How Crediting Mechanisms Function
In the previous lesson/chapter, we covered:
- Types of carbon pricing mechanisms and their share of global emissions coverage.
- Compliance and voluntary carbon markets, and introduced the Article 6.4 crediting mechanism.
- The role of net zero commitments in driving carbon market expansion.
In this lesson/chapter, we will delve deeper into:
- Crediting mechanisms and underlying concepts like additionality.
- Explore the project development process and its key actors.
- Look at the state of the market by project types.
Project- or Program-based
Crediting mechanisms operate under a “baseline-and-crediting system”.
This requires the creation of a baseline scenario upon which a project will need to perform better, i.e., emit less emissions than business-as-usual. Depending on the crediting scheme, this baselining could be defined as a performance standard (benchmark) or be defined on a project-by-project basis.
This improvement should be measurable and will allow for the appropriate crediting of emissions reductions and/or removals.
Additionality is a key requirement to ensure the environmental integrity of carbon credits issued.
Additionality means that:
- The project would not have occurred without the expected funding from the sale of carbon credits.
It helps to distinguish between activities that are already mandated by law or economically viable from those that require “additional” support to be implemented.
Thus, additionality is necessary to solve the market failure addressed through the crediting mechanism.
TYPES OF ADDITIONALITY
TYPES OF CARBON CREDITING MECHANISMS
There are three main types of crediting mechanisms. These are classified according to levels of governance and geographical focus:
- International: established under international treaties (i.e., Kyoto Protocol and Paris Agreement). Includes Clean Development Mechanism (CDM) and Joint Implementation (JI).
- Independent: established by independent standards often managed by non-profit entities (i.e., Verra, Gold Standard, etc.).
- Domestic: established by regional, sub-national, and national governments (i.e., California Compliance Offset Program).
Figure 2.10 shows the distribution of these project-based crediting mechanisms. Overall, we must remember that these instruments cover approximately 1% of global GHG emissions.
As we described the crediting process at the beginning of this topic, let’s take a look at the responsible parties that operate in this market starting with the Project Developer (PD) or Project Proponent (PP).
What is the role of Project Developers?
- Initiate and implement climate mitigation projects.
- Ensure the project follows relevant requirements under the chosen standard and selected methodology
- Monitor the impacts of the project and organize regular third-party audits
- Mobilize finance
- Bear project-related risks
Figure 2.11. Carbon Project Development Organization (Abatable 2021)
DESCRIPTION OF PROJECT DEVELOPMENT ACTORS
Other key stakeholders include:
CARBON PROJECT LIFECYCLE
There is a widely accepted common lifecycle for projects seeking to issue units under project-based crediting mechanisms. It includes the following stages and can be summarized as follows:
- The project is planned/designed according to established rules and requirements by the chosen standard. The project design is validated by an accredited third party for conformity with the Standard.
- During the lifetime of the project, the project is under a monitoring process. Its performance is reviewed and verified by an accredited third party for conformity with the Standard and its validated design.
- Units or credits are issued based on the results of the verification process.
Figure 2.12. Diagram of Project Development Stages
CARBON PROJECT FINANCE MODEL
During the project development process, the risk profile of the project changes. The investor(s) and/or project developer(s) bear a high risk during the early stages.
In Figure 2.13 we see how the risk curve goes down in time as there is more certainty in the execution of the project. After achieving project validation, the monitoring stage initiates the de-risking phase, where the first project verification allows for the issuance of credits. Subsequent verification cycles will continue providing a return on investment at a lower risk.
Also, in the graphic we see how project financing is changing. While in the past there was a larger dependency on development finance and/or grants, or the project developer needed to bear the responsibility for the investment, we see how carbon streaming, investment funds, and corporate carbon trading desks are participating much earlier in the process. Also, we see the appearance of financial intermediaries. This shows how the industry is maturing.
Figure 2.13. Diagram of Carbon Finance Model and Project Risks
CARBON MARKET VALUE
The financial value of carbon markets has accumulated over time. Yet, its development has been anything but steady. In the beginning, the Chicago Climate Exchange (CCX) was a voluntary GHG emissions trading system that operated between 2003 and 2010 until the price of credits crashed around 5 to 10 US cents in comparison to the 750 US cents it reached in 2008.
In parallel, the economic uncertainty and failure of the Kyoto Protocol to develop enough market demand led to several years of accumulated issuance of credits at low values. Post Paris Agreement, we see a significant growth in the value of the market as both countries and companies work towards reaching their net-zero commitments. Nevertheless, as we will discuss the challenges of the market in our next topic, the price per carbon unit is far from where it should be to drive the systemic change needed to achieve global decarbonization.
Figure 2.14. Voluntary Market Growth, 2005-2021 (Ecosystem Marketplace 2022)
CARBON MARKET SHARE BY INDEPENDENT CREDITING MECHANISM
The market is served by several independent crediting mechanisms. The four leading ones are VCS, Gold Standard, CAR, and ACR. Figure 2.15 shows the share of total issuance per Standard. And, while it is important to consider the issuance volume, it is equally important to explore the types of projects that each Standard serves.
Figure 2.15. Quarterly issuance of credits per Standard (Source: SustainCERT Market Intelligence).
CARBON MARKET BY PROJECT CATEGORIES/TYPES
The particularities of each project type influence the trends we see in the volume of credits issued, number of projects, and unit price.
According to Ecosystem Marketplace (2022), Forestry and Land Use dominate by monetary value the market at US $1,327.5 million in 2021. Renewable Energy credits represent an almost equal share of MTCO2e at a unit price of almost half of the forestry one for a total value in in the same year of US $479 million.
Energy Efficiency & Household Devices projects (e.g., cookstoves) represent the largest share of issuing projects (figure 2.16). Yet, ‘only’ 3.8% of total issued volumes (Table 2.1) as these tend to be typically smaller projects.
Figure 2.16. Breakdown of Total Projects Issuing Credits per Project Category (Source: SustainCERT Market Intelligence)
Table 2.1. Credit Volume and Price by Project Type between 2020-2021 (Ecosystem Marketplace 2022)
This divergence in market price per project type can be attributed to market forces as explained by an article published by the Gold Standard Foundation on their website on “Carbon Pricing: What is a carbon credit worth?”. Yet, what is more interesting is the gap between the market value of credits and the monetary value of project impacts as shown in Figure 2.17.
The economic analysis commissioned by the Gold Standard Foundation showed the value beyond carbon benefits by addressing other Sustainable Development Goals. Back to our previous example on Forestry projects, we see a significant gap between the market value of US $5.80/credit versus the monetary impact value of US $177/credit.
This gap and divergence in pricing shows that there is still work to do to solve for the externalities of carbon emissions and the projects that address them.
- There are several project-type categories that require specialized knowledge both contextual (i.e., geographies, technological development), and in technical execution. The credits issued by these types of projects are priced differently. Moreover, there is a gap between the market value and the monetary impact value of carbon credits in the market.
- The Carbon project financing model is evolving as it is expected that carbon streaming, investment funds, and corporate carbon trading desks will participate in earlier stages of project development.
- As mentioned before, there are several risks associated with the development of carbon projects and the next topic will shed some light on these challenges and opportunities.