Carbon's "lemon" dilemma

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In early 2023 I published The signal and the noise: Pricing the carbon credit risk curve, one of my first posts about the verified carbon market (VCM). In the article I introduce how carbon projects generate credits, the six main factors underpinning carbon credit methodologies, and delve into media reports alleging that more than 90% of nature-based credits fail to deliver. The crucial insight, which I coined Carbon’s "lemon" dilemma, is that the VCM resembles the used car market:

"Economist George Akerlof markets noted that markets in which buyers possess imperfect information while sellers possess a profit motive are often thin, insubstantial and low quality. Akerlof used the second hand car market and the imperfect information problem posed by poor quality cars (“lemons”) as an example. The VCM is an equally good example of this problem in action.

For example, suppose buyers in the carbon offset market value good nature-based carbon projects at $20 per tonne, while sellers value them slightly less. A poor quality project is worth only $10 per tonne to buyers. However, buyers of carbon offsets struggle to tell the difference between projects of differing quality. To account for the risk that a project is a lemon, therefore, buyers cut their offers.

They might be willing to pay, say, $15 per tonne for carbon offsets they perceive as having an even chance of being high or low quality. But sellers who know for sure they have a high quality project will reject such an offer. As a result, the buyers face “adverse selection”: the only sellers who will be prepared to accept $15 per tonne will be those who know they are offloading a poor quality carbon offset.

Smart buyers can foresee this problem. With the knowledge that they will only ever be sold a poor quality offset, they offer only $10 per tonne. Sellers of poor quality carbon offsets end up with the same price as they would have done were there no ambiguity. However, there are no buyers for the high quality carbon offsets."

Two reports published this month illustrate the challenges facing the carbon credit market, and suggest that it is much larger than I outlined in the article above. This is important since corporate demand for carbon credits has rebounded strongly from its 2021/22 lows and is set to grow even stronger.

A recent survey of major global companies by Morgan Stanley found that more than 90% of those currently purchasing credits expect volumes to grow over time. The de-risking of credits in the eyes of corporates has taken a further step after the the Science Based Targets initiative (SBTi) moved to a position where credits, at least high quality ones, are much less of a reputational risk (see Eyes on the prize: Revised SBTi standard amplifies role of internal carbon prices, carbon credits, and Environmental Attribute Certificates (EACs)).

Furthermore, international carbon credits under Article 6 will soon be employed by governments seeking to meet their climate commitments under the Paris Agreement. For example, last year the European Parliament voted in favour of cutting net emissions by 90% compared to 1990 levels by 2050, while also agreeing to allow up to 5% of the emission reduction to be achieved through the purchase of international carbon credits.

If carbon credits have as many issues as the reports outline, then there is a high risk of over-crediting, wasted resources, and the environmental integrity of corporate and national climate commitments being undermined.