Demystifying the Carbon Credit Market for Private Equity Firms

The voluntary and compliance carbon credit markets are taking the world by storm, as corporations and organisations across the globe look to offset their emissions through the sale and purchase of carbon allowances. This market is growing at a rapid pace; according to data from Ecosystem Marketplace, “the voluntary carbon market topped $1 billion in 2021.” Over the next two decades, the carbon credit market is expected to become a “multi-trillion-dollar market.”

As the market grows, more and more private equity firms are pursuing the carbon credit market, amid increased pressure to illustrate their environmental, social, and governance (ESG) credentials to investors and regulators alike. But the increased activity and interest in carbon credits among private fund firms raise three nagging questions:  How, and how effectively, is this relatively new space being regulated? Are carbon offset investments really delivering on their promise to combat climate change? And, what are their broader social impacts? 

The Carbon Credit Market and Current Regulatory Landscape

When considering carbon credit investments, it’s first critical to understand the market itself, as well as the regulatory landscape. 

In the compliance carbon market (CCM), carbon allowances are traded and regulated by mandatory national, regional, or international regimes, whereas, in the voluntary carbon credit market (VCM), carbon credits are traded by companies and individuals, driven by commercial, sustainability and marketing considerations. Despite the obvious differences, the premise behind trading carbon credits remains the same across both categories: in theory, carbon credits are a means of responsible investing and incentivizing pollution reduction, all while offering an opportunity to meet ESG investment goals.

The first regulatory step, the 2015 Paris Agreement, aimed to limit the rise in global temperatures caused by the accumulation of greenhouse gases in the atmosphere to 1.5°C compared to pre-industrial levels. It was pivotal in the quest to combat climate change because it establishes an important framework for monitoring, reporting, and enhancing countries’ individual and collective climate goals.

In the fall of 2021, global leaders met in Glasgow, Scotland, for COP26 and agreed on “general principles for projects that generate carbon credits, which include initiatives as diverse as re-forestation, renewable power installation or measures to help household energy efficiency.” The guidelines now require projects that generate credits by claiming to remove carbon emissions must not have been done otherwise; and reductions must be long-term and not lead to polluting elsewhere. COP26 also agreed to the creation of a registry to track credits and the use of proceeds from their issuance.

However, the regulatory landscape in the VCM, in particular, remains fragmented, primarily consisting of private-sector standards that are implemented by independent auditors. There is significant variation between the standards, but there are two key and common problems: the manipulation of baseline calculations — impacting the forecasted and subsequent reduction in CO2 emissions that are directly attributable to the relevant project; and a failure to fully assess non-emissions risks such as financial crime, governance and broader human impact.

Environmental Greenwashing, Financial Crime and Social Impact Sacrifice

Reflecting this, in the VCM space specifically, there is a healthy degree of investor skepticism around the credibility of carbon credit investments because their quality and legitimacy cannot always be independently validated. In fact, according to Compensate, a Finnish non-profit that manages a carbon capture portfolio, less than 10 percent of the 100 projects certified with leading industry standards, which it reviewed last year, “met its criteria on ensuring that projects didn’t inflate carbon savings, weren’t already planned, and other factors including human rights.” These are clear warning signs that could delegitimise any carbon credit investment or project.

These scenarios are common, which is what makes the job of scrutinising the investments to ensure legitimacy so onerous and complex. Coupled with the lack of VCM regulatory standards, the risk of greenwashing can proliferate, which undermines carbon offsetting objectives and can deter investors from participating in the market altogether. Additionally, a host of fraudulent activities have often been associated with carbon credit purchases — tax evasion, bribery and corruption, money laundering, and consumer fraud — to name a few. 

On the social impact side, a lack of regulatory oversight raises the risk of poor human impacts. Carbon offset projects are frequently located in complex international markets and lack of appropriate auditory oversight on social, community and governance issues raises the potential for serious potential reputational damage down the line.

Using Intelligence Gathering to Evaluate Offset Projects

Understanding the reality of the environmental benefits, and of the social impact of these investments is a complicated and onerous process, thanks to a fragmented regulatory environment and opaque project structures. Proper risk evaluation requires specialised skills, including knowledge of the emerging carbon credit market, and expertise focused on gathering the right information when conducting due diligence. 

Some positive changes are pending. A consortium of climate experts from the private sector have banded together to build a framework that helps ensure VCMs are indeed making a real difference in combating climate change. According to non-profit public policy organization Brookings Institution, “voluntary carbon markets need to be verified and produce valid emissions data (or in the case of forests, the amounts of forest mass from which captured carbon can be measured) from each exchange participant.”

However, Brookings’ research has shown that “VCMs have fallen short in assuring the contracts and trading lead to real global emission reductions.” This is referred to as the “additionality” problem. To be sure, VCMs now include fastidious rules and regulations to verify carbon credits, though spending a lot on verification does not ensure additionality. For example, one study suggests that less than 20 percent of the credits sold in the California forest offset program led to additional carbon capture beyond what the forests would have accomplished anyhow (Haya 2019).”

Clearly, this level of verification alone is not enough to validate the impact of these types of offset projects. Particularly because impact investing does not happen in a vacuum — in addition to the environmental impact, investors must take into account the social and governance impact from the project. Impact-focused intelligence is necessary to help authenticate these complex investments, and determine the full range of commercial, reputational and consumer / investor implications of moving forward with carbon credit investments.

This is particularly important at the project level. It is imperative to determine: if a project is sustainable; the human impact of its activities and supply chain supply chain; and whether the investment meets a broader sustainable investing mandate.

Some of the most important issues and questions to address in an intelligence gathering exercise would include:

• Supply chain – What is the human impact of the supply chain? How are goods and services are sourced? Which types of companies are in the supply chain? Is there any evidence to suggest that any part of the supply chain relies on poor working conditions or abuse of labour rights?
   
• Labour rights – Is there any indication of forced labour (i.e., child labour); a history or commonality of poor labour practices more broadly; unions and grievance mechanisms; and adherence to labour standards? What's the broader context of the relevant regulatory environment and jurisdiction? How do these impact attitudes towards worker rights?
   
• Community and Land Rights – What is the impact on a community, vulnerable groups, land and water access, and community safety and environment? Has there been any increase in hazardous waste or water quality? Any impact on biodiversity that has affected food sources?

The Bottom Line

Through the use of impact-focused intelligence, private equity firms can more thoroughly vet carbon credit investments to ensure they legitimately combat global warming and climate change as intended, as well as validate that these investments align with the overall ESG goals set forth in their investment strategy.

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Hannah Gilkes is Director, ESG Intelligence, The Risk Advisory Group

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group