Understanding Carbon Markets, Private Equity, and the Future of Carbon Credits

3rd November 2023

If you're into finance and Wall Street, you've probably heard of Bernie Madoff. Or as the Netflix Documentary dubbed him, 'The Monster Of Wallstreet'. Madoff was the mastermind behind one of the biggest financial scandals in history, a $64 billion Ponzi scheme. When he got caught, he made a bold statement: 'Everyone in finance is motivated by greed.'

There's some truth to that, as most people in finance are indeed chasing profits. Banks, stock markets, cryptocurrencies – they're all about making money. But in this article, we'll talk about a new player in the financial world, the Carbon Market.

As I delve deeper into the intricacies of the carbon market, I not only appreciate the financial opportunities it offers but also recognize the profound and lasting impact of carbon projects. Carbon projects are built upon the noble idea of transforming communities, creating sustainable solutions, and combating the climate crisis. It's arguably the most humanitarian sector in the financial world.

The History of Carbon Credits

To grasp the concept of carbon credits, we must first understand the climate predicament facing our world today. Climate change, characterized by long-term shifts in temperatures and weather patterns, is predominantly driven by human activities, particularly the burning of fossil fuels. The erratic rainfall patterns, droughts, and floods we witness are often not divine punishments from God or our ancestors, but rather consequences of our own pollution. The thinning of the ozone layer, meant to shield us from harmful sun rays, has led to long-term global warming. This is a great problem because we have to think about the world we are leaving behind for our children and generations to come. After all, we do not own planet Earth, we are only passers-by.

In December of 1997, world leaders convened in Kyoto, Japan, to ideate and address this climate crisis.

It was here that the idea of carbon credits was born under the Kyoto Protocol. Recognizing that halting the production of everyday goods to curb greenhouse gas (GHG) emissions was impractical, leaders imposed emission limits on companies. If a company exceeded its allocated emissions, it had to offset the excess by purchasing carbon credits – permits that allow them to compensate for their GHG emissions. These carbon credits are acquired from parties that have generated them. One carbon credit equates to one tonne of CO2 or its equivalent gas removed from the environment.

The objective of carbon credits is to achieve carbon neutrality globally, where emissions in one part of the world are offset by reductions in another, thus creating a balance between the GHG produced and that removed. This equilibrium is what you have probably heard being referred to as "Net zero."

Carbon Project Development

Carbon credits are generated by either reducing GHG emissions or preventing them from entering the atmosphere. Carbon projects encompass a wide range of initiatives, with over 170 different types of projects currently in existence. A few examples are:

• Forestry Projects: These projects focus on carbon sequestration through trees, with different types of trees capturing varying amounts of carbon. According to Slyvera’s 2023 report on the state of Carbon credits, REDD+ projects remain the category of carbon credit projects with the highest issuance of carbon credits. REDD stands for 'Reducing emissions from deforestation and forest degradation.
• Renewable Energy Projects: By shifting from fossil fuels to renewable energy sources, these projects reduce emissions.
• Clean Cooking Carbon Projects: These initiatives mitigate GHG emissions by promoting the use of cleaner cooking stoves instead of wood or charcoal, both of which are fossil fuels.

Surprisingly, even livestock farming can participate in carbon projects. For example, did you know that livestock, particularly through methane emissions, significantly contributes to GHG levels? By altering livestock feed, smallholder farmers can reduce methane emissions, and in so doing could generate and sell carbon credits!!

What makes carbon projects unique is their potential to create substantial revenues and subsequently create permanent community benefits. For instance, the Mikoko Pamoja project in Kenya, facilitated by the organization Plan Vivo, conserves 117 hectares of state-owned mangrove trees. Mangroves are exceptional at sequestering carbon, and Mikoko Pamoja is expected to generate around $130,000 in annual revenue by selling carbon credits, and this is changing the lives of many in Coastal Kenya.

The Role of Private Equity in Carbon Markets

As the carbon market gains momentum, private equity firms and investors are increasingly recognizing its potential. Bill Gates for example founded the climate investment firm Breakthrough Energy, and he's also donated millions through the Bill and Melinda Gates Foundation. He also personally cuts a $10 million check each year to carbon capture company, Climeworks to offset his own carbon emissions.

However, with growing interest comes a series of critical questions: How is this relatively new space regulated? Are carbon offset investments genuinely effective in combatting climate change? What broader societal impacts do they have?

Understanding the carbon regulatory landscape is crucial when venturing into carbon credits. Two distinct carbon markets exist: Compliance Carbon Markets (CCM) and Voluntary Carbon Markets (VCM). A Compliance Market is a market for carbon offsets, created by the need to comply with a regulatory act. In a Cap-and-Trade emissions reduction market, actors buy and sell carbon offsets to comply with the cap or limit imposed on their emissions. The CCM is heavily regulated by mandatory national, regional, or international regimes, while the VCM operates based on commercial, sustainability, and marketing reasons.

While the regulatory framework for the CCM is established through international agreements like the Paris Agreement and COP26, the voluntary carbon market remains fragmented, relying on private-sector standards and independent auditors. This lack of uniformity poses challenges, as standards vary, leading to issues such as manipulation of baseline calculations and insufficient evaluation of non-emissions risks.

In the VCM, doubts about the credibility of carbon credit investments persist due to difficulties in independently verifying their quality and legitimacy. Less than 10 percent of projects certified with leading industry standards meet rigorous criteria, including additionality and human rights considerations. These challenges open the door to greenwashing, where projects exaggerate their environmental impact.

Moreover, carbon credit purchases have been associated with fraudulent activities like tax evasion, bribery, and money laundering, necessitating rigorous due diligence. The absence of robust regulatory oversight further increases the risk of adverse social impacts within these projects.

As COP28 approaches, players in the carbon market, recognize that a meticulous approach is necessary to validate the credibility and impact of carbon credit investments and ensure their alignment with overarching ESG objectives.

With the right intelligence, private equity firms can navigate the complexities of the carbon market and promote genuine sustainability while safeguarding investor interests. As the global community intensifies efforts to combat climate change, the effective mobilization of private capital through informed investment strategies will be paramount in steering the carbon market toward a more sustainable and equitable future.

I hope that this article has improved your understanding of carbon credits and shed light on the opportunity that exists for private equity to participate.

If you would like to learn more about carbon markets and perhaps develop a carbon project, fret not. Verst Carbon and Strathmore University have coupled together to provide a 3-day certificate course in African Carbon Markets. This intensive three-day program will equip you with the knowledge and skills to become a leader in the evolving world of carbon markets.

Secure your participation now by registering using the link below and empower your climate leadership: here.?

Until next time!