Companies have pledged to reduce their carbon footprint against the backdrop of strict emissions norms and ambitious climate targets set globally. While they have achieved or are in the process of crimping their emissions as per the regulatory requirements/sectoral emissions cap, the majority have gone one step ahead, investing in carbon credits to voluntarily offset the greenhouse gas (GHG) emissions to become carbon neutral. Voluntary carbon markets have allowed such organizations to offset their unavoidable emissions by purchasing carbon credits from projects targeted at removing or reducing GHG from the atmosphere. Firms can invest in the voluntary carbon market either individually or as part of an industry-wide scheme.
Before investing in voluntary markets, companies must assess the price of carbon credits. This will help them decide on their emission reduction target and ascertain the quantum of investment required. The price of credits depends on various mechanisms and market dynamics (see the figure below).
The price of voluntary carbon credits largely relies on the factors mentioned in the chart above; some secondary factors also influence the price. The fair-trade minimum price of credits has the following components:
- Investment cost: Capital expenditure to set up a carbon offset project
- Operating cost: Costs incurred in operating the offset project (transportation, maintenance, training, monitoring, etc.)
- Carbon cost: Costs incurred in carbon credit project audit, certification, and validation by the third party
- Business margins: Incentives to ensure the viability and operations of a project (margins range between 5% and 10%)
Apart from helping in transitioning to a low-carbon economy, voluntary carbon projects provide socio-economic benefits to communities, which determine the cost of carbon credits generated from these projects. The beyond the value of carbon creates a tangible impact on the community where a project is implemented. Projects that cater to a slew of UN SDGs require a higher premium than those that focus only on emission reduction and serve a single SDG. SDGs covered include biodiversity, the balance of payments[1], employment, livelihood, health benefits, and climate benefits. The monetary value of the socio-economic impact of projects is provided in the figure below.
It is observed that although wind projects provide clean energy and reduce carbon emissions, cookstove projects cover multiple UN SDGs and have a direct impact on the lives and health of vulnerable communities. Additional benefits correlate to a higher cost per credit compared to wind projects.
Apart from primary factors, secondary factors (such as project quality, location, and project vintage) determine the price of carbon credits generated through different project types in the voluntary market. These attributes include:
- Project quality: A project’s quality assessed through the standard by which it is certified also determines the price of carbon credits (e.g., gold standard carbon credits are often sold at a premium compared to other credits in the market)
- Project size: Smaller projects, which are expensive to implement, produce fewer carbon credits, making it harder to reimburse implementation costs unless the credits are sold for higher prices
- Project location: In some countries, it is difficult to implement emission reduction projects given the lack of infrastructure, resources, and risks. Climate projects implemented in such regions generate credits at a higher price
- Project availability: Prices are subject to the availability of projects. As per Bloomberg, the average price of a forest-based carbon offset in New Zealand is USD 15.9/ ton compared to those generated in Nicaragua, which are typically traded at an average price of USD 6.72/ ton
- Project vintage and methodologies: The price of carbon credits is the outcome of the age of credits issued (the older the vintage (i.e., the year in which associated credits from the project were issued), the cheaper the price). Prices can vary within a project type because of the methodology used in the project (e.g., offsets from avoided ‘unplanned’ deforestation projects are usually higher priced than their counterparts from avoided ‘planned’ deforestation projects, due to the methodology used in the planned case, i.e. the legal clearing plan)
While the socioeconomic value of carbon credit projects depends on an organization’s mission and vision and is subject to demand-supply forces, prices of carbon credit should reflect the true social cost of carbon and the economic value provided by them in addition to the impact created.
In conclusion, companies need to consider the primary and secondary factors before deciding on their investment size in the voluntary carbon market.
[1] Balance of payment is the value created by reducing fossil fuel imports
