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:

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.

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