FT Rethink
Carbon markets – the emerging asset class restoring the world’s lost forests
Every day, the world’s three trillion trees cook the only recipe they know – turning sunlight into sugar. Along with sunlight, the recipe calls for just two further ingredients – water and carbon dioxide. As water is drawn up, and carbon dioxide is absorbed from the air, the sugary sap flows down carrying with it the carbon compounds that will be locked away in wood or soil for possibly thousands of years.
For millennia, this simple yet mysterious process has underpinned the growth of all vegetation, from the smallest grasses to the tallest trees. Now, it is also unlocking a growing flow of cash, cash that is starting to tip the economic balance away from forest exploitation, and towards preservation and restoration.
Over the past century, a combined area of forest the size of the US has been lost from the earth, eaten up by agriculture, logging, mining, and the spread of human infrastructure. Now, high-integrity carbon markets have the potential to become a vital tool in arresting and even reversing this loss, preserving those ancient forests that remain, and restoring those that have disappeared.
A new commercial incentive
As the sun rises over the Central Kalimantan region on the island of Borneo, the trees of the Katingan Mentaya rainforest Project1 begin to stir. Millions of natural solar panels turn to capture the early light, and in their giant nests some of the world’s last remaining Bornean Orangutans rouse themselves. In a region under continued pressure from the commercial forces of the timber industry, the 157,000 hectares of the Katingan Mentaya serve as a fortress.
It is estimated that tropical rainforests hold 250 billion tonnes of carbon2, perhaps as much as half the world’s remaining Paris-aligned carbon budget3. The preservation of the Katingan Mentaya, where tropical trees sit on a more-than 10-metre-deep layer of carbon-rich peat, ensures that 7.5 million tonnes of this carbon remain safely locked away, the equivalent of taking 2 million cars off the road every year.
The forest is not preserved by goodwill alone, however. The area forms one of the world’s largest examples of a voluntary “carbon credit offset” project – the commercial value in forest preservation winning out over the money to be made from logging or other exploitation. Here, income from the sale of carbon credits – where each credit represents one tonne of CO2 emissions avoided, or one tonne actively sequestered, within the project – is used to create local jobs in forest preservation and management, and to foster a local economy that works in harmony with nature. For buyers – most often large corporations – the credits can be used to compensate for, or “offset”, their residual greenhouse gas (GHG) emissions, as they work to decarbonise their business operations.
Read also: The top five reasons why we need to invest in our forests now
Voluntary markets on the rise
At present, over 90% of the world’s GDP is covered by a net-zero target for the emission of carbon dioxide and other GHG equivalents. Carbon credits, and the trading markets that have sprung up around them, have become the ‘currency’ of this decarbonisation4. Carbon trading is now estimated to be worth more than USD 900 billion annually5, and is projected to grow to match major commodity markets for size.
Today, much of this value lies in regulatory compliance markets, in which large emitters are required by law to buy permits to cover their emissions, or face strict penalties. The world’s largest compliance market is the EU’s Emissions Trading System (ETS) – in 2022, EUR 683 billion of permits were traded in the ETS6, while over the last five years, as permit numbers have reduced, and with geopolitical events spurring demand, the price per permit has risen from EUR 7 in 2017, to a 2022 high of EUR 98.
At USD 2 billion traded in 2021, voluntary carbon markets, which fund projects such as the Katingan Mentaya, are a minnow in comparison – but they are playing catch-up fast. Since 2016, the number of voluntary credits issued has more than quadrupled7 and, with growing demand from corporate net-zero commitments, it is estimated that the annual traded value could reach USD 50 billion by 20308.
For investors, carbon markets present a unique opportunity, acting as a natural hedge against the impact of climate policy on company earnings, providing portfolio diversification due to their low correlation to other asset classes, and often containing in-built inflation-adjustment mechanisms. At the same time, investors can support companies’ decarbonisation strategies by enabling price convergence across regional markets, providing liquidity, and supporting price stability and price discovery.
Read also: The global carbon market opportunity
A complex problem
The rapid growth in the voluntary market has, however, been dogged by controversy. At their best, credits for emission reduction and carbon removal activities – such as forest preservation and restoration – give companies, governments, and individuals an efficient means to accelerate climate action, provide sustainable livelihoods for local communities, protect biodiversity, improve soil health, preserve water supplies, and play a role in defending against floods or drought. But done badly, they have the potential to harm biodiversity, violate community rights, and even lead to increased emissions.
Quality assurance is fundamental when investing in carbon projects. First, projects must prove ‘additionality’ – whether a project is really providing a carbon storage benefit that would not exist otherwise. Second, they need to mitigate the risk of ‘leakage’ – where forest preservation schemes merely displace the logging or other degradation, rather than preventing it. Third, they must avoid ‘double-counting’ – where the same tonne of stored carbon is claimed by multiple parties or is covered by multiple credits.
Failing to consider these complexities can increase the risk of underperformance, low-integrity credits or, even, outright fraud. Recent press coverage has raised awareness of some of these potential shortcomings – now, however, profound market shifts are driving up standards.
Read also: Trigger warning: five ways to buy time for net zero and prepare for net negative
Integrity first
On the demand side, wary of the risk of reputational damage from underperforming schemes, buyers are leading the push for high-quality carbon credits. Launched in 2021, the Lowering Emissions by Accelerating Forest finance (LEAF) Coalition has raised USD 1.5 billion by way of public funds and private sector purchases of high-integrity credits for ‘jurisdictional’ programmes. Designed in response to criticisms of ‘project-based’ programmes, jurisdictional credits are issued according to observed reductions in emissions across large landscapes, ensuring additionality and transparent accounting.
For potential buyers of the credits, LEAF is an exclusive club. Only those companies with public, science-based net-zero emissions targets are allowed in – LEAF will sell credits only where they are in addition to, not in place of, real cuts to emissions.
On the supply side, innovations such as geospatial data, including satellite imagery, and dynamic baselines, where protected forests are measured against benchmark unprotected regions, are bringing greater transparency.
And as policy and industry norms evolve, “integrity” has become the watchword. The Voluntary Carbon Markets Integrity Initiative will focus on integrity among both buyers and sellers of carbon offsets. Leading environmental and indigenous organisations have published an updated Tropical Forest Credit Integrity Guide for Companies, to help buyers identify high-quality, indigenous-led programmes. And the Integrity Council for the Voluntary Carbon Market aims to set rigorous, science-based universal targets, to ensure transparency and accountability across the entire sector.
As William McDonnell, Chief Operating Officer of the Council, puts it, “Integrity must come first. If we get the integrity right, the scaling will naturally happen.”
Not just the tropics
According to the United Nations, nature-based solutions – such as forest restoration and preservation projects – offer potential to provide more than a third of the climate mitigation needed to hit the Paris temperature target9. For this to happen, the scale of the restoration needed demands projects not just in tropical regions, but across the globe.
In the Western US, in a bid to fight climate change and the interacting crises of heatwaves, drought, wildfires and biodiversity loss, the Biden administration plans to end livestock grazing on 11 reserves and return the land to nature10. In the UK, plans are underway to restore 300,000 hectares of agricultural land by 2042, through tree-planting and restoring peatlands and wetlands. Meanwhile, in the EU the European Commission’s proposed Nature Restoration Law, currently awaiting approval by the European Parliament, will require member states to restore 20% of EU land and sea to nature by 2030.
Read also: Planetary boundaries: the safe operating limits of humanity
On a smaller, but no less ambitious, scale, Scotland could become the world’s first fully “rewilded” nation11. There, work by the devolved Holyrood government is dovetailing with myriad non-governmental projects, with plans to plant more than 90 million trees and restore more than 200,000 hectares of the Highlands12 across the next three decades. Increasingly, as with the restoration of tropical forests, carbon credits will help many of these projects get off the ground.
To limit global warming to 1.5 degrees Celsius, the world must cut GHG emissions by 43% by 203013. There must also be a vast roll-out of nature-based climate mitigation solutions, restoring lost forests and peatlands, and returning millions of hectares of agricultural land to nature, while improving the efficiency of food production. As carbon markets mature, high-quality credits will be an essential source of funding for these solutions. For investors, carbon markets, both compliance and voluntary, represent one of the most important and impactful opportunities of the entire Sustainability Revolution.
1 Katingan Mentaya Project (katinganproject.com)
2 Benchmark map of forest carbon stocks in tropical regions across three continents | PNAS
3 An integrated approach to quantifying uncertainties in the remaining carbon budget | Communications Earth & Environment (nature.com)
4 Carbon is an emerging asset class, but what is it? Peter Sainsbury
5 Global carbon markets value surged to record $851 bln last year-Refinitiv | Reuters
6 EU Emissions Trading System (EU ETS) (europa.eu)
7 How the voluntary carbon market can help address climate change | McKinsey
8 Carbon credits: Scaling voluntary markets | McKinsey
9 Nature-Based Solutions | UN Global Compact
10 How rewilding the American West can help fight climate change | World Economic Forum (weforum.org)
11 Scotland could become first ‘rewilded’ nation—what does that mean? (nationalgeographic.com)
12 Rewilding project for 500,000 acres of Highlands - BBC News
13 PowerPoint Presentation (ipcc.ch)
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This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
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