17 October 2024
Navigating the Carbon Credit Landscape: Risks, Opportunities and Strategic Solutions
In a rapidly evolving global landscape, industries worldwide strive to decarbonise in response to regulatory mandates and stakeholder pressures. Carbon credits have emerged as a significant mechanism to offset carbon emissions among the various tools available.
Many industries, including airlines, auto manufacturers, banks and tech firms, fast-food and beverage brands, fashion houses, oil and gas majors, and tourism, have started using carbon credits to counteract their carbon footprint.
While they present many opportunities, they also come with their unique set of risks.
The relevance of carbon credits
Carbon credits are seen as instrumental in achieving global warming targets. They serve as a bridge, allowing industries to offset emissions that are difficult to eliminate through direct measures. The aviation industry, for example, has introduced initiatives like the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) to address its carbon footprint.
Since January 2019, international airlines have been mandated to report their CO2 emissions, with offsetting obligations introduced from January 2021. This scheme demonstrates the importance of carbon credits in the aviation sector's broader strategy to achieve climate targets, complementing their efforts to reduce carbon emissions.
Carbon credits are seen as instrumental in achieving global warming targets.
What are carbon credits?
Carbon credits are essentially permits allowing the holder to emit a certain amount of carbon dioxide or other greenhouse gases. They come in various forms:
1. Reduced emissions: projects aimed at energy efficiency.
2. Removed emissions: initiatives like carbon capture and reforestation.
3. Avoided emissions: protecting existing carbon sequestration mechanisms such as rainforests.
These credits can be traded in two key markets: the Compliance Carbon Markets (CCM) and the Voluntary Carbon Markets (VCM). The former is regulated and typically targets heavy-emitting industries, while the latter is unregulated, allowing organisations to purchase and retire carbon credits voluntarily. The VCM is guided by non-governmental and industry standards without formal regulation, making it a complex landscape to navigate.
CCMs, also known as mandatory markets, are the heavyweight champions in the carbon trading arena. These markets are born from legally binding emissions reduction targets set by international agreements, such as the 1997 Kyoto Protocol and the 2015 Paris Agreement.
How they operate
· Emission Trading Systems (ETS): CCMs primarily function through cap-and-trade schemes, known as ETSs. Governments or regulatory bodies set a cap on the total amount of greenhouse gases that can be emitted by entities covered under the system. This cap is divided into allowances, each permitting the emission of a specific amount of carbon dioxide or equivalent gases.
· Trading allowances: Entities that emit less than their allotted budget can sell their surplus allowances to those that exceed their limits. This creates a financial incentive for companies to reduce their emissions. The current global value of these markets hit USD948.75 billion last year.
· Integration with VCMs: Although primarily regulated, compliance markets may allow limited use of carbon offsets from VCMs. For example, the EU ETS phased out the use of international credits from mechanisms like the Clean Development Mechanism (CDM) and Joint Implementation (JI) in 2020. The Paris Agreement further outlines provisions for linking carbon markets globally, potentially integrating compliance and voluntary efforts more seamlessly in the future.
Voluntary carbon markets: the flexible frontier
On the other side of the spectrum are VCMs, where participation is driven by sustainability and individual environmental consciousness rather than legal obligations.
1. Purpose and participants: VCMs allow companies, non-profit organisations, and individuals to purchase carbon credits voluntarily. These credits represent reductions in greenhouse gas emissions from projects such as reforestation, renewable energy, or energy efficiency improvements. The primary aim here is to offset a company’s carbon footprint rather than meet regulatory requirements.
2. Market dynamics: Although smaller in size compared to compliance markets, VCMs are growing rapidly. By September 2023, approximately USD1.16 billion worth of carbon offsets were traded, a significant increase from previous years. This growth indicates a rising awareness and commitment to sustainability among businesses and individuals.
3. Impact: While buying credits in VCMs doesn’t directly help a country meet its obligations under international agreements like the Paris Agreement, it contributes to global emission reduction efforts. By offsetting their emissions, participants in VCMs help fund projects that may not receive support through compliance markets, thus broadening the overall impact.
Although distinct, CCMs and VCMs are interconnected:
· Compliance markets can occasionally tap into voluntary offsets, albeit with restrictions. This interplay ensures some flexibility and additional avenues for emission reductions.
· Future frameworks: The Paris Agreement's provisions for market mechanisms suggest a future where these two markets might be more closely aligned, creating a more integrated and efficient global carbon trading system.
Opportunities in carbon credits
The prominence of carbon credits is rising like a green wave across various sectors, driven by an urgent call for sustainability and climate action:
Energy
Fossil fuel giants are investing in renewable projects and purchasing carbon credits to offset emissions, aligning with global decarbonisation goals.
Manufacturing
Heavy industries are adopting carbon credits to mitigate their carbon footprint, enhancing their competitive edge and compliance with stringent environmental regulations.
Agriculture
Farmers and agribusinesses leverage carbon credits from sustainable practices like reforestation and soil carbon sequestration, turning green initiatives into financial incentives.
Technology & Finance
Tech giants and financial institutions invest in carbon credits to achieve net-zero targets, showcasing environmental responsibility to stakeholders and consumers.
Retail & Consumer Goods
Brands are utilising carbon credits to offset emissions from production and logistics, appealing to eco-conscious consumers and enhancing brand loyalty.
Industry-wide opportunities
The burgeoning market for carbon credits offers several industry-wide opportunities:
Achieving compliance
Carbon credits are crucial for meeting regulatory requirements in industries like aviation. For instance, Delta Airlines reportedly acquired USD137 million worth of carbon offsets to comply with CORSIA.
Sustainability reporting
Various regulatory frameworks, such as the EU’s Corporate Sustainability Reporting Directive and the International Sustainability Standards Board (ISSB), require companies to disclose their transition plans to net-zero. Carbon credits play a vital role in these disclosures, helping firms demonstrate their commitment to sustainability.
Market diversity
Companies can acquire carbon credits through various avenues - directly from project developers, brokers, retailers, or exchanges. The IATA Aviation Carbon Exchange (ACE), for example, provides a centralised marketplace for trading CORSIA-eligible emission units.
Risks associated with carbon credits
A recent analysis conducted by Corporate Accountability, a non-profit transnational corporate watchdog, found that major corporations such as Delta Airlines, Gucci, Volkswagen, ExxonMobil, Disney, easyJet, and Nestlé have purchased millions of carbon credits from climate-friendly projects. However, these credits were found to be ineffective in offsetting their greenhouse gas emissions.
Therefore, while the opportunities are significant, the risks cannot be ignored:
1. Non-delivery: One of the primary risks is the non-delivery of carbon credits. Providers may fail to deliver the promised reductions, leaving businesses scrambling for alternatives at potentially higher costs.
2. Invalidation risks: Credits can be invalidated due to fraudulent or negligent acts, significant reversals of carbon sequestration, or shifts in methodology, rendering them useless.
3. Accumulation risk: Companies may reach a point where they are uncomfortable holding the risk associated with carbon credits, necessitating the transfer of liability onto their balance sheets.
Insurance can play a pivotal role in mitigating these risks. It provides several benefits, including risk assessment, mitigation, and a stamp of confidence for high-quality carbon projects. Coverage is increasingly being sought to provide greater certainty around carbon projects in the VCM by assessing their quality and insuring the buyers and/or sellers of quality projects.
The United Nation's position
The United Nations has clarified its position on carbon credits, emphasising the importance of direct emissions reductions over-reliance on offsets.
1. Emphasis on direct reductions: The UN urges companies to prioritise reducing their own emissions first rather than relying solely on offsets to meet their targets. This resembles the idea that ambulances are not a substitute for regular healthcare – direct action is paramount.
2. Voluntary action: The UN does not discourage voluntary carbon markets. Instead, it supports using carbon credits to compensate for emissions that cannot be eliminated immediately. This complements the path to achieving net-zero emissions
Why this matters
1. CO2 removal capacity: According to a separate report, to stay aligned with the 1.5-degree Celsius target, we must drastically increase our CO2 removal capacity. We remove about 2 billion tonnes of CO2 annually, but we need to scale this up to 4 billion tonnes per year by 2030.
2. Collective responsibility: Achieving this goal requires collective action from all sectors – governments, corporations, NGOs, and individuals. The urgency is such that voluntary carbon markets are not just a nice-to-have but a critical component in our climate strategy.
How Gallagher can help
Navigating the complex landscape of carbon credits requires expertise and a nuanced understanding of both risks and opportunities. Gallagher's dedicated carbon solutions team stands ready to assist you in finding the right insurance coverage tailored to your needs. Whether you are worried about undelivered items, fraudulent charges, or any other risks, Gallagher's experts are available to support you every step of the way. Contact us today to ensure your carbon credit strategies are robust, compliant, and aligned with your sustainability goals.
The sole purpose of this article is to provide guidance on the issues covered. This article is not intended to give legal advice, and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and/or market practice in this area. We make no claims as to the completeness or accuracy of the information contained herein or in the links which were live at the date of publication. You should not act upon (or should refrain from acting upon) information in this publication without first seeking specific legal and/or specialist advice. Arthur J. Gallagher Insurance Brokers Limited trading as Gallagher Specialty accepts no liability for any inaccuracy, omission or mistake in this publication, nor will we be responsible for any loss which may be suffered as a result of any person relying on the information contained herein.
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