What are Carbon Credits? And Why They are Not a Retail Investment Product

By: Invezz
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on Oct 26, 2012
Updated: Jan 6, 2020

Investing in Carbon Credits is Probably a Choice that the Majority of Active Investors Have Been Presented With. The Market Explained and Why One of iNVEZZ’s Experts Would Steer Clear

While fighting global warming and making the rich nations pay for polluting the planet by boosting green investment in poorer countries is a good concept in principle, it would seem that something went wrong along the way. Recently, the United Nations reported that the Clean Development Mechanism – one of the Kyoto Protocol’s fundamental instruments – had essentially collapsed. This in turn prompts the question whether the carbon credit trading system devised to facilitate the protocol’s targets still makes any sense.

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This is of particular pertinence to anyone who has been conviinced to or is considering investing in carbon credits as an ‘up-and-coming-sure-thing-fifty-percent-returns-in-six-months’, investment product by some bloke on the blower calling up from Green Investments Inc. For the past couple of years carbon investment has been the in-vogue ‘alternative investment’ being pushed by every man and his dog with a short-term-contract office somewhere between Bank and Chancery Lane. Shades of ponzi and a certain lack of scruples concerning truthful and transparent representation of carbon credits as an investment product where most of these sales operators are concerned aside, the carbon trading system is something that the international community has poured massive amounts of effort, time and money into. Let’s take a closer look as to whether carbon credits can or should be termed an ‘investment’.

Carbon Credits in a Nutshell

So, what exactly is carbon investment and what are carbon credits? Although they have been around for a while now, they have proven to be a tricky concept to grasp. In short, a carbon credit or a carbon offset is a financial instrument representing one metric tonne of CO2 or carbon dioxide equivalent in another greenhouse gas. Carbon credits were introduced with the Kyoto Protocol in 1997 as a way of commoditising carbon emissions and creating a financial incentive for nations and companies to reduce their greenhouse gas emissions. Carbon offsets are traded on compliance and voluntary carbon markets.

The Clean Development Mechanism

The concept of carbon offsetting and carbon credits is perhaps most visible in the Clean Development Mechanism (CDM) which allows industrialised nations and companies to offset the impact of their carbon emissions by paying for projects aimed at avoiding greenhouse gas emissions in developing counties.The projects in question produce carbon credits called Certified Emissions Reduction (CERs), with the UN recently announcing that the one-billionth CER has been issued. Polluters buy these carbon credits to offset their own emissions. Yet, despite the CDM’s role in lowering global carbon emissions, the carbon market is currently in a grim state. In its September 2012 report, aptly entitled “Call to Action”, the High Level Panel on the CDM Policy Dialogue stated that carbon prices in the CDM market had declined by as much as 70 percent in the past year alone, and were projected to fall further. The Panel attributes the falling prices of CERs to modest mitigation targets which in turn create no incentives for private international carbon investment and local action in developing nations.

The Financial Times recently quoted the UBS (NYSE:UBS) carbon analyst Per Lekander as saying that the UN-backed carbon market had turned into “a complete joke,” adding that the system would never have survived “if it hadn’t been for such a noble cause.” And while the cause is indeed noble, the execution seems to be flawed, with the CDM High Panel reporting that governments, private investors and financial institutions were increasingly losing confidence in the CDM market and the trend was likely to accelerate in the absence of new solutions.

The EU Emissions Trading System

Among the reasons cited for the CDM market’s downfall is the exclusion of a certain type of CERs from the world’s most developed carbon credit market up to date – the EU Emissions Trading System (EU ETS). The EU ETS, often referred to as a “cap-and-trade” system, imposes limits on the total amount of greenhouse gases which can be emitted by factories, power plants and other installations covered by the system. Within this cap, companies receive emission allowances which they can trade between one another as needed.

Effective in 2013, the EU ETS will ban the use of CERs generated from the destruction of waste industrial gases due to concerns about the environmental integrity of those credits. The EU ETS, however, has oversupply problems of its own, with the Eurozone turmoil further weakening carbon credit demand within the EU ETS. With output having fallen many EU countries are either within their emissions allowance or much less in deficit meaning less carbon credits need to be purchased by them. In its report “State and Trends of the Carbon Market 2012”, the World Bank notes that the oversupply of EU allowances (EUAs) is likely to remain for several more years, despite the upcoming more rigid Phase III of the EU ETS, when fewer allowances will be allocated for free. The World Bank also notes that “a considerable portion of the trades is primarily motivated by hedging, portfolio adjustments, profit taking, and arbitrage”.

Other Emissions Trading Initiatives

To complete the compliance markets picture, there are several other domestic and regional low-carbon initiatives, including market mechanisms, which have appeared around the world in recent years. Some of the more notable initiatives include New Zealand’s Emissions Trading Scheme, which is scheduled to include all sectors of the economy and all greenhouse gases by 2015 and California’s cap-and-trade system set to go into effect in 2013.

In addition, Australia is expected to introduce its own nationwide cap-and-trade scheme by 2015, with the system covering about 60 percent of the country’s annual greenhouse gas emissions. China has also become the focus of carbon offsetting attention since it advanced a plan to pilot several regional cap-and-trade systems set to provide the basis for a nationwide system in the coming years. Mexico and South Korea have also passed climate bills aimed at adopting cap-and-trade schemes. Most of those systems, however, have yet to take off, with most of them expected to also limit the trade of CERs.

Voluntary Approach

In addition to the different compliance regimes in their various stages of planning and development, there is also a voluntary approach to carbon offsetting, which involves trading in the voluntary carbon markets. Voluntary carbon markets co-exist with the compliance carbon markets, the difference being that unlike mandatory markets voluntary carbon market transactions are not required by regulation and companies only buy voluntary carbon credits as part of their Corporate Social Responsibility initiatives.

Voluntary Supply & Demand

Similarly to the mandatory carbon markets, the source of carbon offsets for voluntary trading are projects which reduce carbon emissions around the world. Those projects, however, may differ greatly in terms of location, technology and environmental contributions since they are not based on a given compliance regime. In consequence, there is no unified voluntary carbon credit standard, but rather, several with varying degrees of criteria. Generally, the most widely accepted standards for voluntary carbon offsets are the Gold Standard and the Verified Carbon Standard (VCS).What is more interesting as regards the voluntary carbon market is what motivates buyers to invest in carbon offsetting. Some buyers make carbon credit investments with the purpose of offsetting various activities, including personal, employee or corporate emissions whereas others are defined as pre-compliance buyers since they purchase carbon credits in anticipation of a future mandatory carbon offsetting regime, when they will be able to either retire the credits or sell them to others required to comply, at a profit.

Voluntary carbon markets, however, are much smaller in volume than compliance markets, with data compiled by Ecosystem Marketplace and Bloomberg New Energy Finance (BNEF) showing that in 2011, the number of carbon offsets traded voluntarily represented less than a 0.1 percent share of the global carbon markets. Yet, despite its size, the voluntary carbon market is known for being more flexible, providing a framework for innovation such as developing new carbon accounting methodologies.

Carbon Markets Trends

With the CDM carbon market collapsing and the EU ETS plagued by long-term oversupply, the carbon markets’ future does not seem bright, particularly against the backdrop of global economic uncertainty. In its report, the CDM Panel called for action to save the “imperilled” CDM market by means of establishing both a fund to purchase carbon credits and stabilise prices, and “a further institution to serve as a de facto reserve bank for CERs.” As noted by the FT, these steps would require the approval of the 100-plus nations participating in the UN Framework Convention on Climate Change where timely decisions are rare.

The prospects for the voluntary carbon offsetting market seem slightly better, given that despite their slow start, voluntary carbon markets are gaining momentum, as noted in the World Bank’s report. In 2011, activity in the voluntary carbon market stabilised to contract 79 million tonnes for immediate or future delivery, with some 56 million tonnes of all transacted carbon credits being generated from renewable energy projects.

In their report, “Developing Dimension: State of the Voluntary Carbon Market 2012”, Ecosystem Marketplace and BNEF, however, point out that the voluntary carbon market remains illiquid, meaning that buyers are not always available. With one or a few market players being able to influence pricing dramatically, voluntary carbon credit prices are highly stratified and at times unpredictable, even within similar carbon offset classes.

Investing in Carbon Credits – Are Carbon Credits a Retail Investment Product?

In the case of a private investor considering or being offered a carbon investment in the form of carbon credits on the basis of a sales pitch that it is a growing market with a lot of potential for prices to rise there are a number of considerations to evaluate. Carbon credits are a fungible commodity, they are traded, and prices do rise and fall as with any other commodity. Recent history has shown prices only going down, no matter what a telesales chap might say, and I have heard several of them blatantly lie.

However, in the same way that a recent history of positive performance, a bull run, for any given commodity does not guarantee a continuation of the trend, so a negative trend can always be reversed. The carbon market in terms of pricing for individual carbon credits may yet turn around. It may also fade into obscurity as an expensive failure. That is for the individual to weigh up.

What is perhaps more pertinent is the market liquidity for carbon credits. If an individual buys carbon credits, how do they then sell them, either at a profit or a loss? Although there are carbon exchanges, at present there is no clear and cost effective solution for an individual investor to trade relatively small amounts of carbon credits online in the same way that they would do so with established commodities such as gold, oil etc. Exchanges are essentially geared towards large corporate and institutional buyers and sellers and most do not offer facilities for the trade of voluntary carbon credits, though the London based Carbon Trade Exchange now does.

Many carbon brokers targeting retail investors will promise that they will be able to resell the buyer’s carbon credits purchased through them to corporate clients. However, without a clear and liquid market for owners of small volumes of carbon credits to sell the dangers of setting much store by such assurances, however emphatic, should be evident. Price increases, or decreases for that matter, are only relevant in the case that there is a potential buyer for the commodity, and an efficient means to make the trade. Otherwise the owner of the commodity simply has a certificate or a registry number for the carbon credits, which is only that. Especially in the case of an intangible commodity such as carbon credits.

Even against the backdrop of an uncertain future for the commodity and market as a whole this is the most obvious argument against carbon credits as an investment product. With an established commodity even if the price begins to drop sharply the owner can choose when to sell and cut their loss. Whether this is possible for someone investing in carbon credits, especially voluntary carbon credits, is highly doubtful. Essentially, there is no clear and dependable ‘exit’ from the ‘investment’.

Another important point is that the sales prices recorded for carbon credits, as detailed in Ecosystem Marketplace’s annual reviews of the market, fall sharply as the vintage (the year in which the credit was registered) ages. This means holding onto carbon credit investments as a longer term speculation is highly risky. Even if the market price picks up again from its present lows, unless something changes dramatically in terms of pricing behaviour, your older carbon credits would fetch a much lower price than that for recent vintages.

Some investment products are of course simply by nature less liquid than others but the combination of this and the fact there is no clear or established resale market for small quantities of carbon credits should surely be considered a major, if not fatal, black mark against the commodity as an ‘investment’.

Unscrupulous Sales Agents

Falling outwith the auspices of the FSA, the lack of regulation which sellers of carbon credit investments are required to adhere to also means that the market is plagued with unscrupulous and pushy sales companies quite prepared to misrepresent the risks involved for investors in order to close a sale. The UK’s Financial Services Authority (FSA) for instance has intervened in cases where carbon credit suppliers have made contact with individuals, pushing carbon credit investments with assurances that prices are sure to rise significantly as the market develops and have later disappeared with their money. And while the carbom markets cannot be held in anyway responsible for fraudsters, the somewhat vague nature of carbon credits seems to have made them an attractive vehicle for fraudsters and con artists. “Carbon credits can be sold and traded legitimately and there are many reputable firms operating in the sector,” notes the FSA on its website, adding that “we are concerned that an increasing number of firms are using dubious, high-pressure sales tactics and targeting vulnerable consumers.”

In Conclusion

I am not a fortune-teller. The carbon offsetting market that so much international effort and money has been put into may be turned around. If it isn’t it will go down as an embarrassing failure of colossal proportions. Which is usually a good reason for those involved to keep on fighting their corner. The EU in particular has invested hugely into the European Emissions Trading Scheme. However, things are looking very shaky at present.

Combined with the lack of a clear and liquid trading mechanism for holders of carbon credits numbering less than tens of thousands to hundreds of thousands of pounds in value it doesn’t look like something a sane person would invest in.

A trading system lending liquidity and transparency to the market may yet be put in place. Efforts are certainly being made in that direction. However, it doesn’t exist yet meaning it may never, especially in light of the current straights the market for carbon credits is in.

If the carbon offsetting market is pulled back from the brink….if small numbers of carbon credits can be traded in a cost-effective way online…is a lot of ifs.

In any case, trading on the carbon market requires a significant level of expertise, such as knowing the differences between the carbon credits traded on compliance markets and those involved in voluntary carbon market transactions. As with anything, if you are considering investing in carbon credits research the market well, don’t take anything from an unregulated sales person’s mouth as necessarily accurate until you have verified it from another reliable source, and come to your own conclusions. If you have enough spare cash to take a punt and you’ve weighed up the pros and cons and are willing to take a very big risk with a carbon investment then who’s to say it wont come off. But even punts that are accepted as risky should be calculated risks. Investing in carbon credits is not a calculated risk I would personally come down in favour of.

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