Bringing risk-adjusted returns to carbon

Harry Markowitz, the Nobel prize winning economist, sadly passed away recently having revolutionised investing. He introduced the idea of risk-adjusted returns to financial theory, enabling investors to build diversified portfolios. It remains best practice. 

The Voluntary Carbon Market (VCM) is in a pre-Markowitz state akin to the 1930s or 1940s. It lacks a formalised concept of risk and remains stuck in a basic commodity paradigm, i.e. that a credit must equal an exact tonne of carbon dioxide equivalent. But as we’ve been arguing, carbon isn’t just another commodity market.

Recent industry initiatives, namely the Voluntary Carbon Markets Initiative and Integrity Council for the Voluntary Carbon Market, have brought an improved framework for the demand and supply side of the market.

Both are essential building blocks for a market-based approach, but neither tackles this key issue of how to make a credible claim that accounts for the risk inherent in the carbon returns of a credit.

Unlike in financial markets, where historic returns can be observed, the VCM faces the challenge of not being able to fully measure the carbon achieved by a given credit. Factors such as additionality and baselines are constructed using a ‘counterfactual’, or an alternative scenario that cannot be observed. Consequently, while investors can see how their investments perform versus their target over time, the carbon return on a credit can only be estimated against the one tonne it aims to achieve.

This is problematic when users of carbon credits try to make accounting style claims in a balance sheet format; matching an asset, the carbon credits retired, to a liability, an emission. Indeed, the credibility of claims is one of the leading causes of reputational concerns across the VCM today. The introduction of ratings-linked discount rates, similar to default rates used in bond markets, poses a solution.

It involves attaching an estimated return to a credit for each ratings notch that can be used to construct an improved accounting outcome: i.e. X% discount to the assumed one tonne subject to whether the credit is rated AAA through to D.  

This approach would not seek to re-accredit carbon projects by providing just another point estimate, i.e. this credit is 0.8tCO₂e rather than 1tCO₂e. Instead, it would build on the accreditation process, which must deliver a whole unit by design, by providing carbon credit users a way to take a risk-adjusted approach to making claims.  

At present, our carbon ratings imply a subjective level of risk based on our holistic assessment of the drivers of carbon efficacy. While the same is true of financial markets ratings, the risk of default can be derived for different ratings buckets based on historical default performance data. 

In order to minimise the risk of making claims backed by carbon credits, users need to be able to build diversified portfolios. This brings us back to Markowitz’s risk-adjusted return, and why it’s such an important part of the puzzle for carbon markets. The risks of a credit not achieving a tonne may not be precisely quantifiable, but they can be classified. 

Examples of this include sector type. For instance, forestry projects differentially face a spectrum of similar natural risks such as the exposure of different types of forest to pests or diseases. Likewise geography. Projects in the same country face similar political risks and projects in close proximity are exposed to similar natural or anthropological risks, such as wildfires. 

In the same way that modern portfolio theory enables users to maximise risk-adjusted returns by diversifying their risk, classifying the risk to a credit’s carbon returns and what drives this risk would enable the creation of a diversified portfolio of credits.

While this looks like a huge challenge, the upside is worth it. Providing the market with discount rates and a risk classification system will facilitate the construction of the diversified portfolios needed to make robust claims. It will unlock the next stage of growth in the carbon market.

This article is also published on BeZero Carbon. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.