Something isn’t well in the sustainable investment space

9 min readJun 26, 2023

Sustainable Linked Loans hit the headlines in May 2023[1] as the FCA began an investigation into whether the environmental targets are too easy for companies to meet. The Guardian, De Zeit and Source Material investigation into Vera revealed that 90% of the rainforest carbon certificates[2] are worthless. A Bloomberg report raised questions about South Pole and their forest based carbon offsets[3].

There is history with carbon credits which were first proposed in the Kyoto Summit in 1997 and the collapse of the markets in 2009[4] which were knocked by the wider recession following the banking crisis and questions on the quality of certificates.

We saw a rush in the crypto space between 2021 and 2022 with up to 65 different sustainable projects that were digitizing carbon credits, however, they all relied on the existing registries to correctly maintain and assess the projects.

Fundamentally there is an issue around how the carbon offsetting projects are monitored and who is responsible for ensuring that the data held in the registries is accurate. Verra has an accreditation scheme for 3rd party verification of the projects[5], as does South Pole[6], and Gold Standard[7]

There seems to be a vulnerability in the system such as Sustainability Linked Notes marking their own homework to registries who have processes in place with registered and qualified 3rd parties and yet there are still issues.

Carbon capture is an important part of the fight against climate change as the world transitions from the use of hydrocarbon derived energy and by products to a more sustainable future.

To address the issues of greenwashing, confidence in the registries of carbon credits, and a meaningful market; either the registries of carbon credits, and the banks issuing the SLL double down and invest more into the verification processes, or the governments step in and legislate or a system of incentives and punishments is introduced by the markets.

Risks

Discounting the risks of the verification and greenwashing of sustainable products there are further risks that may not have been seriously considered. A warning shot was fired when a passenger brought a case against Delta Airlines over their claim they were climate neutral[8], and this will have board rooms worried about their climate neutraliness and face accusations of greenwashing.

A more long dated risk is the projects themselves. Let’s consider a forestry project on the West coast of Scotland, the projected growth is based on historical data such as the weather data and knowledge of which species grow well in the environment. Carbon credits can be sold forward[9] by the landowner in expectation of the CO2e captured by the growth of the forest, and following regular monitoring of the project may issue further credits as the forest grows. There are some projects that are looking at a 100 year cycle of the forest.

What happens if the forest is impacted by climate change and the yields are substantially lower than anticipated through the effects of drought or higher temperatures? If the CO2e has been sold forward then the issuer would be liable for the gap between the actual amount of CO2e captured and the credits issued. The landowner could simply go to the market place and buy carbon credits to make up the shortfall, however, there is a risk that carbon credits may be significantly more than price they sold forward and the gap could cause significant issues.

Equally the businesses buying the forward credits are vulnerable to claims that they have not fully offset if the credits are not fully backed. They have recourse with the landowners in the case of a forestry project, but if the landowners go bankrupt then the companies, in order to ensure that they have sufficient coverage they will need to go to the market to buy credits.

How does this get fixed and why an economic approach address the issues?

Relying on global standards and regulations will take time and is not an immediate fix. What incentives do the registries have to do anything more than work with 3rd parties as they currently do?

An economic or market based approach is the most effective remedy as through good design there are incentives and punishments which are introduced. The incentives are to reward transparency and disclosure, the punishment is aimed at opacity and poor reporting.

The economic approach ensures that the carbon credit market operates efficiently through the rewards and the punishments. For example, if one landowner published annual data of the tree growth, the local climate data, the estimated tree growth, and satellite data, then you would expect that the landowner would pay a lower premium as they are rewarded for good disclosure and transparency. Let’s consider the landowner who files their data late, some of it is missing or incomplete, the premiums they would need to pay would be higher as it would be hard to assess the risks, and thus they are punished in the markets for their lack of disclosure.

Swap vs Insurance

A Swap is a financial derivative that allows one party to swap or offset their risk of a default to another party. In the case of a carbon credit, we can think of the default event of the failure to deliver CO2e as specified such as a forest not performing due to adverse weather.

Swaps trade on the Over The Counter (OTC) markets and the price of the swaps will depend on the information made available as well as the supply and demand. The forward looking information such as long range weather forecasts, the weather trends that effect the tree growth, or warming that allows invasive species that could have an impact on the trees to move into the forest all become factors in pricing the swap.

Why a swap and not an insurance policy? A landowner could buy an insurance policy that pays out in the event of the failure to deliver the required carbon credit rather than get involved in derivatives?

The problem with insurance is that it is backward looking as premiums are calculated using historical data and probabilities by actuaries, the data may show steady growth of a forest and using the historical weather data it would be possible to calculate the probability of an outlier event which could impact the growth of the trees, however, what we face with climate change is rapid changes that have not been seen historically that has an impact and thus difficult to model. Additionally, insurance is agreed for a fixed term and does not change as the facts change whereas swaps can respond to the information received.

We can think of insurance as a rear view mirror and swaps as a forward looking mechanism that prices in future events.

What is a Carbon Default Swap?

A Carbon Default event is where there is a shortfall in the amount of CO2e captured in a project and the amount of captured CO2e is not delivered. There can be many reasons for this such as climate events. This is of importance to the project originators and to the purchasers of carbon credits who need them to mitigate the impacts of their businesses while they transition to fully sustainable models.

A default event is where the CO2e projected is not delivered. Given that the majority of carbon credits are sold forward this becomes an issue for both the project that was supposed to deliver the credit and the purchaser who bought the credit to offset their CO2e emissions.

The swap is issued by regulated entity on behalf of the project that is selling carbon credits. The structure of the swap is that the issuer pays a premium in return for the coverage of the carbon credit value.

Let’s say a landlord plants a forest to capture CO2e and generate carbon credits. With a planting density of 1111 seedlings per hectare (3 m spaced grid) 100 kg CO2 (i.e., 27.3 kg of C) per tree equates to 30,330 kg C per hectare over a 4 year period[10]. A forest of 100 hectares produces 3m carbon credits which are currently priced €80[11] in the 4 year cycle. Consider a scenario of where the yield of carbon captured is reduced by 10% and the landowner has a deficit of 900K credits. To buy them on the open market in order to fulfil the obligations to deliver would cost a significant amount to buy.

A swap would be a premium paid by the landowner, facilitated through a financial intermediary to a buyer who would receive the premium in return for paying out for the default of delivering the quantity of carbon committed through the credit.

The price of the premium has several factors; the accurate disclosure of the data from the landlord, the amount that is required to be covered which derives from the likelihood of a default and the spot price of carbon credits.

Trading a Carbon Default Swap

The CDS trades OTC and the price will be determined by supply and demand as well as information relating to the project that has an impact on the probability of a default. The structure of the CDS may guarantee 100% of the default or apply a haircut of 50% depending on the quality of the information about the project and the calculation of probabilities of default events.

United Kingdom : Woodland Carbon Code
Project: Gesto (ID: 103000000006187)[12]
The woodland type is described as wet woodland (W4) and it’s a natural element of the Highland’s landscape. Species mixture will include: downy birch, alder, rowan, willows and hazel. The new woodland will enhance the predominantly mountainous and highly visible landscape in the region.

Total predicted carbon sequestration over project lifetime (tCO2e) : 27,213
Predicted contribution to buffer over project lifetime (tCO2e): 4,626
Predicted claimable carbon sequestration over project lifetime (tCO2e): 22,587
The buffer[13] contribution is 20% of verified WCU which the landowner can claim on where the loss due to natural disaster (e.g. severe storms, flooding, drought, fire, pest & disease attacks) or man-made events over which the project has no control (e.g. terrorism, war). Note that verified WCU are verified units, the landowner can also sell Pending Issuance Units (PIU) which have yet to be verified and are not covered by the buffer, meaning that if the PIU is not delivered either fully or partially there is no cover.
Contractual Obligation Where a contract is in place with a buyer covering the landowner’s obligations to provide carbon sequestration through woodlands, claims may be made by the buyer in the event of a breach of contract.
If there is a buffer in place why would there be a need to issued CDS? The buffer only covers 20% under version 2.0 of the WCC scheme. What if there were a further loss? Then the landowner is liable for the shortfall.
The price of PIU is between £10–20 tCO2e and is higher for WCU.
The Gesto project is 53.76 Ha of mixed forest and runs for 100 years.

If we consider the scenario of the climate target of 1.5C not being achieved and the effects of climate change in Scotland are felt with higher temperatures, drought and flash flooding.

Let’s consider that in the 100 year timeframe there is a 30% loss of the planted trees and the price tCO2e has risen from £15 to £80 (close to what the ETS trades at), even with the buffer covering 20% of losses assuming that all the credits have been verified at the appropriate time period a 10% loss represents £217,704.

What are the consequences? The landowner may be contractually obliged to deliver the missing 2,721 tCO2e credits and will need to buy them on the open market. The buyer may need the 2,721 tCO2e as part of their commitment to being net zero and has a shortfall, can they wait for the landowner to procure the shortfall or do they need to have short term cover to ensure they retain their net zero status?

How would a CDS work in this scenario?

The issuer requires cover for a notional 5,000 tCO2e over a 15 year period. The landowner has a webpage giving the information about the project, satellite images and historical growth figures combined with the local weather data (temperature, rainfall etc)

The annual premium is calculated as follows:

The notional cover is for 5,000 tCO2e x £20 (tCO2e) or £100,000. Applying a 2% cost to the principal the annual premium is £2,000. The percentage charged or the spread will vary according to the quality of the data around a project.

In a scenario where the unit price per tCO2e increase from £20 to £80 then the premium will be at the higher rate of £8,000.

A bank or regulated entity would be the issuer of a CDS on behalf of the landlord and would sell the CDS to Hedge Funds, Family Offices and sophisticated investors who would manage the risks by buying weather derivatives or cat bonds.

Note this an illustration and there are many more carbon projects with much higher volumes of credits available.

[1] https://www.ft.com/content/f368121a-8de9-490c-98a5-1635a8a6b81b

[2] https://www.theguardian.com/environment/2023/jan/18/revealed-forest-carbon-offsets-biggest-provider-worthless-verra-aoe

[3] https://www.bloomberg.com/news/features/2023-03-24/carbon-offset-seller-s-forest-protection-projects-questioned

[4] https://grist.org/article/the-great-carbon-market-crash-of-09/

[5] https://verra.org/validation-verification/

[6] https://www.southpole.com/carbon-offsets-explained

[7] https://www.goldstandard.org/take-action/certify-project

[8] https://www.cbsnews.com/news/delta-lawsuit-cabon-neutral-greenwashing-carbon-offsets/

[9] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/707413/Woodland_Carbon_Code_Landowner_Leaflet_links_lowres__1_.pdf

[10] https://www.nature.com/articles/s41598-021-99395-6

[11] https://ember-climate.org/data/data-tools/carbon-price-viewer/