Under-rated

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As governments consider how to relieve the carbon abatement pressure valve, policymakers in Europe are debating how carbon credits linked to international carbon projects and carbon dioxide removal (CDR) can play a role in the blocs climate policies. If they are not careful they risk undermining the integrity of instruments such as the EU ETS. As readers of Carbon Risk know, carbon markets are built on trust, and once its gone its very difficult to get back.

In Carbon's "lemon" dilemma I show that carbon credits exhibit many of the same characteristics seen in the second-hand car market, just to a much greater degree: imperfect information (neither buyers nor sellers are able to assess the quality of the underlying projects) and asymmetric information (one side has more access to information than the other). The knock-on impact of this is adverse selection, a situation whereby one party may exploit undisclosed information to the detriment of the other party in a transaction.

As a paper from the Oxford Smith School highlights, these extreme 'market-for-lemons' characteristics have three important consequences that compound the adverse selection problem. First, there is no role for reputation mechanisms to help buyers judge quality. Second, contractual enforcement is undermined, since even a "well-resourced regulator or auditor" faces the same set of challenges determining the underlying quality of a carbon credit. Finally, the poor cost-benefit ratio (effort required versus carbon price received) weakens the incentive for any seller of carbon credits to do better.

Compliance carbon markets whose rules enable carbon credits to meet some level of compliance (such as the Californian Cap-and-Invest Program) have introduced mechanisms to manage the risk that credits don't deliver what they promise. Amongst the risk management armoury, schemes often include buffer pools, reversal insurance, permanence trusts, and digital monitoring, reporting and verification (MRV). However, it all starts with a methodology that establishes a minimum bar for compliance grade eligibility.

This sounds like a good idea, but a simple pass or fail suppresses price differentiation and weakens the incentive for buyers to verify what they have purchased, and for developers to improve the integrity of their project and invest in risk mitigation. With no mechanism to differentiate between the good, bad, and the ugly, incentives being what they are, the onus is on developers to churn out more and more credits (as long as they meet the minimum standard), rather than high integrity credits.

The upshot is that compliance carbon credits also often fail to deliver on their promises, undermining the integrity of the compliance scheme. For example, the Californian Cap-and-Invest Program and the Australian Carbon Credit Unit (ACCU) Scheme have been beset by concerns that the over-issuance of credits has dampened the incentive to invest in decarbonisation.

Even the best methodology in the world can't cover all the eventualities that could befall a carbon credit project. As with any other activity that takes place in the real world (and not a spreadsheet), shit happens. Could carbon ratings - a structured way of estimating the residual risk that a project fails to deliver - help price the compliance carbon risk curve?