a car, it is very important to know that the producer will continue to exist to service the car.

• The price and frequency of buying.  It should be obvious that food items are bought more frequently than cars.  This means the former is more reversible than cars.  The price per item is also much higher for cars than food.

• The price elasticity. Although it varies the price elasticity for many food items is higher than for medicine because there is more substitute of roughly equal utility.

• Profitability both per unit and for the industry matters in terms of the amount of regulation and requirements that can be placed on the companies for them to remain viable.  Clearly this varies significantly between companies in an industry but generally medicine has a higher profit margin than food and books. 

Next, I will look to analyse how the above differences manifest themselves in regulations and transparency and then look to see which analogy best apply to carbon credits.  This to ultimately provide my suggestions for additional transparency and control.

Analysing the Analogies

In the table below I compare crudely the four products on the four attributes outlined above.

A couple of words to explain the table.  For a fictional book it is not critical to our well-being that the book delivers the reading experience we expected.  We expect very different things of books, and we don’t need any maintenance (maybe we want a sequel of a good book).   For a car I argue that there are some common features we value in a car.  Beyond safety requirements the worst that can happen if we buy Friday afternoon car (a bad car) is poor comfort and many repairs.  It won’t harm us (car lowers would argue that it dramatically impacts their mental wellbeing).   We (some) care about how it is produced including the use of forced labour, sourcing of material etc. For food we buyer will have many needs beyond taste.  We (some) care about the health of the product, whether it is vegan (it is not), the use of food preservatives.   For medicine it is critically important that it has the stated effect and what side-effects it may have.  We require ongoing maintenance in the sense that for a critical drug with few viable substitutes we care greatly that the producer remains in business (or pattern is transferable).

Next let’s look at the implication of the above differences in attributes.  I appreciate that regulation varies between jurisdictions and hence the table is at best directionally accurate but sufficiently to serve the purpose of this article.

 Carbon Credits as Cars

Having looked at different products and the regulation and control that they are subject to we can then look to see what attributes are most alike to carbon credits.  

Summing up the above considerations carbon credits shares attributes with different products.  The closest analogy may be a car even if intuitively cars and carbon credits have little in common (and arguably emission from cars necessitates use of credits but we will ignore this apparent contradiction).  Some companies proudly (and justifiably so) promote their use of high-quality credits (although far too many are afraid of greenwashing) but this pales in comparison to the middle-aged man with mid-life crisis flashing his new sportscar.

What should we require for Transparency and Control

So where does all this lead us?  We can try to use the use the analogy to a car and its attributes to indicate the amount of transparency and control that we should subject carbon credits to.  This will ultimately help determine:

• The amount and type of transparency we can require (paradox 21)

• The control buyers should have over the process and use of funds (paradox 15)

Using the table from the comparison above here are my observations:

Looking at the table above my ultimate conclusions are:

• Buyers of carbon credits (as opposed to investors) should not be able to mandate the use of funds or the process for producing the credits as long as they meet the requirements of standards and methodologies. This is the job of regulators and investors that like shareholders in other industries have ultimate decision making power over a company.  It would seem odd to say at least if a buyer could tell the car producer whether money is better spent on machinery, R&D or bonuses.  The product is evaluated based on meeting the stated output (sequestering carbon).   I can appreciate that carbon credits are more complex, and some may care deeply about how much money reach the local community.  That is reasonable, and I would agree that it is good practice for project developers of e.g. REDD+ projects to disclose this.  But ultimately, we must trust developers to pay an amount to communities to ensure the project is viable.  The issue of whether the developers take an unfair share of profit is better solved by the mandatory provisions of financial statements.  A buyer can choose to buy the carbon credit from different projects just like there is a variety of cars.  

• Compared to the closest analogy carbon credits have similar level of transparency and regulations even not even more stringent regulations.  What carbon credit markets have also is seemingly higher scrutiny, confidence interval expectations (even greater than corporate tax returns), and negative media coverage. What they don’t have is a central point of regulation with consensus on one standard.

• I would welcome further transparency into the financial position of the project developer not mainly to determine the permanence of the project, but mostly for buyers to gauge if the developers get an equitable share of the profits and loss from a project.

• I would welcome minimum prices for carbon credits to ensure they remain profitable but in a voluntary free market with an over-supply of credits this is hard to effectuate. Carbon credits are not a pure market commodity, but a policy tool using markets to achieve climate impact. It is essential that prices reflect the cost of the project and risks taken by project developers. Signs of governments requiring minimum prices for projects with Corresponding Adjustments is a sign of change.  Subsidies for projects may be valuable for project developers but create issues with additionality.

• I would advocate stronger requirements in the carbon standards to ensure the upholding of safe working conditions and minimum wages.  Whilst project developers will be subject to local laws I would like to see the methodologies consistently make clearly reference global guidelines such as the international labour (ILO) standards on forced labour.

Finally, a note on the regulation of carbon market intermediaries.  In paradox 23 portraits convincingly the obvious paradox that “Carbon credits, by contrast, are stuck between small and large size. The market has become large enough to excite the public - but it is still way too small for serious investments in proper regulation and seasoned PR professionals to defend it”.    Whilst market intermediaries can also be subjected to too much regulation that reduces the economic viability and ability to innovate, I see a stronger need for additional regulation here to bring about a robust infrastructure that eventually can create liquidity.  I laud the efforts of IOSCO and other in this regard.  Appropriate amount of regulation and explicit government support for carbon credit markets do add credibility to the overall market

Final Thoughts

In finding the right balance I urge regulators and buyers to be very mindful that every requirement comes with a cost and until the carbon market shows signs of recovery with higher prices, we may end up killing the exact project that we need so desperately to succeed.