Evergrow Questions 1-3: Offsets, generally

Background: I’m exploring an idea called Evergrow, and wrote up a list of 30 questions relating to the idea. I’m now going through and answering each of these questions.

Q1: Discuss carbon offsets, generally. What is a carbon offset? What is a “unit” of carbon offset? Is a carbon offset persistent or is it somehow consumed? Where do carbon offsets come from, and how many exist today/have been generated historically?

Carbon offsets are units of carbon emissions reductions or carbon sequestration meant to compensate for emissions made elsewhere. Typically, carbon offsets are denominated in metric tonnes of carbon dioxide equivalent (mtCO2e). Carbon offsets can originate from a broad range of greenhouse gas reduction projects, including tree planting, energy efficiency retrofits, methane capture on farms, and more.

Producers of carbon offsets sell their offsets to companies and individuals, who then retire them. Generally, these transactions occur in two markets: the voluntary markets and the compliance markets. Prices vary greatly from market to market. The voluntary markets involve companies and individuals voluntarily buying carbon offsets to set off against their own emissions. The voluntary markets transacted roughly 100M mtCO2e in 2018, worth approximately $295M, and representing slightly less than the annual emissions of Belgium.

The compliance markets involve market participants using carbon offsets as a means of complying with legally binding carbon emissions targets. Two of the largest compliance markets are the EU Emissions Trading Scheme and the California Cap-and-Trade Program. Over 2 billion offsets (called “CERs”) have been issued under the EU ETS since its inception in 2008, each representing 1 mtCO2e. Problems with oversupply of offsets in the EU have meant prices for CERs are very low, hovering between 25-50 Euro cents per CER. Meanwhile, California has certified over 170M offsets for use in its market, which at an average price of $15/offset would represent $2.5B in value.

Q2: Are offsets good or bad? Are carbon offsets from a global perspective priced properly such that they are able to achieve their aim of positive environmental impact? Could we end up in a world where carbon offsets are priced sub-optimally, that the buyers are able to avoid fully internalizing their environmental costs?

Opinions vary on the desirability of carbon offsets. On the one hand, offsets can be viewed as a way for emitters to “pay to pollute” and avoid lowering their emissions. In addition, there are real concerns about the validity and efficacy of many offset programs. On the other hand, the offset markets provide funding for projects that may otherwise not have been viable. In addition, the use of offsets in cap-and-trade programs can help companies smooth out their carbon abatement curves and make such programs easier to introduce.

Personally, I think that we are unlikely to ever get to a literally zero-emissions economy (as opposed to a net-zero emissions economy or even a net-negative emissions economy, both of which I think are vital and achievable). Therefore, there will always be a role for carbon removal and sequestration, and offsets are a market mechanism for ascribing value to such efforts. However, that doesn’t mean I think all offsets are good. In fact, I’m highly skeptical of many of the offset projects on the market today, and I’m concerned that even the best projects may not have the means to permanently sequester the carbon they’re supposedly offsetting. For this reason, I would advocate strongly for the implementation of more stringent and global standards on carbon offsets, akin to what California has for its compliance market, for both voluntary and compliance offsets.

Q3: Describe the economics of a carbon offset. How does a carbon offset function from a financial perspective? How does the buyer of a carbon offset come to a determination of value? How does overall supply, demand, and pricing for carbon offset happen? What mechanisms are available to increase carbon offset pricing? Are offsets a commodity, or is there potential to differentiate?

Theoretically, carbon offsets should be a commodity, in that one offset for a given unit of mtCO2e should be fungible for another. In practice, there is a large spread between the price of offsets, from $0.10-20 per mtCO2e on the voluntary markets to over $15 per mtCO2e in California and New Zealand. There are two main drivers of offset pricing: (a) the standards on which an offset is certified, and (b) the compliance markets into which an offset can be sold. There are a number of carbon offset standards and protocols, including the Gold Standard, REDD+, and the Verified Carbon Standard, each with their own set of rules and qualification requirements. Buyers use these as signals of value and may ascribe more value to one standard over another. Similarly, each compliance market usually has its own specifications for whether or not a carbon offset can be used in that market. For example, the EU requires certification of offsets under the Clean Development Mechanism set up as part of the Kyoto Protocol. Meanwhile, California has its own much narrower standard for carbon offsets. In either case, carbon offsets may meet one or more of the voluntary standards mentioned above but not qualify for use in any of the compliance markets.

Pricing on the voluntary markets is largely a function of supply and demand. Compliance markets tend to have their own rules for pricing carbon offsets, typically in the context of broader cap-and-trade programs. I discuss the California cap-and-trade program and its mechanisms for pricing offsets in a separate question.

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