OPINION: Navigating VCMs: The next big thing, or much ado about nothing?
Quantum Commodity Intelligence – Jon Light is head of OTC platform at Devexperts, a company that provides financial software and services for brokerages, exchanges and wealth management firms in equity, options, futures and Forex markets.
A global undertaking is underway to reduce greenhouse gas (GHG) emissions to a level that would limit global warming to just 1.5° Celsius above pre-industrial levels by 2030. The current two-pronged mode of voluntary carbon markets (VCMs) and compliance markets can be viewed as a carrot and stick approach to meeting these global emissions targets.
On one side, companies that fall short of their obligatory compliance requirements, by failing to bring their carbon footprints in line, or not purchasing the required credits to do so, can suffer fines, allowance cuts, and public disclosures.
On the other side, organisations that voluntarily support effective carbon offset projects can gain in a manner that outweighs the cost of the initial investment, such as the PR benefits of funding innovative green projects, or by regarding these offsets as desirable assets in their own right that can be sold on at a profit.
The issues of VCMs
However, it's precisely the voluntary nature of VCMs that is proving to be their greatest obstacle at the current state of the market's evolution. The lack of any universally accepted verification standards or government oversight has seen the emergence of a self-regulated market that has led to fragmentation, lack of transparency, and – perhaps most importantly for the would-be traders of these assets – difficulty in comparison between projects and thus a complete lack of fungibility and effective price discovery between these various offsets.
The opacity of this market has actually contributed to corporate entities that would otherwise be keen on making VCM investments as part of their CSR mandates, holding off for the time being.
The World Economic Forum's January 2023 report on VCMs cites a survey conducted by the organisation in the fourth quarter of 2022 in which corporates were quite emphatic about their current reluctance to invest in VCMs.
More than 55% of respondents cited "lack of transparency" and "varying quality definitions" as an issue, and more than 50% referred to the "complex landscape of standards" as barriers to entry of these markets. Meanwhile, over 40% of respondents reported being concerned about the reputational risk of such investments.
This last point bears expanding upon as it reveals the true double-bind that potential VCM investors find themselves in. On the one hand, firms with a social conscience want to invest in furthering the cause of fighting climate change, on the other, they are cognizant of the disorganisation of the present VCM landscape and are concerned that making the wrong type of investment could actually end up backfiring on them, reputationally.
The bad publicity received in 2023 by Verra, one of the world's leading carbon standards and credit registries is a case in point. When independent studies alleged that many of Verra's issued credits were "phantom credits", connected to projects that do not represent meaningful carbon reductions, this led to a slew of bad publicity for several firms, such as Disney, Shell, Gucci, Salesforce and others that had invested in these projects.
Burgeoning accountability
The recent class action lawsuits filed against Danone, The Fiji Water Company, and Delta Air Lines all testify to the growing sensitivity of consumers to the ways in which carbon offsets are used to 'greenwash', while also bringing growing doubts to the surface regarding the efficacy of the projects behind the issuing of these carbon offsets.
It appears that the tide is turning on this issue, with companies making carbon neutral claims – or even carbon negative claims, in the case of Fiji Water – by purchasing carbon offsets, being regarded by the public as acting in a disreputable manner regarding their green commitments.
A cursory glance at the growing number of organisations in the space that have appointed themselves as standards bodies (Verra, Gold Standard, Climate Action Reserve, American Carbon Registry, Puro.Earth, and Isometric), reveals the confusion that currently reigns in this market, and hints at the conflicts inherent in a standards body essentially being able to generate its own credits, which is tantamount to having the authority to print one's own money.
As a counterweight to the above, and in an effort to force organizations such as these to be more accountable, there have emerged a set of carbon credit and offsetting principles.
The Integrity Council for the Voluntary Carbon Market (IC-VCM) has published a set of Core Carbon Principles, and the University of Oxford has published its own Net Zero-Aligned Offsetting Principles. Additionally, several carbon credit ratings agencies, such as BeZero, Calyx, and Sylvera, have emerged to provide much-needed quality control checks in a market where not all carbon credits are created equal.
Financial Opportunities
Despite the inherent risks outlined throughout this article, the development of mature carbon markets whose claims are verifiable and whose assets can enjoy some degree of fungibility presents significant financial opportunities. Currently these assets can be said to suffer from a lack of trust similar to how crypto assets were initially distrusted by investors in the asset's earlier bull markets (2011-2013). Compare those valuations to crypto valuations in 2020-2022 and the change in popularity, trust, and market cap can hardly be believed.
Many nascent markets appear to follow a similar trajectory. They begin in a 'Wild West' style free-for-all fuelled by speculative euphoria. When the parties concerned realise that lack of transparency is a significant ceiling on the market's legitimacy and scope for future growth, they begin to make efforts to self-regulate. Through this process of self-regulation standards start to emerge that investors can measure market participants up against.
The guidelines of Oxford University and the IC-VCM are an encouraging step in this direction.
They represent a genuine attempt to help differentiate the quality of one carbon credit from another through the outlining of helpful principles such as 'additionality' (investment in the credit removes carbon from the atmosphere that would not have occurred in any other way) and 'permanence' (the removed carbon represents a permanent solution, rather than one that can be undone at a later date by, for example, a change in land management practices or government policy).
Furthermore, opportunities abound not just in the credits themselves, but in all manner of unforeseen investments that will undoubtedly spring up in the wake of these investments. At their core, VCMs represent a new kind of funding mechanism whereby capital can be funnelled into projects that may otherwise have never seen the light of day.
Similar to Ethereum's ICO craze in 2017, and the post-Covid DeFi bubble, much of this investment is ultimately doomed to failure, but some of these projects will undoubtedly lead to novel technologies, consumer products, and even entirely new industries with sustainability as their guiding principle.
Future outlook
Top-down regulation of these markets is unlikely to become a reality anytime soon. If cryptocurrency markets are anything to go by, then it's not even a foregone conclusion that a regulatory environment is even possible, or desirable, particularly in an area where regulatory capture could lead to the same kinds of greenwashing that are currently being litigated.
What's particularly interesting about this specific market, however, is that it revolves around a core issue that people care about so deeply and are fiercely protective of, that of the environment. In this respect, it represents a market for which it will be far harder for investors to focus exclusively on financial gains while turning a blind eye to the issues.
Companies that pay lip service and go through the motions, while actually doing nothing to improve the underlying climate situation, are just as likely to be punished by their customers as an investor would ordinarily be punished by the market for making bad investment decisions. In this sense, there is a great deal more at stake.
While the standards and best practices currently in effect are bewildering at best, it is conceivable that these issues will be ironed out, perhaps even quicker than in an abstract asset such as crypto. After all, the actions taking place that lead to the generation of these carbon credits and offsets are taking place directly in the real world where results can be tested, measured, and compared. Furthermore, no issue is likely to galvanise third parties to test the claims being made by issuers of these credits more than that of the environment.