Carbon credits buyers and investors do not need to know all of the intricacies of how offset methodologies work and how projects are developed. But they should have a high-level understanding of the entire offset lifecycle: how offsets are created, purchased, and used.
That will help them determine the type, price, and risk of investment options available them—and whether or not a purchase will help them meet their organization’s emissions reduction goals.
Each new carbon offset has five major points in its lifecycle:
- Development of a new offset type
- Selection of an offset methodology
- Planning of an individual project using that methodology
- Implementation and verification of the project, registration with a carbon authority, and the beginning of offset issuance
- Transfer to the purchaser and retirement of the offsets
Each phase represents an opportunity for substantial investment: in new offset technologies, in offset project ideation and development, and in offsets themselves. The cost and risk of developing each new offset technology follows the Katusa Curve:
Both price and risk begin extremely high, as there is no guarantee emissions will be removed. As the project enters the planning phase, the price falls and terms improve in order to attract investment. Prices rise again as validation, verification, and registration take place—this means the risk of delivery has decreased and high-quality offsets are more likely. Then prices level off or rise slightly as the risk of double-counting or leakage rises and brokers and retailers take their cut.
Offset purchasers should become familiar with each point on this curve. It will help them determine how to maximize the ROI and other benefits their organization receives in return for offset purchases.
Offset Type Development
Dozens of offset types, such as methane capture from landfills and large hydro projects, have been established over the past thirty years. The two most popular types are currently wind and reforestation.
The problem is that while many types of carbon offsets have proven effective at removing CO2 emissions from the atmosphere, those currently in existence are only stop-gap measures. For example, to erase the emissions from aviation, the entire United States would need to be planted with trees. That’s why investment in new types of offsets is so vital: the technology that will arrest global warming has likely not been invented yet.
Fortunately, new technologies and methods of removing CO2 emissions from the atmosphere are constantly moving along the timeline above. Experimental types of offsets currently in the funding and research phase include:
- Accelerating mineral weathering in rocks using electrochemical forces.
- Genetically engineering phytoplankton to capture CO2 in the ocean.
- Flooding deserts to create manmade oases that phytoplankton can inhabit.
- Developing enzymes that capture carbon.
The holy grail of offset development borders on alchemy: turning atmospheric CO2 into a usable product. For example, Prometheus plans to remove CO2 and turn it into gas and jet fuel; they expect their fuel forges to be operational by the end of 2021. And Coca-Cola has already signed a deal with a company that uses direct air capture of CO2 to make its soft drinks bubbly.
Investing in offsets at this stage is risky: During type development, there is no guarantee that carbon offsets will be able to be produced from the eventuating invention.
It’s also expensive. Experimental methods of removing carbon from the atmosphere can cost hundreds of dollars per ton during development. For example, Climeworks—which captures CO2 and sends it to a local greenhouse (the irony!)—says it currently costs about $600 to remove a ton of CO2 using their methods. (Their cost per tonne is expected to drop below $100 within the decade.)
Investing in carbon offsets at this point does not net an organization any real offsets. Rather, it involves investing directly in companies that are working on breakthrough technology for the capture of CO2.
Thus, it should be undertaken by companies that can make use of the possible co-benefits of the eventual offsets (think of Coca-Cola’s uses for the carbon), companies that do not need the offsets for compliance, and companies that want a reputational bump from supporting the development of new technology.
Offset Methodology Selection
Once a carbon offset technology is ready for a new project to be built around it, it requires the creation or selection of an offset methodology, which is a complex set of rules around the creation of that offset. The methodology provides guardrails for a project developer, outlining what they must do to establish a baseline for the project, determine additionality, calculate project emissions reductions, and monitor external parameters to calculate absolute emission reductions.
Entire libraries of approved methodologies already exist that cover most developed project types. It is up to project developers, though, if they want to create a brand new methodology to get the program approved and moving forward. That adds a resource-intensive, risky layer to the project, but it can be necessary for offset developers that want to attempt novel project activities.
Investing at this point is an ultra-high-risk, high-reward proposition. If the buyer is heavily involved in the selection or creation of the methodology, it can yield assurances as to the quality of the resulting carbon offsets and their relevance to the buyer’s operations. That is paired, however, with a long lead time before offset delivery (likely a few years) and a high measure of risk if the methodology is not approved.
This option is for companies that have a lot of time before they need offsets, and have the time to invest in researching new offset projects and building relationships with project developers.
Offset Project Inception: Project Planning, Validation, and Registration
Once a methodology has been chosen, the project developers generate a project plan that assesses the feasibility of the project, its environmental impacts and possible risks to development. The plan is solidified into a project design document, which outlines the anticipate reduction in emissions from the project, plans for quantifying and monitoring those benefits on an ongoing basis, and proof of additionality for the project.
Independent third-party verifiers examine and approve the project design, ensuring the emissions reductions will actually take place. Then—and only then—can the carbon offset program be registered. This official registration sets the program up to begin issuing carbon offsets.
There are two general options for investment at this stage, both of which involve investing in the project directly:
- Investing for the right to a specific percentage of the offsets created by the project.
- Investing for the right to a specific number of offsets created by the project.
The former requires (and enables) much deeper engagement and a broader understanding of the mechanisms of carbon offsets than do later stages. Investors must be able to evaluate the strengths and weaknesses of specific projects alongside third-party verifiers to decide whether the project is likely to deliver on its plans.
The latter generally looks like an Emission Reduction Purchase Agreement (ERPA). ERPAs take risk away from project developers by letting them pre-sell a specific volume of offsets. In exchange for taking on the delivery risk, buyers or investors get to lock in below-market offset prices.
Both options have a lower cost than later in the development process, and buyers may be able to invest in at-cost offsets. As always, that comes with a price: the offsets will be delivered over time, not all at once, and this type of investment generally requires a long-term agreement (as with an ERPA).
Offset Project Implementation: Verification and Issuance
Projects that have become operational must be monitored over a period of time based on the original methodology and plan. Then, another verification audit process assesses the realness and quality of the claimed reduction in CO2 emissions; these verifications typically occur a year apart. Once a verification has been passed, the project developer can issue carbon offsets equal to the number of tons of CO2 that were verified to have been captured or reduced.
Those verified offsets are deposited into the project developer’s offset “bank account.” This is where the transition from “project readiness” to “pay for performance” takes place. In other words, those offsets are no longer just theoretical; they are continually being created, and the developer can begin delivering on long-term contracts.
Offset Sale and Transfer
Any offsets that have not been pre-sold become available for direct, one-off purchases from consumers and corporations. While purchasing directly from a project developer can help avoid transaction costs, it is not without its risks—especially in terms of the quality of the offsets.
Since there is no centralized marketplace for the voluntary carbon market, finding buyers remains challenging for project developers and identifying quality offsets is difficult for all but the most knowledgeable buyers. Thus, three new entities have been created to facilitate the easy purchase of offsets: brokers, exchanges, and retailers.
Brokers have purchased credits from the project developer or an exchange and can transfer them to clients or retire them on their behalf. Brokers can be used to create a diverse basket of offset credits from different projects, different methodologies, and different project types. Beware that some brokers sell offsets from projects they have directly invested in; while that may reduce fees, it might also make the broker biased toward selling their own offsets, regardless of quality.
Exchanges are places for developers to sell directly to buyers (and for traders to invest in carbon offsets). North America and Europe host a few environmental commodity exchanges that list carbon offsets and facilitate transfers. While purchasing offsets in an exchange can be as easy as using Robinhood, it can be difficult to ascertain the exact quality of the offsets.
Retailers sell off-the-shelf carbon credits (just like the old boxes of Microsoft Windows CDs), then retire them on the behalf of the buyer. Retailers have physical ownership of the offset, while brokers and exchanges do not. Purchasing offsets from a retailer offers the same benefits as buying from Best Buy: unlike Amazon, their employees can help companies understand the process of offsetting and what types of offsets are most likely to help meet their goals.
Offsets can be sold and resold. With each new transaction, they are transferred into a different account in the offset program’s registry. Those new buyers can hold them, transfer them to another account through a sale, or retire them.
Offsets are retired by “using” them by claiming their verified CO2 reductions against an emissions reduction target. Each carbon offset registry has a retirement process that prevents the offset from being transferred or used again—think of it like a dollar bill being removed from circulation.
Making Your Offset Investment Decision
The opportunities to purchase throughout the carbon credit lifecycle look like this:
Where you choose to invest in the carbon offset lifecycle depends on myriad factors, including:
- The business goals and expected advantages behind your purchase.
- How quickly you anticipate needing the offsets to be delivered.
- The guaranteed quantity of offsets you will need.
- The price level that can be afforded or that makes the most financial sense.
- The amount of time and effort available to apply to the offset acquisition.
Answers to each of these questions will guide you toward options that differ in their timing, volume, and price, and your ability to evaluate (or influence) their quality. For more information on why you should purchase offsets, see our article on the Eight Major Business Advantages of Buying Carbon Offsets.