‘This is all very confusing’: Investors grapple with voluntary carbon markets

A growing number of intrepid private markets firms have begun to deploy capital to protect and restore the earth’s natural carbon sinks, which play a huge role in reducing atmospheric greenhouse gas emissions.

More than 50 firms now have strategies seeking to deliver carbon sequestration through natural means, according to research from consultant Bfinance. Just Climate and Ardian brought their funds to market late last year, but the list of GPs with dedicated natural capital funds includes Axa IM Alts, Stafford Capital, Bregal Investments, Mirova, Lombard Odier Investment Managers and Gresham House. Others, such as TPG, are investing in the space from broader climate impact funds.

Should the natural capital investment ecosystem mature, the potential climate impact is huge: A report from the Forest Investor Club, a group convened by the US State Department to accelerate investment in nature, found that nature-based solutions have the potential to account for 37 percent of the cost-effective climate change mitigation efforts needed by 2030 to meet Paris Agreement goals, citing data from the World Business Council for Sustainable Development. For this to happen annual investment into nature-based solutions needs to double by 2025 to around $384 billion.

Returns profile

While some jurisdictions, including the EU, Brazil, China and some US states, have begun to implement emissions trading schemes, the majority of nature-based solutions funds are looking to the voluntary carbon markets as a way to make their strategies financially competitive.

Managers must therefore decide what role carbon credits will play in the returns profile of the fund. Folium Capital is combining traditional agriculture and timberland return – by developing and selling assets such as orchards and vineyards as well as timberland – with carbon credit sales. Stafford Capital is also underpinning carbon credit revenues with a commercial timberland return, which is expected to be around 5 percent. Climate Asset Management, the joint venture by HSBC and Pollination, has two strategies: one, mainly targeting corporate LPs, which will distribute credits directly to LPs. CAM’s other strategy involves selling credits to distribute income to LPs.

Axa IM Alts is taking a flexible approach. The French firm collected €500 million from Axa Group companies to invest in natural capital in 2022, and made its first investments last year.

Head of natural capital Adam Gibbon tells New Private Markets: “When providing project financing to developers for carbon credit generating projects, our strategy has the option to structure this as cash-in cash-out, such as debt, or to do cash-in credits-out in the form of a VERPA (voluntary emission reduction purchase agreement). We have used a mixture of these structures to date. By selling the credits, we give our investors a financial product that is exposed to the future price of carbon. If an LP in the fund wishes to receive or acquire a portion of their returns in credits, then this is a concept we can accommodate.”

Most trading occurs behind closed doors, with project developers and buyers negotiating privately, making accurate information on pricing hard to come by. Though more sophisticated marketplaces are emerging, they are “very early in their development and not quite there yet to be meaningful, because for a market-place to work there needs to be a more homogeneous ecosystem of credits”, Energy Impact Partners European managing partner Matthias Dill says.

As a result, most funds (84 percent) target a conventional base financial return, supplemented with carbon credits, according to bfinance. Only for a minority of funds (16 percent) do credits represent virtually the entirety of target returns.

Gresham House is one manager treating returns from credits as an added bonus. Its Forest Growth & Sustainability fund, which closed on £300 million (€350 million; $380 million) last year, has a target return from the sale of timberland of 6-7 percent, according to Olly Hughes, managing director of the firm’s forestry division. The firm is then looking to “deliver an upside of, who knows, one to two percent on top of that”, through carbon credit sales.

“What we are not is experts in is trading,” Hughes adds. Looking across the ecosystem, it is not clear that anyone is. Market actors expect the average price of a credit to rise from between $15 and $20 currently to as much as $30 by the end of the decade, according to a report from Boston Consulting Group and Shell, but the reality is this is very hard to predict with certainty.

“Not formally, no,” says Robin Rix, chief legal, policy and markets officer at Verra, the world’s largest credit issuer, when asked if it tracks pricing. “Our job is to focus on the integrity of supply and to help bring supply to market by providing the necessary certification infrastructure.”

It is a similar story at Gold Standard, another verification body: “To be honest, historically, we didn’t much,” explains chief growth officer Sarah Leugers in response to the same question. “We’re a step removed from the buyers. We’re not involved in those transactions and in many cases, they aren’t transparent and aren’t known.”

The upshot of this, says Dill, is that landing on a fair price is a tough ask: “If you look at the average price per tonne across credit types and vendor, it shows that quality and price are not necessarily linked. It just speaks to where those markets are.”

Credibility

A fragmented and inconsistent market poses other challenges for managers.

For one thing, not all carbon credits are created equal. Broadly speaking, natural capital funds can produce credits either by preventing emissions from being released into the atmosphere (avoidance), or by absorbing carbon from the atmosphere (removal), though there are a number of different accreditation bodies a project developer can choose to use which may have different methodologies.

Greenly, one of EIP’s portfolio companies, is a carbon accounting platform, but has begun to move into the carbon credits space in response to client demand. The company now works with climate tech company Patch to provide its clients with access to a marketplace of offsetting projects.

CEO Alexis Normand says: “You have projects where it’s like €5 per tonne and you have projects where it’s €1000 per tonne, because one is a forestry protection project, and the other is direct air capture. It seems like tonnes of CO2 avoided are fungible, but they’re not, it’s not the same thing. For end users this is all very confusing.”

There have also been questions raised as to the actual offsetting value of credits being issued. An investigation into the value of REDD+ avoided deforestation credits generated using the Verra standard, carried out by newspapers The Guardian and Die Zeit and investigative non-profit SourceMaterial, found that more than 90 percent of avoided rainforest deforestation credits – which in turn make up 40 percent of all credits verified by Verra – have a “fundamental failing”.

The validity of these criticisms is up for debate – Verra published a response to the findings in which it described the Guardian article and two of the studies it cited as “patently unreliable” – but it is clear that the controversy has undermined faith in avoidance credits. “Among managers we’ve seen so far, there’s very little REDD+,” bfinance ESG director Sarita Gosrani told NPM last year. “They don’t touch it because there’s so much controversy around it.”

Verra has reacted to the investigation by making changes to its REDD methodology to take greater account of jurisdictional requirements, according to Rix, but the damage done to market confidence is wider reaching. “What The Guardian scandal showed is that even if your project has right label, it could be suspicious,” as Normand says.

Whatever standard is used, the market is beginning to shift away from carbon avoidance, in favour of active removal. BCG and Shell’s report predicted that removal credits would make up a growing segment of the market for the rest of the decade.

Gold Standard does not offer REDD+ credits at all. “We don’t recognise REDD+ for carbon crediting, nor for industrial gas projects or anything that perpetuates the use of fossil fuels, like some carbon capture and storage. We won’t certify those, because it’s our view that those types of projects are not the best use of carbon finance. Those types of decisions have established Gold Standard as higher integrity and higher impact,” explains Leugers.

Beyond this, there are other significant issues for managers to navigate. “Jurisdiction is incredibly important,” says law firm Kirkland & Ellis partner Paul Barker. “When you’re dealing with nature investing in emerging jurisdictions, you’re going to have the potential risk of expropriation. There’s still uncertainty as to how emerging jurisdictions in particular will apply the rules on international transfer of credits under Article six of the Paris Agreement.”

There are also local communities to consider. Barker adds: “Then you have all these potentially very complex questions of land ownership and land rights, particularly in certain emerging jurisdictions. Over the last couple of years, there’s been increasing focus on benefit sharing and how local communities, Indigenous communities, can benefit from what is expected to be a pretty substantial increase in the price of carbon over the coming years.”

Future

There is a clear need for institutional investors to enter the space in greater number if nature-based solutions are to scale. Verra is well aware of this, Rix says: “One area worth focusing attention on is what will it take for sophisticated secondary market players to get into the carbon arena. Pension funds, sovereign wealth funds, large top tier financials, what do they need to see? I think we need to better figure out how to align what we do with their expectations.”

Monetising biodiversity in a comparable way to carbon would help, though this is in the early stages of development. Verra has published a draft biodiversity framework, and pilot projects are underway. The framework is set to launched formally “towards the end of next year”.

Harmonisation between regulatory regimes is also key, and here there is reason for optimism. Barker notes that “We have definitely seen the US moving more towards the position in Europe. Singapore is becoming a very important operational and legal hub for voluntary carbon markets. We’re seeing a degree of convergence, emphasizing the importance of measurability, disclosure, and integrity more broadly.”

However, as market for nature-based solutions matures, investors would do well to remember natural capital has a wider role to play in the green transition. Gresham House’s Hughes says: “Where we get a little nervous in terms of that global carbon net-zero ambition is that forestry is just seen as a source of carbon units for offset. And actually, what it must be seen is as a key constituent of a transition to a circular bioeconomy, not just a source of carbon sequestration.”

Though the voluntary carbon market is prohibitively complex for many investors, the fact remains that it has an important role to play in the global response to the climate crisis. Some sources suggested to NPM that the best long-term option may be to expand the compliance markets such that there is little space for a voluntary one, but that remains a pipe dream. For the moment, investors can simply mitigate the risks wherever possible, and hope that price transparency and credit integrity continue to improve.