Written by: Dr. Kate Kwan, CPA(US), CGMA, FRM
What is carbon finance?
Carbon finance is a type of environmental finance that covers financial tools provided to projects that are generating or are expecting to generate greenhouse gas (GHG) emission reductions. It involves the purchase and trading of such emission reductions in the carbon market. GHG includes carbon dioxide, methane, and nitrous oxide. By creating commercial values for reducing GHG emissions, carbon market provides an additional source of revenue and thus increases the commercial viability of renewable energy projects. To find a common unit for this commodity, all GHGs are converted to CO2 equivalents and traded on carbon markets. Emission reductions certificates or carbon credits are the currency of carbon markets. The unit for 1 carbon credit is equivalent to 1 ton of CO2 emissions.
International carbon trading markets have been around since the 1997 Kyoto Protocols and have grown exponentially since then. What carbon markets achieve is to turn carbon emissions into a commodity by pricing it. Under a regulated cap on carbon emissions, permits or allowances are given or auctioned to carbon emitters. Projects that emit below their cap can trade their carbon credits (aka carbon allowances) to those who need additional capacity, thus creating a market for buying and selling carbon credits.
Types of carbon credits
There are two types of credits: 1) Certified emission reduction credit (CER) are emission units / carbon credits created through a regulatory framework with the purpose of offsetting a project’s emissions at the regional and states levels in the compliance market. These carbon credits are issued by national or international governmental organizations. The number of credits issued each year is typically based on emission targets. Credits are frequently issued under a “cap-and-trade” program. 2) Voluntary emissions reduction credit (VER) are carbon offsets that is exchanged over-the-counter or in the voluntary market (mainly private sector), examples of companies offering clients to neutralize their carbon emissions include British Airways offers carbon neutral flights and Morgan Stanley provides the equivalent amount of carbon credits. These carbon credits can be purchased directly from projects and companies and carbon funds (e.g. The World Bank BioCarbon Fund).
The main difference between the above two markets is that the compliance market is mandatory, while the voluntary market is optional (voluntary). Both markets complement each other in the institutional (and personal) world. They also make the pool of buyers more accessible to farmers, ranchers and landowners — whose operations can generate carbon offsets for sale.
The global compliance market has total market size of US$261 billion (according to Refinitiv), representing 10.3 Gt CO2e traded on the compliance markets in 2020. The voluntary market is albeit smaller and was estimated to be worth about US$400 million in 2020. It is expected to grow exponentially and forecasts that by 2030 amounts to US$10–25 billion, depending on how aggressive countries pursue their climate change targets. It is open to individuals and organizations that voluntarily wanting to reduce the carbon footprint.
As mentioned earlier, carbon finance can give new revenue stream for companies. For example, Tesla, the electric car manufacturer, who sold carbon credits to legacy car makers amounting US$518 million in the first quarter of 2021. Aside from this, investors and customers are increasingly concern on climate change and the importance of carbon emissions. By contributing to carbon offset projects, companies would give positive signal to investors and customers for CSR reasons.
Individuals can be involved via third party companies
Global spending on carbon offsets would increase from US$300 million in 2018 to as much as US$100 billion by 2030, according to Institute for International Finance’s Taskforce on Scaling Voluntary Carbon Markets.
Bill Gates spends about US$5 billion per year to offset his family’s carbon footprint, as illustrated by Gates in his blog in February. He invested in multiple companies that provide offsets. For individuals, you can buy credits from 3rd party companies that function as intermediaries, companies and programs that fund renewable energy projects or plant trees or even from farmers who capture methane emissions from livestock. It is estimated that an average driver could cover his/her car’s carbon footprint for under US$100 per year. The cost of carbon offsets typically costs between US$2 to US$20 per metric ton of emissions removed, according to Bank of America’s research note published in September 2020
It is becoming more and more important for governments, associations, companies and individuals to find ways to minimise carbon footprints and embark on an environmentally friendly lifestyle. Carbon offsets helps individuals to minimise their carbon footprint. The size of this market is growing tremendously. There is big potential for companies that produce carbon credits over the next decades til 2050, where companies want to meet the 2050 net-zero GHG goals.
Many organisations also provide carbon footprint calculator. One can use these calculators to estimate how many carbon offsets needed in order to become carbon neutral