Q27: “The trade” – Is this business long or short carbon, land, and/or trees? To what extent are our buyers and partners taking other sides of this trade? Describe the incentives that occur or may occur over time as a result of these dynamics.
Evergrow is long land, long timber, and long carbon. This is because we own the land and the trees, which over time produce timber and carbon. We benefit if the prices for land, timber, and carbon increase over time. I believe the outlooks for both sustainably farmed timber and CCOs in the CA compliance market are positive: both have steady demand and are very supply-constrained, and it takes a long time for new supply to enter these markets. Also, unlike other commodities, both timber and CCOs can be stored for a very long time, so if you don’t like the price at any given time, you just harvest fewer trees, sell fewer CCOs, or both.
Of these three, I am most nervous about CCOs because of how sensitive our financials are to CCO revenue. I think the market for compliance offsets will grow over time, but offsets will always be a small part of a net-zero carbon emissions strategy because the focus is (rightly) always going to be on the abatement of emissions. For this reason, I would like to develop a way for Evergrow to get exposure to the abatement market – e.g., insuring abatement finance projects against the risk of non-performance by providing an amount of CCOs equal to the expected GHG emissions in exchange for a premium. Said more simply: I would rather be long “the world is going to figure out a way to price carbon and reduce emissions” than simply long CCOs, which are a very specific commodity and may or may not reflect that thesis.
For investors, Evergrow represents an opportunity to get long exposure to carbon with timber returns as a kicker. There aren’t many good ways of getting long carbon exposure at the moment, short of buying CCO futures on ICE (which carries $100K+ minimums and means trading a commodity directly). For this reason, I think companies who are exposed to timber and carbon prices are natural partners and investors for Evergrow – e.g., companies that use timber as an input in their business (furniture makers, housing developers, etc) and/or emit large amounts of CO2 (utilities, heavy industry, etc). I’m sure many companies either have or are exploring ways to hedge this exposure, but both the magnitude of exposure and number of companies exposed will increase in the future if consumer demand for sustainable timber rises or more carbon pricing/cap-and-trade comes into force (both of which feel likely to me). Because Evergrow profits when this happens, investing in Evergrow would make sense for these companies, particularly if our securities are publicly traded and marketable and they can do this as part of their ordinary treasury investing.
This is a potentially double-edged sword because different investors will have different needs. Purely financial investors will want us to maximize growth and yield. Corporates looking to hedge their carbon exposure may want us to prioritize CCOs, and may even prefer that we hold back CCOs (i.e., not sell them) so as to maximize the future value of their hedge. Meanwhile, corporates looking to hedge their timber exposure may want us to sell our timber to them as soon as it matures, even if we can make more money by keeping them standing and producing CCOs. Ultimately, I think the way to balance these needs is to separate the concerns. Evergrow should treat all investors and shareholders as a single class and optimize for total return, and we can separately enter into CCO or timber purchase agreements with companies who want them.
Q28: Drucker: Taking into account all of the above, what is the company in the business of? Who is the “customer”?
I think we’re in the business of (i) helping companies manage their carbon and timber exposure, and (ii) giving investors access to the carbon and timber markets.
Q29: Think bigger, financially: Under what circumstances does this become a $1TN company?
According to the IPCC, in order to limit warming to just 1.5°C above pre-industrial levels, we need to:
- Reduce global emissions by about 45% from 2010 levels by 2030;
- Reach net zero emissions by 2050; and
- Remove on the order of 100-1,000 gigatons of CO2e from the atmosphere over the course of the 21st century.
This is truly terrifying for me to write, given that:
- the consequences of 1.5°C of warming aren’t exactly great;
- we are nowhere near achieving this today, meaning it’s likely we will experience 2°C+ of warming; and
- the consequences of 2°C+ of warming are truly cataclysmic – e.g., the total collapse of the ice sheet in Antarctica and the death of all coral reefs, to pick just two.
We are especially behind when it comes to inventing and deploying negative emissions technologies at scale (#3 above). In the words of one climate scientist, the world has “gambled its future on the appearance, in a puff of smoke, of a carbon-sucking fairy godmother.” In the face of such an awe-inspiring challenge, it feels wrong on some level to consider it as an opportunity to build a $TN company. At the same time, I believe that (a) we need to quickly mobilize all available resources to combat climate change, and (b) everyone can play a part in this effort, regardless of their background. When I first started researching climate change a few years ago, I wondered if I would be relevant, given that I’m not a scientist. I now believe that starting and scaling a for-profit enterprise can be my way of contributing to what I believe is the defining challenge of our generation and that our success may inspire others to join the fight as well.
So with that said, let’s try to put a number on the size of the “opportunity”.
- Let’s imagine that the whole world implemented the California cap-and-trade program as-is, with immediate effect. For convenience, we’ll call this world “Planet Cali”.
- We emit roughly 35 gigatons of CO2e into the atmosphere every year. On Planet Cali, 85% of these emissions, or roughly 30 gtCO2e, would be covered by cap-and-trade, and companies responsible for these emissions would become subject to an aggregate emissions cap that goes down every year.
- Let’s say Planet Cali sets its emissions cap at the levels recommended by the IPCC in #1 and #2 above. Thus, Planet Cali’s companies would need to reduce their aggregate annual emissions to 15 gtCO2e by 2030 and zero by 2050.
- Like in California, on Planet Cali, companies can use compliance offsets for 6% of their emissions. Thus, in 2030, the Planet Cali compliance offset market represents 900 million mtCO2e, which at $15/mtCO2e is worth $13.5BN per year.
- However, by 2050, this market goes to $0, because 6% of zero emissions is zero!
This is both an appropriate and tragic result. In a perfect world, the offset market would be worth $0 because we would not be emitting any greenhouse gasses and therefore not have anything to offset. Unfortunately, Earth in 2020 is far from perfect. Simply going to net zero emissions alone isn’t going to keep us to 1.5°C anymore. In addition, we must also remove 100-1,000 gtCO2e over the next 80 years (#3 above). But how do we incentivize people to produce negative emissions?
At the moment, the world has no other means of paying people for negative emissions except offsets. When you buy an offset, you are paying the offset producer for a negative emission, which cancels out a unit of emissions you made yourself. But if we successfully reduce total emissions to zero over the next 30 years, then we will simultaneously shrink the market for offsets to zero and thus eliminate our only means of funding negative emissions! This is the tragedy of using offsets to pay for negative emissions: it only works so long as emissions continue.
Some may point to altruism – and the voluntary offset markets – as an answer. The argument goes that even zero-emitting companies and individuals will buy voluntary offsets “because it’s the right thing to do”. I am skeptical. First, it’s been the right thing to do to be a net-zero emitter for a long time now, but despite this, most people do not buy voluntary offsets. The entirety of the voluntary markets today accounts for slightly less than the annual emissions of Belgium, home to less than 0.2% of the world’s population. Second, the willingness to pay in the voluntary markets is very low. While Microsoft and Stripe have signaled that they are willing to pay an appropriately high price for voluntary offsets, most voluntary offsets are sold for less than $1/mtCO2e. Said another way: today we emit lots and offset little. We’re betting our future on everyone waking up one day and deciding to stop emitting and start paying for offsets on top? (NB: I believe this even though I am one of those people. I offset 2X my estimated emissions through Project Wren.)
So if not through offsets, how do we pay for negative emissions? Having pondered the question for some time now, I honestly don’t know. Asking this question is like asking “how does a society fund the repair of the damage caused by the sins of its past?”, and I’m not sure anyone has a good answer for that. Taxes?
Returning to the question at hand, what this tells me is that:
- Like on Planet Cali, the widespread rollout of cap-and-trade programs would initially be a boon to Evergrow given the attendant growth in compliance offset demand.
- Over time, the more successful the world is at reducing emissions, the smaller the offset market will be. It’s difficult to see a path to $1TN in market cap for Evergrow in just the offset market.
So how might Evergrow reach $1TN in market cap on the Planet Cali Stock Exchange? Here’s one idea: using offsets as a way to backstop carbon abatement risk and accelerate the rollout of emissions-reducing technologies. Let’s return to Planet Cali:
- Remember that on Planet Cali, companies need to reduce their aggregate emissions from 30 gtCO2e today to 15 gtCO2e by 2030 and zero by 2050.
- At a price of $15/mtCO2e, that represents $225BN of annual avoided emissions by 2030, and $450BN of annual avoided emissions by 2050.
- Assuming a 10% discount rate, flat carbon prices, and that Planet Cali maintains its global cap-and-trade program in perpetuity, then the present value of these emissions reductions is $2.25 trillion in 2030 ($225BN/10%), and $4.5 trillion in 2050.
- Said another way, it would be rational for companies on Planet Cali to spend between $2.25 to $4.5 trillion in aggregate between now and 2050 to achieve the necessary emissions reductions, adjusted upwards or downwards depending on their individual costs of capital.
Where would all this money get spent? Given that most emissions come from energy, transport, and heavy industry, I imagine most of it would be deployed into either the construction of new zero-emissions facilities to replace existing ones (e.g., replacing coal plants with solar plans) or the retrofit of existing facilities to reduce emissions (e.g., changing cement manufacturing processes to emit less during production). However, a company may invest in an emissions reduction project only to find that the expected reductions did not fully materialize when the project was completed (e.g., maybe the projected CO2e reductions relied on assumptions that later proved to be wrong). This would be a major setback and make both companies and lenders reluctant to invest in the future. Therefore, I believe Planet Cali’s project finance lenders would develop ways to evaluate and price the risk of non-fulfillment of carbon abatement goals on a project-by-project basis, similar to how they already analyze and price credit risk for a given project, because ultimately that’s what they would be underwriting. And just like with credit, we would also see the development of a carbon derivatives market where companies, banks, insurers, and speculators trade in this carbon abatement risk.
Over time, Planet Cali’s carbon markets would separate into three distinct segments:
- The market to develop and deploy abatement technologies;
- The market to supply the capex to deploy these technologies; and
- The market to insure against the risk that these technologies don’t work.
The race to capture the first market will be won by the companies who are the fastest to develop and deploy the most effective abatement technologies. The race to capture the second market will be won by the institutions that bank those companies and have the lowest cost of capital. The third market will be won by the company that (i) develops a large pool of offsets that it can use to backstop carbon abatement risk at a lower cost than its competitors, and (ii) becomes the most sophisticated at measuring carbon abatement risk. This is Evergrow’s race to win.
Here’s an example of how this might work. Let’s say you’re the CEO of Calico, a maker of widgets on Planet Cali. Business is booming, and you expect to double widget production next year. Unfortunately, that means that your emissions will also double, going from 100 mtCO2e to 200 mtCO2e, costing you an incremental $1,500 per year ($15 mtCO2e * 100 mtCO2e in extra emissions). One of your engineers proposes a solution: retrofit your widget factory with a new machine that will produce the same number of widgets at half the emissions. The machine costs $10,000 to buy and install, including the cost of financing, which your friendly neighborhood banker is more than happy to provide to you. There’s just one problem: the machine relies on a new technology that has only a 50% chance of achieving the expected reduction in emissions.
At a 10% cost of capital, the present value of $1,500/year in perpetual savings is $15,000. But discounting this by 50% for the machine’s probability of success yields an expected value of just $7,500, which is 25% less than the machine costs. For this reason, you decide not to invest in the machine. Everyone loses:
- You pay $15,000 in fines for your new emissions;
- The machine manufacturer doesn’t get a sale;
- The banker doesn’t get to make a new loan;
- Widget prices go up;
- Fewer consumers get widgets;
- The economy shrinks; and
- Emissions grow.
One day, an Evergrow salesperson walks into your office and offers you a new kind of insurance policy. Under the policy, if you install the machine and it doesn’t work (i.e., it fails to produce the expected emissions reduction), then Evergrow will pay you for the difference in value. The policy costs $2,500, paid upfront, for 20 years of coverage. You buy the policy and install the machine. So long as Evergrow priced the policy correctly, everyone wins:
- You pay $12,500 in costs;
- The machine manufacturer gets a sale;
- The banker makes a new loan;
- Evergrow collects an insurance premium;
- Widget prices go down;
- More consumers get widgets;
- The economy grows; and
- Emissions stay flat.
The reason I believe Evergrow (and not, say, Allianz) will win this market is that Evergrow will own forests that produce a large and known number of offsets each year. We use those offsets to fund claims. If a claim comes in for carbon abatement equal to 100 mtCO2e, we simply (a) give the policyholder that number of our offsets, or (b) sell an equivalent number of offsets and settle up in cash. Either way, because I believe the quantum of emissions and demand (and thus price) for offsets are correlated as described above, the more claims we see (i.e., the more emissions that happened), the more our offsets in appreciate in price. Therefore, so long as our cost of generating offsets is lower than the market price for offsets, we have a lower cost of claims than any competing insurer in the carbon abatement risk market. This enables us to undercut all competitors on price and take more risk, and is a durable competitive advantage. This framework also feels like a philosophically neat way of thinking about offsets: as tokens representing insurance against a fraction of the risk of failure of our collective carbon abatement efforts. In other words, insurance against climate change, backed by real negative emissions.
How big could that be? Planet Cali’s companies planned to spend $2.25 to $4.5 trillion in aggregate in capex to fund abatement projects over the next 30 years. Let’s assume that with financing costs and inflation, that works out to $200BN/year. If Evergrow captured 25% of the value chain (whether through insurance or lending and/or otherwise), that would be a $50BN revenue company. Apply a growth multiple to that revenue and add the value of Evergrow’s land and timber holdings as a kicker, and you have a $1TN company.
To summarize, the path to arbitrary bigness for Evergrow is:
- Raise institutional capital to acquire large areas of land and plant large areas of new forests;
- As cap-and-trade programs proliferate, produce and sell more compliance offsets;
- Recycle the capital into acquiring more land and planting more trees;
- As the world reduces emissions, shift capital from offset production to emissions reduction finance and insurance;
- Collect the most data on emissions reduction performance;
- Use data and lower cost of funding claims to dominate the carbon risk insurance market;
- Recycle that capital into emissions reduction project finance to capture more value;
- Meanwhile, continue to own and operate timberlands.
Q30: Think bigger, impact: Under what circumstances does this company make a planetary scale impact toward combating climate change?
It’s 2050 on Planet Earth. It’s a bit hotter than it used to be, but to borrow an old saying, we flattened the curve. Things got a bit dicey in the ’20s, but finally, in 2029, the world’s leaders gathered at the United Nations and committed to the Carbon New Deal. At the time, the world was in crisis, with the effects of climate change displacing hundreds of millions of people and worsening each year. In a remarkable show of unity and courage, world leaders responded by:
- Committing to achieving net-zero economies by 2050;
- Implementing a global cap-and-trade system for greenhouse gasses, with the cap on emissions minus a small number of offsets set at zero by 2050; and
- Guaranteeing to purchase 50 gtCO2e worth of negative emissions at a minimum price of $50/mtCO2e for the next 20 years, with costs shared pro-rata among nations and funded by domestic Carbon Added Taxes.
The ’30s were the offset boom years. When global cap-and-trade came into effect, compliance offset prices on ICE skyrocketed to record levels overnight. Carbon prices were high through most of the ’30s as companies struggled to roll out emissions-reducing technologies and relied heavily on offsets to meet their cap-and-trade obligations. Over time, spurred on by the spiraling cost of carbon emissions, companies succeeded in developing sophisticated new technologies that reduced emissions faster than the emissions cap was lowered. To everyone’s surprise, we achieved our goal of net-zero emissions by 2046, 4 years ahead of schedule. And because of how effective we got at reducing emissions, we now only emit less than 1 gtCO2e each year, 1/35th of the amount we emitted just 30 years ago.
Meanwhile, we’ve planted new trees on over 1B hectares of land all around the planet. At first, this mass replanting was funded by private companies during the offset boom of the ’30s. But from 2036-2050, most offsets were sold to governments as part of their commitment to purchasing negative emissions every year through 2050. These new forests sequester 50 gtCO2e each year. As a result, our global net carbon emissions went from an all-time high of 43 gtCO2e in 2023 to negative 49 gtCO2e in 2048.
Once we reduced our emissions and planted enough trees to meet our negative emissions needs, we no longer had much use for offsets, so the market disappeared almost as quickly as it had originally blown up. The carbon offset market is now an obscure niche, but the old-timers on the few remaining carbon trading desks swear they have the best stories from “back in the day”.
There’s this company called Evergrow that’s traded on the Bronx Stock Exchange (the NYSE was relocated to the Bronx in 2027 when Lower Manhattan was permanently flooded following the collapse of the Greenland ice sheet). I’m told that Evergrow was one of the first companies to sell offsets to finance mass reforestation in the early ’20s. By the mid-’30s, Evergrow grew to become the biggest carbon abatement finance shop, underwriting a record $412BN of abatement financing and risk in 2039 (remember when abatement finance was a thing?!). Today, nobody really buys offsets or needs abatement finance anymore, so Evergrow just owns a bunch of trees. Pretty boring. Nobody cares what its market cap is.