Beyond the Binary: How To Help Carbon Credits Reflect Their True Environmental Impact

While attending New York Climate Week, I had several conversations about how we HELP ensure carbon credits reflect their real environmental impact. I shared some ideas based on how financial markets have traditionally addressed the issue of quality and integrity. Here’s a summary:

In simple terms, when a company seeks to borrow money, it does so by issuing bonds.  At the time of issuance, investors value the bonds at 100% of their face value because they believe the company will repay 100% of the bond’s value (including interest).

However, the financial health of a borrowing company may change over time.  Ignoring interest rates, some investors may choose to sell the bonds of a company when they no longer believe the company will be able to repay the full value of the bonds, thereby driving the price of the bonds below their initial 100% face value.  Other investors, however, may decide to buy these very bonds if they believe the adjusted price decline accurately reflects the risk of being repaid.

This system allows for bond prices to continually adjust, up or down, to reflect new information and what investors ultimately expect to be repaid.  If, however, a bond’s value drops too far, a company may be forced to restructure its bonds such that the old debt would need to be exchanged for new debt that more accurately reflects the company’s repayment capacity.

The bond market continually integrates this new information, whether positive or negative, to influence the ongoing valuation of the bonds after issuance.

By contrast, in the VCM, when a carbon project’s environmental impact is deemed less than what’s reflected by its carbon credit issuance, the market treats such shortfalls as a binary trigger that often drives the price of the credit to effectively zero.  Rather than discarding a project entirely, if the prices were adjusted to reflect the true carbon impact of the project, it would be better for project investors as well as the buyers and sellers of these credits.  Many such projects have created meaningful and measurable environmental impact even when the precise ratio of one carbon credit to one tonne of actual carbon dioxide is greater than 1 (a quantification of its overcrediting).  Rather than discarding the project entirely, the goal should be to adjust its credits to reflect its true environmental impact.

Many impactful projects are tainted by such a binary trigger, even when exogenous factors such as methodology revisions, changes to on-the-ground conditions, or other benign factors are responsible for the divergence between a project’s environmental impact and its credit issuance.  Instead of having a binary system, I envision three structural market adjustments that can help re-calibrate these projects and increase the amount of investments in carbon markets.

First, for some types of nature-based projects, issuances of future vintages could be reduced to compensate for the over-crediting in earlier vintages. Such a move would be the equivalent of restructuring a bond and would help ensure that a project’s environmental impact is evaluated dynamically, almost in real-time.

A second option – for issued credits – would be for registries to transparently re-evaluate projects’ climate impact using newer approaches. If over-crediting is detected, the registries could work with credit owners to cancel credits and re-issue a reduced number reflective of the project’s true environmental impact. In such a scenario, the credit owner would take a loss because the number of credits they hold would be reduced.  That outcome is preferable to losing the entire value of the original credits, especially as the value of their portfolio improves by no longer holding questioned credits. This option also removes tainted credits from the market, which should ultimately help improve the reputation of the market overall.

As a third option, Rubicon Carbon currently offers an innovative risk-adjustment feature whereby we independently calculate the over-crediting risk of a project using geospatial techniques. We then offer our clients the option to over-retire credits on behalf of no one, effectively canceling the over-credited portion of a client’s retirement.

All of these approaches can help reduce the risk of greenwashing, minimize risks for investors, and drive increased liquidity and investment in the market while simultaneously recognizing two important truths. First, as science and technology advance, our ability to measure carbon stocks and fluxes will improve. We need flexible systems to incorporate new advances into existing projects without invalidating older vintages. Second, climate action targeting emissions reductions and removals is only effective on a large scale. Given the planet’s near-term need for emissions reductions, it is better for us to scale up our impact now, even if we have to adjust our measurements in the future.

Many of the market dynamics of our existing financial system were born of problems many have since forgotten. Similarly, we need to build voluntary carbon markets to allow for necessary course corrections now and in the future.