Insight

Carbon offsets: No substitute for carbon reduction

Carbon offsets (or credits as they are commonly known) allow issuers to report lower than generated emissions. We take a closer look at developments in this area to assess when their use is justified, “greenwashing” risks related to their usage and implications for net zero portfolio construction. We find a rapidly growing offset market with inconsistent disclosure, making it hard to distinguish between “clean” and “dirty” issuers.

  • As clients seek to align their investment grade portfolios toward net zero, we are expecting increased focus on the steps that issuers are taking to achieve their own net zero targets. As well as sourcing clean electricity (as previously discussed in Clean electricity is a vital first step toward net zero, October 11, 2021) and re-engineering their processes to minimize their environmental impact, we expect issuers to increasingly look to the rapidly growing carbon offset market to reduce reported emissions.
  • The carbon offset market has not attracted much attention from fixed income investors, not least because issuer disclosure is generally poor. However, guidance from the Science Based Targets initiative (SBTi), a global collaboration to set science-based climate targets, says that issuers should only seek to use carbon credits to help accelerate their emissions reduction beyond a science-based pathway (only use them to beat, not to meet their target) and to offset residual (or unavoidable) emissions in the net zero year.1  We believe this is only credible if carbon credits are independently verified.
  • We believe issuers that rely on transparent, third-party verified emissions roadmaps (with clearly identified interim targets) are best positioned to keep emissions aligned to a net zero pathway by 2050 or sooner, and this should not rely on carbon offsets.

While 2021’s COP26 in Glasgow set an agenda to keep 1.5°C alive, we believe the proof of the pudding will be how global CO2 emissions evolve in the coming years. We also expect investors to take a closer look at the emissions their portfolios are responsible for generating. Consequently, we expect issuers to attempt to reduce their own emissions generation to positively differentiate themselves. There are several options open to issuers, but we hope issuers take the route of carbon reduction within their value chains, rather than carbon offset.

Figure 1: Global CO2 emissions (GtCO2)

Source: Global Carbon Project’s Global Carbon Budget. Data from December 31, 2010 to December 31, 2021.

What is the carbon offset market?

There are several routes to carbon reduction through offsets. The compliance market includes a government mandated cap-and-trade model, which sets limits on industry emissions but allows trading between emitters, creating a market price for emissions. This is the California Air Resources Board’s approach. In contrast, the voluntary carbon offset market is unregulated and allows anyone developing projects that will result in the decrease or removal of carbon emissions (e.g., reforestation, generating renewable energy) to obtain carbon credits.  When these carbon credits are verified by external agencies (e.g., Gold Standard, Verra’s Verified Carbon Standard, Social Carbon or Climate Community and Biodiversity Standards), they can be used or traded to allow the owner of the credits to net them off against other carbon emissions generated. In 2021, Ecosystem Marketplace reported that the average trading price of CO2 credits was USD4.1/ton, though we would expect this to increase over time as the market grows.2 Given the increased focus on ESG and carbon emissions, it is hardly surprising that this market has grown significantly over the past decade, with well over 200Mt of CO2 traded in the past year.3 However, the disclosure of where these credits are being used has yet to match the carbon offset market’s rapid growth. This makes it hard for analysts to differentiate between “clean” and “dirty” issuers.

Figure 2: Traded volumes of voluntary carbon offsets (Mt)

Source: Ecosystem Marketplace. Data from December 31, 2010 to August 31, 2022.

What are the potential problems with the carbon offset market?

Although the carbon offset market creates a method for issuers to reduce overall reported carbon emissions, there are several problems with its current form. One significant concern is “additionality”. Are these carbon credits resulting in incremental CO2 reduction or would these projects (e.g., reforestation, renewable energy) have occurred anyway? Although these concerns are valid, we believe this can be addressed by strong external verification. Indeed, we would echo the view of global environmental disclosure manager, CDP, that good offset projects should be monitored, verified and have clear ownership leading to real reductions or sequestration of carbon. Nevertheless, we believe this is a market worth monitoring. A recent study by McKinsey & Company (A blueprint for scaling voluntary carbon markets to meet the climate challenge, January 29, 2021), suggested that the demand for voluntary carbon credits could increase by one hundred times between 2020 and 2050.

As we contemplate net-zero portfolio construction, we believe the biggest concern on carbon offsets relates to an issuer’s disclosure. There is inconsistency among issuers regarding how the use of carbon offsets is reported. This is problematic, as it could lead to a misunderstanding of which issuers are “clean” and “dirty”. The SBTi has taken an appropriately firm line and will only consider offsets for companies that wish to finance additional emission reductions beyond their science-based target (SBT), or net-zero target. Other more tolerant approaches cite the need for the offset sector to gain sufficient scale before companies reach their point of residual (or unavoidable) emissions. However, given that carbon offset is not the same as carbon reduction within a company’s value chain, we are inclined to view SBTi’s strict approach as the most appropriate, especially for heavy emitting sectors.

What do we look for in net-zero portfolio construction?

We have outlined many aspects of our approach in “Targeting net zero: Practical implications for global investment grade credit portfolios”, July 9, 2021. We favor issuers that rely on transparent and third-party verified emissions reduction roadmaps to lower emissions aligned to a net-zero pathway by 2050 or sooner (with clearly identified interim steps). We take comfort that a company solely reliant on carbon offsets to achieve reported emissions reduction would not qualify in this framework. However, we do believe that the carbon offset market creates potential for “greenwashing”. Reducing reported carbon emissions through offsets could make it harder to identify indirect sources of emissions (i.e., Scope 3 emissions) that may occur in a company’s value chain.4  This is another area where we believe engagement and working with management teams to understand their net-zero philosophies will be vital to ensuring investment suitability.

Given the numerous factors incorporated into a decision to invest in a fixed income portfolio (fundamental credit quality, environmental, social, and governance (ESG) credentials, net zero alignment, climate change exposure), we believe investors cannot adopt a “one size fits all approach”. IFI is closely monitoring ESG risks across its portfolios and especially in the rapidly evolving net zero alignment space. We believe having a well-resourced and experienced credit team is important for assessing the issues raised here and to inform our investment decisions. IFI seeks to ensure that credit spreads adequately reflect downside risks, including ESG factors, or, where this is not the case, that “at-risk” names are avoided.

^1 Residual emissions are emissions that remain after a project or organization has implemented all technically and economically feasible opportunities as determined by a climate professional as part of a carbon footprint assessment, to reduce emissions in all scopes and from all sources.
^2 Source: Ecosystem Marketplace. Data as of September 15, 2021.
^3 Source: Ecosystem Marketplace. Data as of September 15, 2021.
^4 According to Carbon Trust, Scope 1 emissions cover direct emissions from owned or controlled sources. Scope 2 emissions cover indirect emissions from the generation of purchased electricity, steam, heating and cooling consumed by the reporting company. Scope 3 emissions include all other indirect emissions that occur in a company’s value chain.

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