CA-EN Advisors
CA-EN Advisors

Introduction to Carbon Credits

Carbon offsets play an important part in curbing the effects of climate change and enabling a sustainable future.
February 2022
February 2022
Daniel Shannon

Daniel Shannon

ESG Analyst

ESG: Environmental

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  • Carbon offsets play an important part in curbing the effects of climate change and enabling a sustainable future. Carbon markets have grown substantially around the globe in recent years as companies, individuals and investors purchase carbon credits.
  • Carbon offset projects face inherent risks, as well as opportunities. The construct of a fair and transparent global carbon market system is required to manage these risks and scale the technologies we need to reach net zero.
  • At BMO GAM, we are committed to understanding the risks and opportunities associated with the carbon markets on behalf of our investors. BMO has committed to being a carbon neutral business, enabled partially by our offsetting activities.

Background

The urgency of the climate crisis is often times summarized by demonstrating one simple number; temperature rise. Changes in this number show the true story of how our climate is shifting as a result of human activities. It not only defines what we have done to our planet, but how the planet will treat us in the future. Our releasing of carbon dioxide and other greenhouse gases into the atmosphere has climbed at unprecedented rates. Over the past 50 years, our population has doubled, the global economy has grown four times the size, and global trade has grown ten times the size, all supported by fossil fuels and over-consumption of the earth’s resources.

In order to curb the effects of climate change and limit global temperature rise to 1.5C by 2050, we must act swiftly to reduce our global carbon emissions and ambitiously achieve net zero. This concept of achieving net zero carbon emissions will take a global movement of profound levels. One that goes beyond transitioning a fossil fuel-dependent global economy to a sustainable energy-based economy, rather to one that changes the behaviors of consumers, businesses and governments.

Until our greenhouse gas emissions are in balance with the earth’s ability to sequester it, global temperatures will continue to rise. Balancing those sources and sinks gives rise to the concept of a carbon budget. This budget details the total emissions we have left to emit in order to be a net zero world by 2050 and limit global temperature rise to 1.5C, which experts insist involves a 50% reduction of emissions by 2030. As of the end of 2020, the global carbon budget was 500 Gigatonnes of CO2. If we produce more than this in the 21st century, temperature rise levels will likely be above 1.5C, causing profound negative effects on our planet.

This is where carbon offsets come into play.

What Are Carbon Offsets?

Carbon offsets are certificates demonstrating the reduction or removal of greenhouse gas emissions, typically measured in tonnes of carbon dioxide equivalent, that can be purchased and exchanged in order to counterbalance the release of carbon dioxide emissions generated elsewhere.

Carbon offsets are typically generated through project-based activities, and can include things like renewable energy, methane abatement and reforestation. In addition to providing environmental benefits, these projects often have social co-benefits in local communities.

For example, consider a carbon offset project that reduces carbon emissions and enhances carbon sequestration through the adoption of regenerative farming practices. This emerging practice in agriculture is in-fact not new – humans deployed regenerative practices before the rise and use of newer technologies like pesticides and advanced machinery. By incorporating regenerative practices like crop rotation and diversity, year-round organic soil coverage and minimal soil disturbance, farmers can reduce their energy usage and increase their soil-carbon sequestration. These increased sequestration rates can be scientifically determined with high accuracy.

The net carbon emissions reductions from these practices can then be quantified using standard methodologies, verified by an independent third party, and certified as a carbon offset which can then be purchased by companies seeking to “offset” their own emissions. The proceeds of the sale create opportunities for farmers to cover the costs of the project, earn additional income, while also providing cleaner drinking water to local communities by reducing or eliminating the use of pesticides.

When reductions or removal of greenhouse gas emissions from these projects are verified, they can be sold as tradable certificates. These credits are certified and registered, in order to provide the buyer with verification of emissions reductions. Carbon credits are held to high global standards in order to protect the environmental integrity of offsetting activities. Credits are typically generated after third-party verification, though some credits can be issued for future projected emissions reductions, known as Forward Crediting. However, the practice of Forward Crediting has inherent risks, including the potential for over-crediting carbon emissions.

Once a carbon credit is generated by an activity whereby one metric tonne of CO2e emissions is removed (I.e. direct air capture, reforestation), reduced (I.e. energy efficiency projects), or avoided (i.e. stopping deforestation activities), companies can then purchase them to offset their own carbon emissions and meet their climate targets. A baseline example would be a company that produced 100 tonnes of CO2e in 2020; the company could purchase 100 carbon credits in 2021 in order to become carbon neutral for 2020. Once a company or individual uses the carbon credit to offset their own emissions, they are ‘retired’ and taken out of circulation. Ambitious companies can purchase enough offsets to compensate for their historic emissions as well.

What Are The Risks?

Carbon offset projects have inherent risks that investors and purchasers of credits should be aware of. These risks come in many forms, depending on the project and those involved. Examples may include:

  • Reversal risks. Many offset projects face the risk of reversals in sequestered carbon. One example would be to look at reforestation offset projects, which have inherent risks to due to climate change. Carbon credits related to reforestation or avoiding deforestation can face reversal risks as forest systems around the globe experience varying substantial effects due to changing temperatures and more volatile weather systems. Disturbances such as fire, wind (hurricane & tornado), ice, insect and drought all effect forest systems, with the potential to reverse the carbon sequestration of said protected trees. Offset projects of this type need to set the importance of risk management above the goal of maximizing carbon sequestration rates. Projects following the REDD methodology (reducing emissions from deforestation and forest degradation) include measures to safeguard long-term carbon sequestration and account for reversals should they occur.
  • Local effects. Offset projects may pose a risk to local communities. Conflicts must be managed at the community level when new offset projects are built – especially those which require large amounts of land. This includes Indigenous communities who may be negatively affected or not afforded Free, Prior and Informed Consent (FPIC).
  • Additionality. Purchasers of carbon credits should consider the additionality risk of an offset project. If a project does not actually contribute to achieving additional climate benefits, compared to if the project had not existed, then it would not be considered ‘additional’ and would be at risk of failing. An example of this may be the protection of a forested area to prevent an estimated 100% deforestation rate over 10 years. The project would have to determine with high certainty that deforestation activities would in fact occur in the protected area within the time frame, otherwise the project has no base for additional climate benefits.

What Are The Carbon Markets?

Just like all public market assets, carbon credits too need to be transparent, fair and accurate. Before purchasing carbon credits, purchasers look for third-party verifications which confirm that the offset has in fact reduced or removed one ton of CO2e. There are two major markets for carbon offsets – the Compliance Carbon Markets and the Voluntary Carbon Markets.

In Compliance Carbon Markets (i.e. for companies in a cap-and-trade or similar carbon trading scheme), emitters are given an emission allowance which specifies how many tonnes of CO2e they can emit for a given period of time. Governing bodies control the supply of such allowances, and emitters determine the demand for such allowances. If emitters produce more emissions than their allotted amount in carbon allowances, they have to purchase additional allowances from other emitters or the government at set prices, thus penalizing them for their increased emissions. If emitters generate less emissions than their allowed limit, they can then sell these allowances to other emitters, thus rewarding them for their reduced emissions. Depending on the region, examples of emitters may include establishments like cement plants, steel mills, mines, refineries, fossil fuel distributors and certain electricity producers.

In voluntary markets (i.e. companies and individuals with their own emissions targets), carbon credits are generated by offset projects and typically verified by any one of the major carbon standards bodies which deploy third-party verification on each credit before they are sold or listed on an exchange. A carbon credit can be sold multiple times and is only retired when the holder wants to claim that emissions offset. The voluntary Carbon credit markets have seen substantial increases over the past few years, marking the rise of a new major commodity market.

Carbon offset projects, Verifiers, and the Compliance and Voluntary Carbon Markets work to provide carbon credits to the global economy in various ways. Businesses and individuals can then trade and retire these credits in numerous markets.

Voluntary carbon markets allow organizations and other buyers to neutralize or partially offset their own emissions, thereby contributing meaningfully to the transition to a net zero economy. In this market, purchasers can acquire and retire various types of offsets, ranging in price from $2 to as high as $500 depending on the scale and availability of such technologies and projects. By connecting buyers and sellers of carbon credits, the voluntary carbon markets can support the path towards net zero by both providing fair and transparent access to offsets. According to the Taskforce on Scaling Voluntary Carbon Markets, these markets go well beyond supporting nature-based solutions and scaling existing technologies but are also a key component of financing and supporting new technological advancements that will help the global economy to meet net zero targets by allowing these technologies to be sold directly to purchasers looking to diversify their offset sources. The taskforce estimates that in order to meet 50% emission reduction targets globally by 2030, roughly 2GtCO2 will need to be offset by sequestration and removal. In order to meet this imminent demand for offsets, the voluntary markets will need to scale 15-fold by 2030 compared to 2019 levels. After accounting for the need to finance avoidance and reduction of emissions (beyond just sequestration and removal), the required growth in voluntary carbon markets will likely be significantly larger than 15-fold. By 2050, this number is estimated to be near 100-fold.

In the first eight months of 2021, voluntary carbon markets grew roughly 60% in size with US $748M in sales, transacting 239 million credits (i.e. 239 million tonnes of CO2). This signals the improving state of corporate ambitions to achieve the Paris climate goals. These markets are made up of a diverse group of buyers and sellers. Emitting companies are not the only buyers – individuals and investors have also been participating in the market. Individuals can purchase offsets in many ways, such as measuring one’s own emissions and purchasing enough verified credits to offset those emissions, or by participating in offset programs upon larger purchases, such as airline tickets, Christmas trees or weddings. Voluntary carbon markets are already being utilized in the investment world, with certain funds using these offsets to effectively construct net zero portfolios based on emissions data from underlying holdings.

Investors can also participate in the Compliance Carbon Markets (CCMs) – unlike the voluntary carbon markets, CCMs have government-mandated supply according to local regulatory carbon schemes. According to McKinsey, investors who allocate a portion of their portfolio to purchasing carbon allowances through the CCMs can potentially mitigate negative effects on their portfolio and improve their return profile in the long term as carbon prices (the price per ton of CO2e emissions) may benefit from new climate policies.

What do we do at BMO?

At BMO Financial Group, we have been carbon neutral since 2010. By collecting data on energy usage and emissions across our entire business and at all our facilities world-wide, we are informed as to what we need to do in order to be carbon neutral. In addition to deploying capital to reduce energy usage and drive energy efficiencies, we have a long track record of purchasing renewable energy certificates and carbon credits.

Our approach to carbon credits has been community-based. We support local projects and initiatives that reduce emissions and benefit the communities in which we serve our customers. We also purchase a variety of different types of offsets to manage risk.

We also recognize that beyond current technologies, new technologies will need to be created and adopted at scale to meet key climate target dates like 2030 and 2050. While new technologies pose higher risks for investors and face challenges earning trust in the rapidly growing carbon credit space, support across companies, governments and investors will be key to reaching a net zero world.

One example of how we support new technologies is through our recent pre-purchase of 1,000 tonnes of permanent carbon removal via direct air capture which deploys an engineered approach to capture carbon directly from the atmosphere and permanently sequester that in the earth (i.e. 100+ years), developed by a company called Carbon Engineering. Technologies like this will benefit from early stage support as they aim to provide more commercially scalable options for companies to offset their own emissions. In 2020, BMO Financial Group retired 40,317 carbon credits.

At BMO Global Asset Management, we hold a fiduciary responsibility to our clients to understand and manage risks in their investments. As the global carbon markets grow, and associated policies and regulations develop, we place high importance on our understanding of associated risks and opportunities. Recently, we engaged our investment professionals in a workshop dedicated to carbon offsets, furthering our collective understanding on the topic.

About BMO Global Asset Management's Responsible Investing Team

BMO Global Asset Management’s Responsible Investing team manages and develops the firm’s Responsible Investing (RI) thought leadership, publishing regular insights and deep dives on a variety of emerging environmental, social and governance (ESG) topics. The team collaborates with investment teams on emerging ESG developments, provides ongoing ESG integration support, employs a progressive approach to stewardship activities and oversees BMO Global Asset Management’s ESG initiatives and commitments to responsible investing.

Disclosures

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

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