State and Trends of Carbon Crediting Mechanisms

Learning objectives:

• The project developer should be able to distinguish between different project-based crediting mechanisms.

In the previous topic, 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.
• Recommendations on how to use voluntary carbon credits.

In this topic, 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.

CREDITING MECHANISMS

Project- or Program-based

Crediting mechanisms operate under a “baseline-and-crediting system (ETS)”.

This requires the creation of a baseline condition  upon which a project will need to perform better, i.e., emit less than business-as-usual. Depending on the crediting scheme, this baselining could be defined as a performance standard (benchmark) or be define on a project-by-project basis.

This improvement should be measurable and will allow for the appropriate crediting of emissions reductions and/or removals.

Figure 2.9. Depiction of a Crediting Baseline (Source: WB-PMR 2011 Crediting Mechanism Overview)

ADDITIONALITY

A Key Requirement of Crediting Mechanisms and proof of the purpose of the instrument in solving for the market failure in accounting for the negative externalities of carbon emissions.

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 for 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) & 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 these project-based crediting mechanisms. Overall, we must remember that these instruments cover approximately 1% of global GHG emissions.

Figure 2.10. Market Share of Crediting Mechanisms (Source: The World Bank. 2023. State and Trends of Carbon Pricing)

CARBON CREDITS & OFFSETTING

Now, let’s take a moment to review some basic terminology to understand when we refer to the product of crediting mechanisms and distinguish that from its potential use.

Carbon Credits: these are generated from projects or program of activities that reduce GHG emissions via a variety of methods. These methods adhere to strict standards and are scrutinized through a monitoring, reporting and verification process. Credits are measured in metric ton of carbon dioxide equivalent.

Carbon Allowances: work as permission slips. A company can buy or gains these permits from an ETS to gain permission to generate one metric ton of CO2e emissions.

Offsetting (of emissions) is the act of claiming carbon allowances or credits in order to compensate for unavoidable emissions.

PROJECT DEVELOPMENT

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 projects.

• Bring multiple stakeholders together to deliver auditable carbon offsetting claims and other SDG co-benefits.

• Mobilize finance for climate mitigation

• Reduce greenhouse gases (GHG) or enhance carbon removals.

• Bear the financial risk of the project.

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 independent standards. 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 from 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 in time. Yet, its development has been anything but steady. At the beginning, the Chicago Climate Exchange (CCX) was a voluntary GHG emissions trading system that operated between 2003 to 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 country-level and companies work towards reaching their net-zero commitment targets. 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 systematic change for 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

As we mentioned earlier, a key requirement of carbon projects is “additionality”. This translates into certain categories of projects that need that “additional” finance to operate. Moreover, under these categories there are several project types that could be carry out by Project Developers. For instance, under “Forestry and Land Use”, we could find the following project types:

• Afforestation/Reforestation
• Avoided Forest Conversion
• Avoided Grassland Conversion
• Improved Forest Management
• REDD+
• Sustainable Grassland Management
• Wetland Restoration

According to Ecosystem Marketplace (2022), Forestry and Land Use dominates by monetary value the market at US $1,327.5 million. Also, it has an almost equal share of issued credits as Renewable Energy Projects that have an unit price of almost half of the forestry one. In addition, the particularities of project types also explains how volume of credits issued, unit price, and number of issuing projects can vary per category. Another good example can be found in Energy Efficiency projects (e.g., cookstoves and/or household devices) include the largest share of issuing projects as shown in Figure 2.16. Yet, these projects are not the largest issuers of credits as we can see from Table 2.1.

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 in 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.

CLOSING REMARKS

• The market for the issuance of new carbon crediting projects is growing slowly. Although the value of the market has grown substantially in the last few years. This could be a reflection of the growing commitments across all levels of society to invest in decarbonization.

• 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 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 to the development of carbon projects and the next topic will shed some lights on these challenges and opportunities.