# README This project's mission is to make climate investing actionable. It includes both open source software and a free book to help you identify relative value trades, optimize portfolios, and structure benchmarks for climate aligned investing. ## The Software The software is a multi-factor equity returns model which adds a climate factor, or Brown Minus Green, to the popular Fama French and Carhart models. See the [short video](https://youtu.be/0sdhTd0E9s0) This additional Brown Minus Green (BMG) return factor could be used for a variety of climate investing applications, including: * Calculate the market-implied carbon risk of a stock, investment portfolio, mutual fund, or bond based on historical returns * Determine the market reaction to the climate policies of a company * Optimize a portfolio to minimize carbon risk subject to other parameters, such as index tracking or growth-value-sector investment strategies. ### Setting It Up Install the required python modules (use `pip3` instead of `pip` according to your python installation): ``` pip install -r requirements.txt ``` Initialize the Database using: ``` python3 scripts/setup_db.py -R -d ``` ### Trying It Out Let's get the historical stock prices and returns of the MSCI World Index and its constituent sectors: ``` python scripts/get_stocks.py -f data/msci_etf_sector_mapping.csv python scripts/get_stocks.py -f data/msci_constituent_details.csv ``` Now let's calculate the risk factor loadings for these stocks using 60 months of monthly data at a time: ``` python scripts/get_regressions.py -d -f data/msci_etf_sector_mapping.csv -s 2010-01-01 -e 2021-01-31 --frequency MONTHLY -n DEFAULT -i 60 -b python scripts/get_regressions.py -d -f data/msci_constituent_details.csv -s 2010-01-01 -e 2021-01-31 --frequency MONTHLY -n DEFAULT -i 60 -b ``` Next, let's create a daily version of the BMG climate risk series based on the difference between the stocks XOP (brown) and SMOG (green): ``` python scripts/bmg_series.py -n XOP-SMOG -b XOP -g SMOG -s 2018-01-01 -e 2022-02-01 --frequency DAILY ``` Finally, let's calculate the risk factor loadings for stocks using 2 years of daily data. This will take a long time: ``` python3 scripts/get_regressions.py -d -f data/msci_etf_sector_mapping.csv -s 2018-01-01 -e 2021-01-31 --frequency DAILY -i 730 -n XOP-SMOG -b python3 scripts/get_regressions.py -d -f data/msci_constituent_details.csv -s 2018-01-01 -e 2021-01-31 --frequency DAILY -i 703 -n XOP-SMOG -b ``` ### Viewing the Results Follow directions from the [dashboard README page](https://github.com/sichen1234/open-climate-investing/blob/main/ui/README.md) to look at your results. ## The Book The included [free book on climate investing](/main/book) explains both climate investing concepts and how to use this project. You can also [read it online at gitbook](/main/book). ## Project Files * [scripts/](https://github.com/sichen1234/open-climate-investing/blob/main/scripts/README.md) contains the python scripts used to run the models. * [ui/](https://github.com/sichen1234/open-climate-investing/blob/main/ui/README.md) contains the dashboard. * [data/](https://github.com/sichen1234/open-climate-investing/blob/main/data/README.md) contains the data files for the models and a list of their sources. * [R/](https://github.com/sichen1234/open-climate-investing/blob/main/R/README.md) contains R scripts which were used to develop the models. * [book/](/main/book) is the included book on climate investing. ## References * [Constructing and Validating Climate Risk Factors from ESG Data: an Empirical Comparison](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3967613) * [Carbon Risk Management (CARIMA) Manual](https://assets.uni-augsburg.de/media/filer_public/ad/69/ad6906c0-cad0-493d-ba3d-1ec7fee5fb72/carima_manual_english.pdf) * [A Practitioner's Guide to Factor Models](https://www.cfainstitute.org/en/research/foundation/1994/a-practitioners-guide-to-factor-models) * [The Barra US Equity Model (USE4)](http://cslt.riit.tsinghua.edu.cn/mediawiki/images/4/47/MSCI-USE4-201109.pdf) * [Network for Greening the Financial System, Case Studies of Environmental Risk Analysis Methodologies](https://www.ngfs.net/sites/default/files/medias/documents/case_studies_of_environmental_risk_analysis_methodologies.pdf) #### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). #### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer) *and* [*license*](https://github.com/sichen1234/open-climate-investing/blob/main/LICENSE/README.md)*.* # The Open Climate Investing Book Investors have a central role to play in stopping climate change. As the group used to analyzing risks over long term horizons, they must allocate the capital necessary to bring about the transition to a zero carbon economy. They must also capture the opportunities and avoid the losses that climate change will bring. To make this happen, climate or green investing must go from being a niche investment to being a part of every investment. It must go from talk to action. This book is about how to make climate investing actionable. It is designed to help you investments and trades, structure portfolios and benchmarks, and find new opportunities. Best of all, it shows you how to do it with [open source tools](https://github.com/opentaps/open-climate-investing/) and freely available data sets. ### Table of Contents * [Introduction](/main/book/introduction) * [Climate and Investing](/main/book/climate-and-investing) * [Analyzing Investments](/main/book/analyzing-investments) * [Interview - CDP and Climate Disclosures: a Corporate Perspective](/main/book/analyzing-investments/interview-climate-disclosure-corporate-perspective) * [Structuring Portfolios](/main/book/structuring-portfolios) * [Setting Benchmarks](/main/book/setting-benchmarks) * [Interview - Engaging with Banks and Fund Managers for Climate](/main/book/setting-benchmarks/interview-engaging-banks-fund-managers) * [Taking Climate Action](/main/book/climate-action) * Legal and Regulatory Considerations * Emerging Asset Classes: Carbon offsets and negative carbon projects * [New Technologies](/main/book/new-technologies): DeFI and blockchains * [New Assets](/main/book/new-asset-classes): Carbon as an Assets * [Interview - Inside Carbon Markets Today](/main/book/new-asset-classes/interview-inside-carbon-markets-today) * [Conclusion](/main/book/conclusion) ### How to Use this Book Please do not think of this as a "book." It is a how-to manual that you can talk back to. Use it for your climate investing, and then share what worked, what didn't, and how to make it better. [Use the GitHub Discussions forum](https://github.com/opentaps/open-climate-investing/discussions) to tell me about the bugs and mistakes you find. [Ask questions](https://quant.stackexchange.com/questions/tagged/opentaps-climate) using the tag `opentaps-climate` on [quant.stackexchange.com](https://quant.stackexchange.com/questions/tagged/opentaps-climate). [Create issues on github](https://github.com/opentaps/open-climate-investing/issues) for your ideas and suggestions. It will be continuously updated to reflect the latest of all its readers' experiences. If you're new to investing, welcome! Let this book help you learn about this interesting field. Ask questions. Ask for clarifications. Suggest changes. Help spread the word. Finally, don't forget to [sign up](https://opentaps.org/subscribe/) for an occasional email about our work with open source, climate finance, and climate investing. ### About the Author [Si Chen](https://www.linkedin.com/in/opentaps/) was a Portfolio Manager at Fischer Francis Trees & Watts and MKP Capital Management, where he specialized in managing mortgage-backed securities, derivatives, and securitized assets for pension funds, endowments, central banks, and hedge funds. He left fund management to start an [e-commerce company](https://www.graciousstyle.com) and an [open source software company](https://www.opensourcestrategies.com). He is currently leading the development of open source software at the Linux Foundation's Hyperledger project to use blockchain technology for climate action. He has been published in [The Journal of Portfolio Management](https://jpm.pm-research.com/content/22/4/104/tab-pdf-disaabled) and [Fixed Income Solutions: New Techniques for Managing Market Risks](https://amzn.to/3nCg65r) He thought that would be the end of it until he read a recent research paper from The Wharton School, his alma mater, about climate investing and decided he had to [do something about it](https://www.opensourcestrategies.com/2021/06/02/why-finance-professors-think-sustainable-green-investing-as-a-fad-and-why-its-dangerous/). #### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). #### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Introduction ## Introduction If climate change is the epic challenge of our time, then we're all showing up like a half dressed, sleepy eyed mob for the game. International agreements are slow in the coming and non-binding. National emissions regulations, where they exist, are limited in scope. Local government initiatives are underfunded. Financial regulators are busily meeting and advising, but not requiring anything concrete. Investors love to sell ESG, talk about engagement, but the markets act like climate change is far off. Businesses caught the sustainability marketing bug but are slow to commit to emissions targets. Environmentalists are increasingly shrill in their warnings but quiet on actionable plans. Meanwhile the general public is just sleepwalking along. Most people believe climate change is real and want something done. But outside of recycling some bottles or making some donations, most of us are just waiting for someone else to fix it while we're busy with the rest of our lives. I'm not here to point the finger. We all need to do more, myself first and foremost. This book is my attempt to fix that before it's too late. ### Investors' Role in Climate Change Before you go further, let's all first recognize that climate change is a very hard problem to solve. Otherwise you wouldn't be reading this -- I certainly wouldn't be writing it. Climate change is difficult because it is a complex global problem that happens in small increments over long time horizons. Our institutions, from governments to banks to businesses, are not well suited to solve problems like these. They are focused on short time horizons, from quarterly earnings results to multi-year election cycles. They are regional or national in size. They are saddled with outdated technology that create disconnected silos of information and activity. Most of all, they are so slow to innovate. As a result, nearly three decades after the United Nations Framework Convention on Climate Change was signed, most of the world still chugs along as it always did--on fossil fuels and inertia. But this is a problem that we investors could play a crucial role in solving. Investors are the group with the longest time horizon: Pension funds and life insurers invest for up to 30 years, and foundations and endowments are supposed to continue in perpetuity. We are also the group that's professionally trained and tasked to analyze complex data and scenarios and make risk/reward decisions. Finally, we have a track record of affecting change on a global scale. The fact that you're reading this is proof that investors have helped turn utopian technologies into everyday realities before. We are now needed to turn climate change from a raucous political debate into investment decisions. We should be pouring through companies’ climate disclosures as we do their earnings announcements.\ We should be grading their climate risk the same way we grade their creditworthiness. Portfolio managers and hedge funds should be trading stocks based on their relative climate risk profiles.\ Plan sponsors and fund investors should be using climate risk in all their asset allocation decisions. They should also be judging their funds’ climate risk profiles with the same quantitative rigor as their tracking errors. Activist investors should be looking to aggressively change the climate laggards and holdouts to boost their values. And we should all be working hard to protect our portfolios from the effects of climate change. ### Objections Or can we? Let's take a look at some good objections to climate investing. Please read [Tariq Fancy's Secret Diary of a Sustainable Investor](https://www.dropbox.com/s/bvskswxwkro41rh/The%20Secret%20Diary%20of%20a%20Sustainable%20Investor%20-%20Tariq%20Fancy.pdf?dl=0) if you have not already. It's very well written and sounds totally real. Having been a portfolio manager myself, I could completely picture the people and their dialogs. In summary, his key points are: * Fund management companies are happy to sell ESG, or at least a simplified version of them. * But portfolio managers day to day do not incorporate ESG into their decisions, unless they see how it could generate higher returns. * The ESG data itself is confusing and often conflicting. * As a result, ESG investing is in fact lulling the public into thinking that we don't need government regulations, when in fact that is exactly what we need. While the events he describes certainly sound true, I also see another interpretation of them: * Yes, portfolio managers would not incorporate ESG into their investments unless it generates higher returns. That is the life of a portfolio manager. We are like professional athletes without contracts or the Hollywood starlet who is only as good as their last role. We are judged against indices given to us by the pension funds, foundations, and investment guidelines of our mutual funds or hedge funds. And we're all just one trade away from humility. * This means, though, that we need to talk to those same pension funds and foundations. They're the ones who are supposed to invest long-term for their beneficiaries. If they've already signed to one of many climate investment pledges, then they need to use climate-aligned investment indices so that the fund managers could act accordingly. * Similarly, when marketing ESG to mutual fund and hedge fund investors, we must sign them up for the long-term with climate-aligned indices as our benchmarks. This may mean fewer investors initially, but the greatest investors like Warren Buffett all know that the key is cultivating relationships with long-term investors. * Yes, it's not clear how useful a lot that ESG data really is. We have a few suggestions. Stay tuned... * Government action is necessary but not sufficient. After about fifteen years, the European Union's Emissions Trading Scheme is the world's largest government program on climate change. It's also a good example of what governments can and cannot do. It has imposed emissions caps on the industries with the highest emissions, but with significant "holes" (See [this article](https://www.eca.europa.eu/en/Pages/DocItem.aspx?did=54392) about what it misses.) It is limited to the big companies in those industries located in the EU. Faced with carbon taxes, every business will have to decide on what to do: Evade them? Comply to letter? Or get ahead of curve? These decisions will depend on time horizons and risk appetites -- exactly the sort of questions investors must answer. Another interesting objection which I heard yesterday: "Public markets are just trading existing assets and don't affect the real economy." Sadly true for many of the people who spend their days shuffling paper. Long term, though, public markets play an enormously important role. As investors shift from one asset class to another, the relative valuations change. Higher valued public companies fund more investments, buy more innovative startups, which in turn create the eye-popping unicorn valuations and exits that pull in venture capitalists to invest in startups. They also lead to higher management bonuses and option payouts. Lower valued public companies, in turn, attract mergers, buyouts, and vulture investors, who like to consolidate operations, cut costs, and trim management along the way. As a result, management of public corporations are highly sensitive to stock prices and will work hard to boost them. What do they have to do to boost their stock prices? Another question for investors. A similar objection: "One fund shifting from some stocks to another make no difference at all in the world." Also true, but true of anything climate related. What is the impact of one flight not taken or one person changing their diet? It is only when we all act together that we can stop climate change. This is true for investors as well. "You cannot stop climate change by funding the same capitalist system that caused climate change." Perhaps. You can fund a great variety of grass roots projects all over the world, from forestry to sustainable agriculture, through the [voluntary carbon offsets market](https://opentaps.org/2021/08/23/voluntary-carbon-offsets-market-in-2020/). Take a look at these numbers, though: * Amount of financing for voluntary carbon offsets - about $1 billion per year * Amount of financing for renewable energy - $322 billion per year * Amount of financing for all energy infrastructure - $1.26 trillion per year There is absolutely a place for funding the projects of the voluntary carbon offsets market (Most of them, anyway, but that could be a book of its own...) Given how quickly we need to affect real change, though, we cannot just let the main economy, with its corporations and financial markets, continue as they are. Isn't "The Social Responsibility of Business is to Increase its Profits?" So said the great Milton Friedman in his [1970 essay](http://websites.umich.edu/~thecore/doc/Friedman.pdf), who then went on to argue that corporate executives who take on social responsibilities "becomes in effect a public employee, a civil servant, even though he remains in name an employee of a private enterprise. On grounds of political principle, it is intolerable that such civil servants--insofar as their actions in the name of social responsibility are real and not just window-dressing--should be selected as they are now. If they are to be civil servants, then they must be elected through a political process." Ah, life in the ivory tower of the economist. I wonder if Milton Friedman ever tried to get a building permit? But I digress: I will show you that climate is a real financial, investment risk. It is not a political, moral, or social issue. Even if businesses and investors should not impose their views of "doing good" for the society, as [Warren Buffett apparently said](https://www.forbes.com/sites/michaelchavez/2020/01/16/is-buffet-wrong-about-companies-doing-good/?sh=2d384bfa76c3), we must all be careful to protect our investments from the effects of climate change. Speaking of which, [Berkshire Hathaway, Warren Buffett, and Charlie Munger did reject proposals for more ESG disclosure](https://www.etftrends.com/esg-channel/buffett-berkshire-hathaway-brush-off-esg-proposals/).\ They say they're already doing a lot and don't have the time or staff to fill out surveys. If you watch the full video, it's actually pretty technical, going through Berkshire's utilities and transportation businesses' climate plans. Are their [commitments](https://www.brkenergy.com/assets/pdf/Berkshire%20Hathaway%20Energy%20Climate%20Pledge.pdf) real? We hope to provide you with tools to determine that. Are there easier ways for the smaller Berkshire subsidiaries (small for Warren Buffett is not too small for the rest of us) to disclose climate risks? We're working on tools for that as well. If you think of other objections, please tell me by [creating an issue on github](https://github.com/opentaps/open-climate-investing/issues). Otherwise, let's move forward. Like many things climate related, a lot of great initiatives have been started. What we need is a way to bring them together, make them actionable, and scale them. ### Is this Book for You? This book is meant for investors (in the Ben Graham and Warren Buffett sense of the word) with a long-term focus who are looking to do something about climate change while improving their investment results. It is not a book of investment advice and won't help you speculate on cryptocurrencies or day trade to riches. Instead, it is for professional fund managers like I once was, pension fund sponsors, foundations, endowments, consultants, and the increasingly sophisticated individuals who are beneficiaries of institutional investment funds or who are investing for themselves. When completed, it will cover a range of topics including: * Impact of climate change on investment results * Analyzing investments and portfolios for climate risk and opportunities * Structuring and screening indices for investment guidelines * Finding and using climate data and disclosures * New asset classes such as carbon offsets * Legal and regulatory considerations, including ERISA Fiduciary responsibility rules * Using the latest technologies such as DeFI, blockchains, and open source software * Engaging with your plans, beneficiaries, and investee companies Climate change is happening because we're all living and working in our own little silos. The only way to fix is to work together. Ultimately we will live in the world that we worked to create, so let's get started and work to make it better. *"If you only do what you can do, you will never be more than you are now." ― Master Oogway* #### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). #### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Climate and Investing *It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. – Mark Twain.* Catastrophe. That word is used a lot (more) with climate change now. I'm not here to convince you that climate change is real, or what the consequences of it will be. Instead, let me show you what the investment implications of some of the climate predictions are. Climate change will pose several different categories of risks for investments: * Physical risks - Hurricanes, fires, and droughts * Transition risks - Carbon taxes, shifts in demand * Liability risks - Liability from climate risks, such as [PG\&E's bankruptcy](https://www.wsj.com/articles/pg-e-wildfires-and-the-first-climate-change-bankruptcy-11547820006) * Second order risks - Water, biodiversity, supply chain interruptions and breakdowns, carbon border taxes, falling property values, rising insurance costs, and more Each risk category will be affected differently: Physical risks depend on the effect of GHG levels on storms, while transition risks depend on the measures taken to limit the effects of climate change. Thus, measures which reduce physical risk for some assets may increase transition risk for others. ## Physical Risks The NGFS Case Studies book performed several such analyses: * In Chapter 6, an analysis of the impact of natural disasters on residential mortgages in China's coastal cities showed an increase in defaults by anywhere from 0.04% to 0.38% (from baseline of 0.4%) and losses by 0.01% to 0.11% (from baseline of 0.11%) under the RCP 6.0 scenario. This wide variability results from differences in climate scenarios and variability in the effect under each of those scenarios (Mean, Severe, and Extreme) around those scenarios. These numbers sound smaller than they actually are. At the baseline 0.4% default rate and 0.3% loss severity, the cumulative losses for a 30-year mortgage pool assuming 8% constant prepayment rate is 1%. If the default rate increases to 0.58%, the cumulative loss is 1.43%. At 0.78% default rate, the cumulative loss is 1.9%. Compared to [Fannie Mae's historical loss rates](https://capitalmarkets.fanniemae.com/media/20926/display), we see that the cumulative lifetime loss rate rose from 1% for 2004 originations to 2.4% for 2005. So we're not quite at full blown credit crisis levels but getting there. * Chapter 20 of the NGFS Case Studies book analyzed P\&C losses from climate change under 2 and 4 degree scenarios using Climada and Future Flood Explorer on mortgages, showing 61% and 130% increases in losses due to flood risk in the UK. This seems to agree with the results from Chapter 6. It further stated that such analysis may understate risk, and insurance may become generally unavailable if the annual probability of flooding is greater than 1.3%. (Don't worry -- if the State of Florida is any guide, we can just socialize insurance to keep things going and pay the bill later.) * Closer to home, Chapter 24 of the NGFS Case Studies book analyzed the property value at risk in San Francisco at the high end of the projected sea level rise by 2100, which is an amazing 66". (At least Nob Hill will be OK?) The total value of the property at risk was $55 billion. The [total value of real estate in the San Francisco metropolitan area](https://www.bizjournals.com/sanfrancisco/news/2018/08/29/value-sf-real-estate-homes.html) is about $1.3 trillion. ## Transition Risks * Chapter 7 of the NGFS Case Studies book analyzed the effect of transitioning to the Paris Agreement's 2-degrees scenario on coal-fired power generation companies in China. The analysis projected the effects of higher carbon taxes (RMB 508/tCO2e, or about $78/tCO2e), lower demand (-30%), and lower price for power generated (RMB 0.20/KW instead of 0.33/KW) due to falling price of renewables on the income statement and balance sheets of the electric utilities. It did not look good. The combined effects of all these shifts would push the probability of default for these companies to over 20% by just 2030. This would push the credit ratings to the single B category. * Chapter 16 of the NGFS Case Studies book estimated the Value at Risk (VaR) of the Chinese equity market from higher carbon prices. It found that "if the carbon price rises from 20 yuan to 200 yuan (approximately USD28), the market value of CSI 300 index has a 40% chance of dropping 8.4%, a 30% chance of losing 10.4%, and a 20% chance of falling 12.7%" and "According to the World Bank, a price at USD 80-120 (approximately 560-850 Yuan) a tonne in 2030 is needed to meet the Paris Agreement targets." * Chapter 19 of the NGFS Case Studies book shows a study by [2 degree investing](https://2degrees-investing.org/) which estimated the impact of a "too late, too sudden" transition on bond values. It showed that for bonds with 10 years to maturity, the repricing would be -17% for coal power, -16% for oil, -13% for coal, -9% for gas, -6.5% for steel, cement, and airline sectors. These repricings imply downgrades of all these sectors to non-investment grades. For equities, the change in value would be -80% for coal electricity, -57% for coal mining, -53% for upstream oil, -52% for crude steel, -30% for upstream gas, -27% for cement, -21% for aviation, -20% for gas electricity, and -9.5% for automotive. On the bright side, wind electricity, solar PV, and nuclear power would gain 13%, 19%, and 20%, respectively. * Chapter 22 of the NGFS Case Studies book compares the transition versus physical risks across industries and countries. They show that real estate, materials, and food/staples retailing industries and China and Canada had the highest transition risks, while real estate, materials, and consumer durables industries and China had the highest physical risks. Meanwhile capital goods and technology hardware and equipment industries had potential to gain from transition risks, presumably from required equipment upgrades. ## Second Order Risks * Chapter 9 of the NGFS Case Studies book analyzed the effect of water shortages on different companies in the mining, power generation, and beverage industries by applying a "shadow water price" to the amount of water used. The shadow water price is based on what the price of water *should* be given its economic value. It was calculated for different regions of the world based on availability and use of water, and then allocated to different companies based on the locations of their operations. Surprisingly, it found a much greater impact on mining and power generation companies than beverage companies. Because of the higher operating costs from higher water prices, the Net Debt/EBITDA increased by 2x to 3x for BHP Billiton, Glencore, and Rio Tinto (mining), Eskom and Sempra (power generation), and Femsa (beverages), putting their debt into non-investment grades. * Chapter 14 of the NGFS Case Studies book analyzed the transition risk to the South African economy. They found that transition to limit climate change to 2 degrees C would cost a staggering *one third* of South Africa's GDP, concentrated in its coal mining, power, refining, ports, freight rail, and pipeline sectors. Furthermore, most (75%) of the transition risk is due to policies outside of the country's control. * A study of the [effect of the climate change on credit spreads of corporate and sovereign bonds](https://ssrn.com/abstract=3376218) that combined climate policy models with credit default models showed an increase in the sovereign spreads of 245 bp for the sovereign bonds of Australia, 205 bp for Norway, 175 bp for Poland, implying all three countries are non-investment grade given the carbon intensive nature of their economies and their lack of climate aligned policies. In comparison, US and UK bonds would see 52 bp and 6 bp increases in credit spreads. * Moody's publishes a [Environmental Heat Map](https://esg.moodys.io/reports) which as of December 2020 showed $3.4 *trillion* in debt faced heightened environmental credit risk, $4.5 trillion have high transition risk, and $7.2 trillion have high physical risks. While they provide this as a warning, they have not acted to downgrade, because "There is also typically greater scope for issuers to adjust to or manage environmental risks; for example, by adapting business models, changing policies (in the case of governments), or by passing on expected cost increases to customers or taxpayers.” In other words, maybe we'll all come out OK. * Or are we sitting on a [carbon bubble](https://www.forbes.com/sites/ashoka/2021/03/26/were-living-through-a-carbon-bubble--heres-what-we-can-do-about-it/) of trillions in fossil fuel assets that can never be safely extracted, yet have been financed by the global banking system? What will happen if the financial markets come around to this point of view? ## What it all Means *“It's tough to make predictions, especially about the future.” - Yogi Berra* Did you know [Nostradamus and Niels Bohr also said the same thing](https://www.economist.com/letters-to-the-editor-the-inbox/2007/07/15/the-perils-of-prediction-june-2nd)? The fact is, everybody knows predictions are hard to make. Yet scenarios help us see and prepare for the range of potential outcomes. Even more importantly, they're read by policymakers and regulators and thus have a habit of actually influencing the future. Take a step back, and you'll see that a few things are already clear: * Climate change is happening. * The longer we try to ignore it, the higher the costs which will be disproportionately concentrated in some geographic areas and specific sectors of the economy. * If we manage a gradual transition, the costs of mitigation and adaptation could be spread out for an orderly transition. * In any scenario, there will be winners and losers. What makes it complicated is that mitigation and adaptation could take place over decades. While it's good to have time to prepare, it also creates a lot of different options. Once you add different industries, countries, and the politicians who support them, it becomes even more complicated. Hence the difficulties of knowing how it will play out. But as investors, our job is to judge, not to know. As I will show you in the [next chapter](/main/book/analyzing-investments), we can compare the market's expectations with our analysis and make investment decisions, even if we don't know exactly how climate change and its related transition will play out. ## References All references to "NGFS Case Studies book" is the [Case Studies of Environmental Risk Analysis Methodologies](https://www.ngfs.net/sites/default/files/medias/documents/case_studies_of_environmental_risk_analysis_methodologies.pdf) from the [Network for Greening the Financial System](https://www.ngfs.net/en). ### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). ### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Analyzing Investments True story: I used to manage portfolios of mortgage backed securities. These were very complex to analyze, because as interest rates changed, their rates of repayment changed. As a result, their value relative to other bonds such as Treasuries would move differently as rates rose and fell. So we and other investors and traders used very complex models called "Option Adjusted Spread" or OAS models to evaluate them. These models projected interest rates and then repayment rates of the mortgages for 30 years under thousands of different scenarios, then aggregated the scenarios to come up with values for securities in the present day. The OAS models were calibrated to the market prices of treasury or interest rate swap rates and options, so that they, in effect, valued the mortgage backed securities against them. This also allowed mortgages to be hedged with treasuries, swaps, and options, which is what mortgage hedge funds in fact did. But since these OAS models all relied on models of prepayments based on historical analysis of the data, in effect these funds were making bets on the correctness of their prepayment models. Then I met a Trader at a Big Firm. This Big Firm had lots of analysts, including one of the best prepayment analysts on the Street. But he just sat there by himself off to the side and kept sending us scatterplots that looked like this: ![A Market Based Model for Mortgage Backed Securities](/files/-MlB3t5Y03LRfdpnR8W0) That's it??? It was a spreadsheet he maintained himself. People thought of his scatterplots as something between a toy and a joke. But first appearances are deceiving. In fact, the Trader understood OAS models so well, he took it part to its basic components. Then instead of putting it back the usual way, he opened it up and fitted it with market prices. As he explained, "This is the market's OAS model. I've got the history of the market and all those analysts with all their models to compare the current prices with. That's better than any one person's model." In this way, he was way ahead of the Wisdom of the Crowd talk. This market-based model helped him identify mispricings and opportunities where big fancy models could not. He went on to be *very* successful. Today we're told that ESG or climate investing is hard because it's hard to get the data and hard to interpret them. Hard to know which long-term scenario to use and how to analyze them. But this is nothing new, and there is a way to get around these problems. Let the market tell you. There are hundreds, probably thousands, of smart people already looking at the climate risks of all sorts of traded investments such as stocks and futures. You can piggy back on all the time and money they spent on data services, computer models, and research -- for free! All you need is market prices, a computer, and some [models](https://github.com/opentaps/open-climate-investing) -- which we gave you for free! There are some very successful investors who only trade with market implied models and do no fundamental research. For most investors, though, this kind of market implied model is not the end, maybe not even the beginning of the end, but it is the end of the beginning. It is a good way to quickly flag down opportunities, such as mispricings between securities and differences between the market's thinking and your fundamental analysis. It is a great check on your analysis, those "Am I Sure?" moments that could save your career. It is also the best way to make sure that a fund you're sold really does what they said it would do. ## Market Implied Model *"Come on pal. Tell me something I **don't** know. It's my birthday. Surprise me." - Gordon Gekko* The problem with financial data and analysis is that if you know it, and I also know it, then it's not worth much. You got to find something other people don't know yet. Long ago (up to the 1950's), investing meant sifting through financial statements, combing through the news wires, and scuttling about for every little "butt" of information about companies. Then in the early 1960's, a young group of finance professors revolutionized the field by saying none of that mattered. In fact, it didn't even matter if you knew you were investing in livestock or preferred stock. All that mattered was how the assets you owned moved with the overall market. That could be summarized in a simple statistic, called the *Beta* or *factor loading*, which could be calculated as the relative returns of an asset versus the returns of the market from a regression. Once you had this Beta, you could tell how risky an asset was, how two assets should move versus each other, and whether an asset returned enough to compensate for its risks. This revolutionary insight turned finance into a quantitative field. Today few finance departments teach investing the way Ben Graham taught it to Warren Buffett. The top traders at hedge funds are more likely to be physicists than accountants. And though it is still vociferously denounced by the "stock pickers" in the industry, the truth is that this new way of thinking, called "Modern Portfolio Theory," works well in some important applications: * It's great for finding short-term mispricings and trade around them. If two stocks are supposed to move together at a certain ratio with high probability, and one moves first, it's (usually) a good bet the other will move soon. * It's great for analyzing the performance of portfolios. While the investment industry touts its stock picking prowess, most funds contain so many stocks, their returns could be reduced to statistical relationships versus major index returns. The first model of Modern Portfolio Theory, called "Capital Asset Pricing Model" with the single Beta, was just the beginning. Over time, researchers found other statistically significant factors in returns. The [Fama French 3-factor model](https://rady.ucsd.edu/faculty/directory/valkanov/pub/classes/mfe/docs/fama_french_jfe_1993.pdf) from 1993 became popular because it added two more parameters, one for size and one for balance sheet leverage. This was followed up by the [Carhart 4-factor model](https://doi.org/10.1111/j.1540-6261.1997.tb03808.x) from 1997, which introduced a fourth factor, momentum. Today there are ever more sophisticated factor models with ever more factors, such as the [MSCI BARRA Multi Factor Model](http://cslt.riit.tsinghua.edu.cn/mediawiki/images/4/47/MSCI-USE4-201109.pdf). For analyzing climate risk, we started with multi-factor equity returns model such as Fama French and Carhart models, and added an additional factor for climate exposure. The factors we are using are: * Market: Returns of the market over the riskfree rate, similar to the original Beta from CAPM * SMB: Small Minus Big, the return difference of small cap stocks vs large cap stocks * HML: High Minus Low, the return difference of stocks with high book equity/market equity vs low book equity/market equity. The stocks with high book equity/market equity are usually companies in financial distress (ie, banks where the market sees more credit losses than has been written down), while the stocks with low book equity/market equity are usually high-growth companies (ie, tech companies without much earnings.) * WML: Winners Minus Losers, the return difference of stocks with high momentum (winners) vs low momentum * BMG: Brown Minus Green, the return difference of stocks with high climate risk (Brown) vs low climate risk (Green) What this model does is explain the sensitivity of any asset (could be a stock or a fund, or even futures on commodities -- anything that is traded would work) based on the return differential of stocks with high carbon risk (Brown) vs those with low carbon risk (Green). With this model, we could now get the market's measure of the climate risk of a stock by seeing how its prices have behaved. In other words, what do all those smart people pouring through carbon disclosures, ESG data, and running scenarios, not to mention analyzing the company's business model, assets, and operations, really think? Most importantly, we have turned all those disclosures, data, and scenarios -- the vague ESG stuff that make portfolio managers say "How do I monetize this?" (and traders say "How the f@#! am I going to make money with this s#&!") -- into something you could trade with. Furthermore, we've gotten around the commonly known problem of inconsistencies between ESG disclosures and scores by using the market as the benchmark. So using a market implied model, you don't have to bet on which ESG disclosure is "right." You just have to be more right than what the market, as an aggregate, thinks. All you have to know is which stocks are Brown and which are Green. Using a BMG factor we developed from the return difference of the SPDR Series Trust - SPDR S\&P Oil & Gas Exploration & Production ETF (XOP) as Brown stocks and the VanEck Vectors Low Carbon Energy ETF (SMOG) as the Green stocks, we developed a BMG series called the "XOP-SMOG ORTHO 1". It was quite an adventure. We wrote it up as a [research paper](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3967613). Now let's see how it works like with an example. ### Analyzing Stocks and Funds Let's look at a list of [7 Best Oil Stocks to Buy](https://money.usnews.com/investing/investing-101/slideshows/best-oil-stocks-to-buy) and [7 Renewable Energy Stocks and ETFs to Consider](https://money.usnews.com/investing/stock-market-news/slideshows/renewable-energy-stocks-to-consider), and see what the market tells us about them: ![Market Based Carbon Risk Factor for Oil Stocks and Renewable Energy Stocks and ETFs](/files/h5rx2JSdCWGYaNftjIZI) Look in the "BMG" column. This is the market implied climate risk for these stocks. What these numbers mean is that all else equal, for every 1% that the Brown stock XOP outperforms the Green stocks SMOG, ConocoPhillips (COP) will on average outperform by 0.55% and Marathon Petroleum (MPC) by 0.25%. Conversely, when SMOG outperforms XOP by 1%, we could expect Vestas Wind Systems (VWDRY) on average to outperform by 0.48% and NextEra Energy (NEE) by 0.20%. Note that these are average expected results -- The last column, R-squared, shows how well the model explains the returns of each stock. The oil stocks are generally well explained by the model with R-squared of up to 0.87 for Schlumberger, while the renewable stocks much less so, with NextEra Energy at only 0.31. In general, the oil stocks have positive climate risk factor loadings, and the renewables have negative ones, and they're all statistically significant except for Albermarle which is greyed out. This seems to show that the market is generally pricing the climate exposures of these energy companies in line with their oil versus renewables exposures. Whether their relative amounts are correct, though, is another question. Does Marathon Petroleum really have half the climate exposure of ConocoPhillips? Is Vestas really that much more sustainable than the stocks in the Invesco Solar ETF? Or are there inefficiencies in how the market is analyzing the climate exposures of these companies. Having a measure climate risk like the BMG factor loading then allows us to compare companies' valuations versus their climate risk exposures. This table shows that the companies with negative BMG factor loadings have much higher price to book ratios than the oil companies with positive BMG factor loadings: ![Price to Book Ratio versus BMG Climate Factor Loading](/files/rg43MejDoCV0S6iR2MyW) If you're a visual person: ![Price to Book Ratio versus BMG Climate Factor Loading Chart](/files/OonkfNaUuNnreWDYoLhT) Even though they're across industries, the general message is clear. The stock market values companies more when they have less climate exposure. Alternatively, you could look at this table/chart as a place to start looking for opportunities. Will some of the oil companies will be successful at reducing their climate exposure, so that in time their prices would rise as the market recognizes it? Is Vestas Wind (VWDRY) so much better than the other NextEra Energy (NEE), and is it in turn so much better than First Solar (FSLR)? ### Analyzing Market Sectors This is where we still have work to do. In our [research paper](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3967613), we found that the XOP-SMOG ORTHO1 BMG series could explain the climate exposures of the Energy industry quite well, but really doesn't work outside of it. Meanwhile other BMG series constructed from different ESG metrics could literally give you the opposite answers to the climate exposure of whole industries. Depending on which one you used, you could believe that Auto Manufacturers, Utilities, Banks, and even Mining companies could either gain or lose from climate change. What does this mean? One of three things: * The market isn't pricing in climate risk in other industries, because it doesn't know how climate change will affect those industries. * The market doesn't have a consistent climate risk gauge across industries, because each industry has a different mix of transition and physical risk. * We haven't found the right way to capture the market's climate risk exposure in other industries. We are continuing to work on this. [Sign up](https://opentaps.org/subscribe/) to find out what we find. ## Fundamental Analysis *"The most valuable commodity I know of is information" - Gordon Gekko* I'm going to (figuratively) bet that given the limited awareness of climate among investors, the market is probably still missing a lot. In other words, there are probably a lot of opportunities if you invested some time in analyzing companies' climate exposures. Whereas the market implied model allowed you to cut out the whole issue of inconsistent data and disclosures, fundamental analysis is all about comparing different points and figuring out which one is actually right. So let the market implied model be a starting point, and let's dig in. Climate change is a long-term process with a lot of uncertainty. How it plays out, and then how that affects an actual company, could depend on a number of scenarios. Thus analyzing climate exposure is, in many ways, similar to analyzing mortgage-backed securities: You will need to project multiple scenarios far into the future, calculate their financial impacts, and then attach probabilities to the scenarios to arrive at their expected values today. (Now you see why I needed to tell you about mortgages and OAS models.) The key steps of this analysis are: * The company's current climate exposures: How much are its Greenhouse Gas (GHG) emissions now? What are its assets? * How those exposures will change: Every company talks about "sustainability" these days. What is it really doing to reduce its climate exposures or "decarbonize"? * Overlaying scenarios: How will potential events affect the company, given its current exposures and its path to decarbonize? * Valuing the scenarios: Under each scenario, what is the economic impact (positive or negative) to the company? * Comparing versus the market: Now the market implied values come in handy. As you can see, climate investing is not as simple as divesting from oil companies. Just like you wouldn't buy a stock based on its most recent earnings, you shouldn't just rely on current emissions to make climate investment decisions. Instead, you have to account for both current positions, management actions, and potential long-term scenarios. This is what makes investing fun! ### Data and Where to Get Them The most basic data you will need is the emissions of a company. While we usually talk about CO2 emissions, there are other gases that cause climate change and do a lot more damage. According to the [EPA's Overview of Greenhouse Gases](https://www.epa.gov/ghgemissions/overview-greenhouse-gases), methane (CH4) is 25 times, nitrous oxides 300 times, and fluorinated gases 10,000 to 20,000 times more potent than CO2. (Maybe that's why the agricultural chemicals, copper, and gold stocks had such high carbon risk factors?) All these gases are collectively called "Greenhouse Gases" (abbreviated "GHG"), and their emissions are converted to their CO2 equivalents, or "CO2e," based on these ratios. Furthermore, companies emit GHG in a variety of activities. The standard for GHG emissions reporting is the [GHG Protocol](https://ghgprotocol.org/), which breaks down a company's emissions into three scopes: * Scope 1 is emissions from fuel directly combusted on site at a company. For example, utilities and steelmakers burning coal or natural gas, or airlines burning aviation fuel. * Scope 2 is emissions from energy purchased by a company. For example, buildings purchasing electricity from a utility. * Scope 3 is emissions from all the upstream and downstream activities of a company. It is a very broad category and includes all of the following and more: * Oil extracted by an oil company and burnt by an airline or car * Flights taken by employees of a company * Steel bought as raw materials * Shipping a product to customers * Using cloud-based servers (Yes, that includes your reading this article right now.) ![Scope 3 Emissions - Source EPA/WRI](/files/-MlLKOyW7Bp0u2UA1R7l) *Source:* [*EPA Scope 3 Inventory Guidance*](https://www.epa.gov/climateleadership/scope-3-inventory-guidance) Naturally, this means emissions are transferred between companies. Natural gas that is extracted by an oil company is Scope 3 for the oil company, Scope 1 for the utility that uses it, and then Scope 2 for the office building that uses the electricity from the same utility. Because Scope 3 emissions are so broad and tangled up and down the supply chain, they are the hardest to account for. It is also what many climate investors analysts and ESG data providers are missing, and where some companies are deliberately trying to hide their climate exposures. So be very careful about any analysis that does not include Scope 3 emissions. So where do you get this information? There are a lot of reporting standards out there, but let's take a look at a few common ones: * [CDP (Carbon Disclosure Project)](https://www.cdp.net/en) is a self-reported survey of carbon emissions and policies by companies. Here is an example of [Adobe's response to CDP questionnaire](https://www.adobe.com/content/dam/cc/en/corporate-responsibility/pdfs/Adobe_CDP_Climate_Change_Questionnaire_2021.pdf). The data they collect is available to paid subscribers. * Taskforce for Climate Finance Disclosure (TCFD) and Sustainable Accounting Standards Board (SASB) are general guidelines for reporting on climate and sustainability. Take a look at the [TCFD disclosures](https://about.ups.com/content/dam/upsstories/assets/reporting/sustainability-2021/2020_UPS_TCFD_Report_081921.pdf) and [SASB disclosures](https://about.ups.com/content/dam/upsstories/assets/reporting/sustainability-2021/2020_UPS_SASB_Standards_Table_081921.pdf) for UPS as examples. * [GRI](https://www.globalreporting.org/) is a more comprehensive set of sustainability reports, somewhere between the CDP's surveys and the disclosures of the TCFD and SASB. Note [Adobe's Corporate Social Responsibility](https://www.adobe.com/content/dam/cc/en/corporate-responsibility/pdfs/Adobe-CSR-Report-2020.pdf) follows points from the GRI. Also note that some companies (Adobe) supply a third party audit letter, some companies (UPS) have their auditors review some of their disclosures, and others provide disclosures without any auditor backing. Want to learn more about climate disclosures? How about hear what it was like from somebody who actually made the disclosures? See [Interview - CDP and Climate Disclosures: a Corporate Perspective](/main/book/analyzing-investments/interview-climate-disclosure-corporate-perspective). ### Do Goals Matter? Related to disclosures are organizations that help companies set climate goals. They also provide helpful information about companies' climate exposures. A few well known ones are: * [Science Based Target Initiative](https://sciencebasedtargets.org/) (SBTi) validates companies' climate targets against the Paris Agreement 1.5 degree goals. They publish [standards for emissions reductions by industry](https://sciencebasedtargets.org/sectors), known as the [Sectoral Decarbonization Approach](https://sciencebasedtargets.org/sectors). They publish a [list of companies taking action](https://sciencebasedtargets.org/companies-taking-action) under their emissions reduction targets. There are currently 1750 companies with either approved targets or in the process (committed.) * [Transition Pathway Initiative](https://www.transitionpathwayinitiative.org/) (TPI) assess management awareness of climate issues and carbon performance based on International Energy Agency (IEA) Energy Technology Perspectives report. * [Climate Action 100+ Net Zero Benchmark](https://www.climateaction100.org/progress/net-zero-company-benchmark/) is focused on about 160 top emitting companies, relying in part on TPI data. Their [2020 report](https://www.climateaction100.org/wp-content/uploads/2020/12/CA100-Progress-Report.pdf) has detailed information about the companies. Importantly, note that these initiatives are very high level and do not actively monitor the companies' progress along their targets or commitments. This is a big void in climate investing and an area we're working to address with an open source [Investor Climate Disclosure Project](https://wiki.hyperledger.org/display/CASIG/Investor+Climate+Disclosures+Project). Why do these targets matter? Because they are a measure of a company's seriousness in addressing climate change. While many companies now have departments who submit ESG surveys, few (only 5% to 25% of the S\&P 500, for example) have committed to meeting the goals of the Paris Agreement through SBTi or others. Therefore, a commitment is by itself the sign of a climate leader. (Follow through is something we as investors should hold the companies to.) Furthermore, if and when the world's economies follow their Paris Agreement's National Defined Contributions (NDC's), then the public policy and carbon task transition risks in those economies would probably follow the Paris Agreement goals. Therefore, companies could be minimizing their risks by getting onboard with Paris Agreement goals early. Time will tell, of course, but that's the point of the next part: Scenario analysis. ### Scenario Analysis In a [previous chapter](/main/book/climate-and-investing) I went through the results of different analyses on the effects of climate change on investments. Now let's take a closer look at how the analyses were done, so that we could perform similar analyses for our investments. Analyzing the effects of climate is a multi-step process which involves projecting several key variables into the future: * Trajectory of Greenhouse Gas (GHG) emissions based on current trends * Effect of GHG emissions on changing the climate, both locally and globally * Physical effect of those climate changes, such as droughts or hurricanes * Financial impact of those physical effects * Mitigation measures, such as the various policies to reduce emissions and "decarbonize" * Adaptation measures against the risks, including hardening infrastructure and reducing emissions Physical risks are calculated by mapping assets, such as buildings or plants, and then running models for hazards such as hurricanes, flooding, and fires on the assets. The models would project physical damage, which would then need to be converted into financial losses to calculate the additional expected loss due to climate risks and identify portfolio vulnerabilities. There are both commercial models such as ClimateWise and FourTwentySeven and open source models such as [CLIMADA](https://github.com/CLIMADA-project/climada_python) that could be used. ![NGFS Physical Risk Framework](/files/-MlN3HjqckxbKVbMwZzy) \_Source: [NGFS Overview of Environmental Risk Analysis by Financial Institutions](https://www.ngfs.net/sites/default/files/medias/documents/overview_of_environmental_risk_analysis_by_financial_institutions.pdf) Transition risk requires a process of mapping changes in regulations and consumer demand on companies' financial results. Typically, these scenario analyses incorporate changes in energy mix and technologies, such as switching from fossil fuels to renewables and electric vehicles. They also incorporate carbon taxes, which are calculated against the companies' projected GHG emissions. For example, here is an example from chapter 4 of the [NGFS Case Studies book](https://www.ngfs.net/sites/default/files/medias/documents/case_studies_of_environmental_risk_analysis_methodologies.pdf), where Oliver Wyman shows a calculation of the impact of carbon taxes on oil and gas exploration: ![NGFS Oliver Wyman Carbon Tax on Oil Gas Exploration Costs](/files/-MlN3HjrEk9RV1yM2Vpn) *Source: NGFS and Oliver Wyman* This could then be extended into the financial results, as in this example from "Climate Credit Analytics: Model Documentation" by S\&P and Oliver Wyman: ![NGFS Oliver Wyman Financial Projections](/files/-MlQt9NGIG7rNQCCmRH4)\ *Source: NGFS and Oliver Wyman* Some useful resources for constructing your scenarios: * [NGFS Climate Scenarios for central banks and supervisors](https://www.ngfs.net/sites/default/files/media/2021/08/27/ngfs_climate_scenarios_phase2_june2021.pdf) is the most up to date (2021) and best resource. It covers a wide range of scenarios that span orderly transition to 1.5C, current trend to 3C, and sudden transitions after 2030 to reach 1.8C. The carbon prices in these scenarios reach an amazing $800/ton in some cases. * [TCFD The Use of Scenario Analysis in Disclosure of Climate-Related Risks and Opportunities](https://assets.bbhub.io/company/sites/60/2020/10/FINAL-TCFD-Technical-Supplement-062917.pdf) is a bit old, from 2017, but it describes in detail different scenarios from the IEA and a few others. These scenarios show the increased need for biofuels, renewables, and nuclear energy, as well as carbon prices going up to $140/ton to $210/ton under some scenarios. * [SBTi Sectoral Decarbonization Approach (SDA)](https://sciencebasedtargets.org/resources/files/Sectoral-Decarbonization-Approach-Report.pdf) breaks down the path of emissions reduction necessary to reach 2C by industry, such as steel, cement, power generation. A more updated version for reaching 1.5C target is in the works. For companies which are committed to SBTI targets, this could be useful in constructing their path of future emissions. * [CarbonBrief's Explainer: The high-emissions ‘RCP8.5’ global warming scenario](https://www.carbonbrief.org/explainer-the-high-emissions-rcp8-5-global-warming-scenario) describes what the "Representative Concentration Pathways" are, how they were derived at, and why the RCP8.5 scenario that is often cited "Business as Usual" may be too severe. (Some good news finally?) Now let's look at how to do the scenario analysis. For all companies, transition risk is an important concern. Start with the current emissions and factor in futures emissions paths, using the SBTI targets if the company is committed or other scenarios for the industry if it is not. Then calculate the cost of the emissions with carbon price scenarios, and add that to the company's costs. Assume some rate of pass-through to the customers and add that to the revenues. From this, you could derive the change in net income from a climate scenario. For companies which are very location-specific, such as those with a lot of real estate, facilities, or agricultural land, physical risk is also a concern. Look at the location of the companies' assets and overlay the impact of weather. From that, figure out the potential for loss, and back out an expected loss. This should be a proxy for the insurance costs for carrying those assets and added to the company's costs. For companies which are very energy-intensive, different analyses are required. Energy producers, such as oil and gas companies, are sensitive primarily to shifts in demand, part of which would be reflected in carbon prices. Energy users, such as power generation utilities and materials (mining and steelmakers), may have to make heavy capital investments to shift their energy mix. Here, you would have to look beyond financial analysis and think about both the management's plans and how the financial markets will accommodate them. For example, the steel industry requires capital investment decisions made decades in advance. Is the management investing in the right technologies, or will carbon pricing makes its products uncompetitive? Could the company raise the money to invest in those technologies? In other industries, ask questions like "What is the management of an oil and gas company planning to do with its proven reserves?" "Does an oil exploration company have alternative business models?" All these questions would lead to comprehensive adjustments to balance sheets and income statements. Finally, in all cases, use some common sense to think through second order effects. Maybe you're invested in a restaurant chain that doesn't have physical locations. But how will the consumer shift to vegetarian diets affect business? Is it situated in storm sensitive areas? Or maybe you're invested in an automobile manufacturer. How well could it shift to electric vehicles and on-demand transportation? Even without precise scenarios, you can use some rough, back of the envelope calculations to come up with the potential impact on a company's business results. It's not enough to run through a single scenario, even if it's a "worst case" scenario. That's probably just something you'd run once a year for the risk auditors, management, or regulators and then put in a drawer somewhere. To really understand your portfolio, run it through a range of scenarios. Pick some reasonable values for the variables--flood levels, carbon prices, demand shifts, additional CapEx required--and see which of those a company is most sensitive to. Attach probabilities to the scenarios. Even some rough probabilities for probable (50%), possible (20%), extreme (5%) would help put a number on the risks. Now you'll have a number for climate cost that would allow comparing different investments to each other. ## Putting it All Together *"In the short run, the market is a voting machine but in the long run, it is a weighing machine." - Ben Graham* In the end, investments converge on fundamentals: Bonds are either repaid, or they default. Stocks are ownership in businesses, which either make or lose money. Any investment model must be rooted in the fundamentals of the assets you invest in, or they will lead you astray. Either you will lose money, or worse, lead a career full of sound of fury, but ultimately signifying nothing. The goal of climate investing is to pick the companies that are really reducing their exposures to climate change, and in the process encourage all companies to do the same. Therefore, it must be rooted in sound fundamental analysis about companies' real emissions and their strategies to reduce them. But fundamental analysis is hard, because it involves forecasting the future. Many investors have also gone astray believing in their analysis all the way to the bankruptcy court. And if we get climate investing wrong, it's the whole financial system that would be headed that way. So the market implied models could help us as a sanity check. Are we sure what we're right? Or does everybody else know something we don't? It is the yin to the yang of fundamental research. It could also help you make some money finding mispricings in the market, which is always a nice thing. ### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). ### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Interview - CDP and Climate Disclosures: a Corporate Perspective *What are climate disclosures such as the CDP (Climate Disclosure Project) really like? In this interview, we spoke with Ermanno Camerinelli, Sustainability Specialist for an Italian SME who completed their first climate disclosures. Hear firsthand what parts of the CDP were really important, where the data came from, how you should use it, and how participating in the CDP benefited his company. You can also* [*watch the video of the interview on Youtube*](https://youtu.be/aTuabVaoECg)*.* SC: Thanks for joining me today. EC: Thank you for for asking me. SC: Sure. This is for this book I'm putting together about climate investing, and I wanted to have a section from somebody who's done the carbon disclosure project CDP disclosures to hear firsthand from you what your experience was. So I had some questions that I sent you earlier and if you could just start telling me about it, I'll prompt you and follow you along. So if you could tell us a little bit about the company that you work for and why they decided to do this in the first place. EC: Well I work as a sustainability specialist in an Italian fashion company that supplies fashion accessories to the most important fashion brands worldwide. We supply natural materials like corozo or mother of pearl and also synthetic materials like polyester or metal. Since we supply also natural materials of course we have a lot of standards we have to comply with. We have many regulations we have to to comply with of course, so our company has always been committed to sustainability from the very beginning of its from its early life. We started to get into the CDP carbon disclosure project because my boss collaborates with the some working groups in the United Nations, and some entities thought this could be a good opportunity for us to disclose our commitment to sustainability. We only filled the environmental and climate change fields of the CDP. The CDP is divided into different areas: climate, water, and another area, but we are not into that because we do not hold a production department in our facility, so we only showed our commitment to sustainability in the sense that we commit to all the regulations of fishing or the fishing of the shells. We also comply to many of the SDG's not only water or climate SDG's. We also comply to many social SDG's because our company was the first one to locate the production and the cultivation and fishing of shells in protected areas, where the shells are born, in middle Asia, Australia, Tahiti. We also involved the native populations in those processes so we gave working job opportunities to people who had no job opportunities. Of course all these areas are protected and controlled. So this is why we decided to join the CDP. I personally filled the CDP questionnaire. The main challenges of the CDP: Since we are a very small company, it was really hard for us to gather all the information, because all the information we hold in our company are not stored on an online platform. It's just me. They are just stored in a in a database. We didn't implement a blockchain technology yet, so we have no automatic data collecting or data analysis. So it was hard for me to analyze the data, because it was my very first experience with CDP and with the sustainability. So I started to get into sustainability just from that experience, and massive quantitative quantitatives of data were involved. It was difficult to me in the first place to understand what scope 1, scope 2, and scope 3 were, but then of course I was able to manage it. The advantages we received from filling the CDP: Actually we gained a lot of competitive advantage because we got in touch with many companies after we filled the CDP that were really interested in our commitment and in our activity, just because they read our CDP disclosure. So I think it's a great opportunity for companies to disclose their commitment not just to their clients or potential clients but also to investors and to other stakeholders. It's a great opportunity because CDP is an online platform, so it's open. Everyone can join, and everyone can see what other companies are disclosing. So this is a great opportunity. SC: Okay interesting. So did you only do CDP or did you do some of the other ones like GRI, the Global Reporting Initiative, or TCFD? EC: Not yet. SC: CDP was the only one by far. And did you make quantitative disclosures like your full scope 1, 2, and 3 emissions footprint? EC: Yes. So sorry let me just add one thing. Another weakness of the CDP I think is that at least for the area I personally covered, the questions asked were whether we used some science-based targets or international standards that are internationally recognized. But I think it is not good that CDP does not provide standards itself. After all, the information are gained and all the information is collected. I think a good thing CDP could do is to develop some standards that could be internationally recognized. SC: OK. So what kind of standards? EC: Maybe qualitative standards. Not just quantitative but qualitative standards for climate change, forests that's what the the additional area was, and water. For example, a lot of their questions are "do you have a policy in place" or "who is in charge" kind of qualitative. So are you saying some kind of standard on how an organization should manage its climate impact rather than just having people answer those questions? SC: Okay. That's a good point, to develop a set of best practices, if you will. So coming back a little bit to the quantitative data. So scope 1 is the energy that you consumed at your facilities, and scope 2 is the purchase of electricity, and scope 3 is supply chain -- up and down your customers as well as your vendors. So how did you do all three of those segments? EC: It was very very easy for me because after understanding what scope 1, scope 2, and scope 3 meant, it was really easy for me. Since we are a very small company, we do not have much data. It was hard to me to understand because it was my first experience, but this year 2021 was the second year that i filled the cdp questionnaire. Of course it was way easier. The Scope 1 data was just collected by me by asking my colleagues. Actually we do not have official reporting processes in place, nor do we have measuring processes in place. We are working to implement one but we do not have one yet. SC: So scope 1 is usually like a manufacturing plant where they're burning some kind of natural gas to make a product. Do you actually do that very much like direct machinery? EC: We do not have direct productions. So we do not okay so I just highlighted that our facility in Asia or in Turkey or in Europe are compliant to the Ecotex or GRS, GSR standards. No massive CO2 emissions are registered in those companies but they are also committed to compensate it, to offset. SC: Scope 2 is electricity. EC: Yes it was the manual collection of data, of electricity bills. I only included the electricity for light and for heating and cooling because the only electricity. SC: Did you use emissions factors for different countries’ utilities or how did you go from the electricity data to the carbon emissions of the electricity? How did you calculate the carbon emissions from the electricity bills or was there a database or or service that did that for you? EC: Actually it was just something that was amateur. I did it manually. I searched how this CO2 equivalent tons can be calculated, and then I tried to calculate it, because we actually don't have uh external services that do it for us. SC: There's public data sets for that information that you used. So now the most difficult part is scope 3. How did you calculate your scope 3 emissions? EC: I asked our suppliers for scope 3. I had the idea of making my own questionnaire that I shared with my suppliers where my question was just something like the interview in December if you remember. It was just do you have a reporting process in place? Do you have a measuring process in place? If yes, how do you measure and how do you disclose your emission data? Do you have any any projects to offset your CO2 emissions? Of course some of this information was a bit confidential so it was not included in the CDP, but our suppliers are compliant with all the regulations. Some of them have some projects to offset their emissions, so it was just an interview to my suppliers. SC: Did a lot of them provide you that information, most of them did, or about half? EC: Most of them did provide the information. Of course i shared the questionnaire with all our suppliers, but the main suppliers that actually produce the majority of our buttons or our accessories are really a few. They all disclosed their impacts. SC: So what kind of information did they give you? Did they actually tell you how much CO2 emissions per dollar, or per pound or kilogram, or per unit of product? EC: No it was just from zero to one ton, from one ton to two tons, two tons to three tons. It was just an approximate range. SC: So they give you a range of results like one to three tons. So you mention offsets. Are they including offsets? Are you using some form of offsets in terms of their emissions footprint calculations? My company? Yes, your company and your suppliers. Do you use offsets in your emissions calculations? EC: I don't know. I cannot tell you from my supplier's point of view because I did not investigate much deeper. Our company does not have offsets initiatives because we do not emit a lot of CO2, so our company is not required to compensate or to offset its emissions. SC: OK. There's a lot of other questions on the CDP like management processes and who's responsible and kind of just soft questions. So did you answer that? EC: Yes. SC: Did you interview people at your company or was it just basically you're the person so so that's the answer? EC: Actually we are just seven of us in our company. It's just seven employees so it was really easy to understand who is in charge of what, and of course we all work in the same facility. It's just one building, and I speak to all my colleagues every day. So I already had all the needed information because I know what people are in charge of in my company. There is my boss, there is me, there is the production manager, and there is the sales manager. My boss is in charge of investigating all the new standards our company must comply with. I'm in charge of finding the best way to comply with those standards. Our production manager is in charge of telling our suppliers that products must be made in a certain way to be compliant with environmental standards, product standards, or working standards. Our sales manager with me, we are both in charge of disclosing our commitment through awareness campaigns, through marketing campaigns, to our our stakeholders, clients, and financial institutions. So this is basically how our company is made. SC: OK. So how big, how many pages, are your disclosures all together? EC: Let's see, front and back--it is approximately 20 to 25 pages 30 pages. Actually some of my answers were quite long, so I think it's 30 pages. SC: And you're saying this is available on the CDP website now? I might have to ask you for the link just to see. because I wasn't able to find the answers. So let me ask you now that you've done this: I'm looking for example at the Adobe CDP disclosures so I'll share my screen with you. This is theirs and it's really long. Theirs is a hundred some pages long for a very large company. So what do you think is important to read? What do you think are the most useful and important questions? Here's one: detailed risks. This one is talking about risks. Before they're talking about different organizational types of risks and whether they're relevant or not, and then there's a lot of different material here. EC: Many people say this kind of questionnaire can be also problematic for many companies, especially large companies, because they ask for sensitive information like potential financial impact figure. This can be information that some companies may think is sensitive. Some companies may not be willing to disclose such information, so the cost to realize the opportunity in the section is something that can be omitted or can be altered by companies. I think the most important sections here are of course the impact magnitude and the risk area. Are there organizational or operational risks connected to your activity or to your companies? This is one of the most important areas. Others of course are the scope 1, 2 and 3 emissions reporting. SC: Okay so the company is going through a list of all their different types of risks. And did you do a similar analysis for your company, like of all the different risk types of climate-related risks to your operations? EC: Yes of course it was way simpler than this, but yes we did do it. SC: What about sections like strategy in terms of a transition plan or scenario analysis. EC: This could either be something that can be useful or something that can distract companies or readers from the scope of CDP. SC: That's a good answer thank you. So taking a step back like what do you think was good and bad, strengths and weaknesses of the disclosures? How do you think it could be better? EC: I think, as I told you earlier, it's a great opportunity for companies especially small companies to be more present on the market, to give a better impression of themselves, and to reach more and more readers, more and more stakeholders in a very short time, because CDP is followed by and read by thousands of companies or thousands of users every day. So it's a great opportunity. I think one weakness can be that the CDP actually asks for some sensitive information that companies may not be willing to disclose, for example the strategies or the cost and opportunities. The risk session is really helpful, but again this can be a tricky question to many companies. SC: Yes I see that. How do you think it could be better if you were to try to improve the whole disclosure process? EC: Well it's a good question. Maybe fewer questions I think, because it can be too many questions. It would also be very helpful if the answers are guided answers and you have different options, and then you have to write your comments in. For example in the risks and opportunities sections you have some options that you can choose from, and then you have to only write your comment. So I think it's a very good thing if there are maybe fewer questions. That's my only concern. SC: so are you saying it is currently guided or is it kind of open-ended? EC: Yes, it's guided. SC: Okay so basically the key is fewer questions and just the important ones like the risks and the scope 1, 2, 3 emissions reporting. EC: Well actually the opportunity section is also useful to stakeholders like clients or financial institutions, but for the very scope of the CDP carbon disclosure project I don't think it's very useful for this purpose. SC: So it's useful but not for the carbon and climate. EC: Yeah. It should be a different section of the CDP platform. SC: Okay so how was it prepared? Was it just one big document that you sent back to them ? EC: In the first year in 2020 I downloaded the questionnaire on excel and then I uploaded it and submit it on the website. In 2021 I just filled it online. This was way way simpler to do. So I'm just very quickly looking at their website now. Let me share with you. So where do I find the results of the companies in the cdp website? Or how are people finding the surveys that you filled out? Actually I don't know from here since we are logged in in the CDP, we have our account, so I have the results of my questionnaire there on my account. I guess it could be on data and insights, or you go on the research icon on the the top part in on the right. SC: Over here right? Search response. Okay search for company. Please sign in or register. So you need to register. I did not know because they also have data sets that they sell to companies of the responses so I didn't realize where you could actually find these but this is helpful to actually be able to find it on their website as well. So anything else I should know? I'm trying to ask a lot of questions but you're the expert here. EC: No I'm still learning about this, about the CDP. I'm sorry I can only help you on the climate section because we were not asked to fill the water and forest sections, but I guess they are very similar to the one I filled. SC: Great. EC: Yes, my suggestions can always be good for forest and ocean sections. SC: Great. Well thank you very much. Really helpful information and I'll put this together and send it to you. EC: Good thank you for having me. #### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). #### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Structuring Portfolios *"I don't throw darts at a board. I bet on sure things." - Gordon Gekko* More true stories. Early in my career, a man came into office and said he was the heir to a hair care products fortune. He was moving to Los Angeles and looking for an investment company to manage his money. Would we be interested? We weren't sure he was who he claimed to be. (His hair didn't look good.) But how much did we have to lose? It was a great opportunity for the newbies (me) to sit in on an investment presentation by the firm's founders. So there I sat in a conference room overlooking the Pacific ocean, listening to our founders talk about our investment management process and risk management. The man nodded and smiled as we went on. Then they all went to lunch, and I went back to work. We never heard from the man again. We called their family office. He was not real. Fast forward a few years. I'm now in New York. Another man (yes, they were both men) came recommended as the "shoo in" for the Governor of a major State. He's meeting people in town today. It would be a *really* good idea for us to meet him. So another conference room, this time overlooking the rooftops of the Manhattan skyline. Now I'm one of the featured attractions. We talked about our investment process and risk controls. The man nodded and smiled. A couple of weeks later, we got a letter on fancy bond paper inside a velum envelope. He found what we talked about fascinating! Would we support him to bring integrity back to government? We did not. He didn't become Governor of his State either. Moral of the stories? Most institutional investment presentations are about the same: Our firm has been around for (a long time) and specialize in (what you're looking at right now.) We have really smart people (just listen to them) which do in depth analysis. Just take a look at these examples of the (amount of industry knowledge | detailed financial analysis | sophisticated analytical models | impenetrable math | data mining and AI) we do. On top of that, we overlay a disciplined risk control (look at these complicated charts.) This is why we deliver you (consistent | high) returns, and here is a (client list) to prove it. Which is not to say that the presentations aren't true. In fact, most investment managers do follow a process like this, even if some of it is a little "aspirational" at times. The difference is how it's done versus how plan sponsors and consultants may think it should be done. As a portfolio manager, I always felt that they were too academic in how they viewed investing. They seemed to believe the academics, who believe that sophisticated factor models are the answer: "My 3/5/7/13 factor model can explain all the return differences in returns and understand what the managers are doing better than they themselves do!" Outside of a few high quant shops, though, most investors just don't think of things in factor terms. We don't show up to work thinking "I got to adjust my HML today because I see a big move for low book value stocks next month." Instead, we show up to work like shopaholics heading to the mall. Most investors, whether individuals or big institutions, show up every morning looking to hunt down the latest bargains (those are your value investors), the latest and greatest (growth/momentum), or the truly unique, one-of-a-kind Sneakerhead finds (special situations, distressed, arbitrage.) We then tuck away our finds and reminisce about how we found each bargain in our collection. We can tell you exactly how it felt on the day we bought our favorite stock/bond/derivative years after the trade. Even the ones who trade in esoteric derivatives are like that. They just know their investments by serial numbers instead of company names, and think of them in terms of mathematical models instead of real people. For individual investors and funds managed by star stockpickers, that's usually it. They know what they know, and they're so good at it, they don't need to bother with a little bit of everything else. You never hear Uncle Harvey talk about his buying Microsoft, AOL, Facebook, or Tesla in the early days, then explain about the utilities and non-bank financials he bought to diversify his portfolio. At larger firms, there is (usually) some adult supervision involved, in the form of a Chief Investment Officer (CIO) or investment committee, or both. They'll look over the portfolio and gather the key metrics, usually an overall risk measure (duration for bonds, market beta for stocks) and a sector breakdown. These metrics are compared to the index that the portfolio is benchmarked against. The adult supervision is there to make sure that the differences are reasonable, that the portfolio manager is not taking too much risk. Here is where we could have some fun. Some investment management firms's investment policies are extremely conservative. They want no measurable difference versus the index. All the return differences should only come from superior security selection. But unless you knew something nobody else knew, this is like trying to turn lead into gold in markets with hundreds or even thousands of competitors. A few brave ones (Bill Gross and PIMCO come to mind) will proclaim that they believe the market will systematically go in one direction over the long term. They then maintain a calculated bet against their benchmark. It will result in greater short term volatility, and some clients will not take it. Over time, though, if they're right, these long-term views will really boost returns. The key is to make sure that your bets taken don't cause you to wipe out due to short term volatility. Many others believe they can tactically trade against their benchmarks. For example, generally overweight some sectors or go long the market, but take them off from time to time. This is not easy, though, because markets could be quite volatile in the short term. The great thing with climate investing is that given how little it is understood right now, there are several different ways to incorporate it into your investment process. First, let's say you want to be pure stockpickers and want no systematic biases versus your benchmarks. The carbon risk loadings that our model could identify is an additional way to find market anomalies that's not in the general know. You could keep your portfolio aligned with your benchmark but have upside as climate change plays out. Or you could even find stocks with the same carbon risk loadings as the market *right now*, but which could perform differently as their climate risks become better known. Think of it as an option on climate risk embedded in your portfolio. What's difficult about this approach, though, is that it requires the portfolio manager to be actively knowledgeable about climate risks in their day to day stockpicking. Otherwise, it's like asking somebody to develop a sixth sense. The typical manager is already looking at a lot of often contradictory variables: earnings, earnings growth, balance sheet leverage, and industry specific numbers like number of users, ARPU, churn, amount of real estate owned, barrels of proven reserves, etc. etc. How does a new variable like carbon risk loading fit into it? What's the time frame of carbon risk playing out, and how much of an impact would it have? A more straightforward approach is for the CIO or investment committee to put on a controlled, long-term climate bet versus the benchmark by either underweighting specific high climate risk stocks in each sector or some key sectors that have high climate risk. This is a four step process: * Calculate the volatility of carbon risk factor * Based on the volatility, size the bet -- How large a carbon risk loading different can we stomach against our benchmark, so that even in large moves against us, the performance will still be acceptable? Essentially, this is a "Value at Risk" calculation. For example, given a 2 standard deviation move in carbon risk factor in any year, should we limit the performance downside to 50 bps versus the benchmark? This determines the amount of carbon risk loading difference we can maintain. * Identify the stocks within each sector with the highest (lowest) carbon risk loadings that we could underweight (overweight) * Identify the sectors of the index with the highest (lowest) carbon risk loadings that we could underweight (overweight) This is not as easy as it first sounds. The choice of risk sizing could make or break your investment strategy. Too little risk, and it won’t give you enough of a performance boost, but too much risk could cause to incur larger losses than expected. If you’re managing against guidelines or using leverage, it could actually cause the loss of the client or wipe out of the portfolio. Finally remember that measurements of volatility are themselves flawed. Virtually all the academic research and risk models assume that asset prices are normally distributed, but in fact they are not. Large movements — three, four, five standard deviation moves — are rare, but much more common than the million to one occurrences the models assume they are. Short term movements are more volatile than longer term movements multiplied by the square root of time, which is what normally distributed volatilities mean. Covariances between assets may hold steady in ordinary markets, but when start to hit the proverbial fan, all assets move together — down. Even the hedges will move against you. Taken together, this means that once in a long time events happen more often and with greater ferocity in the markets than the models predict. When you make these kinds of bets against your benchmark, be careful. Don’t oversize these long term core bets. Then it's time for one of those meetings in the conference room. Are we better off changing our selection of stocks to maintain the sector weightings, or changing our sector weightings? This is where the portfolio manager's judgement on the individual stocks comes in. If their opinion on the individual stocks goes along with the climate risk strategy, then you can realize your climate strategy through issue selection. Otherwise, go with the sector weightings. The last option, tactically trading the climate risk of the portfolio versus the benchmark, is really a trading strategy. It should be attempted if there is a real reversal patterns in the price movements *and* a fundamental reason why it's happening. For example, if there's intervention or regulatory-driven trading in the market. Otherwise, just be careful that you could get whipsawed by the noise. Or worse, you could decide to sit it out and spend the rest of your life playing "Could have. Should have. If only." Now let's look at some examples based on the model from the chapter on [Analyzing Investments](/main/book/analyzing-investments). ![Portfolio Optimization using BMG Factor Loadings](/files/Kpn28JHJeWCIRfhl8kQX) Here are those oil companies and renewable stocks again. Let's say that you're managing against the Energy index--maybe you have an "Climate Transitions Energy Fund", or you're just the energy specialist in a team. What do you do? If you're a stock picker, you've probably already thought a lot about whether ConocoPhillips (COP) is better at a 6.89x EBITDA multiple or Chevron (CVX) better at a 8.9x EBITDA multiple. Now add the fact that ConocoPhillips (COP) has a BMG factor loading of 0.32 and Chevron has a BMG factor loading of 0.55 to your thought process. If you're making a more strategic climate bet, then you might want to try to create a portfolio which will track your index but have a lower climate risk exposure. As a very simple example, the index has a market factor loading (Beta) of 1.23 and a BMG factor loading of 0.29, so you could try to structure a portfolio with a market factor loading also of 1.23 but a BMG factor loading of 0. Let's assume (again, just for example) you can put at most 20% into any stock and cannot short any stocks (not uncommon for pension funds.) An optimizer could give you a portfolio which has an EBITDA multiple of 27.49. A little off the targeted values could bring that down to the 17x - 18x EBITDA multiples range. How good is this bet? Let's take a look at the distribution of the BMG series since 2010: ![Distribution of BMG Series](/files/EZUbQFFUU29h3i8MzZ2V) Interestingly, the BMG series has an average of -0.65% per month but a standard deviation of 9.27%. The information ratio of the performance versus standard deviation is 0.07, compared to 0.22 for the stock market and 0.09 for long-term interest rates. In other words, a lot of variability for the performance gain. A look at the distribution of results shows that there were many periods where Brown stocks in fact outperformed: ![Histogram of BMG Series](/files/UTKk4mRtmEIk2dCqfxs1) If you structured your portfolio with a BMG factor loading of 0 versus 0.29 for the index, you could expect * An average outperformance of 0.29 \* 0.65% = 0.19% per month * A tracking error or standard deviation of 2.69% per month * A 5% probability of a 4.9% underperformance That's the theory. Now for a dose of reality: look at the low R-squared for the renewables stocks versus the oil companies. This means that the model doesn't track their returns as well as the oil companies, so there could be a lot of times when your oil stocks are down, you think the renewables should be up, and they're not. This is called "basis risk" -- the risk of your hedge not moving as expected against your risks. An easy way to see how much basis risk there is is to run a simulation of the actual portfolio. Here, we ran the optimized, zero climate risk optimized portfolio against the index and calculated the monthly relative returns: ![Zero Carbon Optimized Portfolio Minus Energy Index](/files/7VVyHZ3j0PswDhkAxV57) In reality, there were more instances where the portfolio underperformed the Energy index by more than 5% in one month -- 19 months out of 144, or 13.2% of the time, nearly three times more often: ![Zero Carbon Optimized Portfolio Minus Energy Index](/files/fUkG105TLt9bQnWao3jz) If this is shocking to you, welcome to the markets. Correlation shifts, volatility drifts, and extreme market moves are just the realities that traders and portfolio managers deal with. And if you recall from the [Analyzing Investments](/main/book/analyzing-investments) chapter, this is when there is even some correlation between high and low climate risk stocks. We found **no** correlation, for example, be carbon credits markets and stock markets, so if you tried trading stocks against carbon credits such as the EUA futures, who knows where you'd end up. And finally, half the stocks in your zero climate risk portfolio are oil companies! Imagine the uproar! It'll probably sound like [this debate at MIT about divesting from fossil fuel companies](https://mitsloan.mit.edu/ideas-made-to-matter/mit-divest-all-ideas-welcome-pursuit-one-big-goal) Which brings us back to my original point in the [Introduction](/main/book/introduction): Climate investing is not the job of the portfolio manager. Asset owners must specify their climate goals in the investment guidelines of their funds. They must be willing to make those long term choices. That is our topic for the next chapter. ### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). ### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Setting Benchmarks *"There's no use running if you're on the wrong road. " - Warren Buffett* As a portfolio manager, I often felt like we were in the mud up front while our clients sat in castles miles away, obliviously sipping tea while giving us benchmarks that were out of touch with reality. They would exclude out of favor assets that offered the best opportunities while piling into flavor of the month investments that offered few. They wanted short-term results from investments that clearly required long-term time horizons. Finally, they would exclude perfectly safe investments while allowing highly risky ones on the basis of arbitrary ratings. The last one, by the way, is exactly what caused the Credit Crisis and Great Recession of 2008 -- read [The Big Short](https://amzn.to/33TkSnl) by Michael Lewis. If only I could be the client... Then I started to invest for myself. True to my wish, when I made my own direct investments, I never cared about any benchmark index. But when I invested in funds managed by others, I would compare the managers' results versus their benchmarks and fees. Sure, I took a longer perspective, took the time to understand their investment process, and looked for out of favor sectors. But if the manager couldn't outperform by at least twice their fee over a five year period, then it was time to say good bye. Eventually, I ended up replacing several actively managed funds with super low cost index funds, not because I believe markets are efficient or indexing is the best way to go, but simply because their performance couldn't justify the fees. Because even though the portfolio manager in me likes to be Hans Solo -- "Never tell me the odds"--as the client, how could I decide except by looking at the numbers? Yet judging "by the numbers" alone could also lead to a short term, academic view of risk and return that would not only be bad for your long-term investment results but also have disastrous consequences for climate change and the economy as a whole. This chapter, then, is my attempt to bring the two sides together. It's me the portfolio manager talking with me the client, in the hope that we could integrate long-term thinking about climate change into the investment process. The first thing we should all do is take a look at risk. This chart shows the performance of the optimized zero carbon risk portfolio versus the Energy index from the previous chapter on [Structuring Portfolios](/main/book/structuring-portfolios): ![Value of Zero Carbon Optimized Portfolio Minus Energy Index](/files/guITqyeSjqH95YJEoDU8) At first blush--The good guys won! Everything worked out. The climate aligned portfolio also way outperformed. But how does this look? ![Dark Valley of Zero Carbon Optimized Portfolio Minus Energy Index](/files/2Y1PdQipea0PQJKa1j1O) Starting in 2010, after two and a half years in mid-2012, the optimized zero carbon risk portfolio would have been down nearly -47% versus the Energy index. This was the dark valley of clean tech, after Solyndra went bankrupt and venture capital funding for clean tech practically came to an end in 2011. A Harvard Business School article put it succinctly in [Clean Tech VC: A Decade of Failure](https://digital.hbs.edu/platform-rctom/submission/clean-tech-vc-a-decade-of-failure/): *In 2016, after nearly a decade and over $25 billion invested by L.P.’s,\[11] 90% of clean tech investments can be considered abject failures, and close to 100% can be considered poor investments.* Or how about now? The optimized zero carbon risk portfolio has outperformed the Energy index by a whopping 260% over the past decade. Renewable energy stocks trade at two to three times the Price/Book ratios of the oil majors: ![Relative Value of Renewable and Oil Majors Stocks](/files/rg43MejDoCV0S6iR2MyW) The oil stocks are rallying again. The press is calling it an [ESG bubble](https://www.bloomberg.com/news/articles/2021-10-28/trillion-dollar-esg-boom-rings-bubble-trouble-alarm-in-new-study), because some [academic research papers](https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=3929359) said that the outperformance is the result of favorable capital flows rather than fundamental. Do you stay the course? Warren Buffett famously said that "The true investor welcomes volatility." But he has the rare luxury of time that most do not. He invests with a faith in the long-term principles that is also backed up by a reputation and an investment vehicle that took decades to establish. Most portfolio managers and their clients, the investment officers of pension fund, endowment, reinsurer, or private banks, would not be around to see the rebound after a 40% underperformance. Even principals investing their own money usually have liquidity needs, as well as a partner who would (reasonably) question their sanity. Yet [Buffett and other great investors](http://mastersinvest.com/volatilityquotes) are right. Great investments, like the transition to a low carbon economy, take time. The path to get there could be rocky, but the long-term outcome is not in doubt. Volatility is not risk but opportunity--if you could survive the journey. So the first important consideration is how to get there. In other words, how much volatility could you tolerate? How much of an underperformance would cause you to lose the portfolio--by getting fired or being forced to liquidate? Stop this from happening by sizing the risk properly, like we had discussed in the previous chapter on [Structuring Portfolios](/main/book/structuring-portfolios). Part of your decision will have to be based on actuarial analysis: How much contributions and withdrawals would be expected. Make sure you will not be forced to sell to meet those obligations. If you're making a leveraged bet on a long-term trend like climate change -- ***DON'T DO IT***. A bigger part, though, is one of values. Why are you making a climate-aligned investment? Do you believe some companies will outperform during transition to a low carbon economy? If so, what is the time horizon for this to happen? Five years? Ten? Twenty? Thirty years? Or do you believe that climate change is fundamentally harmful to the well being of your constituents, so that you cannot invest in companies that contribute to climate change? In that case, then are broad market benchmarks such as the S\&P 500 even relevant, since they contain companies that contribute to climate change? Taken a step further, do your constituents agree with you? Do they want you making this decision for them? Do they agree with your analysis of which companies contribute to climate change, and which do not? The more you are aligned with your constituents, the more they will be willing to ride through the cycles with you, and the greater volatility you will be able to bear on the road to your ultimate goals. Assuming that you decide "Yes, this is fundamental to our investment policy," the next question is how to do it. Do you engage or divest? On the surface, it seems the answer is simple. As the Harvard students who wrote an [open letter](https://divestharvard.medium.com/letter-to-harvard-corporation-on-its-2050-net-zero-pledge-a7260fd2e76) put it, "...engagement with the fossil fuel industry is dangerous and irresponsible. These companies are bad-faith partners in an effort towards decarbonization: their business models are predicated on continued extraction and exploitation of the world’s most vulnerable communities. They are not substantially transitioning to clean energy systems, have a record of attacking climate researchers (including Harvard’s own), and continue to block meaningful climate policy solutions..." Yet nothing in climate change is ever simple. An article by Daniel Yergin, "[Why the Energy Transition Will Be So Complicated](https://www.theatlantic.com/international/archive/2021/11/energy-shock-transition/620813/)" points out that petroleum is so embedded in our world that many parts of our lives could not go on without them, not to mention the major countries whose economies are entirely dependent on oil and natural gas exports. Articles like [Why divestment doesn’t work — and just won’t die](https://www.greenbiz.com/article/why-divestment-doesnt-work-and-just-wont-die) are even more blunt. Divesting has its appeal. These companies are off your books. You send a message about doing something for climate. You could also avoid the potential losses of being caught on the wrong side of the carbon transition. If enough people do it, then the stock prices of the companies will fall and their cost of capital increase. But perversely, then, the opposite happens: The companies look more attractive on a pure value basis. This is already happening. Look again at the relative valuations of the oil companies versus renewables: ![Relative Value of Renewable and Oil Majors Stocks](/files/rg43MejDoCV0S6iR2MyW) The market is already pricing in a hefty premium for the renewables companies. Even in the course of a long transition to a low carbon world, if the oil companies just have a few "dead cat bounces," it would cause the kind of short-term underperformance discussed earlier. And what if a few of them really did change their act and became viable in that low carbon world? Removing them completely could be a costly, not to mention unnecessary, mistake. Meanwhile, falling stock prices would make these companies attractive candidates for Leveraged Buyouts (LBO's) by private equity and sovereign wealth funds. A reshuffling of the players, but all the same questions remain. You're just paying someone else to guide them through the energy transition. Finally, where does the divesting stop? Airlines? Utilities? Car manufacturers? Companies who use plastic packaging like Coca Cola and Pepsi? Freight carriers like UPS and Fedex? Their customers like Amazon? Amazon's customers like you and me? It feels good to wash our hands clean and divest, but somewhere along the line, we all have to get down to the hard work: Engaging. In 2015, after trying for several years, leading UK environmentalist Jonathon Porritt wrote "[It is 'impossible' for today’s big oil companies to adapt to climate change](https://www.theguardian.com/environment/2015/jan/15/it-is-impossible-todays-big-oil-companies-adapt-climate-change-jonathon-porritt)". Yet we're still trying. Last year, institutional investors of ExxonMobil banded together to elect new directors with a focus on climate change, despite intense management opposition. Meanwhile, CEO'S of major oil companies have come together under the [Oil and Gas Climate Initiative](https://www.ogci.com) with the stated aims to "accelerate the industry response to climate change" and "explicitly support the Paris Agreement and its aims." Will this do any good? The UN Partnership for Responsible Investing's [collaborative engagement between major oil companies and their institutional investors](https://www.unpri.org/climate-change/engaging-oil-and-gas-companies-on-climate-results-of-the-pri-collaborative-engagement/6826.article) is a good summary of where the industry really is. Twenty-five major oil companies sat down with institutional investors and other groups over a two and a half year period, and * All the oil companies acknowledged that climate change as a significant issue for the business and have a policy commitment to act on it. * 16 of the 25 have improved their climate disclosures. * and 19 of the 25 have set long-term quantitative targets for reducing emissions. But * 15 of the 25 companies are only committing to reducing their operational emissions from extracting and refining (Scope 1 and 2) * Only 5 have targeted reducing Scope 3 emissions from the use of their products. * Meanwhile, they all keep on drilling: "approximately 30%-40% of the engaged companies’ capex is unviable in a below 2˚C pathway." Reducing Scope 1 and 2 emissions from oil and gas production is no small potatoes. [Methane flaring](https://www.iea.org/reports/flaring-emissions) causes between 265 million tCO2e of GHG emissions, more than Florida or the Philippines and five to ten times that of Bitcoin, to perhaps as much as [1 billion tCO2e](https://business.edf.org/files/ESG-by-EDF-Flaring-Report-Book-V2-Reduced.pdf), more than Germany. But is it realistic to think that's all there is for the industry to do? I could just picture it now: A group of environmentalists go to a conference and ask an oil company to reduce their Scope 3 emissions from the use of oil and gas. The company executives respond, "You caused those emissions by flying and driving here, staying at a hotel, and using the internet to organize. So those emissions are on you." Perhaps true technically, but then what? ![EU Carbon Prices to December 29, 2021 - TradingEconomics.com](/files/OxEpXx1NBMVt85GGhQP6) As countries implement carbon pricing and carbon prices rise, would there not be natural economic substitution to low carbon energy sources? Would that then reduce the demand for the output of oil and gas companies? Meanwhile, as oil companies continue to spend billions drilling for oil in the face of falling demand, they may be setting up a [carbon bubble](https://carbontracker.org/terms/carbon-bubble/) Would they then fight to keep up demand for the oil, making climate change worse? Or would they have to write off their assets, costing you billions in losses? Or both? To be viable long-term, these companies must address more than just Scope 1 and 2 emissions. They must address the Scope 3 emissions in a way that is acceptable globally, not just in the host countries where the companies operate. Otherwise, they will all be much smaller as rising carbon prices, not to mention consumer boycotts, will cause the utilities to switch to renewables, airlines to switch to alternative fuels, and car manufacturers to switch to electric vehicles. As investors, then, you must make a call here--it's your job. Do these companies in fact have a viable business model? * Could they invest the cashflows from legacy oil and gas businesses in renewable energy *successfully*? * Could they create a low or zero carbon energy product, using carbon capture and sequestration technology, hydrogen, or carbon offsets, that will be *acceptable* in enough markets around the world? * Is there another use for their output, such as plastics, that will also be *acceptable* to the general public? * Failing all of the above, will they reduce capex and return capital to shareholders? If they do, then engage with them and help see these strategies through. Perhaps it will happen in stages, and eliminating those methane flares would be a good first step. But we also need to move quickly and cannot stay there. Nobody--not the general public, the companies, and least of all us investors--have decades to wait passively any more. As the investor, you need to act like a coach and not a buddy. You need to do more than just say "Great job" and actively understand the companies' strategies and monitor their progress. If you realize there is no viable strategy, or the companies are not following through with them, then you must think about whether it would be better to divest after all. You can at least save your own investment if not the world. But if the companies are pursuing a viable transition strategy, then be their champion as well. Make them see that doing the right thing will reward them with higher valuations, stock prices, and bonuses, rather than fall prey to buyouts and layoffs. This is what is really hard about engaging right now. It's easy to jump on the divest bandwagon. You've sold your shares, announced it to the public, and you're one of the good guys. But if you're engaging, how does anyone know that you're really working through the carbon transition with your companies, instead of just greenwashing? What do those of us who choose to engage rally around? It requires many stakeholders to work together: investors, the companies, the general public. Could we agree on what the goals of the engagement should be? Could we agree on what the metrics of progress should be? One possibility is to rally around the Science Based Targets Initiative (SBTi)'s commitment to a 1.5 degree transition. Amazingly, there are nine oil and gas companies that have signed up for it, including oil exploration companies like Schlumberger and Halliburton: ![SBTI committed oil and gas companies, December 30, 2021](/files/QvCc7X2jmG4FVMkDzDmM) But what have they committed to? Unfortunately there's no more information available on the SBTi website. In conclusion, divesting and engaging should not be opposites but rather two sides of the same coin. Think of it as "selective engagement." Some companies you would engage with, and some you would just have to divest. To divest alone would not have much impact in the real world. To engage without the prospect (threat?) of divesting would probably achieve very little as well. Now that you've made the important long-term decisions, the next step is to work out a set of benchmarks for your portfolio managers. The benchmark should reflect your long-term climate strategy into a neutral index so that your portfolio managers would manage (and hopefully outperform) against it. It should include the amount of climate-aligned difference or "tilt" versus standard indices such as the S\&P 500 or MSCI World. If you choose to divest from oil companies, they should not be in the index. If you choose to engage with them, it should include only the companies that qualify for your engagement strategy. You could construct a benchmark yourself, or you could choose from one of many that's being pumped out to support the boom in ESG investing. There are, for example: * The [S\&P Paris-Aligned & Climate Transition, or PACT™, Indices](https://www.spglobal.com/spdji/en/education/article/faq-sp-paris-aligned-and-climate-transition-pact-indices/), which "are designed to measure the performance of eligible equity securities from an underlying benchmark index, selected and weighted to be collectively compatible with a 1.5ºC global warming climate scenario and to meet several other climate-themed objectives at the index level, as of each rebalance." * The [MSCI World Climate Change ESG Select Index](https://www.msci.com/documents/10199/84e37acb-a91e-8ff3-a909-6f8c7c6306dd), which excludes companies engaged in Nuclear Weapons, Tobacco, Thermal Coal, Nuclear Power and Unconventional Oil & Gas, companies which are "not in compliance with the United Nations Global Compact principles", and companies which are not "rated B and above." (A "B" means "laggard" and is probably a company in the lowest quartile compared to its peers.) * Finally, for hard core divesters, there's the [S\&P 500 Fossil Fuel Free Index ](https://www.spglobal.com/spdji/en/indices/esg/sp-500-fossil-fuel-free-index/#overview), which is simply "companies in the S\&P 500 that do not own fossil fuel reserves. Fossil fuel reserves are defined as economically and technically recoverable sources of crude oil, natural gas and thermal coal." But how good are these benchmarks in real life? With colorful titles such as [The ESG Mirage](https://www.bloomberg.com/graphics/2021-what-is-esg-investing-msci-ratings-focus-on-corporate-bottom-line/) and [The Trillion Dollar Fantasy](https://www.institutionalinvestor.com/article/b1tkr826880fy2/The-Trillion-Dollar-Fantasy), critics have pointed out the key problems, some of which we've already discussed, with using ESG-based indices for climate investing: * The ESG ratings only incorporate direct Scope 1 (on site) and Scope 2 (purchased electricity) emissions, not the much larger and harder to measure Scope 3 (supply chain) emissions. * They incorporate a broad range of criteria, so improvements in employee diversity or governance policies could cause ESG ratings upgrades even for a company with high climate risks. * They try to measure the impact of climate and environmental risk on a company's business risk profile, rather than its total social risk profile. In doing so, they could underestimate the long-term climate risk of the company. * They are graded on a curve, relative to other companies its own sector. So a company with high climate risks that is marginally better than others would still receive higher ESG ratings. As MSCI succinctly puts it in [What MSCI’s ESG Ratings are and are not](https://www.msci.com/our-solutions/esg-investing/esg-ratings/what-esg-ratings-are-and-are-not), "ESG ratings are not climate ratings." Yet many investors act like it is, or at least it's better than nothing. But it may not be. With an incorrect benchmark, you could be giving the wrong instructions to your portfolio managers. You might think you've reduce your climate risk, when in fact the index is giving them marching orders to keep investing or even adding to high risk industries. There's a relative easy way to check on how good a benchmark is for climate investing: See how it compares to the market's view of climate risk. Unlike rating agencies, the market relies on the collective wisdom of all the investors out there, and they're not paid by corporate issuers. Even if a small number of them understand the true climate risks of a company, their trades could push the prices in a way that reflects them. To see if your benchmark is "aligned" with the market's view of climate risk, you can perform an analysis similar to what we did in the chapter on [Analyzing Investments](/main/book/analyzing-investments). You can follow these steps based on \[our paper]\( for a benchmark you constructed yourself or one constructed by an ESG ratings service: * Set up your climate-aligned benchmark as the Green portfolio and its matching index as the Brown portfolio * Calculate a Brown Minus Green (BMG) series * Regress the returns of the industries in a major market index such as the MSCI World against this BMG series to get its BMG factor loadings. These are the market implied climate risks of the industry sectors. * Run rolling regressions of the stocks in the index against this BMG series to get their BMG factor loadings. These are the market implied climate risks of the stocks. * Now look at those market implied risks, and ask yourself: Do these make sense? * Is your BMG series, based on your climate-aligned benchmark, identifying statistically significant climate risk sensitivities in the industries and the stocks? * Are those sensitivities relatively stable over time, which makes sense since climate risks don't change much in the short term? Or do they drift up and down? * Are those climate risk sensitivities *logical*? Do they agree with the [fundamental research on climate risk](/main/book/climate-and-investing)? These questions may be hard to answer if you're just looking at one benchmark index, but when you compare it with others that we've analyzed, you'll be able to see a pattern. For example, we did identify that the market priced the climate risk of the oil and gas and renewable energy stocks correctly. Using the [open climate investing project](https://github.com/opentaps/open-climate-investing)'s default BMG factor, you can see that only the energy sector has a significant number of stocks with market-based climate risk: ![Open Climate Investing Market-Based Climate Risk by Sector](/files/McpXjvjbKMarQOYOPCrX) These are the energy stocks that have significant market-based climate risks: ![Open Climate Investing Energy Stocks with Significant Market-Based Climate Risk](/files/OopFqH1v5QjDuc8uIZRZ) When you look at a particular stock, it should have a market-based climate risk that is relatively stable and trending over time: ![Open Climate Investing Market-Based Climate Risk for BP stock](/files/VBGVDtRuePlyLhqVFiHG) So if your climate-aligned benchmark does not identify statistically significant climate risks in the same stocks, then it's not in sync with even the market's analysis of climate risks. Similarly, if your benchmark thinks that many high climate risk stocks have little or even negative climate risk sensitivities, then there's probably a problem with your benchmark. And finally, one last question: Should portfolio managers vote proxies? A strangely interesting and difficult question to answer. Let's let the provocatively titled [Could Index Funds Be 'Worse Than Marxism'?](https://www.theatlantic.com/ideas/archive/2021/04/the-autopilot-economy/618497/) be the starting point. It suggests that since so many stocks are owned by the major index funds (and the author didn't even count the closet indexers -- Yes, we know you're out there -- disguised as active managers), the true owners of public companies have little incentive to make companies, well, do anything. As a result, academic papers have found that industries including [pharmaceuticals](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3194394), [banking](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2710252), [airlines](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2427345), and even [commodities markets](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2663398) have become less competitive. Of course, the asset managers disagree, with [BlackRock's white paper](https://ccl.yale.edu/sites/default/files/files/viewpoint-index-investing-and-common-ownership-theories-eng-march.pdf) and [The Brooking Institution's working paper](https://www.brookings.edu/research/the-common-ownership-hypothesis-theory-and-explanation/) challenging the methodologies of the research and therefore their conclusions. So, let's see: If the Workers invest in a mutual fund managed by BlackRock based on an index published by Standard & Poor's, and the mutual fund owns shares in a public company regulated by the SEC -- Do the Workers then Own the Means of Production? Or must they rise up against the shackles of oppression -- but from whom? Meanwhile, how is this for a reasonable proposal: * Portfolio managers have shorter tenures compared to the long-term returns of the fund. * Therefore, many proxy decisions, especially climate-related ones, have impacts longer than the expected tenure of the portfolio manager. These should be decided on by the ultimate asset owner. * Some proxy decisions, however, could affect the immediate prices of the companies. Portfolio managers are therefore right to say that a proxy vote affects their results (and bonuses.) * Therefore, portfolio managers should have input on how to vote on proxies. In the end, we come full circle. Asset owners and portfolio managers are really part of the same time. How about let's try to work together? ### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). ### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Interview - Engaging with Banks and Fund Managers for Climate *What are banks and institutional fund managers really doing about climate change? What are their priorities? What are their limitations and challenges? Could they do more? In this interview, hear from Gabe Malek from the Environmental Defense Fund about their experiences working with major banks and fund managers on climate change.* SC: Please tell me generally what your work at the EDF involves as a starting point. GM: So my work involves collaborating with finance sector partners on the energy transition and net zero planning and strategy, the motivation being if we can get banks and asset managers to set rigorous climate standards, then we can push a variety of companies across industries to cut emissions more ambitiously. SC: So that's both commercial banks in their lending side and asset managers as equity investors in the companies, right? GM: That's right. SC: Do you find those two to be similar or very different when you work with them? GM: They have different interests and incentive structures. I think the asset managers we're talking about are really big and passive asset management firms, and their key tool in the toolkit is engagement. They're not going to divest from particular sectors. That's just not within their strategy. So our focus in speaking to them is more about what questions should you raise with management teams when you go about that engagement. When should you vote against a board member at an annual meeting? What does "good" look like for a net zero plan, and how can you communicate that through your investment stewardship? For the banking side there are probably more tools available to directly influence the ways companies behave, but the incentive structure is different because these companies are their clients rather than their portfolio companies. So they're cautious about how they interact with those companies, because they want to retain that business. So it means that the pace from the banks is maybe not always as fast as it is from some of these investor coalitions, but there are a wider array of tools banks can use, whether that's adjusting cost of capital, integrating certain climate standards, and their advisory services for mergers and acquisitions. So we're trying to explore basically all aspects of what a bank does and connect those to climate. SC: So it's all aspects of the bank's business, including lines of credit financings, project financings, and M\&A. Do you see any particular aspects of those being more responsive to climate concerns? Is there some pattern in it at all? GM: Yes. So the US banks have taken a similar path so far on addressing climate. The six largest US banks are members of the Net Zero Banking Alliance, and that alliance has some general ideas about steps banks can take to move towards net zero. So it makes sense that a lot of these firms are working in parallel. What we've seen so far is banks prioritizing their direct financing and underwriting. I think it's just easier for them to quantify, control, and attribute those emissions to themselves. It's harder to say we helped advise this oil and gas merger and acquisition, and this project has x amount of CO2 emissions, and because we played this role, we now attribute the fraction of that to us. It's hard to make that calculation, whereas for financing and lending, the Partnership for Carbon Accounting Financials (PCAF) has already developed a methodology that's become widely accepted for banks to calculate financed emissions. So they're using that as a starting point to say we're going to reduce financed emissions by X percent for these sectors by 2030. Those are their concrete objectives that they've stated. JP Morgan was the first bank to make a commitment and release these 2030 targets, and then Morgan Stanley, Goldman Sachs, and then recently Citi followed. So we now have four US banks that have released 2030 finance emissions targets. They've all started with the energy sector and the power sector. Then three of the four banks have also included targets for transportation. They're not saying if we fail to meet these targets, we will exit our financing for these companies. They're not going that far. They are just saying "these are the benchmarks we hope to hit and here's how we're going to work with our clients to ensure that we meet those targets" SC: Are they setting higher cost of capital, like credit spreads in those sectors because of the emissions cost or credit costs? Or are they still doing it as before? GM: I think it's a safe assumption. In their public disclosures, they don't mention explicitly the extent to which they're adjusting cost of capital in those sectors, but in many conversations I've heard just with industry, there seems to be a growing recognition that cost of capital will be changed to account for the physical and transition risks that those sectors are facing. SC: So for people in the industry, as these large banks exit the sector or reduce their financed emissions, what do you think would be their options? GM: It's the golden question, because worst case scenario is that now they go to less ambitious banks that are just willing to do these deals anyway. It's this prisoner's dilemma that we're facing across the energy transition, but I think in actuality there's a human element to this. The banks and companies have long-standing relationships, and there's a reason that the six major banks in the US are so dramatically bigger than some of their competitors. It's because they have top talent in their firms, and they attract companies looking to do deals with really strong advisory services. So I think it's very possible that companies will respond to this pressure from banks because they might not want to exit that relationship and find a new banking partner. But I think the short answer is that it's unclear at this point. We're still kind of early days. SC: What is the impact of a bank saying "we want to reduce our financed emissions"? Are they looking for the companies to then reduce their emissions, so that they could continue to lend the same amount, but then the companies have to do the work to reduce their emissions? GM: From EDF's perspective that's the ideal path, because as we're discussing you could take two paths. The first is "I'm just gonna provide less financing to this sector and as a result reduce my financed emissions." Or you're really going to depend on those companies to use the financing you provide to cut their own emissions. The latter path has real climate impact, and the former is just moving money around. It's just moving the emissions around too, so hopefully banks will not only raise cost of capital for continued exploration and production in oil and gas or continued development of diesel trucks, but lower cost of capital for innovative green technologies that are necessary for these companies to transition. SC: How are the banks monitoring the total emissions? Are they relying on the things like the CDP disclosures or the TCFD disclosures of emissions from the companies? GM: It's a very convoluted calculus. You have to get the emissions data from the companies. Step one, it's probably coming from CDP disclosures, TCFD reports now. The companies are sometimes including emissions data in their sustainability reports directly. I think TCFD has done a strong job as a first step to get companies reporting more, and then hopefully the SEC will release new rules this year mandating climate risk disclosure. Once they have that emissions data from companies, most of these banks are using a similar methodology. They're basically saying, okay what's the total financing this company receives, where does our bank fit into that total financing (what percentage), and then we can essentially weight the percentage of emissions that we're responsible for. SC: Do you work with the European banks as well or just the American-based banks? GM: We haven't done much work with the European banks. So far it's mostly been American. SC: So is there some kind of line that these banks are drawing in terms of saying "We're going to engage, but if we don't see the progress, then we're going to reduce our financing to these companies to meet our goals?" GM: Nothing that explicit. They've said in abstract terms that if companies are not moving forward with a responsible and orderly transition, then they might withdraw some financing. But there's no minimum standard, for example if the company doesn't reach X percent methane emissions reduction by 2025, you're going to stop financing. There's nothing that explicit. SC: So when they say they've set a goal to reduce their financed admissions by 2030, how are they releasing data that the rest of us could monitor how they're doing and whether they're on track to meet those goals? GM: The ones that have made these 2030 targets have committed to publicly report on their progress towards the target. SC: Is that something that you participate in when you monitor what they're doing? Is monitoring a part of what you do? GM: Certainly. When any bank releases a net zero report, we look into it and review it and try to understand the strengths and weaknesses. Once we start seeing these incremental updates we plan on doing the same. SC: So how do you envision this working with the commercial banks to scale up? By finding more banks to commit to this, or by increasing their targets, or following up on their targets? What is your plan with this process? GM: I think there are a number of ways to scale up, and we're trying to decide how best to prioritize. The first would be extending climate to additional aspects of what the bank does. Right now we're looking mostly at direct financing and underwriting. So can we get banks to integrate climate standards into their M\&A advisory services? Can we get banks to integrate climate into their legislative affairs teams and start advocating for public policy that's needed to support the transition? Can we get some of those minimum standards in place for financing so that there's just more meat on the bone, that we can say you need to reach this level of methane intensity in the oil and gas sector if you want to continue to receive financing, or you need to have this type of electric vehicle transition plan if you're a major shipper? So that's work to be done with the US banks that have already taken a step in the right direction. Then I think another opportunity to scale up, and we haven't explored this in depth thus far, is trying to engage more banks internationally on the transition. Many of the world’s largest banks are in China, and they're providing a lot of financing to projects that have serious climate implications, and we're just not plugged into that yet. So maybe down the road seeing how we could shape the dialogue there would be productive. SC: What about going to the smaller or more regional banks in the United States? GM: I think smaller regional banks have important exposure to climate risk. Climate risk for them is more acute than it is for a large multinational like JPMorgan, because their assets are more geographically concentrated, and they might look at fewer sectors. So others in EDF have started talking to major agriculture banks, which face extreme risks from climate change. The difference there is that, in many instances, these regional banks aren't the ones financing new carbon intensive projects, so they're less important from a mitigation standpoint. But from an adaptation and resilience standpoint they're essential to address. There's work to be done. We just haven't embarked on that yet. I'll just add that the agriculture team at EDF just did work with finance sector partners to release a new type of bond for farmers that essentially incentivizes farmers to use sustainable practices in their farming. And they did work with agriculture banks to make that happen, so there is some of that going on. It sits at a different part of the organization. SC: So what are the biggest challenges when you work with banks that you found? GM: I think the biggest challenge has been getting banks to support climate-aligned public policy. Banks don’t want to jeopardize their relationships with clients. Though we’ve seen larger asset managers write investor letters to congress and to other elected officials on key policy topics like the EPA's methane regulations, we haven't seen banks take a similar step. I think the feedback we've gotten is that "If an investor writes a letter, that doesn't change much for them, because they don't have to manage this relationship with a portfolio company. For us if we write a letter supporting methane regulation perhaps we're going to lose business from some of our oil and gas clients." So they're more cautious on that front, and it can impede the pace of progress. SC: How do you think you could get past this conservatism that you're seeing in terms of banks relationships? GM: I think when some of the effects of climate change start manifesting in the performance of these companies and their ability to pay back loans, banks will be forced to acknowledge the risks posed by climate change and will naturally want to accelerate the work they're doing on the energy transition. You start to see some of that in small doses already, with extreme weather that we've witnessed in recent years, but even still for banks like the top five in the US that are so diversified, those events haven't yet made the same impact, but undoubtedly they will. The report a few years ago from the CFTC really made the point that climate change poses a systemic risk to the finance sector, both banks and asset managers. So in my opinion it's just a matter of time, and luckily banks are starting to move. They're doing way more now than they were a few years ago, dramatically so. SC: You've raised a lot of good points, which is at what point does it affect the bottom line of the banks? Is it going to take regulators' changes in capital requirements, risk scenario analysis? A lot of that has been done, but not necessarily implemented to a point where it will become a real thing. Do you think the banks realize that that is all or believe that that could be coming in their way? GM: I think they definitely do. They look across the pond and see Europe taking steps towards stronger regulation of the finance sector on climate change, whether it's the EU sustainable finance taxonomy or stress testing from the European central bank. I think they know that that's on the horizon here in the US, at least with the current administration, and I think it's probably too high of a risk for them to try to wait it out and bet on a new administration in 2024. So they're starting to prepare. It'll be crucial for an organization like EDF to really monitor how the banks weigh in on those topics, because they're they're putting forward these net zero plans now, and they're joining coalitions on climate, but it's very possible that their regulatory teams could be working to undermine enhanced regulation around stress testing. I think it's a safe assumption that these companies prefer as minimal red tape as possible, but when that regulation is actually in the long term going to help them manage climate risk, EDF would certainly hope that we see support from the banking community on that. SC: That's great to hear about that. Now let's switch a little bit to the asset manager side. There you're working with the asset managers, not the pension fund plan sponsors at the companies, but actually the companies that manage the assets. Is that the focus of your work? GM: That's right. SC: OK. So you're saying passive managers--so basically people who manage index funds like Vanguard and Fidelity with their huge passive S\&P 500 and similar types of indices. So obviously being an index fund, like you said they cannot just divest, because then they are then no longer an index fund. GM: Right. SC: So when they engage does that mean basically to vote on proxies? Does it mean more than that to actually have conversations with the company and their management in terms of what they're doing? Do index funds do that? GM: It does involve a lot of conversations. Actually I think certainly in the news it culminates with the proxy vote, but throughout the year these stewardship teams are having semi-regular conversations with companies of interest. What's typical is that a stewardship team will say "These companies are on our watch list because they fail to align with these stewardship principles that we've established as a firm, and for those companies on the watch list, there will be more frequent check-ins between the team and management than there would otherwise be." I think just by nature of the number of companies that any of these firms invest in, they just can't possibly meet with all of their management teams, so they're essentially just prioritizing: "These are the ones that are at risk. We think that esg issues are resulting in underperformance financially, and we want to intervene." SC: So again, what are they relying on to make those decisions for this? The disclosures from the company such as the CDP and TCFD? GM: Yes, so that's an area we're trying to address. So a lot of the information they're getting now is from ESG data providers--Sustainalytics, MSCI, Refinitiv basically--around greenhouse gas emissions, and any sort of plan that the company is released related to net zero. A lot of these databases will just aggregate the company's disclosures, and these stewardship teams are using those data subscriptions to determine which companies to watch. What EDF is trying to do, and we launched this new platform--it's free publicly--is [ESG by EDF](https://business.edf.org/esg-by-edf-actionable-insights-for-a-decarbonizing-world/). The motivation was that investors have all of this data through ESG platforms, they don't quite know what to do with it and they don't know which metrics matter. What we're trying to say as an environmental organization based on climate science policy and economics is that these are the metrics that you should focus on for carbon intensive sectors, and all of the other data that you're swimming in is largely noise. So let's make this a much more simple process and prioritize along these these key areas. So for oil and gas, as an example, we released a report in October on flaring in the oil and gas sector. It's a key climate risk. It's a big driver of methane emissions. You won't find flaring data in a refinitiv data set, so it's up to us as EDF to alert investors to other sources they can use to monitor flaring and raise it with companies as a priority ESG issue. SC: So this is a publicly available data information set that you're providing, ESG by EDF? GM: Yes, so it looks quite different from a data platform. It's not going company by company and saying here's how they're performing. It's a website that's more of an insights research platform where we have reports. We have shorter form analyses, so the flaring report was about 35 pages long, where it started off explaining flaring to investors, outlining why flaring presents financial risks for companies, and then highlighted about 20 companies that are oil majors, some independents, some national oil companies, and then rated them on flaring. So we couldn't cover every single company, but we just said these 20 are probably most important for you as an investor, and here's how they're performing. SC: So this is the data that you're providing to the asset managers, and then what's the response when they see an additional ESG or a climate data set like this in their decision-making process? GM: People have been quite receptive and enthusiastic. So far we've had a variety of conversations with investors helping them make best use of that report. One thing that was important to us and that will remain important is in the report providing about five questions already written that investment stewardship teams could pose to companies in that sector. That's, in our opinion, taking this whole process a step further and making it even more simple for these teams. So you're not just presented with the raw data, you're then translating that data into questions that stewardship teams can then use to monitor future progress. So really we found that when we hand our report over to investors and say "Oh, you're interested in this company. Here's how they're performing, and if you want to follow up maybe consider posing these questions." They're quite enthusiastic, because it just makes the process a lot more straightforward for them. SC: OK, so they present these questions to the companies, but the companies are part of the index. So ultimately they can't divest from the companies, so what is the company's response? Or what range of responses do you see from the companies? GM: It gets back to one of the big questions about whether and how this type of engagement can actually make meaningful change, because like you're saying companies that are part of an index are going to remain part of that index. So where's the leverage? I think the main point of leverage is in the ways that management teams essentially are influenced by share price. They don't want to see their share price go down. Their compensation is heavily tied to the performance of the stock, and if the stock underperforms, then they might not stay on as CEO. In the case of Board members, if you have enough investor pressure, then perhaps the Board member is going to get voted out by the investors. So they're trying to protect against that risk. So even though they feel confident that they'll remain part of the index for the foreseeable future, they still listen to investors, especially the big ones, quite closely. Back in 2017, no company was putting out a TCFD report because the TCFD was just being launched. Then in a matter of five years, hundreds of companies released TCFD reports. And why did they do that? Blackrock and others said explicitly we're going to vote against management teams that do not disclose to the TCFD, and we're going to keep engaging companies that don't disclose to TCFD. So all of a sudden you see the industry respond. SC: So what do you think of the whole Exxon proxy and how their additional directors? Do you think that's a positive trend, and is it in fact making a difference in what the company is doing? GM: It was an exciting inflection point to really understand the extent to which investors care about climate risk. I think it's too early to fully grasp what impact it's made, if any. Changing a company like EXXON is trying to make a U-turn with a massive cargo ship. It's just going to take a ton of time, and early results aren't stellar. Exxon just put out its net zero commitment, and that commitment did not include scope 3 emissions, it didn't include their non-operated assets, so they're still behind some of their european peers. But can we say that the Board vote was a complete failure? I just don't know yet. I think we need to give it a bit more time, because change at any organization of that size is just going to be slow. SC: Sure. So as they put out the net zero targets and goals, is that something that you're also monitoring and putting out your analysis on them? GM: Definitely. So my team hasn't put out a formal analysis of their commitment because they haven't yet released a plan. It was just a high level commitment, but the director of EDF's energy team was quoted in The New York Times analyzing the commitment, and EDF monitors those types of developments quite closely. SC: OK, and when these stewardship teams engage, are they one stewardship team that covers all the different funds at say a Blackrock, so it covers their index funds and their actively managed portfolios? GM: Yes, they're often breaking up these stewardship teams by sector similar to how you would have an analyst on a trading desk for example. So they'll have their oil and gas stewardship analysts and so on and so forth. SC: OK, so when that person meets with the company, he or she also represents the funds that could sell the shares and divest, so it's not always a "This is a nice meeting to have but you are always going to keep us around in your portfolio and everything" GM: Right. SC: What is your general feeling about the ESG funds and the ESG indices that have become very popular in the first place, and the ESG indices that are following along like some of the MSCI or S\&P PACTA index that are coming up? GM: It's a whole wild west right now. ESG means very different things for many financial products, and again there's the potential for regulation this year from the SEC. They've alluded to it. It's unclear when and if it will happen, but there needs to be more transparency around what ESG means as a label. I think that's less important for impact - you could call these funds whatever you want. What really matters is their underlying holdings. I think transparency is important for consumers, because ultimately a lot of the ETFs are being purchased by retail investors. If I'm just the average person trying to invest my 401k, I don't want to be misled by a product that I think is doing more than it is. That's where i think the labeling matters, and in that labeling process I don't think there's actually one specific way to do ESG. You could have an ESG fund that includes companies like BP and Shell because they're leaders in their sector relatively, and I think that's a valid argument to make. You have other funds like Engine No. 1's Vote ETF, which is looking at a wide range of companies, basically the S\&P 500, and just saying we're going to engage actively with all of these companies on ESG issues, and I think that's ESG. Then option three you have a portfolio that's all clean energy companies or all electric vehicle companies and that too is ESG. I think we don't need one concrete label that applies to every single thing. We just need to be more transparent about what we mean in those specific instances when we're claiming that something is ESG. SC: Have you at some point work with companies or the fund sponsors to switch to more ESG or climate aligned investing funds? Was that over something that you were doing? GM: So we have been and are still working with companies to encourage them to add more ESG or climate aligned products to their 401k retirement plans, and we ran into a regulatory barrier early on. We ended up focusing a lot of attention on regulatory change because the Trump administration introduced a rule that put a major chilling effect on companies. Nobody really wanted to go near ESG when it came to the 401k market. So we worked all of the Fall basically trying to encourage the Biden DOL to introduce new rules that thawed that chilling effect and made it clear that fiduciaries could consider ESG. Now the Biden administration already released their proposed rule. They're moving towards the final rule that will have a major effect, more of an effect than any direct engagement with companies could have, but we're still talking to them. We're still trying to just educate people about the space, because they are the bottleneck here. Employees want it, fund managers want to sell it, they just need to be added to the plans. SC: So what do you see as the biggest challenges for this route of going through the asset managers to get the companies to change or improve their climate performance? GM: I think it's just one tool in the toolkit, and so my team takes that route. If EDF as a whole were just looking at that strategy, our approach would be incomplete. But luckily EDF is working in parallel along a variety of tracks, so while my team's looking at asset manager engagement, there's a whole other branch of EDF that's doing policy advocacy, and there's a whole other set of teams at EDF that's engaging directly with companies on these issues. If we are just trying to rely on asset managers to drive this transition, we're not gonna get to where we need to be. I think we can use asset managers as a catalyst to encourage and accelerate corporate action in the absence of more ambitious climate policy, but I do think ultimately climate policy and regulation is the linchpin. We just don't have that right now, and in the meantime we need to make sure that asset managers are using the influence that they have on companies effectively. SC: There's been a debate: There are some people, even former people from the asset management field, have said that you absolutely need governments to step in, but others have said no it's better that the asset managers take the the lead. So i'm curious what makes you feel that ultimately asset managers cannot get this done? GM: I think that we're seeing in many instances, already, that absent effective policy, clean technology is not cost competitive with the carbon intensive alternative. They're not going to take the option that delivers lower returns, and in many instances they have a fiduciary obligation to take the path that delivers higher returns, so they're pigeon holed. That's why i think policy is essential. If you had a price on carbon, then all of a sudden, you would have a completely changed perspective in the asset management and investor community about what's valuable and what isn't, and what's risky and what isn't, because you would finally integrate the externalities of emissions into the valuation of these carbon intensive assets. That's just one example. There are others that are more sector specific. If we're actually trying to transition truck fleets across the US to electric trucks as opposed to diesel trucks, the total cost of ownership right now for long-haul trucking really depends on enhanced incentives from federal and state government in the intermediate term to balance out the cost of ownership. In the long term we'll see that electric trucks are the superior choice to diesel. But for now when we need to transition we need that policy catalyst, and asset managers can't input that, because of the incentives that are needed, and that's just not what they're designed to do. Investors are equipped to react to market trends and invest where they see strong risk adjusted returns, but what shapes those risk adjusted returns is the policy landscape to a large degree, and that's out of the investor's control. SC: So what are your key hot button or priorities as you move forward here? Are you focusing more on banks or more on asset managers? What are you trying to do in each of those fields to scale up? GM: There's work to be done on both fronts. One of our key projects this year that unites the two is this question of asset divestiture in the oil and gas sector. So BP sets a net zero target. To work towards that target, they start to sell off some of their carbon intensive assets, and ultimately those assets go to either other public companies with worse track records on climate or private companies with worse track records and worse disclosure, or national oil companies that have the same problem. So we're starting to see this transfer of emissions to other financial players that are going to be less effective environmental stewards than public companies like BP that have made ambitious commitments. Again this is a prime example where regulation could play a really strong role, is just a classic externality problem that governments are theoretically designed to address. But absent that we're trying to work with companies, asset managers, and banks to address this issue, so can we get a company like BP to commit to integrating methane standards and flaring standards into the contracts that it uses to structure transactions with prospective buyers, essentially requiring buyers to maintain certain levels of stewardship in order to take on the asset. And then where do investors and banks play a role? The banks are the ones advising these M\&A deals, and they can actually integrate some of these standards into the deals. They hold the key there to a large degree. Then asset managers are well positioned to drive disclosure around this. I think disclosure is what comes easiest for a lot of asset managers because they're just trying to collect more data, so they can say BP when you put out that annual report on your progress towards net zero, disclose not only the emissions you've reduced, but segment what percentage of that emissions reduction came from asset divestiture, because that's functionally different from lowering emissions through stewardship. SC: Yes. I think this is a real problem, because basically people are going to kick the emissions ball around and eventually it will find its way into a sovereign wealth fund or private equity-owned entity that will not respond to any public concerns or outside interests. I can see this is a very interesting problem because then the question is what is the role of these public markets and public investors? If we're all just here to trade the assets around without really acting like owners in some collective sense, then everybody will just say "Fine it's off my books, it's your problem." I've been reading a pretty interesting book about the whole private equity industry, about how they function and the roles of each of of the public markets. I'll send you some links--I've been putting together some stuff about the whole divestiture issue I'd like to get your feedback on. I'm seeing the similar issue with the multiples of these oil companies are just lower, and they're getting to a point, where especially I would imagine BP is selling off these assets, they're probably selling them a very attractive prices for a private equity buyer to pick them up and leverage with a bank that doesn't care and will do the business. GM: Yes, absolutely that's exactly the combination you want to avoid. SC: And is methane flaring something that you're actively working on, and is that something that you have a lot of conversations with investors about or with different companies? GM: Yes, that's probably the biggest focus for our team because we see that near-term emissions reduction opportunities in oil and gas. There are other questions that the sector needs to address around decommissioning and capital allocation towards renewables, but the near-term immediate opportunity is methane flaring, so that's where we're having a lot of conversations. SC: Great. Well this has been great. You're giving me a lot. I think I might want to follow up with you on some of these points and schedule another call, but you're giving me a lot of material. So let me get that organized first and send it to you. GM: Thanks so much. #### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). #### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Taking Action *If we could change ourselves, the tendencies in the world would also change. - Gandhi* With that inspirational thought, let's take a look at what we could each do to turn climate investing into climate action. ## Fund Managers Look for opportunities ## Plan Consultants Highlight hidden climate risks ## Plan Sponsors Adopt climate aligned benchmarks Monitor climate risks of investments and fund managers ## Beneficiaries Ask for climate aligned investments Monitor climate risks ## Individual Investors If you've ever envied those Big Shot Fund Managers, I hope my book has at least dispelled some of it. Unless you have some deep, unfulfilled need to be told how smart you are on a daily (hourly?) basis by salespeople, that is. The truth is, while big swinging trades and TV appearances might sound very glamorous, you have a kind of freedom that those who manage money for others will never have. As a sophisticated individual investor, you can play any or all of the roles listed above. You can get down in the haystack to search for opportunities like a fund manager, or come up to the sky and watch funds from above like a plan sponsor. You can do your own research, think your own thoughts, without being burdened by guidelines written by someone else (or someone else's parents or even grandparents. Yes, I've really seen guidelines that look that old.) ## Engaging with Companies Reduce climate risk Monitor results Group together They're your companies. Don't think of proxies as junk mail. * [Companies are under pressure on climate change and need to do more](https://www2.deloitte.com/us/en/insights/topics/strategy/impact-and-opportunities-of-climate-change-on-business.html) - Deloitte survey ## Final Thought Be patient -- climate will be big, but we have to work together. ### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). ### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # DeFI, Blockchains, and Climate *The ability to speculate on a cryptocurrency is insignificant next to the power of the Blockchain. - Darth Vader* Given all the bad press about the energy use and environmental consequences of cryptocurrencies and blockchains, you might be surprised to see a chapter on web3 and climate change. In reality, only a few cryptocurrencies such as Bitcoin and the Ethereum Mainnet still use the proof of work consensus algorithms that are slow, energy intensive, and release high Greenhouse Gas (GHG) emissions. As a whole, web3 and DeFi are moving away from proof of work for performance reasons: They are too slow. Meanwhile web3 is a lot more than just cryptocurrencies. Some see it as the solution to some of the hardest problems in climate change. Let’s start with one of those world changing, disrupt everything idea. ## Planet Crypto *Luke Skywalker: I feel the Force!* *Obi-Wan Kenobi: But you cannot control it!* There's been a disturbance in climate finance. The long obscure world of carbon offsets has collided with the red hot crypto universe. The new technorati are turning to offsets as no less than a way to overturn the existing economy and financial markets. They want to usher in a new world order of "regenerative finance" to heal (or, as they prefer, "unf\*ck") the planet. Their manifesto could be summed up as the following: * The existing economy, with its governments, financial markets, and Paris Agreement, will not be able to stop climate change. * To stop climate change, we need real financial incentives. * To create those financial incentives, let's start a cryptocurrency backed by carbon offsets. This varies from buying existing carbon offsets to commitments to buy carbon offsets from carbon direct removal projects. * Let's use all the tools of Decentralized Finance (DeFI) to draw in speculators, who'll ape (*v:* [*deploy large sums of capital with minimal diligence*](https://keepcool.co/klimadao-deepdive/)) and pump up the cryptocurrency. * Higher price for the cryptocurrency will lead to higher prices for offsets, which will finance more projects to unf\*ck the planet. Perhaps the best example of this today is the combination of the [BCT](https://docs.toucan.earth/protocol/introduction/defi-refi) and [KLIMA](https://www.klimadao.finance/) tokens. The BCT "bridges" the carbon offsets and the blockchain by retiring one ton of offsets in the Verra voluntary carbon offsets registry and then creating a fungible ERC20 token on the Polygon Ethereum Layer 2 network representing one ton of carbon.[\[1\]](#footnote-1)[\[2\]](#footnote-2) KLIMA then created a new cryptocurrency based on BCT and used staking rewards, where holders of the KLIMA could deposit them in the treasury to earn additional KLIMA tokens, to draw in buyers. With a discord channel of over 40,000 members, the KLIMA token traded as high as an $3,777.30. To true believers, this must be exactly the [Promise of Web3](https://mirror.xyz/0x26163318B9972E41A734602Fe00A5683D233613f): *...to be totally opposed to web3 necessitates a strong belief that the incumbent system is good enough, with USD as the global reserve currency, the Federal Reserve printing money at will, and Big Tech owning your data and original content. It’s not hard to speculate that most people who think they’re opposed to web3, are actually believers who just don’t know it yet.* *One of the great things about crypto is how it democratizes access to investments.* *In order to gain access to early stage startup investment deals in tech, you've traditionally been required to be accredited and connected in Silicon Valley. In theory, the only true barrier to entry in crypto should be awareness.* *When you envision a future where any human can easily invest any amount of any asset into anything or anyone at any time, the future of traditional investing begins to appear bleak indeed.* *Founders have many new ways to fundraise with less friction. This means more focus on ideation and execution of the business, with less schmoozing, building decks, and painstaking interaction with legacy financial systems.* *Web3 will lead to unprecedented value creation because it provides exponentially better methods for the appraisal and management of digital property.* Meanwhile, those of us in the old fashioned world of carbon offsets might notice a few interesting things: * Most of the carbon offsets used to back BCT and KLIMA are renewable energy offsets such as hydropower in China and Brazil (Source: [Toucan Monitoring Dashboard](https://colab.research.google.com/drive/1i1RM51WzPjccXnwgMjabwYHpRtQt39Ju?usp=sharing#scrollTo=aWYy5jxkRZlC)) * These offsets were trading with an average price of $1.1 as recently as September 2021. (Source: [Ecosystems Marketplace](https://www.ecosystemmarketplace.com/articles/press-release-voluntary-carbon-markets-rocket-in-2021-on-track-to-break-1b-for-first-time/)) * When the offsets are "retired" from the Verra registry, it means that they are used to offset the emissions footprint of the retiring party (retiree?) They should never be traded again and therefore have no value any more. Toucan Protocol, creators of the BCT token, acknowledges that it is a [one way bridge](https://docs.toucan.earth/protocol/bridge/carbon-bridge). * In other words, BCT tokens and anything based on it could only be considered assets by those who believe. They could never be converted back to offsets and traded in the existing offset markets. They're a one way ticket to Planet Crypto. * This isn't the first time (and won't be the last) we see a developing economy try to tap into short-term speculative capital with high interest rates. * Not is it the first time somebody has tried to [create a liquid asset from an illiquid one](https://www.oaktreecapital.com/docs/default-source/memos/2015-03-25-liquidity.pdf). ![Toucan Projects List](/files/bwVUMv9VmMBdqyEcPc0n) UPDATE: On May 25, 2022 VERRA issued an \[updated statement] (): *Verra will, effective immediately, prohibit the practice of creating instruments or tokens based on retired credits, on the basis that the act of retirement is widely understood to refer to the consumption of the credit’s environmental benefit. This announcement follows Verra’s statement on 25 November 2021 emphasizing that entities engaging in this activity do so entirely at their own risk.* This is the correct thing to do. Otherwise, anybody could retire some offsets on their registry, "bridge" them to a blockchain token, and claim their benefits at the same time. Verra could not possibly police all the blockchains and registries out there, especially since blockchains are psuedononymous. Some have asked if this is the death of web3 for climate. Far from it -- there are much bigger applications for web3. See below. You might look at all this and shake your head, "We've seen this all before." Or, as [Tim O'Reilly puts it](https://www.oreilly.com/radar/why-its-too-early-to-get-excited-about-web3/): *Repeat after me: neither venture capital investment nor easy access to risky, highly inflated assets predicts lasting success and impact for a particular company or technology.* *Cryptocurrencies may well be the future of finance, but at the moment it’s hard to see what’s really working, given how much smoke is being blown.* *The failure to think through and build interfaces to existing legal and commercial mechanisms is in stark contrast to previous generations of the web, which quickly became a digital shadow of everything in the physical world—people, objects, locations, businesses—with interconnections that made it easy to create economically valuable new services in the existing economy. The easy money to be made speculating on crypto assets seems to have distracted developers and investors from the hard work of building useful real-world services.* But if you think this is just a rerun of the dotcom boom, with discord channels replacing AOL chat rooms and cyrptocurrencies replacing AOL, CSCO, and YHOO, you might've missed an important detail. The dotcom boom of the late 90's was about technologies. People speculated on stocks which represented ownership interests in the companies and their technologies. Today's cryptocurrencies are not so much about the technology -- blockchains, smart contracts, and consensus mechanisms -- as they are about financial engineering and financial leverage. In that way, they're more similar to the junk bond/LBO boom of the 1980's and the conglomerate boom of the 1960's. If you read about letter stocks, zero coupon convertible bonds, and pay-in-kind bonds, you'd find eerie similarities to today's crypto tokenomics. So where do we go from here? It's easy to dismiss it as the worst excess of crypto speculation ($1.1 to $3,777.30 should set a record for "alchemy of finance" somewhere.) But isn't it more fun to speculate (ha ha) about what happens if this is the wave of the future? What happens if Revolutionaries of today won and became the Oligarchs of tomorrow? Will they horse trade like COP26, across all the DAO's that seem to be forming up daily on Discord to fund carbon offsets, carbon removals, regenerative agriculture? How will they meet the needs of speculators and short-term traders while working on a very long-term problem like climate change? Those interests are not naturally aligned. For example, to stop climate change, we need to ramp up the amount of carbon offsets/reductions/removals, but the value of any currency, crypto or otherwise, increases when there is less supply of it. Furthermore, the treasury behind any currency, crypto or otherwise, gains when it mints liabilities (tokens or currency) at a higher value than the reserve assets (in this case, offsets.) Unfortunately, there are plenty of low price offsets that could be created, even now, under approved standards and methodologies. They could boost the treasury and cryptocurrency values while having no positive or even negative climate impact. Finally, will the offset market really accept speculators? Developers would probably welcome higher prices but not volatility, which would make financing long-term projects more difficult for them. Buyers benefit from lower prices and would call foul if outsiders push up prices. Whatever happens, everybody will blame "financial players," especially the hated "speculators," who provide an easy excuse to discredit the whole system. Already we see this in the European Union's Emissions Trading Scheme (ETS): [Poland, Spain, and Czechia are protesting](https://www.euractiv.com/section/emissions-trading-scheme/news/europes-energy-price-hike-fuelled-by-speculators-spain-and-poland-say/) that financial players are driving up the cost of electricity and must be barred from the market. [Poland and Czechia have even called for suspension of the ETS.](https://www.euractiv.com/section/politics/short_news/czech-minister-would-support-polands-call-for-suspension-of-eu-ets/) Time will tell. Meanwhile the world continues to move forward. Web3 is a new set of technologies. Its effects are right now less obvious because it does not itself do something differently, but rather organizes the doing differently, sometimes radically so. If it could be linked to real world activities as Tim O'Reilly suggests, then it could unlock tremendous possibilities for climate action. Let's look at a few examples. ## Supply Chain Emissions Imagine you're a major corporation. You purchase products from all over the world, from suppliers who purchase parts from all over the world themselves. You want to reduce your emissions footprint. How do you know where to do it? Do you encourage your suppliers to switch to renewable energy or low carbon alternatives? Do you switch suppliers? Reconfigure your logistics networks? Now imagine you're a high emissions manufacturer, for example a steelmaker. Your products are sold all over the world, used to manufacture parts and products of all kinds, and then re-sold and re-shipped all over the world. You also want to reduce your emissions footprint. But is it worth it to make the massive capital investment needed? Would any of your customers pay for, or even care about, a lower carbon product from you? Amazingly, neither company could answer these basic questions right now, because we simply don't know where the emissions are through the vast global supply chains. Emissions footprints, when they are reported at all, are at the company level. Emissions reductions programs, where they exist, are at the national level. Since supply chains run multi-levels deep across the world, we quickly lose track of where the emissions are occurring. The best we could do is rely on lifecycle analysis database such as EcoInvent to give us estimates of the emissions for different products. As a result, companies don't know what their true emissions are. There's no incentive for suppliers to reduce emissions below the database averages, and every incentive for them to cut costs and make products with higher emissions than the averages. Where climate regulations exist, it's easy to hide them in the supply chain by moving production somewhere else. This is exactly why the European Union is considering the [Carbon Border Adjustment Mechanism](https://ec.europa.eu/taxation_customs/green-taxation-0/carbon-border-adjustment-mechanism_en) Solving this problem is not easy. Since supply chains span across borders, we cannot rely on the traditional government authorities to require audits and enforce limits. The blockchain, however, could solve this problem because it allows collaboration without a central authority. Members of a supply chain could use it to form a network to measure and reduce emissions: * A distributed ledger could hold immutable emissions records from members of the supply chain so that they could be available for audits. * Tokens for emissions footprints could be issued to supply chain partners for purchases and transportation as they happen, based on ERP data or invoices. * Smart contracts could set limits on total emissions for each member with penalties and rewards for higher or lower emissions, similar to a cap and trade scheme. We currently have a [Supply Chain Emissions Ledger Project](https://wiki.hyperledger.org/display/CASIG/Supply+Chain+Emissions+Ledger+Project) hosted under the umbrella of the Linux Foundation's Hyperledger open source project to implement some of these concepts. [Sign up](https://opentaps.org/subscribe/) to get updates about our work there. ## Ratings *Given enough eyeballs, all bugs are shallow. - Linus Torvalds* Quiz: Which of the following companies has the highest market capitalization? * Colgate-Palmolive * eBay * FedEx * General Motors * IBM * Lockheed * Marriott * Moderna * Standard & Poors Answer: Standard & Poors. If you've ever worked in the industry or read [The Big Short](https://amzn.to/3yt2bSs) by Michael Lewis, you'd be excused for thinking that S\&P and Moody's were the poor relations of Wall Street. But you're wrong. They are the Matrix of high finance. They are everywhere. They are all around you. If money makes the world go around, then information makes money go around. And now they're setting out to provide ratings for climate investing. It's too easy to criticize the ratings agencies and their much smaller cousins, the standards organizations of the voluntary carbon offsets market. When times are good, they're the bureaucratic gatekeepers who prevent access to capital. Everybody cheers startups that are "democratizing access." When times go bad, though, it's the rating agencies that are subject to [Congressional investigations](https://www.hsgac.senate.gov/imo/media/doc/PSI%20REPORT%20-%20Wall%20Street%20&%20the%20Financial%20Crisis-Anatomy%20of%20a%20Financial%20Collapse%20\(FINAL%205-10-11\).pdf). We take for granted the fact that credit ratings, by and large, do work: Lower rated companies are more likely to default. Overall, the ratings provide a way for investors to limit their risks and companies to raise capital. Yet when they fail, they fail spectacularly. The collective mis-rating of subprime mortgage securities led to the near collapse of the global financial system. A similar mistake with climate risks could lead to the collapse of a lot more. Even today, there is doubt about whether the ESG ratings are helping us with climate change, or if they are a [mirage](https://www.bloomberg.com/graphics/2021-what-is-esg-investing-msci-ratings-focus-on-corporate-bottom-line/), a [bubble](https://www.bloomberg.com/news/articles/2021-10-28/trillion-dollar-esg-boom-rings-bubble-trouble-alarm-in-new-study), or a [fantasy](https://www.institutionalinvestor.com/article/b1tkr826880fy2/The-Trillion-Dollar-Fantasy)? The problem with ratings lies in the system: * Ratings agencies develop methodologies, which are modified periodically. * Both the methodologies and ratings are produced by people with similar backgrounds using similar data. * They rely primarily on information from corporate issuers. * They are paid by the issuers to rate new issuances of securities. Most of the resources are therefore allocated to rating the issuance of securities. Follow-on monitoring of existing securities is underfunded. Further, negative opinions are naturally "controversial" and likely to elicit harsh blowback, so the analyst better be sure. The result is that all the major rating agencies usually assign about the same ratings and keep them relatively static over time. Only when there is drastic news do they go back to reassess those ratings, and then, when they are sure, it's a race to downgrade before defaults roll in. Seeing this, does it make sense why [Moody's](https://www.politico.com/f/?id=00000176-6343-df7e-a37f-f7d32a810000) would say the following about climate risk, which always seems to be far on the horizon? *our ability to forecast the impact of trends that will only unfold far into the future is necessarily limited. Nearer-term risks generally have a more direct impact on ratings because there is typically far greater certainty of their impact on credit profiles. As a general principle, as the time frame for a source of risk lengthens, the less certain we can be of its impact on an issuer’s cash-flow-generating ability and other credit metrics, and the less clarity we have regarding the importance of that risk in relation to other risks the issuer faces. For example, longer time frames give an issuer more time to adapt by lowering costs, adopting new technologies, or realigning its business model, budgetary spending or balance sheet to changed circumstances; however, some issuers may not be able to or may fail to take effective mitigating actions.* Is it also any wonder why [ESG ratings services would grade on a curve](https://www.bloomberg.com/graphics/2021-what-is-esg-investing-msci-ratings-focus-on-corporate-bottom-line/) relative to their peers and prefer to upgrade rather than downgrade companies' ESG ratings? This is where the Distributed Autonomous Organization (DAO), a relatively lesser known mechanism of the blockchain until recently, comes into play. A DAO is a way to organize collective decision making amongst otherwise unaffiliated members (hence "distributed.") Instead of a group of analysts working for a company, a DAO could allow anybody to play a role in setting a rating. The DAO could be algorithmically set up to protect both sensitive data from issuers and objectivity of the analysts and use tokens to distribute rewards and assign reputations. Think of it as a TripAdvisor model, but with more rigor. Such a DAO could introduce a broader, more diverse range of inputs. We do not have to wait for information to filter up to the ivory towers of the rating agencies through third party research reports or the issuers themselves. Instead, ground truths from observers close to the action could alert us to important changes sooner. We also do not have to rely solely on the handful of ratings agencies, who by employing similar analysts to produce similar ratings have become a single point of failure in the markets. As an example of a DAO, see the [DAO proposal](https://github.com/opentaps/open-climate-investing/tree/main/dao) for governing the development of this book and the related project. ## Better Offsets *You're going to find that many of the truths we cling to depend greatly on our own point of view. - Obi-Wan Kenobi* What does the offset market *really* need? In a [recent paper](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3981914) sponsored by the Linux Foundation's Hyperledger project, we found that the top concerns of the offset market participants were actually Quality, Cost, and Transparency: ![Top Concerns of Offset Market Participants - from Voluntary Carbon Offsets: An Empirical Market Study](/files/ytQzM48pwtxsk65FnZvC) The blockchain could address each of those in turn. First, Cost: Offsets are very expensive to issue. After all the fees, only about 30% of the price of the offsets actually go to the projects: ![Cost to Issue Offsets - Union Square Ventures Energy and Climate Market Map](/files/0GWimmi9S4bQKVFdODDX) A large part of these costs is the fees for auditors to validate and verify the project, including site visits, project documentation, and records of project activities. While obviously a critical step, it is also often a labor-intensive, paper and spreadsheet process today. The blockchain could significantly reduce these costs through "Digital Measurement, Reporting, and Verification (Digital MRV)" by automating the collection of data from many participants on a distributed ledger. Second, Transparency: At first blush it might be hard to see what the issue is. After all, the offset registries keep detailed records, and the data available is available on their websites or from sources such as the [Berkeley Carbon Trading Project](https://gspp.berkeley.edu/faculty-and-impact/centers/cepp/projects/berkeley-carbon-trading-project) and our [Open Offsets Directory](https://offsets.opentaps.org/). Indeed, [our paper](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3981914) found that this was a greater concern for regulators and government agencies than for the project developers and offset buyers. This is because the problem arises because there are so many carbon credits and offsets registries, both for government compliance programs and for voluntary offsets. If a project developer registered the same project on two registries, such as a government registry and a voluntary offset registry, it would be difficult to detect. This is the [double counting problem](https://keepcool.co/klimadao-deepdive/) that many crypto carbon projects have cited as a top concern for the offset market. This problem cannot be solved by just tokenizing the offsets from one registry, however, because that registry could not guarantee that the credits have not been issued elsewhere. It could only be solved by creating a meta-registry of carbon credits and offsets from *all* the registries, both government compliance and voluntary ones, so that the data is available for cross-checking. The [World Bank Climate Warehouse](https://www.worldbank.org/en/programs/climate-warehouse) is a project aiming to do just that with a blockchain that connects multiple carbon registries. It would support transfer of credits between registries, solving the tokenization versus retirement problem of the BCT token, as well as provide data for a global view of the carbon credits market. Finally, Quality: It must be disheartening to be an offset project developer. You do all the work, spend lots of money to get it verified, only to hear it disparaged. Not disparaged by climate deniers, but by the very environmentalists that should be your strongest supporters. Yet they do not hold back. [Project Drawdown](https://drawdown.org/news/insights/opinion-the-world-needs-better-climate-pledges) calls offsets "problematic," "dubious," a "shell game", and "imaginary." Greenpeace is more blunt: [Carbon Offsets are a Scam](https://www.greenpeace.org/international/story/50689/carbon-offsets-net-zero-greenwashing-scam/), "a bookkeeping trick" and "the next big thing in greenwashing" that "feigns compassion," "preys on fear," "takes advantage of uncertainty," and is driven by "Greed" - "Big Oil and corporate polluters want to keep putting profits over people and the planet." These critics raise some valid points, even if they offer no viable solution. First, there are many low quality, low cost projects which are available, and certainly some parties could buy them to make empty climate claims. At the heart of the problem is "Additionality," the requirement that a project could not have taken place without funding from the offsets. [Gold Standard explains why this is crucial](https://goldstandardhelp.freshdesk.com/support/solutions/articles/44001989691-what-does-additionality-mean-and-why-is-it-important-): *Additionality is a defining concept of carbon-offset projects. To qualify as a genuine carbon offset, the reductions achieved by a project need to be ‘additional’ to what would have happened if the project had not been carried out (e.g. continued as business-as-usual). For instance, if a project is viable in its own right, say through the sale of electricity, or because of government funding, regulation or other policies, then it cannot be used as an offset project as it would have been undertaken regardless of investment secured through carbon markets.* For example, let's consider renewable energy projects. At one point, renewable energy was more expensive than fossil fuel alternatives, and without carbon offsets or credits to support them, they would not have been deployed. But now, with the dramatic fall in renewable energy prices, they are economically competitive against alternatives and do not need carbon offsets to support them: ![Renewable Energy Prices - IRENA](/files/z3BuIeVpjATywFZdHZXd) So what happens if we *still* issue carbon credits for renewable energy projects? To a project developer, it is simply free money. It doesn't matter how much those credits sell for. They would be happy to issue as much as they could and pocket whatever is left over after issuance costs. This, however, would also create exactly the type of low quality, low cost credits that the environmentalist groups are citing. In early 2021, both the Gold Standard and VERRA changed their methodologies for carbon credits to severely limit the carbon credits from renewable energy projects. The markets were already ahead of them -- prices for those credits were below $1 per ton. Yet other carbon standards continue to issue credits from the same renewable energy projects. Nor is the problem restricted to renewable energy -- similar arguments could be made about monoculture commercial forestry and other types of projects. As an example of how serious this problem is, a [paper from 2016 entitled "How Additional is the CDM?"](https://ec.europa.eu/clima/system/files/2017-04/clean_dev_mechanism_en.pdf) found that " 85% of the covered projects and 73% of the potential CER supply have a low likelihood of ensuring environmental integrity (i.e. ensuring that emission reductions are additional and not over-estimated). " But does that mean we should reject voluntary offsets altogether? They are a form of carbon credits, and carbon credits themselves are not going away. Cap and trade has been an established mechanism for pollution reduction since the 1990's sulfur dioxide regulations. Carbon credits were affirmed by COP26 in 2021 and are used in climate programs all over the world to reduce GHG emissions, including Europe, California, and now China. If the voluntary offsets market went away, we'd be left with just government compliance programs, which support a much smaller scope of project types and are even less responsive to criticisms about their validity. Is that really better? Second, trying to offset emissions without reducing them in the first place is a race that we could never win. We must decarbonize first and use offsets only as a complement. Some industries, such as commercial buildings and cloud computing, including blockchains, could already decarbonize economically by switching to renewable energy. They should not use offsets. Other industries, such as airlines, heavy transportation, steel, and cement, do not have large scale direct decarbonization options right now. Carbon credits could be a way to fund decarbonization or an interim measure until viable decarbonization options are available. Government compliance programs are set up with this in mind, with the permitted allowance of baseline emissions credits falling over time as industries decarbonize. The voluntary offsets market needs a similar mechanism. [CORSIA](https://www.icao.int/environmental-protection/CORSIA/Pages/default.aspx), for example, promotes both [eligible carbon offsets](https://www.icao.int/environmental-protection/CORSIA/Pages/CORSIA-Emissions-Units.aspx) and [sustainable aviation fuels](https://www.icao.int/environmental-protection/pages/SAF.aspx). Although critics argue that [the combination does not work well together](https://theicct.org/icaos-corsia-scheme-provides-a-weak-nudge-for-in-sector-carbon-reductions/), it is at least a step in the right direction and an example for other industries. Could we envision a DAO which incorporates a broad range of participants, from industry to project developers to environmentalists and the general public, to select the right mix of carbon offsets that could be used to complement decarbonization? ## Parting Thoughts Blockchain is nothing but a mechanism for collaboration, but what kind of collaboration will we have? Will it be increasingly fractured islands, each espousing their versions of the truth and backed by their own economic interests, be it a cryptocurrency, an existing industry, or government? Or could it knit all the diverse groups together to work on climate change, the ultimate long-term global challenge? Time will tell. ## Footnote 1 There are in fact several steps: The [Carbon Bridge](https://docs.toucan.earth/protocol/bridge/carbon-bridge) of Toucan brings carbon credits to the blockchain. First, they create a BatchNFT of the bridged carbon credits. Once approved, the BatchNFT can be converted into fungible TCO2 Toucan carbon credits. TCO2 token contracts still carry all the attributes and metadata of the NFT, making them specific to a given project and vintage. [Carbon Pools](https://docs.toucan.earth/protocol/pool/pools) turn the TCO2 tokens into a more liquid index token like BCT with each pool having its own gating attributes. As for BCT reference pool, the attributes are "Verra VCUs" and vintage of 2008 or greater. ## Footnote 2 By using a Layer 2 Ethereum network, they're at least avoiding the high energy usage and related carbon emissions that cryptocurrencies have become infamous for. ### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). ### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Carbon as an Asset Ever wonder who would play you in a movie? Unfortunately, Hollywood has been unkind to the financial whiz these days. Just look at Mr. Big. If finance is what you do, then you're a big short. But what if you were actually using finance to save the world? What if, instead of financing shopping malls, you financed wildlife habitats? Instead of structuring buyouts, you structured deals to fix climate change? A [recent report from McKinsey](https://www.mckinsey.com/~/media/mckinsey/business%20functions/sustainability/our%20insights/putting%20carbon%20markets%20to%20work%20on%20the%20path%20to%20net%20zero/putting-carbon-markets-to-work-on-the-path-to-net-zero.pdf) says that this might even be possible. This chart alone is already enough for some venture capitalists to open their wallets. We might one day call it "the chart that launched a thousand startups": ![Projected Growth of Voluntary Carbon Markets, McKinsey & Co.](/files/nc29vChz6jWUlzDwf9WE) But is it real? Part of it depends on what "Commitments" means. Are they commitments to buy voluntary carbon offsets? Net zero commitments from companies which could be fulfilled by voluntary carbon offsets or by compliance carbon credits? Commitments which must be fulfilled by voluntary carbon offsets because alternative decarbonization options are not available? [I've asked McKinsey](https://twitter.com/opentaps/status/1494439046327668737)--hopefully they'll write back and let us know. Meanwhile let's look at what kind of an asset carbon *might* be, and what it *might not* be. Note this chapter is about project investing, not venture capital investing: We're not going to talk about how to evaluate novel technologies, but rather investing in the output of those technologies. ## What are Carbon Assets? With sustainability and green being slapped on every old thing these days, let's first narrow down what a carbon asset is. For our purposes, let's define a **Carbon Asset** as a quantified, exclusive, and unused traceable claims of climate benefit, such as a reduction or removal of Greenhouse Gas (GHG) emissions. This means to be considered a carbon asset, it must be: * a Climate Benefit: While Social Development Goals (SDG's) and biodiversity are important, there are a lot of compliance carbon markets that don't require any other attributes. To be consistent, then, we should restrict ourselves to just the climate aspect of these. * Quantified: It must be quantified in units such as tons of CO2 equivalents. This would exclude all sorts of activities, products, and services which may be better for the environment but which do not have a specific measurement of climate benefit and therefore cannot be valued or traded. * Exclusive: This is a requirement for being an asset. While a climate positive activity benefits all of us, it could only be considered an asset if only one party could claim it against their account of Greenhouse Gas (GHG) emissions. You can own it collectively as a shareholder, or the government can claim it as state property, but being an asset means somebody owns it while others do not, so that it can be valued and traded. * Unused: This claim must not have already been used in anyone's emissions account. If a carbon credit has already been retired, than it has been consumed and is no longer an asset. * Tradeable: Finally, this means a claim which could be bought, sold, or traded for other assets, rather than a climate claim which is an attribute of another asset but could not be separated from it. For example, the LEED certification of a building could be an "asset" to the building, but it is not an asset that could be separated from the building and traded on its own. While most carbon assets today are verified by an external auditor, this may not always be a firm requirement. For example, utilities' energy efficiency programs are often based on model or calculated energy savings, rather than actual data. Two out of four options (A and B) of the [International Performance Measurement and Verification Protocol (IPMVP)](https://www.nrel.gov/docs/fy02osti/31505.pdf) allow energy savings to be calculated based on model data (A) or model plus some instrument readings (B). If cities or utility regulators were to institute a compliance carbon credit program that included utility energy efficiency programs, then those carbon credits would probably not require verification. **Investing in a carbon asset** is then the exchange of money for a stream of carbon assets. It could be the purchase of equipment to reduce or remove emissions from the atmosphere, to plant new trees or restore a forest, and, as you'll see, lots of other activities. A carbon asset could have a lifecycle that involves many activities, such as capture, transport, and storage of the GHG emissions. The buyer of the carbon asset pays for "permanent" removal or reduction of GHG emissions, and the payments are split between the activities of the carbon lifecycle. Carbon assets are usually thought of as credits, since they could be used as a credit against your GHG emissions or your tax bill from those emissions. For the rest of this chapter, we'll use "carbon asset" and "carbon credit" interchangeably. ## How do Carbon Markets Work? There are three major kinds of markets for carbon credits: voluntary, compliance, and industry. Voluntary carbon credits are certified by entities such as The Gold Standard, VERRA, Plan Vivo, Climate Action Reserve, and Global Carbon Council, among others. They establish methodologies and certification processes, review projects, and issue the credits. The keyword here is "voluntary": The offsets are not required by any regulatory entity, and so they are for use as you'd like. Concerned about the climate impact of your wedding or trip to space? Buy some offsets and retire them in your name. Want to tell your customers you're a sustainable brand? Buy some offsets and put it on your website. The great thing about voluntary offsets is that they support a large set of potential project types, developers, and users all over the world (see [our paper](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3981914) for a breakdown of the market.) The downside is that the market is very small (it just recently surpassed $1 billion in **annual** volume) and the prices low. The compliance market is the opposite. They are run by government agencies, usually as part of cap and trade emissions reductions programs, and companies are required to buy credits when their emissions are over the allowed amounts. As government programs usually go, they are politically negotiated, target only the largest companies in key sectors, allow only certain types of emissions reduction or removal projects, and have rules and enforcements that may seem arbitrary to anybody outside the bureaucracy. The best example is the European Union's Emissions Trading Scheme (ETS), which is a GHG emissions cap and trade program in all 27 EU countries plus Liechtenstein and Norway. It covers major GHG emissions sectors including electricity and heat generation, heavy industrial manufacturing, and commercial aviation, for a total of about 40% of total emissions in the EU. It has [legal requirements](https://ec.europa.eu/clima/eu-action/eu-emissions-trading-system-eu-ets/monitoring-reporting-and-verification-eu-ets-emissions_en) for monitoring and reporting as well as accredited auditors. At $200 billion per year, it is the largest carbon market in the world. But it is not the only one. China launched its emissions program in 2021, focusing initially only the power generation sector and using emissions intensity rather than absolute emissions as its metric. A bevy of other national, state, and regional compliance carbon markets such as California Air Resource Board's cap and trade program exist all over the world. As a result, the price of carbon varies widely from country to country: ![Carbon Prices around the World - citizensclimatelobby.org](/files/P2OiZ1Bc53Jom3q9Xk1K) Finally, some industries are organizing carbon markets of their own. The best example is the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA), a consortium organized by the UN's International Civil Aviation Organization (ICAO). CORSIA covers international flights of most major international airlines (except India and China) and mandates measurement of total emissions, reducing emissions through efficiency improvements, and offsetting. It publishes a [list of eligible voluntary carbon credits](https://www.icao.int/environmental-protection/CORSIA/Pages/CORSIA-Emissions-Units.aspx) that could be used. A key motivation for CORSIA was that international flights did not fall into any particular country's emissions account and therefore their Paris Agreement obligations. Since many supply chains also span multiple countries, other industries may follow suit with carbon markets as multinationals try to manage their emissions and climate risks. A subtle but important difference between voluntary offsets and compliance carbon credits: Voluntary offsets are based on the concept of additional emissions reductions or removals. To be a valid offset, the project must've not been possible without funding from the offsets, and the amount of offsets issued must be additional to a business-as-usual baseline. Compliance credits are based on actual emissions versus either an absolute amount cap or an amount calculated from output multiplied by the carbon intensity of production. You pay if you're above your cap. It's that simple (well, no, nothing with a government regulator is ever simple, but ...) As a result, for example, renewable energy projects may not qualify as valid voluntary carbon offsets because the low cost of wind and solar have made them the most economical choice, but they would qualify for compliance credits if they lower your regulatory emissions account. ## Investing in Carbon Assets *It's easy to do the math but hard to do the work. - Anonymous* With the basics out of the way, let's look at investing in a carbon asset project. Remember when you invest, you're handing out cash for a promised stream of future claims denominated in units of CO2e emissions, then looking to sell those claims for cash again. Every step of the way involves uncertainty. Except the part with you handing out the cash. ### Promises, Promises, Promises *This is very basic stuff. Feel free to skip this part if you've ever tried to collect on a bad loan.* The first thing you should think about is whether the investment is debt or equity. Debt is a loan. Equity is ownership. Debt has promised regular payments, but no upside above them. The other party just has to make those payments to you. Equity investments have no promised regular payments, but all the upside. You own it! As long as it keeps producing income, it should be all yours. The flip side is that debt must be paid back before equity investors get anything, so if things don't go well, their claims take precedence before the equity investors. Or so in theory. The reality is, when you're ready to write the check, everybody promises you all sorts of protection. But when the borrowers don't pay, the lenders are always the bad guys. (Trust me -- I was a mortgage portfolio manager.) For example, let's say your investment is a loan backed by solar panels. In theory, if you don't get paid, you could get the solar panels back to install at another customer's site or just sell them. In reality, could you really turn off a customer's electricity, then go and physically remove the panels? Or would doing so violate public safety and threaten basic livelihoods? Or simply be so expensive legally as not to be worthwhile? If so, then even though your loan is theoretically secured by a hard asset (solar panels), in reality it's not -- it's just another unsecured loan backed by a signature. Or, let's say your investment is a solar or wind farm where a local utility buys the energy from you. Then the utility goes bankrupt and stops paying. Would the local government make you pay for the operations and maintenance expenses to keep the power on, while the courts figure out how much you'll get paid, and when you'll get it? Finally, debt often relies on the kindness of strangers. You'll need them to make a new loan at a later date so you could get paid back. We call this "rollover" risk. It happens because the projects themselves are very long-term, but term-matched funding is either not available, or borrowing for shorter terms is just less expensive. Will those kind strangers always be there? If it's an established asset class with a long history of financings, most likely. If not, who knows? Moral of the story: Don't let promises lull you into a false sense of safety. ### Technology Risk OK, I lied. Even though this chapter is not about venture capital investing, you're still going to have to evaluate some novel technologies. The fact is, our understanding climate and nature are relatively immature and changing. We've been burning large amounts of coal since the 1700's, but it wasn't until the 1960's that scientists started to realize what that could do (ie, cause climate change.) Sixty years later, we're still learning. This means that our attempts to capture or manage GHG emissions is just today's best estimate. How well each of the following would actually work as the climate itself is changing remains to be seen: * Solar: Could a warming planet cause more cloudy days and reduce the output from solar panels? ([Princeton](https://www.princeton.edu/news/2020/10/07/climate-change-could-mean-fewer-sunny-days-hot-regions-banking-solar-power)) * Wind: How would climate change affect the amount of wind available for wind power? ([Harvard](https://www.seas.harvard.edu/news/2021/03/less-wind-due-climate-change-wont-impact-wind-power-generation-india-and-china), [Nature](https://www.nature.com/articles/s43017-020-0101-7)) * Hydropower: Do hydropower projects actually contribute to climate change by releasing methane? ([Science.org](https://www.science.org/content/article/hundreds-new-dams-could-mean-trouble-our-climate), [TheGuardian](https://www.theguardian.com/global-development/2016/nov/14/hydroelectric-dams-emit-billion-tonnes-greenhouse-gas-methane-study-climate-change)) * Mangrove forests: Will mangrove forests survive climate change and the related storms? (See [TheConversation](https://theconversation.com/extreme-weather-likely-behind-worst-recorded-mangrove-dieback-in-northern-australia-71880), [NPR](https://www.npr.org/2020/09/11/912045029/climate-change-may-wipe-out-large-mangrove-forests-new-research-suggests), [NASA](https://svs.gsfc.nasa.gov/13885)) * Forestry: How much do forests really help cool the climate? ([Nature](https://www.nature.com/articles/d41586-019-00122-z) As the planet warms, would terrestrial forests release more carbon than they absorb? ([InsideClimateNews](https://insideclimatenews.org/news/13012021/forests-heat-climate-change/)) Is this already happening in the Amazonia? ([Nature](https://www.nature.com/articles/s41586-021-03629-6), [LiveScience](https://www.livescience.com/amazon-rainforest-accelerate-climate-change.html)) Is it already happening here in California, where climate change induced droughts are causing wild fires and burning down forests behind carbon credits? [BioRXiv](https://www.biorxiv.org/content/10.1101/2022.04.27.488938v1.full) * Soil carbon: Could we actually be wrong about whether soil really sequesters carbon, or how much or how permanent the sequestration is? ([Quanta](https://www.quantamagazine.org/a-soil-science-revolution-upends-plans-to-fight-climate-change-20210727/), [Nature](https://www.nature.com/articles/s41586-021-03306-8.epdf)) As an example, take a look at [this article about Running Tide](https://www.technologyreview.com/2022/06/16/1053758/running-tide-seaweed-kelp-scientist-departures-ecological-concerns-climate-carbon-removal/), which is trying to develop technologies to capture carbon from the atmosphere using kelp. Would you invest in this company? ### Regulatory Risk Or does it really matter? The answer is it depends. Concerns about the quality of the credits eventually drive the prices, but in different ways. In the voluntary offsets market, participants react like in most markets -- If bad news pile up, prices fall (remembering that it is a very small and fractured market.) For example, renewable energy projects have traded to less than $1 per ton CO2e because participants no longer believe they are additional. The problem with voluntary carbon offsets is that the market is traded over the counter and fairly illiquid, so you may not have a chance to adjust your position in time. In compliance markets, the regulators may change the rules after criticism, such as [concerns about too many free credits under the EU ETS](https://www.eca.europa.eu/en/Pages/DocItem.aspx?did=54392) leading to [potential rule changes](https://www.euractiv.com/section/emissions-trading-scheme/news/leaked-the-eus-carbon-market-reform-proposal/). This is a slow, political process similar to rezoning. If the market is driven by end user compliance demand rather than trading, then there would probably be time to react. But when the change happens, as it did with the CDM (see below), the effect could be dramatic. Meanwhile, remember that carbon assets directly affect critical parts of the economy, such as food, water, and energy. So whether you think climate change is the most important challenge of our lifetime or free enterprise is the pillar of a free society, jobs and livelihoods will usually take precedence. Therefore, carbon markets will always be highly controlled by governments, and your investments will always live under the shadow of that control. For example, climate activists and investors may both want higher carbon prices. But most industries view carbon cap and trade, and therefore the need to buy carbon credits, as a tax. Therefore, even if they're willing to participate and pay that tax for the long-term good of the society and their business, they will not accept outsiders driving up the prices of carbon credits for financial gain. Everybody hates speculators whose greed cause unemployment, higher heating bills for the elderly, or losses for small businesses. The runup in EU ETS carbon credit prices has already provoked a backlash: [Poland, Spain, and Czechia are protesting](https://www.euractiv.com/section/emissions-trading-scheme/news/europes-energy-price-hike-fuelled-by-speculators-spain-and-poland-say/) that financial players are driving up the cost of electricity and must be barred from the market. [Poland and Czechia have even called for suspension of the ETS.](https://www.euractiv.com/section/politics/short_news/czech-minister-would-support-polands-call-for-suspension-of-eu-ets/) Or consider changes in land use due to production of sustainable biofuels or forestry carbon offsets. Maybe good for climate, but if it happens at the expense of land for food production, expect backlash like this: ![Food or SUV? from vanhsieh71442.wixsite.com/fuel-the-world/socialimpact](/files/t5rhlLYlyGdKPtZlMqA0) It probably wouldn't help much to say that the land was in fact being used for a forestry project, which then offset the emissions of your SUV. ## An Asset to Your Country Let's say you've funded a project. They go to file for a permit or tax credit. They're routed to the environment ministry or agency. The helpful official reads through the project description and says "This is great! This is exactly what our country and the world needs. You're approved!" They enter your project into their carbon registry, which is the connected to all the other carbon registries in the world through a system like the [World Bank Climate Warehouse](https://www.theclimatewarehouse.org/about). Guess what? Your carbon credits have just been nationalized. They really became an asset to their country. How is this possible? In just about every country, you need a permit for land use change or energy projects, which also requires environmental review. Many countries also offer conservation tax credits, which could help pay for carbon projects but also require official review and registration. Meanwhile, the Paris Agreement has specified that each national government will make National Defined Contributions (NDC's) on climate change. Countries which exceed their NDC goals could trade the excess to another country under Internationally Transferred Mitigation Outcomes (ITMO's.) These are country-to-country transfers under bilateral trade agreements.([Source](https://www.ndcs.undp.org/content/dam/LECB/docs/pubs-tools-facts/undp-ndcsp-faqs-itmo-article6.pdf?download)) Some countries will need to claim every bit of climate action to meet their NDC's. Other countries may view the ITMO's are a source of ready money if they could exceed their NDC's. Brazil surprised the world by supporting international carbon markets under Article 6 at COP26 in Glasgow. Now it's planning to become a [major exporter of carbon credits](https://www.iccbrasil.org/cop26-icc-brasil-launches-the-english-version-of-report-opportunities-for-brazil-in-carbon-markets/) of up to $100 billion by 2030. ### The Other Usual Risks At the risk of becoming a prospectus filled with pages of warnings nobody seems to read, here are the usual risks of any project finance deals you *should* be aware of: Term matching: Are the prices for the carbon assets locked in for the life of your project, or will you get the market price over time? If the latter, how will it change? Market risk: During the pilot phase, there are philanthropic funders who will pay to help new technologies get off the ground. But to scale up for mass adoption, the technology will have to tap into the next tier of buyers, who may not be so generous. For example, today people are willing to $200 or more per ton for pilots of direct air capture. People are also willing to pay up for nature-based solutions with a lot of co-benefits for the local communities. But both are small. If these projects are going to scale up, they'll have to tap into compliance markets, where carbon is just carbon. They'll have to be priced competitively versus the cheapest credits available in those markets--and those could be very cheap (see below.) Obsolescence risk: This is the opposite to market risk. Certain types of carbon credits have fallen out of favor and lost value over time. For example, renewable energy was a dominant part of the market, but the falling prices of renewables have made carbon credits unnecessary for supporting them. As a result, existing carbon credits from projects issued years ago have fallen in value. Are they any less valid now that new renewable energy projects are no longer eligible for carbon credits? Technically, no -- the contracts are valid for the term of the credits. But that's small consolation if your credits are falling in value. Currency risk: In case the project is in another country. Liquidity risk: If these are long term projects, will you be able to sell your interest in the project if you need the money for something else? If you are planning to finance them, how will your lender appraise your project? Could there be additional capital requirements from your lender? Counterparty risk: How likely are the project developers to develop the promised carbon assets? How likely are the buyers to purchase the carbon assets they've promised to buy? What happens if either side fails to do as promised? Basis risk: If you're thinking about using carbon assets to hedge your stocks' climate risk, don't. There is no correlation -- for example, [our paper](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3967613) found no correlation between the European Union Allowances (EUA) futures for GHG emissions rights and the stock market. ## How Carbon Markets *Really* Work Now comes the million (billion?) dollar question: What will your credits be worth? To help answer that, let's take a look at how some major carbon markets have played out over time. ### Renewable Energy First the success story. Renewable energy, such as wind and solar, have been around for a long time. Medieval windmills dot the scenic Low Countries of Europe, while NASA's Skylab featured prominent solar panels back in the 1970's. Neither was a significant source of energy, though, until the oil crisis of the 1970's followed by the environmental concerns about burning coal and then climate change prompted major government investment in R\&D and policies such as the Renewable Portfolio Standards (RPS). Together they created a boom in demand for renewable energy which led to manufacturing efficiencies and falling costs. From 2009 to 2019, the cost of solar energy declined an astonishing 89%: ![Cost of Renewable Energy vs Other Sources - Kottke.org, OurWorldInData.org](/files/pPrQVW2SUGKpkXM0iKkZ) This now makes solar and wind the least expensive sources of energy available (when the sun shines and the wind blows, that is. Storage for the rest of the time remains a big technological hurdle.) So what happened to carbon assets based on renewable energy? In the 2000's, when renewable energy was expensive, they were purchased as part of government mandated programs such as the RPS. Buyers supported the market by entering into long-term offtaker agreements at premium prices. Meanwhile, two types of virtual certificates were available to help funnel investment in renewable energy. One was the Energy Attribute Certificate (EAC's), also known as Renewable Energy Certificates (REC's) in the US. EAC/REC's simply attested that energy was generated from renewable sources, and they transferred the renewable or green attribute of a commodity, electricity, to buyers who needed that attribute. They were mostly bought by utilities to meet their RPS mandates. Through EAC/REC's, buyers who were willing to pay the green premium for renewable energy were essentially pooling their purchases to reach the amounts required for actual plants and facilities. The other virtual mechanism was carbon offsets, which is a more direct carbon asset based on the emissions reduction of renewable energy versus standard grid electricity. The [Clean Development Mechanism's ACM0002 methodology](https://cdm.unfccc.int/methodologies/DB/XP2LKUSA61DKUQC0PIWPGWDN8ED5PG) was adopted by the voluntary carbon offsets standards organizations such as Verra and Gold Standard to issue carbon offsets based on renewable energy. A key requirement was that renewable energy projects would not be economically viable on their own, so carbon offsets were "additional" in their emissions reduction. By mid decade of 2010's, the prices of renewable energy had fallen so much that they were in fact economically viable, but carbon offsets could still be issued based on the rules of the time. As a result, they were basically free money for project developers, and there was a boom in renewable energy-based offsets. They became the dominant sector of carbon offsets. Prices fell as a result of supply and as buyers began to recognize that the projects were not truly additional any more, falling to as low as $1 per ton CO2e by 2021. Finally in 2021 the Verra and Gold Standard both revised their rules to exclude grid-connected renewable energy projects from their carbon offsets standards. They now require projects to be either non-grid connected or to be in very low income countries. However, other standards will still certify these types of projects, and therefore they are still issued and accepted into programs such as CORSIA. This has held down the general price of voluntary carbon offsets, since cheap large scale renewable energy projects are a plentiful source of "cheapest to deliver" offsets. There was a similar fall in the prices of EAC/REC's, as plentiful renewable generation during peak hours led to a flood of certificates being issued. While some RPS programs still accept them, others are tightening up to require that the certificates be matched to the time and grid location of generation, so that they actually account for energy at a time that was needed. Initiatives such as [Google's 24/7 Carbon Free Energy](https://sustainability.google/progress/energy/) and [EnergyTag](https://www.energytag.org/) are examples of how the industry is becoming more sophisticated in its use of EAC/REC's. ![The Duck Curve - Overgeneration of Solar Energy - CAISO/DOE](/files/txDCT7RtdW67zC6n7Bzp) Finally, the renewable energy as a sector continues to grow, but because they are now an economically competitive asset, the market is also changing. As renewable energy goes from being the most expensive to the least expensive source of energy, project owners could now afford to take the risks of owning the assets and supplying energy at whatever prices the market will bear, knowing that they have a cost advantage versus the alternatives. The industry is starting to shift to "merchant power agreements," where project owners are selling energy on shorter contracts or even at spot prices. So what can we learn from this little history lesson? * Offsets were a "bridge" measure for projects while they are not economically viable on their own. If the technology scales successfully, then offsets will need to go away. If the technology does not scale successfully, then well... * Attribute certificates will always be around to differentiate green commodities. As green commodities saturate some parts of the market, the market will become more sophisticated over time and try to find the remaining parts where green commodities are still scarce and valuable. This will lead to ever more complex attributes certificates to help find those green commodities. * While new technologies or project types could find support in the voluntary markets, which offer a greater variety and more flexibility, compliance markets are much, much bigger and will provide the scale. * Both voluntary and compliance programs are slow to move, creating long windows of opportunities. * In the early days, there will be advantageous terms and high prices paid for new projects, thanks to government policies and general goodwill. To scale, though, prices for carbon assets must come down significantly to be competitive. * Because of this, new and novel technologies could try to get premium prices based on differentiation, but large scale technologies will need to trade as commodities where "a ton of carbon is a ton of carbon." ### The Clean Development Mechanism Now the most famous failure of carbon markets. In 1997, negotiations for the Kyoto Protocol at COP3 were not [going well](https://www.brookings.edu/research/salvaging-the-kyoto-climate-change-negotiations/). The EU wanted aggressive emissions reductions targets. The US was tentative on even moderate emissions reductions targets. The developing countries wanted no restrictions on their economic development. So the Clean Development Mechanism (CDM) was created to at least start taking steps to reduce emissions. The EU and Japan committed to reducing emissions (the US never did sign on) but would allow companies to purchase credits from developing countries to meet their targets. It was supposed to be a win-win that provided development capital for green projects in developing countries while lowering the cost for companies in developed economies. For a while it worked. During the first commitment period of the CDM (2008 to 2012), 6,600 projects were registered under the CDM for 1.2 billion tons of CO2 equivalent credits, called "certified emissions reductions" or CER's. A small amount but respectable. Meanwhile prices were as high as 25 Euros per ton CO2e in 2008 and eventually settled to around 10 Euros per ton by 2012. Then EU abandoned the CDM, and the market crashed. In 2012, the EU voted to no longer accept CDM credits in its emissions trading scheme. Prices for CDM credits fell to 0.50 Euros per ton. There was a rush to register new projects before the EU's deadline for accepting for CDM credits, and afterwards volume dropped to practically nothing: ![Monthly Number of CDM Projects Registered - Wikipedia, UNFCC](/files/7qwtKhgbIGFhtQ55Qmxs) [As one CDM Executive Board member recalled](https://voxeu.org/article/collapse-clean-development-mechanism): *The atmosphere at the first meeting of the CDM Executive Board in 2013 was combative as if it were a gathering of distressed creditors of a failed company. Executives from developing countries directed harsh criticisms at the EU and Japan. ... Although we avoided using the term ‘liquidation’ as requested by executives representing developing countries, the board decided to go ahead with the de facto liquidation of the CDM scheme. ... Fed up with the scheme’s dismal prospects, many executives left the Executive Board.* Why did the EU stop accepting CDM projects? From the environmentalists' point of view, the CDM credits were simply not credible: * Credits for destroying HFC-23, a refrigerant with very high global warming potential, were actually creating an adverse incentive to produce more HFC-22 refrigerants just to earn credits. ([CarbonMarketWatch](https://carbonmarketwatch.org/2010/07/15/hfc-23-offsets-in-the-context-of-the-eu-emissions-trading-scheme/)) * Credits for forestry were awarded to monoculture commercial forests, which could be displacing farmers to clear old growth forests. ([CarbonMarketWatch](https://carbonmarketwatch.org/2012/05/30/forestry-projects/) and [Ecosystem Marketplace](https://www.ecosystemmarketplace.com/articles/credits-for-sinks-understanding-the-case-against/)) * Credits were even being issued for massive coal power plants([Reuters](https://www.reuters.com/article/us-india-carbon-coal-idUSTRE76B1XI20110712)) Later [research](https://ec.europa.eu/clima/system/files/2017-04/clean_dev_mechanism_en.pdf) suggested that 85% of the CDM credits were in fact nonadditional, meaning that the projects credited would have been able to go forward without the credits. In other words, the credits contributed nothing to reduce emissions. From the developing countries' perspective, though, this was simply [protectionist trade policies](https://voxeu.org/article/collapse-clean-development-mechanism) at a time when there was a surplus of EU ETS credits: *The European Commission was operating the EU Emissions Trading System (EU-ETS) alongside the CDM scheme, but the slumping price of the EU intra-regional emission permits became a cause for concern for the Commission against the backdrop of economic stagnation in the former Soviet bloc countries in Eastern Europe. ... Although the European Commission initially allowed (CDM) certified emission reductions credits to be used in place of permits, it announced an isolationist policy reminiscent of the bloc-economy era. To raise the (EU-ETS) permit price through reducing supply, it banned the use of certified emission reductions credits, starting in 2012, for existing and future projects other than those in least developed countries.* There was then a "revival" of the CDM, as developing countries started to buy up CDM credits in anticipation of using them in future climate accords. Being both sellers and owners of credits, it's not surprising how they felt about the EU's pro-environment stance: *Naturally, the EU’s proposal to invalidate certified emission reduction credits all at once in the name of ‘environmental integrity’ has invited a firestorm of opposition. ... Therefore, in the eyes of developing countries, the EU is simply a bully trying to ruin a system that they are no longer a party to. ... As long as the EU tries to bind the hands of developing countries under the pretext of environmental integrity, the negotiations over the Paris Agreement will continue to become more complicated and the conclusion will remain out of reach.* On that he was right. At COP26, the agreement on Article 6 of the Paris Agreement did allow for post 2013 CDM credits to be transferred into a successor global carbon market, much to the dismay of environmentalists. ([EnergyMonitor.ai](https://www.energymonitor.ai/policy/carbon-markets/carbon-markets-get-amber-light-from-cop26)) The lesson is that carbon markets are precariously balanced on several pillars: * For a carbon market to exist at all, there has to be a significant cost differential for the participants to reduce their emissions. Otherwise there would be no benefit to trading and no point in the market. On this the CDM was very successful. Too successful, as it turned out, because many of the credits may not have been real. * The carbon market will probably need fine-tuning. This is to be expected. Climate is complex, but market rules need to be simple enough to administer. Plus, carbon markets are relatively new, and the theories behind them often will work differently in the real world. The market participants need to accept this and be willing to adapt. So when questioned about the validity of its credits, [comments from the CDM office](https://www.reuters.com/article/us-india-carbon-coal-idUSTRE76B1XI20110712) such as "The project was registered and there is no story there. The project would have gone through the regular vetting process" were probably not the right ones. * Unfortunately, once a market is established, participants tend to negotiate from vested economic interests and lose sight of the bigger picture, thus degrading the environmental integrity of the carbon market. * Without sufficient environmental integrity, though, the carbon market will lose the support of the environmentalists. When that happens, it becomes easy for other parties to turn away from it, and the carbon market would collapse. Questions about the quality of CDM credits certainly made it easier for the EU to abandon the CDM, even if its true motivations were protectionism. ### The European Union Emissions Trading Scheme Finally, a few observations about the most successful carbon market in the world, the European Union's Emissions Trading Scheme or EU ETS. At $200 billion per year, the EU ETS is easily the world's largest carbon market. The carbon credits are traded on several futures exchanges, giving us a real tradeable carbon asset with a price history: ![By Allavion - Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=112457320](/files/ICsqUNlYCzz1D3gfvXbY) This chart also sums up the troubled history of this carbon market. As a cap and trade scheme, the EU ETS is based on the total amount of emissions, and countries were supposed to reduce their emissions over time from an initial level. Free allowances of credits were also given out to some industries and countries to help ease the transition. Then the recession of 2008 to 2010 caused economic output and emissions to fall, reducing demand and creating even more credits. There were simply too many free credits floating around, and most of the ETS requirements were met with free allowances. As a result, prices crashed. They remained low even as the economy recovered because the system continued to issue too many free allowances. Now with the third phase of the ETS coming to an end, the EU is in the process of [reforming the ETS](https://www.cleanenergywire.org/factsheets/understanding-european-unions-emissions-trading-system.) The proposals include setting more aggressive emissions reductions targets, adding new sectors such as shipping and buildings, tightening up the free allowances, and, most controversially, introducing a Carbon Border Adjustment Mechanism (CBAM) to level the playing field between EU products and imports. Optimism has sent prices skyrocketing. Will history repeat itself? Time will tell. Meanwhile, the EU ETS gives us a good idea of compliance carbon markets look like: * Compliance markets rely on simple measures, such as total emissions or carbon intensity. Both of these could lead to oversupply of credits, either due to falling output from other causes (if using total emissions) or rising output with small gains in efficiency (if using carbon intensity.) * While initial optimism buoyed prices, there was again an oversupply of credits, which made the market ineffective from a climate perspective and caused prices to crash. * Over time, the market naturally grows. It may start with the largest companies in the highest emissions sectors, but that naturally causes "leakage" as emissions find their way into other sectors. Targeting major electric utilities creates incentives to shift to combustible fuels--bad for environmentalists. Targeting domestic companies creates incentives to substitute with imports--bad for jobs. Soon environmentalists and industries will join the bureacuracy to (maybe) preserve the carbon market's environmental integrity and (definitely) increase the scope of the market. ## Conclusions *It happened before. It will happen again. - Ray Dalio* It's a beautiful day when carbon markets are announced. Environmentalists, government leaders, and captains of industry join hands to save the world. Yet time and again, we see that carbon markets suffer from oversupply of cheap credits with questionable climate benefit. It happened to voluntary offsets, the CDM, and the EU ETS, and it will probably happen to the new Paris Agreement Article 6 mechanism from COP26, which has already agreed to accept some CDM credits. Fixing the carbon market would require invalidating credits which have already been issued, a radical step that will certainly draw fierce opposition from existing participants. It has never happened. So eventually the environmentalists and the general public are fed up and stop supporting the market or buying credits. Prices crash. A new carbon market is set up. The cycle starts again. (Oh no! This does sound like a Ray Dalio book now\...) From an investor's perspective, this means an optimisticallly high price in the early days, followed by a crash due to oversupply and a drying up of the market, forcing us to look for new markets again. So: * Think carefully about where your asset in its life cycle. Is it early stage and experimental? Is it scaling up to mass adoption? Or is it widely adopted already? * For early stage technologies, like renewable energy 20 years ago or direct air carbon capture today, lock in long-term purchase agreement at the high prices. Look for supportive government programs and philanthropic funders. * As the technology scales up to mass adoption, like renewable energy 10 years ago, it's a rush to get as many credits as possible, but also a time to be careful of lower prices in big carbon markets with excessive supply. As your technology goes from a premium novelty to a mass market commodity, make sure you're the low cost provider. * If your technology is late stages, be aware the carbon prices could fall a long way. It'll soon be time to move on. * Keep looking for new markets. In addition to national and international carbon markets, expect new ones from industries (such as CORSIA), local governments, and even major multinational corporations and institutional investors. Industries will try to head off government regulation by self-regulating. Local governments are already setting up carbon accounts to comply with their countries' Paris Agreement NDC's. It's just a matter of time before they set up their own carbon markets. Meanwhile, with increased focus on Scope 3 supply chain emissions from institutional investors and new technologies lowering the costs of collaboration, it's only natural for multinationals try to meet their emissions targets by setting up cap and trade with their suppliers. Wal-Mart's Project Gigaton, for example, already sets a target for emissions reductions from its suppliers and even offers financing to help them. Apple and IKEA have programs to increase renewable energy use in their supply chains. None of these programs have removed laggards, but a cap-and-trade credit system would seem to be a logical alternative to severing long-term relationships. Markets like these are made for arbitrage. With all these markets big and small, who could resist trying to choose the right market for your carbon assets, or even transferring credits from one to another? There is at least one nice arbitrage between Renewable Energy Certificates (REC's) and carbon markets (shhhh...) The [California Low Carbon Fuel Standard](https://ww2.arb.ca.gov/our-work/programs/low-carbon-fuel-standard) allows using REC's to claim that your electric vehicles were charged with renewable energy, so that you could earn a carbon credit versus standard transportation fuels. With prices as high as $200 per ton, this might be the most expensive carbon market in the world. All you need is a transportation fleet, and some EV chargers. More opportunities may be coming as carbon markets get more linked: For example, the voluntary carbon offsets certifiers have been working with government regulators to have their projects be accepted into compliance schemes. Government regulators may also see voluntary offsets and industry consortia as a way to meet climate goals. [Sweden's acceptance of carbon offsets from the Gold Standard](https://www.goldstandard.org/blog-item/gold-standard-and-swedish-energy-agency-partner-ensure-integrity-international-cooperation) and [potential EU legislation](https://ec.europa.eu/info/sites/default/files/notification-carbon-offsetting-and-reduction-scheme-international-aviation-corsia_en.pdf) requiring member airlines to comply with CORSIA may well be harbingers of what's to come. Considering how small these markets are, though, this is just small potatoes. We need to think bigger. We need to move the prices of carbon credits up to where they would have a real impact on climate--and meaningful returns. That means carbon credits must become true assets. Which means they must behave like assets. There must be a difference between performing and non-performing carbon assets, just like there is a difference between performing and non-performing loans and real estate. There must be objective criteria of what constitutes a performing carbon credit, and there must be a financial loss when a carbon credit becomes non-performing. This is simply not the case today. Companies buy carbon credits to meet compliance goals or put on their websites. They pat themselves for being environmentally responsible. If the projects turn out to be bad, well, it's not their problem. In fact, as much as possible, everybody tries to keep their offsets a secret so they couldn't be blamed for buying bad offsets. As a result, there's virtually *no* transparency in the carbon markets. This is a real email exchange I had: ![Would you believe these offsets?](/files/bo41gpHMrTUDzf1fTKY2) I'm still waiting for the answer. Could we then blame [Project Drawdown](https://drawdown.org/news/insights/opinion-the-world-needs-better-climate-pledges) for calling offsets a "shell game", or [Greenpeace](https://www.greenpeace.org/international/story/50689/carbon-offsets-net-zero-greenwashing-scam/) for calling them "a bookkeeping trick"? This is where we as investors could lead. It's not enough just to talk about how our carbon credits are better. Developers and owners of high quality carbon credits need to join the environmentalists in weeding out the bad credits. Those credits are written off at a loss like any other non-performing asset. Only then would we clean up the oversupply of dubious credits that have plagued every carbon market. Only then would there be value in owning and developing high quality carbon credits. To do that we must put our money where our mouths are. We must truly believe that our carbon credits helped fix climate change. We must require the companies and project developers we invest in to do the same. They must realize that if the buy or create carbon credits that are later invalidated by neutral and objective evaluation, their loss of reputation is a risk to us. So if that happens, they must stand behind their climate commitments, void the purchased offsets or credits, and replace them. This is what every carbon market has failed to do. Yet this is what would truly make carbon an asset with real value, for you as the investor and for climate as well. ## Epilogue ### Why We Need Carbon Markets Given all their problems, many environmentalists have called for an end to carbon credits altogether. To them, using credits or offsets is just a form of greenwashing that delays real emissions reductions. While they are right to say that we must decarbonize as much as possible ourselves, they're also missing the forest for the trees. In Europe and the U.S., we plan to fix climate change by "reducing emissions." The developing countries of Asia, Africa, and Latin believe that climate change is caused by the total volume of emissions over history, not the emissions today. Looked at [this way](https://twitter.com/CarbonBrief/status/1120715988532629506), it's pretty clear who's responsible: ![Cumulative Emissions - twitter.com/CarbonBrief](/files/FlYc71BrymC0pFYg1DW0) So, as [India's Environment minister puts it](https://indianexpress.com/article/india/india-didnt-cause-climate-change-prakash-javadekar-7101545/), "Historically it’s the developed countries that have been major contributors to carbon emissions." India's former EU ambassador, Mr. Chandrashekhar Dasgupta, stated it eloquently in his [Climate Change – An Indian Perspective](https://www.eesc.europa.eu/sites/default/files/resources/docs/dasgupta-climate-change.doc): *Each inhabitant of the planet has an equal right to the atmosphere. By have grossly exceeding their fair share of atmospheric resources, the industrialized countries have caused climate change. ...* *Though the responsibility for causing climate change lies with the affluent countries, its main victims will be the world’s poor. ... Wealthy countries can build embankments to protect coastal areas threatened by sea-level rise, construct physical infrastructure capable of withstanding extreme weather events, switch over to new seed and plant varieties better suited to cope with climate change, adopt water conservation and other necessary measures. ... Poverty stricken people, dwelling in flimsy huts, living in villages lacking durable infrastructure and decent communications, are unable to cope even with annual seasonal change, leave alone the sweeping transformation that may be wrought by climate change.* *How should a low-income country like India respond to climate change? It is obvious that we must build up our capacity to cope with climate change and adapt to its impacts. This will be possible only if we can overcome the currently severe constraints of financial, technological and human resources. The only hope lies in rapid economic and social development. Without rapid economic development, we cannot overcome the grievous lack of financial resources required for adaptation. Without rapid social development in fields such as education and public health, our workforce will be unable to adapt successfully to climate change. For a low-income country, accelerated development is the key to successful adaptation. If development slows down, future generations in our country will be grievously incapable of coping with climate change. For a low-income country rapid development is synonymous with sustainable development.* At Kyoto, carbon credits were invented to solve this problem. By paying for carbon credits in developing economies, we could be supporting their economies and their net zero transition at a lower price than we could do it ourselves. It was supposed to be a win-win. It's also the glue that holds international climate cooperation together. Without a functioning global carbon market, the developing economies would find it better to grow at all costs, so they would have enough resources to adapt to climate change. Meanwhile, costs to decarbonize would be much higher in the developed economies. The combination would naturally drive carbon intensive production to developing economies. We would never be able to fix climate change. So when I see analysis like the [NGFS climate scenarios for central banks and supervisors](https://www.ngfs.net/sites/default/files/media/2021/08/27/ngfs_climate_scenarios_phase2_june2021.pdf) that show carbon prices going to $600 to $800 per ton CO2e under scenarios of delayed or divergent climate policies: ![NGFS Scenarios Carbon Prices](/files/TGNDY1DB2UGeWA5IiRKP) Don't believe it. If we fail to work together on climate, don't expect a scramble for carbon credits. What's the point? Who would you sell them to? We'll all be scrambling for local adaptations--against floods, fires, droughts, heatwaves, and failing food production. We'd be building flood barriers and levies with concrete and steel. The developing countries would be burning more coal to make them for us, so they could pay for their own survival. #### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). #### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Interview - Inside Carbon Markets Today *Carbon markets are notoriously opaque. Much of what happens goes on directly between big trading desks at banks and major corporate buyers. This interview lets you take a peek behind those closed doors, thanks to Pedro Carvalho of Ecosecurities Ltd. Find out what's really driving the carbon markets today. How do the voluntary and compliance carbon markets work together? How are the players using carbon offsets to support Carbon Neutral LNG, Renewable Biomethane, and CORSIA aviation targets? How could the blockchain benefit carbon markets?* SC: Hello Pedro. I thought we could start by you introducing yourself and telling us more about your business at Ecosecurities. PC: I'm the carbon portfolio manager of Ecosecurities. Ecosecurities is a carbon project developer with 25 years experience in the market. We registered the first CDM project. We were very active on all energy related projects that were developed in the past and currently we're still very close to the supply side of the market but with the focus now on conservation and reforestation projects, blue carbon and what they call community-based projects. So cook stoves, water purification and things of the like. SC: Since we last talked COP 26 happened and the Paris Agreement Article 6. What is your reaction to that? PC: I think it was a good outcome, a realistic outcome. We got some guidance on how our projects can move forward. The scientific body meeting in Bonn at the headquarters of the UNFCCC is taking place as we speak, where we expect that a lot of the work to operationalize Article 6 will be implemented. So in the end I thought the outcome was interesting. I was expecting a bit more stringent rules to be honest, especially the transition from CDM to the new scheme. But this is not to say that the system in a broader sense is flawed. It’s just opening the chance that more stringent regulations take place on the infra-legal side, in the sense that this could be decided by some cut-off date and transition rules. I'm happy, but it's very hard to get any material or concrete indication from what was decided at COP 26. SC: So you're still waiting to see where it all falls out. PC: Exactly. From a project developer's perspective we had a lot of signs on how corresponding adjustments would be implemented and what will be demanded. But we still don't have any indication of how they will be implemented or what will be demanded from countries to give the corresponding adjustments. We know that we have to face the corresponding adjustments, but at the moment it's quite impossible to get them, and that's because the governments don't know what is a correspondingly adjusted credit. Funnily enough, you do have market players that are getting letters signed by governments saying that they will give the corresponding adjustments. But I have my doubts on how material those letters are or whether those letters are just empty words, because a lot of governments, especially governments of small countries, are giving those letters just to attract attention. But they're not sure of corresponding adjustments for each kind of project. Now that all the countries need to implement their decarbonization strategies, as time passes countries will start to realize that most of the carbon projects that are developed today, especially conservation ones, are the cheap emission reductions to achieve. So why would a government give to private initiatives the cheap things and stay with the hard to abate sectors? That's something that I think that as governments start to understand this element, they will be a bit more restrictive on giving the corresponding adjustments. So we have to see how the rules are enacted so that's why I'm going to Bonn next week to try to get a grasp on those. SC: So in terms of the market after COP 26 what has been the reaction that you're seeing? PC: Lots of things happened after COP 26, not precisely because of COP 26, but COP 26 helped to foster and shape the markets as they are today. The Russian invasion of Ukraine was of course a shock -- the prices of carbon dropped across the different technologies and vintages. Now you see that NBS (nature-based solution) credits are at a lower price than they were in the past but the price is increasing. That's not true for technology credits: renewable energy, landfill and methane capture, and other project types. There's a decoupling between NBS projects and technological projects, right, so you see the price levels of CORSIA credits and so on they're still very low as compared to the $8.50 that they reached in November or October of last year. Today they are trading around $5, while the NBS credits are almost at the same level that they were being traded before. I think that currently we have a lot of uncertainty in the market, so if you want to take a long position you're buying something that you're sure will have a market in the future and that's NBS. You would not buy long positions based on renewable energy credits or other technologies that you're not sure whether they would be accepted by Article 6, whether they would be accepted by other initiatives in the market such as the core carbon principles, or even the VCMI, the voluntary carbon market initiative. You do have those self-regulated initiatives that are trying to give guidance for best practices to the market, and I do think that a lot of market players in the home market as a matter of fact are waiting to see what will be the guidance from those actors, so that they can better position themselves. They don't understand what they will buy or not. At the moment I see that a lot of people are still buying positions to take long positions on NBS but not so true on other technological interventions. We had a very interesting movement on renewable energy and CDM credits, because six months ago if you were trying to trade a CDM renewable energy project, people were paying big discounts compared to renewable energy, same technology, same project but registered under VCS. Today it's the other way around. People are saying “Oh, I'm not buying a VCS credit from Verra and paying $5 because I don't know what I'll do with this credit in the future. So if I buy a renewable energy credit, I am willing to buy a CDM credit, because it's a bit cheaper and methodologically it's as stringent as a VCS credit. You're just changing the wrapping.” There's also a bit of education in the market, as new players enter. In the beginning they were very scared of CDM, because it is a bit more complex. But now that they see that CDM was the first standard and is still the most robust standard that we have, they are more confident in getting those credits. Based on our experience, we have some inventory of CDM credits and the demand for those increased in the past. SC: Do you see the CDM demand being driven by CORSIA and so tied to that? PC: Not necessarily, CORSIA is a quality indicator. So people are like "I want to buy a CORSIA credit" not necessarily to use under CORSIA but maybe just to have an indication that the project is of quality. Based on CORSIA rules, if I have a CDM credit today, and I deliver it to you as a transfer – I send it to you at your national registry. Once the credits are at your national registry outside the CDM registry, they are not good for CORSIA purposes anymore, because the registry cannot segregate and clearly indicate that those credits are CORSIA eligible. So they lose the CORSIA eligibility. You see a lot of buyers and they say “I want to buy CORSIA.” Then I tell them “I’m delivering those credits to your registry account and you’ll lose the eligibility, is that OK for you?” Then they’ll say, “Yeah, sure, I’m not using them for a compliance purpose but I just want CORSIA because that’s my mandate.” SC: What do you think they are planning to do with it other than re-trade it? PC: I think the primary role is to decrease the average price of a carbon portfolio. If you're buying one million tons, of course everybody wants to buy one million tons of reforestation projects, but the reforestation of native species today is traded around 20. So hardly would they buy 20 million tons at $20. They'll buy potentially 20 or 10 percent of their credits as reforestation, another portion of that as renewable energy, with a lower price, and then another portion as REDD+ and so on. They create a basket of projects to bring the average price around any given number. SC: So the idea is to assemble this basket and then deliver to another customer to offset say LNG or something to create a carbon neutral product with? PC: Yeah it could be to create a carbon neutral product, or it could be for their own climate pledges. We have to remember here that from a CDP perspective or even Science Based Targets Initiative, they make a distinction on the type of credit that you can use. But generally speaking you do not have any distinction at all for offsetting purposes where "you can only use the NBS credits." There's nowhere written that you can only use NBS credits, so provided that is a carbon credit you can use them. Maybe to avoid scrutiny from the market, if you're an oil major, you buy only NBS credits and so on. But there's no hard restriction on that, so I think that people are buying this basket of projects either for their own consumption, for their own pledges, to embed into products, or for other uses of offsetting. SC: One of the interesting new products from the oil majors is the carbon neutral LNG, where they are shipping LNG with carbon offsets. Have you seen that driving the market at all or is it still too early? PC: I think that Japanese players are doing a bit more of those operations, but there was a lot of criticism of greenwashing based on those transactions. There was even a report that was published scrutinizing ten LNG shipments and saying who bought, who did not buy and what kind of credits they used. Speaking with some brokers here in Geneva, I got the information that this scared the interest of buying offsets, because using the offsets attracted public scrutiny. So they're not wanting to pay more to try to be aligned with ESG, if in the end it’s backfiring on me. Speaking on carbon neutrality, one thing that I saw that was very interesting: Now more than ever people are trying to deliver biomethane. They produce biomethane out of their own processes, and then they have an agreement for biomethane with another person in the market. If they were not able to produce the full amount of biomethane, they can also provide part of the methane with fossil fuel natural gas. Then the portion of the natural gas that they're providing, they’re providing with carbon offsets, so they can deliver the whole shipment as carbon neutral, because there's no emissions from biomethane and the other part because it's already compensated. So from the buyer's perspective there's no GHG effects in their inventory. For those specific cases, the buyers will go with something that is connected with their activities, for example credits out of methane capture, so very connected with their activities. SC: Do you see more compliance markets accepting voluntary credits like VCS or Gold Standard? PC: Not with the rules that are in place. But we do have a lot of indications that compliance markets will start to accept voluntary credits. This is coming from conferences in Brazil and Europe. For example, they are discussing the sustainable carbon cycles for the European Union carbon farming initiatives. There was a panel the other day, and they were saying that they would use the Gold Standard methodology. So it's not that all of the voluntary credits would be used for all the compliance purposes, but specific projects from the voluntary market will be able to be used in specific markets. Colombia is very good to exemplify this --for the carbon tax they accept voluntary credits, provided that they are forestry credits from projects located in Colombia. So if you have VCS from Cambodia you can do whatever you want with these credits except trade in Colombia for compliance purposes. So the market is getting more and more granular and fragmented before there's a broader consolidation I think. SC: In CORSIA they have all sorts of different types of credits that they accept -- from ACR, ART, to China’s GHG voluntary program, CDM, CAR, GCC, Gold Standard, and Verra VCS. Which of these standards do you actually see traded of all the different types out there in the market? PC: Mostly VCS, because this is already up to date and good to go for exchanges. That's not the case for instance with Gold Standard. Out of the CORSIA basket, I see 95 percent of the trades are happening in CDM, VCS, or Gold Standard. GCC I think they had one issuance, but not very significant. SC: There's been talk of speculators in the EU ETS market driving up the price and even some governments being pretty upset about that. In the market that you see, are there a lot of speculators or traders that are buying and selling? Or is it people taking them for immediate use, keeping them in inventory for later use for themselves, or using them for their products and their customers? What's the motivation? PC: I think that trading houses are okay with risk. One year ago if I wanted to develop a project, if I knocked on a door and said "Do you want to invest five million dollars so that I can create this reforestation project and deliver the credit to you in 10 years time" They would say "no that's not my business." But when I'm now at the trading house company’s doors, they'd say "Sure let's do that, I can give you the money now." They’re taking the credit at a discount to the market and then reselling in the market, so they are making a margin. It's not necessarily bad because they provided finance for my project at the end of the day. Under that circumstance I think there is value. They're reducing some market inefficiencies. But you do have a lot of brokers in the market today that are operating as back-to-back traders so they say “I'm representing someone. I have a demand” Then you make the fundamental question, “Who will be my counterparty?”, and they say “Oh your counterparty is me.” Then you’re like “Okay, so you're making a margin on this thing.” That's what came out the other day at Financial Times saying that you have a lot of brokers in the market making big margins at the expenses of the project. Is this good? Definitely not. It undermines the confidence of the project. Is this good for me? It is amazing for me because being a project developer and speaking with my project partners, they trust me because I'm not a trader. And that's exactly the reason why I'm not leveraging my balance sheet to buy credits and buy and hold volumes, because that's not what I do. My margin is on the project, my margins develop the projects with my partners. So does this happen? Yes. Is it always bad? No. Do we have bad cases? Yes. SC: Another question I have is there seems to be a lot of new types of offsets coming to the market, like new project types. On the other side there's new companies coming into the market to do quality and rating assurances of credits -- where do you see these two trends going? Do you see the existing standards expanding their scope, or do you see new players rating the credits and taking over some of that? PC: I think we do have several new standards coming into the market and I believe that there is a natural trend for specialization in this market from the carbon standard perspective. If you look at VCS, the bulk of their issuance is in the reforestation and forestry projects. If you look at Gold Standard, they have high impact types of projects, which is their characteristic. If you look at GCC, the Global Carbon Council, most of the projects that are being registered there are renewable energy projects. If you look at this Finnish new standard, Puro Earth, they are only focused on carbon removal initiatives, so that's their specialization. If you look at the Colombian standards -- there was a long discussion that I had with them in Barcelona at a summit, and I was telling them they already have an expertise on how to deal with Latin America, so they should specialize in Latin America. They have contact with the local indigenous communities, they visit the local communities, so they should have a local standard that is in that region the best standard you could have. I do see that this market is evolving to have more specialization. So whether we will be speaking about VCS reforestation in five years time, 10 years time I'm not so sure. Whether we'll be speaking about how much it costs to remove a carbon from the atmosphere in 10 years time, in 50 years time I'm quite sure we will be doing that. So there will be a broader fragmentation of the market, especially with new technologies and minimum methodologies coming online. SC: So who will decide what is a legitimate standard or not if there are more technologies and more standards to support them over time? PC: In the voluntary market you have this initiative, the core carbon principles, that I think the market is waiting for to have some guidance. But based on the discussions that they're having I'm not expecting it to be a hard criteria. So "VCS is good, CDM is not good if you buy only from vintages 2020 onwards" -- I don't think that the criteria will come like that. I think the criteria will be: a high quality project is a project that has these KPIs for additionality, is a project that the baseline is defined according to those principles. So we will have a bit more subjective criteria that will demand further elaboration by market players, but it will be a bit more resilient in time. For example, if I created a hard criteria that CORSIA is VCS 2016-2020, and I have a 2021 credit, formally speaking, it's not eligible. But in the spirit of the rules it should be eligible, because it's a new credit. I think that's the reason why CCPs are being enacted because of the profusion and fragmentation of market players and standards. Of course, everybody knows that CDM, VCS and Gold Standard are the standards to go with, but what about biocarbon registry, Carbono, Puro Earth, GCC? What makes a credit high quality? That's the voluntary market. On the compliance market, it doesn't really matter if it's a high quality credit or not, it just matters whether it's eligible or not. Because then it becomes a license to operate provided that it's eligible under the compliance market. It's up to the government to decide what kind of credit they want to foster. And that is relevant to the point that I was making about Colombia. It's sometimes a political decision around what the government wants to foster. SC: Given the high difference of carbon prices in different countries, do you see any arbitrage opportunities, or how could such big differences persist for a long time? PC: There’s a fundamental distinction between carbon offsets and allowances. For ETS carbon pricing schemes, if you look at the european allowance for instance, the price is, say, 80 euros price per allowance. It's not reflective of the price of the carbon but it reflects the abatement costs. It's the abatement curve of the technology. So someone that is buying the allowance will make the assessment whether I'm buying the allowance or maybe I'm implementing the decarbonization. The good example that I like to give here is the electrification of a fleet. So let's say that the cost per ton of carbon to electrify my fleet is at 100 dollars, and the price of my ETS is at 80. So far I'm better off buying the ETS allowance. Let's say that the price jumps to 150, then this actor will be like "Okay, I'm better off implementing the decarbonization strategy than by buying the allowances." So there's this fundamental distinction on the price of carbon. Sticking with the compliance markets, it's very important, there's a very interesting graph by ICAP demonstrating exactly that: ![Scope and Coverage of Emissions Trading Systems, ICAPCarbonAction.com](/files/57hCbYPjnAZTXxo5NS09) Because the breadth and the coverage of different compliance carbon schemes across the world are not the same, the pricing of carbon is not the same. If you're looking in Switzerland, for instance, where I'm speaking from, the price of carbon is one of the highest in the world. But the coverage of their system is very narrow. It's not encompassing a lot of sectors in the economy. So do you prefer to have a $150 allowance with a very narrow application, or do you prefer to have a national wide application with a higher breadth? Take this information with a grain of salt, because I'm not sure if they're comparable per se. Coming to matching the price of the carbon credit and the compliance markets, of course there is a big opportunity for arbitrage there. But if I was developing my projects Ii know where they are most valued at, and I'll be sure to negotiate a very good agreement with my off-takers so that I'm not trying to sell let's say a reforestation project with a price of voluntary market, knowing that this credit is good at three times that price under other standard. SC: In the next five years, what do you think will be the biggest developments for the carbon markets? PC: I think corresponding adjustments, because corresponding adjustments have several implications, not only in the voluntary market but also in the compliance markets. If you have the corresponding adjustment, then for instance, there’s a real case that's happening today in Indonesia. They imposed a suspension on the issuance of 2021 onward credit vintages, because they're saying that they are deciding what they want to do internally with their carbon. There is some “corridor information” saying that the landing area for the regulation in Indonesia is that they will demand that 30 percent of the credits that are already in the country will need to stay in the country. So if you need to trade 30 percent of the credits in the country in Indonesia, which is a country with a lot of projects, you could expect that this portion that you need to trade domestically will have a discount on the price of the carbon that you'll be trading internationally. On international credits you could experience that the prices are going up for the same reasons. Verra, Gold Standard, and also the UNFCCC are discussing shortening the crediting period of the credits. This would also drive the prices up because the time to repay your investment on the carbon is reduced. Also Verra, Gold Standard, UNFCCC are discussing how to review additionality on a rolling basis. So let's say that today and that's the point: Carbon market and carbon projects will be very connected to the countries’ NDCs. The message here is if a country says today in 2022, "My NDC, my nationally determined contribution, is I will reduce the emissions from my power sector 40 percent." Great. Then in 2025, we do the revision, take stock. Then the country says, "I reduced 40 percent of my emissions from the electric power sector," or maybe not, but you know what, I'm changing my rules. I'm changing my objectives. Instead of reducing my emissions from the electric sector, I'm also reducing from my forestry, because I have a lot of deforestation. So now I'm also reducing from deforestation. And then what would happen with the REDD+ projects conservation projects that were developed in this country? Let's put a name: Brazil. Let's say we have a lot of projects in Brazil today, and today my project is not overlapping with the country's NDC, but let's say that this is the case in five years time. So today my project is additional because the government wouldn't be doing that, but let's say in five years time the government says I'm investing one billion dollars per year on deforestation activities then my project all of a sudden is not additional anymore. So you have those things and I think that all of this is connected at some level -- directly or indirectly -- to the NDC, and thus also with the corresponding adjustments. So the biggest single change that we have in the current markets from the regulatory perspective will be the corresponding adjustments. Not only the corresponding adjustments as in the metrics, but also the costs and financial effects that it will have in the market. SC: In both the compliance and the voluntary markets? PC: Exactly. Because even in the voluntary market, you already have players saying “I want my credits with corresponding adjustments.” Then my answer is, "but what are you using those credits for"? They're saying, "I'm using for voluntary purposes but I want to ensure the highest levels of integrity" Then I'll tell you, "okay so that's a premium of 30 percent or 50 percent.” The level of the premium still has to be decided, but it's something that would need to be agreed. We were discussing in the beginning of the interview about Article 6. One of the things that is evident already is that if you want to develop a carbon project under the UN rules it will be more expensive, because to start off you'll have a seven percent withholding. Two percent for the overall mitigation goals to ensure that the project is indeed additional, and the other five percent is as SOP, or share of proceeds. With every credit that you issue, they would get five percent to resell to the market at another stage. With the revenues from the project from that sale, they would implement adaptation initiatives, so that's the share of proceeds to the adaptation fund. So if you're developing a project under CDM, you already have a five percent reduction on your credit, so you could also expect that the price for CDM or like the UN system will be higher than the price from the voluntary standards. People will buy credits with and without corresponding adjustments for voluntary purposes. Again, it would depend on the buyer. SC: The last question that I have is: Have you thought about the effect of these web3 or blockchain projects in carbon credits, carbon offsets? What do you think of them and their effect on the market so far? PC: Based on the initiatives that we have in the market, I mean it might be a bit of ignorance or maybe the role that I play in the market, but I don't see a lot of added value from all the things that they're doing. As a matter of fact, they say that they're increasing security and transparency in the market, but to the contrary I think that there is another flaw in the system. Because they undergo the whole process with the analog system that we have today, and after the credit is issued, then you retire at the registry like Verra, Gold Standard, and then they tokenize that. Who is the one ensuring that this process from the registry to the tokenization is the right way? I don't know. It stays in the registry, it's a token, it's like Moss, it's any other player engaged in the market. But what I think is interesting is before the issuance, in the upstream, so the blockchain can be embedded into the monitoring and the project development. Today the project cycle is still grounded on the rules and the assumptions that were established in 1997 together with the Kyoto protocol. So today I still develop a report, prepare a PDD, and engage the auditor. He prepares another PDD, and it's like a very analog process. So for instance, we can have satellite images feeding an API system based on blockchain and ensuring automatic monitoring. Then you can see by the day, by the minute, how much carbon your forest is absorbing. That's amazing, that reduces transaction costs, that increases the gains of the project, and also ensures more stringency in the process. So the blockchain as an additional layer after the product is issued -- I don't see a lot of added value because today. If you look at the Verra registry, it's already a stringent registry. You might have some IT problems if someone has a system, but still if you would ask a secondary market player -- and that's a very important thing to say, I only operate on the primary market, I do not take positions in the market -- maybe they'll say it's better to trade with Toucan or like a tokenized credit because I can ensure higher levels of stringency. But for me as a project developer, I think it's not adding a lot of value. But they do have a lot of potential. SC: I agree with you on both. But there's a lot of potential in enhancing the product development cycle for carbon credits using these techniques. PC: If you look like two weeks ago, Verra published this public announcement saying that they are restricting the tokenization, and that's good, because Verra is saying "do not retire and issue something out of this credit that is dead. Let's just think about an escrow account and let's block this product." I mean provided Verra have like a streamlined process–Great, let's do that. SC: But if the project development cycle is done on the blockchain, for example, all this data is on the blockchain, then- do you still see a place for these entities like Verra or gold standard? Or like if all the data is already on the blockchain, could some other entity just issue credits off of those and be credible? PC: Their role will change. Instead of being standard setters and registered operators, they will be only standard setters. So what kind of deforestation rates, how to implement a conservation project -- this will still be done by Verra for instance. But then I'll get all this information and I would just dump it into a blockchain system, maybe a third party and so on to ensure that this is done in the right way. SC: So you see a hierarchy where there's these core carbon principles, and then below that specific standards would say this is exactly how we interpret it. These are the deforestation rates, and this is how much leakage protection, all the different terms that need to be precise parameters that implement the core carbon principles. Then somebody could then take that standard and then operate the issuance of the project and a registry for it. For example, using the blockchain. PC: I think so. It would take a couple of years, I don't think that's near that, but yeah I think that's very feasible and it would make everybody's life much easier. SC: Ok, that’s a lot of things to think about. This would be a great thing to start a discussion around this, and thank you for your time today. # Conclusion *“In the beginner's mind there are many possibilities, but in the expert's there are few." - Shunryo Suzuki, Zen master* ## Where We are Today Climate investing has come a long way. Investors now finally recognize the dangers of climate change and would like to fix it. It's given the impetus for companies to do something, and some companies have taken the lead. Meanwhile, standards for climate accounting and disclosures have been developed and starting to be utilized. Pathways for industries to be decarbonize have been researched and published. New technologies on the horizon offer at least the hope that we could reverse the damage before it's too late. At the same time, there's much more that needs to be done. The ESG metrics used to guide climate investing have generally proven to be of limited value. The stampede into ESG funds happened before clear definitions of what an ESG fund really is. While companies are starting disclose their climate risk and strategies, the disclosures are often incomplete and inconsistent. Many companies are talking about climate, but they routinely reject calls to take action. Activist shareholders have even succeeded in electing directors on climate ballots, but we don't know how much influence they could ultimately exert. 2021 may turn out to be the peak of expectations for ESG investing. With a decade of outperformance, it seemed like a "have your cake and eat it too" time where climate investing was the same as profitable investing. Yet much of ESG investing was a shifting of assets from carbon intensive industries such as oil and gas to low carbon industries such as technology and healthcare. The resulting underpformance of oil and gas companies led to their having the lowest relative valuations of any major industry, prompting them to sell assets to private equity and other buyers. They also set the stage for a comeback rally that we're seeing now. This may cause a thinning out of the ESG space, both for fund managers and investors. Perhaps it would be a necessary step for us to move forward. I hope in the next phase of climate investing some of these things will happen: * Companies improve their climate disclosures. More companies disclose. They disclose all their Scope 1, 2, and 3 emissions. The disclosures become consistent and understandable. * With these disclosures, investors could understand companies' climate risks and strategies much better than with today's ESG scores. * Investors would monitor companies' progress to on climate. * Companies which are taking real action get favorable valuations from long-term, supportive investors. * Carbon markets are fixed so that they could finally fund climate action at scale. Each of these is big. We may decide to take on different challenges, but we must all act now to make them happen. ## Now It's Up to You So that's all I have to tell you for now. The book is unfinished, but as I said at the beginning, it never will be. This is a quest we're going on together, and now it's your turn. Use what I've given you as a starting point, but go out and find new and better ways to make the world and the financial markets better. This book will never be finished because there are so many opportunities out there. So many crucial services are underfunded because we have not figured out how to make them a part of our financial markets. When I was a portfolio manager, I spent a lot of time with people who spent all day talking about how there were no opportunities left. In fact they just needed to get out of their ivory towers and look in the real world -- and get ready to do some real work. Climate, biodiversity, and nature are just a few important ones that we need to fix, and urgently so unless we're consumed by climate change in our own lifetimes. Sometimes it might seem too hard to fix these problems. That there is too much inertia. But don't get discouraged. In time, smart people will make these things happen. The voluntary carbon offsets market, for example, is a fully functioning market for climate and nature. It is still tiny, but then again, it didn't exist a couple of decades ago. So change is possible. We've just got to work faster and bigger. But then that's what you're here for, isn't it? I also take comfort in a couple of other thoughts. Looking over the long arc of history, healthcare and education once were unattainable luxuries except for the elites. Then they became charitable works and public goods. Now they are serviced by private industry and financed by the capital markets. Why can't we do the same for climate and nature? Of course, you've probably heard that the problem is that there's too many people, and we consume too much. Just remember people have been saying this for, well, ever. Apparently even the [ancient Babylonians](https://medium.com/lessons-from-history/worries-about-overpopulation-are-as-old-as-civilization-9f009fb785e4) thought the world was getting overpopulated, 3700 years and 7.8 billion people ago. In recent times, yo've probably heard about Thomas Malthus, who in 1798 predicted that population growth would eventually exceed food production, leading to catastrophe. Think about how wrong he has been. For over 200 years (4000 years?), successive generations have innovated to create a world that supports more people with a far higher standard of living than he could've ever imagined. Will we really be the first generation to fail? We don't have to be. Ultimately we'll live in the world we worked to create. So let's get to work. ### Get Updates [Sign up](https://opentaps.org/subscribe) for our email newsletter to get updates on this book and the [Open Climate Investing project](https://github.com/opentaps/open-climate-investing). ### Disclaimer *This content is published for informational purposes only and not investment advice or inducement or advertising to purchase or sell any security. See* [*full disclaimer*](/main/book/disclaimer)*.* # Disclaimer The content of this book and its associated content, including but not limited to websites, emails, newsletters, and videos (herein referred to as "Content"), is published in the United States of America and persons who access it agree to do so in accordance with applicable U.S. law. The Content is published for informational purposes only. Nothing in the Content constitutes investment advice, performance data, or any recommendation any security, portfolio of securities, investment product, transaction or investment strategy is suitable for any specific person. You should not treat any part of the Content as a specific inducement to make a particular investment, purchase or sell any security or asset, or follow a particular strategy. The Content is based upon information deemed reliable, but there are warranties of any kind, express or implied, as to its completeness or accuracy. No party is not under any obligation to update or correct the Content or any information provided. The Content is subject to change without notice. Past performance is not indicative of future results. No party guarantees any specific outcome or profit. You should be aware of the real risk of loss in following any strategy or investment discussed in the Content. Strategies or investments discussed may fluctuate in price or value. Investors may get back less than invested. Investments or strategies mentioned on the Content may not be suitable for you. This material does not take into account your particular investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. You must make an independent decision regarding investments or strategies mentioned in the Content. Before acting on the Content, you should consider whether it is suitable for your particular circumstances and strongly consider seeking advice from your own financial or investment adviser. Some of the links in the Content are affiliate links, meaning, at no additional cost to you, the authors of the Content may earn a commission if you click through and make a purchase and/or subscribe. This has not influenced the Content as it is written. # Decarbonization DAO ## Why this DAO? A common problem with climate solutions is that we want somebody else to do something about the climate. Let's get the oil companies to stop drilling. Let's get farmers to use less fertilizers and less water. Let's get building owners to improve energy efficiency. Let's get people to fly less, drive less, take more public transportation, etc. etc. Then we see it's not working, and we're frustrated and upset. We end up shouting at each other on social media instead of solving problems. The truth is, when other people don't do what you want them to do, it's probably because you didn't understand them well enough in the first place. That's empathy. Meanwhile, when we can't do something that we're afraid of, like climate change, we get angry. But as Master Yoda teaches us, "Fear leads to anger. Anger leads to hate. Hate leads to suffering." But we don't have to go down the path to the Dark Side. This DAO is an experiment in using the open source principle of "scratching your own itch" to come up with climate solutions. If you want to do something about climate change, then do something. Right where you are. Build something that works for you, based on your real needs and experiences, first. If it works, then get others to use it. ## Some Examples When you get on a flight, there's probably a checkbox to offset your emissions. But where does your money go? What are these "offsets" the airline is offering to buy for you? Does paying to "plant trees" really help the climate? Or is it just the airline's way of making you feel better? At home, you probably use electricity. You could get solar panels. Have you? If not, why not? If so, how much good does it really do? You probably also use natural gas. What could you do there for the climate? Is "sustainably sourced," "renewable," or even "carbon neutral" natural gas real? This seemingly simple questions have big implications: * Are carbon offsets real? * What is the right pathway for airlines and utilities to decarbonize? * What is the role of oil and gas companies? We're here to answer those questions, **based on direct personal experience**. ## Why You Should Buy Offsets with Your Own Money Me: Would you like a free copy of my book on climate investing? You: Sure. Me: Great. Could you just send me $10 to cover my shipping cost? You: Uhh... This is a basic lesson from marketing: People will take things more seriously if they have to pay for them. That's why you should buy some offsets with your own money. It doesn't have to be a lot -- just one flight or one month worth of home heating will do. But it will focus you on whether your real money is leading to real climate benefits. ## If You Want a Job in Climate Fact of life: Your first job in climate isn't going to be setting national or international climate policy. You'll probably be gathering data and making sales pitches. Welcome to the real world, but don't get disappointed. This is what solving real climate problems is all about: data, analysis, and convincing people. This DAO will help train you for getting that first job. You'll have a chance to work on getting data, from yourself, your friends, and companies. You'll learn to analyze the data and make recommendations. You'll do this in the context of other research we've identified and work by other DAO members. You'll get reputation tokens and badges for your work. So when you sit down for your interview, you won't be talking about some school project paper (which will make interviewers roll their eyes) or your political views (NEVER do that in an interview.) You'll be able to point to a real project, where you used real world data and convinced people to do something. That works. ## Why Offsets Happen in the Dark Nobody -- sellers, buyers -- wants to disclose the prices they paid for offsets. Companies don't want to disclose what offsets used to be "carbon neutral." Why? Because we all know, deep down inside, they're too good to be true! How could it cost only $1, $5, or $10 to offset a ton of CO2 when research shows they should cost at least $100 per ton to be effective. So we buy them to meet government rules, put "carbon neutral" on a product, or just feel better about the flight we took. Then we keep quiet about them. Some would say the way to fix this is to make offsets easier to buy. Easier to buy = more demand = higher prices. This is generally true, but not in the case of offsets. The problem with offsets is that they are not truly valid, if there's no "additionality" or hurdle for them, then an infinite supply of them could be issued at very low prices. It's free money for a project developer whose project already pencils out economically. And of course, "easier to buy" usually means a lower price. But this is not just for fun. Here's what at stake: If done correctly, they could funnel much needed capital to developing markets and reduce emissions while the world transitions. If done incorrectly, they are simply licenses to pollute and emit more CO2. They're the placebo that will delay us from taking real action...until it's too late. ## What We Will Do Offsets are necessary but they're not simple. We can't figure this out by writing white papers or shouting at each other on twitter. We can only figure this out by working on a specific use case. The Oxford Offsetting Principles sound great, but how does it really apply? For every industry, a different solution is required. A ton is not just a ton. They must be used and aligned with the industry's emissions reductions. In some cases, they simply should not be used. In other cases, they are necessary as a bridge. Where should we draw the line? This DAO will answer that from a real personal experiences air travel. It is something many of us experience, yet it's also complicated and difficult to decarbonize. IATA, for example, shows that offsets will play an important role for aviation for at least a decade ([source](https://www.iata.org/contentassets/b3783d24c5834634af59148c718472bb/factsheet_offsettingandcarboncapture.pdf)): ![IATA Airlines Reliance on Offsets over Time](/files/AYJdhbKBSejFIFgUUIjn) But CORSIA's [list of eligible offset](https://www.icao.int/environmental-protection/CORSIA/Pages/CORSIA-Emissions-Units.aspx) is too broad. (See [CORSIA TAB comments](https://www.icao.int/environmental-protection/CORSIA/Documents/TAB/TAB_Public%20comments_Consolidated.pdf), [Carbon Direct/Carbon Plan/Berkeley Carbon Trading Project TSVCM Comments](https://carbon-direct.com/wp-content/uploads/2021/02/Carbon-Direct_Carbon-Plan_Berkeley-Carbon-Trading-Project_TSVCM-Comments-1.pdf).) This range of eligible offsets lets airlines "meet" their climate obligations for as little as $1 per ton of CO2 for a decade. So now is our chance to use our personal experiences to understand climate action at a deep level. We'll voice our opinions, but very importantly, we'll buy offsets with our own money and stand behind them if they turn out to be invalid. That makes us take them more seriously. "Proof of stake." :) The goal of this DAO is to leverage those experiences to develop analysis, software, and ultimately expertise about analyzing companies' emissions and climate strategies and the carbon offsets markets. We will follow open source practices to be an inclusive, community-driven, and open group. A DAO will help formalize the reputations earned and work done. Each member of the DAO commits to: * Record their own travel emissions. * Participate in discussions, such as what the right way to calculate emissions is or which offsets or sustainable fuels credits are legitimate. * Vote on the issues we discuss. * Purchase DAO-approved offsets or sustainable fuels credits, though not necessarily from the DAO or its members. * If later the offsets or credits are shown to be invalid, replace them with new purchases. This DAO is for serious climate thinkers only. It's not for you if you're looking to ape a cryptocurrency or think climate is easy. It's not for you if you're not willing to think seriously and objectively and change your mind when the facts require. It's not for you if you're more interested in winning than getting closer to the Truth. ## How It Will Work Everyone is welcome to participate. You will get reputation points for activities such as: * participating in discussions * taking courses, for example on analyzing companies' climate disclosures or carbon offsets * producing content, such as articles and courses, on these topics Once you have a high enough reputation, you will get NFT badges for your skill level. Some badges will allow you to participate in DAO votes, such as valid carbon offsets or ratings of companies' climate performance. Other badges will qualify you to be an emissions auditor on the network. Your reputation will decline over time. You will also lose reputation tokens for making the wrong votes. So if you do not continue to contribute, you will no longer have badges or be able to participate. For more details, see the [general DAO document](/main/decarbonization/dao). ## The DAO's Business Model The DAO is not here to make money selling offsets or credits. Nor is it here to create a cryptocurrency for speculators. We're the open source expertise that could be paired with [open source carbon accounting software](https://github.com/opentaps/blockchain-carbon-accounting) Our long-term business model create business opportunities for its members based on their reputation and expertise. Ultimately we want to build enough expertise and momentum to design and implement offset and decarbonization programs for companies big and small. Think of us as a decentralized TripAdvisor, Yelp, Instagram, or TikTok for climate, but with more credibility. Our members are climate influencers. DAO votes may be funded, so the participants will get direct compensation based on their vote. For more details, see the [general DAO document](/main/decarbonization/dao). ## Where We are Now We're just getting started. Right now: * Please test calculating your own travel emissions at [emissions-test.opentaps.org](https://emissions-test.opentaps.org). This is on a testnet. We'll soon set it up on the live net. * We've published our first canons for decarbonization and offsets, the [Tao of Decarbonization](/main/decarbonization/decarbonization_tao). Please give us your feedback on discord. * Discussions can happen on discord * Vote can start on discord and be moved to a DAO * We're looking for sites like the [Gold Standard Marketplace](https://marketplace.goldstandard.org/collections/projects) to buy offsets from. See [issue #28](https://github.com/opentaps/open-climate-investing/issues/28). If you'd like to get invovled, join the #decarbonization-dao channel on [Discord](https://discord.gg/7jmwnTyyQ8). # Tao of Decarbonization This is a set of hypotheses about how to use offsets. We use the term **hypotheses** as George Soros does: Our best guess about the truth, which could be changed based on testing in the real world. These hypotheses are meant as an implementation of the [Oxford Offsetting Principles](https://www.ox.ac.uk/news/2020-09-29-oxford-launches-new-principles-credible-carbon-offsetting). The Oxford Principles are a good starting point but general and subject to interpretation. We're here test and implement it in the real world. By offsetting our own emissions, from travel to home heating, we'll study the emissions and offsets in detail. ## The Hypotheses The first step is to analyze the companies' general climate performance. Companies which are not doing enough to reduce emissions should require more offsets. This will make it naturally more preferable to buy from the better companies. While sustainable fuels are coming, offsets will be the only way to reduce our travel emissions and natural gas use for at least another decade to mid 2030s. Both reduction and removal carbon credits are equally preferable given the high levels of emissions and the need to reduce emissions now. Favoring removals when there are plenty of legitimate reductions is not a good idea. If we don’t reduce first, we could never remove enough later. For an offset to be valid, it must satisfy all these criteria at the time of the activity - not when the original project was certified: additionality, baseline, leakage, permanence, real. Permanence means minimum of 50 years. Offset must prove it is valid on all criteria or will not be considered valid. Offset must not be issued or retired already in another registry, or it is double counting and will be invalid. Offset must be purchased for a specific project and retired in your name or in your account name at a broker. If the latter, you must be able to prove that you're the account holder at the broker. Offsets must follow standards that are maintained independently of project developers. Offsets must be audited by auditors who are independent of the project developers. Auditors can be involved in developing the standards, but the standards should not be maintained solely by auditors and definitely not by one auditor. If invalidated after purchase, replacement offsets must be purchased. All members of the DAO must commit to this. ## What We're Working On We're reviewing some actual offsets on the [Offsets discussions channel](https://github.com/opentaps/open-climate-investing/discussions/categories/offsets) to gain a deeper understanding of them. Everyone is welcome to join. ## Where to Buy Offsets So far we have identified the following sources where we could buy offsets from specific projects, rather than generics: * [Gold Standard Marketplace](https://marketplace.goldstandard.org/collections/projects) * [Puro.earth Marketplace](https://puro.earth/CORC-co2-removal-certificate/?sort_field=available_now) * [Patch.io](https://www.patch.io/) # General DAO Document ### Open Source Everybody loves open source. And why not? Open source is inclusive, giving everyone a voice. At the same time, the output is free for everybody to use. By creating the largest base of potential users, we create an incentive for them to want and work for a better that is more useful for them. As more users use it and improve upon it, it becomes more useful and draws in more users, creating a "flywheel effect." If successful, such a community could produce the highest quality, least cost, and most inclusive source of information. This is difficult to achieve, though, because open source projects usually under-funded and stay small. **This is because they are too informal.** There is an ecosystem of users and developers who symbiotically support each other, but without any formal reputation or funding schemes, there is a lot of information asymmetry which means that economically sound transactions do not happen. For example, you might like the ideals of a project and want to contribute, but could you make at least a reasonable living do it? Alternatively, you might be the loyal user of an open source project and would be willing to pay to support or improve it. But whom do you pay? It's not easy to know the skill levels of the various contributors in a project, or even if they're interested in working for pay. And how do you know what other users will do if they paid to support the project? Would some big corporate user pay for all the improvements anyway, so there was no need for you to pay? Or are you the only one who would pay, so even if you paid, it wouldn't be enough? Finally, if a group of you paid a few of the developers to do the work, who would judge if the work was satisfactory or not? The DAO solves these problems with a formal implementation of the informal governance behind every open source project: * The Reputation tokens let everyone see each contributor's level of expertise. * The Activity tokens allow users to pool their resources to pay for improvements. * A blockchain removes the need for the project to maintain a registry of these tokens. Open source projects are small and don't need more overhead. * The tokens are permanently owned by the members. They don't depend on the continued existence of one contributor or company in the project. ## Mechanism This DAO will use a combination of non-fungible Reputation, fungible Activity tokens, and badges: * Reputation tokens represent the holder's level of expertise and cannot be transferred, bought, or sold. All members will start with a small balance of Reputation tokens. They can earn more by taking some short online classes. Most importantly, members earn more Reputation tokens by creating or improving the quality of the project's work: Its models, analyses, and training materials. Reputation tokens gradually expire on their own, so inactive members eventually lose their standing. * Activity tokens can be used to pay for work by community members and can be transferred. Members are given Activity tokens for performing work for the project, which could include building analytical models, analyzing companies, as well as writing code, maintaining content, and serving as ambassadors or community managers. * Badges represent the holder's specializations and cannot be transferred. For example, they could represent specific areas of knowledge ("carbon markets", "climate accounting", "energy") or contribution ("investment analysis", "community building", "software development") Over time they could be used to make Reputation tokens more "specific", for example identifying experts in specific areas. Work is performed collaboratively in the DAO. Each member contributes to a project and stakes a certain amount of Reputation tokens. Once the required number of Reputation tokens is staked, then the project can be judged. Only Reputation tokens can be used for staking on the validity of work for the project. Each member who contributed in a project receives an allocation of the Activity tokens in proportion to the Reputation tokens they staked in the project. All work performed by the DAO is part of the open source project. Companies may engage the contributors "off project" to work on other jobs, and the contributors' Reputation tokens could help them get these jobs, but the results will not be certified by the DAO. Contributors will need to stay active in the project if they want to maintain their levels of Reputation, as existing Reputation tokens expire automatically. The DAO will eventually have a group of Judges (similar to committers or maintainers of open source projects and editors at Wikipedia) who will decide on whether to accept contribution or work for the project based on purely technical merits. Once their work is accepted by the Judges, the members will receive Reputation tokens. To become a Judge, a member must have a very high number of Reputation tokens. The DAO will also have a group of Administrators to manage the project. This group includes Judges and other members who are not technical experts (based on Reputations) but have made significant contributions based on their holdings of Activity tokens. Each member's standing in the Administrators is determined based on 2x their holdings of Reputation tokens and 1x their holdings of Activity tokens. A member can participate in votes of Administrators if they have at least 5% of this (2x Reputation + 1x Activity) tokens total. Administrators will vote on a range of issues such as approve a new release or changes to the project (mundane) to revoking tokens for bad behavior (extraordinary.) Mundane issues can be decided by a simple majority, and extraordinary issues will require super-majority (2/3) or more (80%?) The DAO will have a Treasury which sells and redeems Activity tokens for stablecoins. Customers could buy Activity tokens to sponsor work in the project. Contributors could redeem Activity tokens to get cash payments for the work they did. The bid/ask spread of Activity tokens provides a permanent source of revenue to support the project. Activity tokens will only pay for the work and not its outcome. There is no way to tie outcome to payment. This is to ensure objectivity and quality. ## Examples Members will get Reputation tokens for doing the following: ``` Joining 100 Read Article and Pass Test 100 Report a bug 200 Fix a bug 1000 Author Article/Chapter 1000 Contribute Model 5000 Analyze Company 5000 ``` A sample project could be: "Rate the Climate Risk Exposure of Company X": * A quorum of at least 10,000 Reputation tokens is required. * The project period is 10 days * 30,000 Activity tokens are allocated * 3,000 Activity tokens (10%) are allocated to Judges to certify the results * 5,000 Reputation tokens are allocated * Judges must stake 5,000 Reputation tokens (a maximum of X per Judge?) Work is done by 4 developers who each stake their Reputation tokens: ``` Arun 5,000 Barak 2,000 Chip 12,000 Duong 11,000 TOTAL 30,000 ``` Then 3 Judges vote: ``` Farooz - YES 2,000 Gita - YES 2,000 Harold - NO 1,000 ``` The project is accepted. The payout of Reputation tokens to the contributors is `(Reputation tokens staked / Total reputation tokens staked) * Reputation tokens allocated`: ``` Arun 833 Barak 333 Chip 2000 Duong 1833 ``` The payout of Activity tokens to the contributors is `Reputation tokens staked / Total reputation tokens staked) * Activity tokens allocated to contributors`: ``` Arun 5,000 Barak 2,000 Chip 12,000 Duong 11,000 ``` The payout of Activity tokens to the Judges is `Reputation tokens staked / Total reputation tokens staked) * Activity tokens allocated to Judges`: ``` Farooz 1,200 Gita 1,200 Harold 600 ``` ## Questions * How do we prevent the project's tokens from being used for speculation? Should the Treasury fix the bid/ask prices of the Activity tokens with a stable coin? * Should Reputation tokens be "staked" so each person can only work on a few projects at the same time, and do not spread themselves too thin to earn income? * Should those who voted on the wrong answer lose Reputation tokens? * How quickly should Reputation tokens expire? Is 2% per month reasonable (half life of 36 months)? * Should Activity tokens expire to discourage hoarding? What is a reasonable rate? * How to keep Judges honest and agreeable to working together? * How to prevent collusion and bad behavior, possibly off chain? * Do we need a separate token for general standing in the community, or is the 2x Reputation + 1x Activity tokens count sufficient? * What is the right combination of Reputation and Activity tokens to determine general standing in the community? * Should Administrators be voted in, or just based on their Reputation and Activity tokens? If the latter, what happens if a big holder who suddenly goes quiet? ## Reference * [A Novel Framework for Reputation-Based Systems](https://future.a16z.com/reputation-based-systems/) * [Decentralized Society: Finding Web3's Soul](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4105763) # Initial page