A look into how soil organic carbon may give companies the option to make a positive climate impact today while amplifying the impact of their climate budget for durable carbon credit purchases.
Financial products are generally designed to do one of two things: earn a return, or manage risk. Some products can do both. For example, buying a type of option called a put gives the buyer of the option the right, but not the obligation, to sell an underlying stock to the seller of the put. This can be either a tool to manage risk or earn a return.
Option mechanics, risk management, and returns
A simplified example of how this type of option works: The buyer buys 1 put option contract for XYZ stock with a strike price of $50. Each option contract represents 100 shares of XYZ stock, so owning the put option gives the buyer the right, but not the obligation, to sell 100 shares of XYZ to the option seller for $50 per share.
The option buyer believes that the price of XYZ may fall below $50. If the option buyer already owns 100 shares of XYZ, the option functions like an insurance policy against the risk of loss; in fact, the cost to purchase an option is called the “premium”. If the price of XYZ falls to $40 per share, the option buyer has the right to sell the shares to the option seller for $50 per share, saving the buyer from losing $10 per share, or $100 in total, less the cost of the premium. In this case, the option was a tool for risk management.
In an alternative scenario, the option buyer believes the price of XYZ will go down, but this time does not own any XYZ shares. The buyer again pays the premium and buys 1 put option contract for XYZ stock with a strike price of $50. If the price falls to $40 per share, the option buyer can go out and buy 100 shares for $40 a share, and then sell them to the option seller for $50 a share, earning a profit of $100 (less the option premium). In this case, the option was a tool to earn a return.
In both cases, if the price of XYZ remains at $50 or increases, the option expires worthless and the buyer loses the premium. The expiry is an important component of options contracts, just as it is for an insurance policy. The seller who is assuming the risk for a price is willing to do so only for a specified period of time, The seller believes that the price of the underlying stock will not go down before the expiry of the option contract. Once the time expires, a new option contract must be purchased.
Soil organic carbon credits are conceptually similar to options contracts
In the CDR market, soil organic carbon (SOC) removal credits with a minimum 10-year carbon sequestration period can conceptually serve a similar function to option contracts. If the SOC credit buyer believes that the price of durable CDR credits will come down during the next 10 years, the buyer may be willing to pay a “premium” for the option to sequester one tonne of carbon in the soil for 10 years to “buy time”. If the price of durable CDR credits comes down over the course of the next 10 years, the buyer will be better off than having immediately bought a durable carbon credit.
An example to illustrate:
- Current price of a durable CDR credit = $500
- Interest rate over the next 10 years = 2%
- Current price of a SOC credit with 10-year sequestration = $25
- The buyer’s per credit budget today = $500
The buyer has two choices. Choice 1 is to buy the durable credit outright today for $500 (assuming a durable credit is even available at $500, or at any price for that matter, in today’s durable-supply-constrained market). This creates certainty, which may be the desired outcome. A price is locked in, the emissions have been addressed, and claims to that effect can be made.
Choice 2 is to buy a SOC credit today for $25 and put the remaining $475 cash into an interest-bearing account. Assuming the 2% rate of return, the $475 in cash would be worth ~$580 in 10 years. This implies that the buyer could pay ~$605 per tonne of durable CDR in 10 years and be roughly in the same position as Choice 1, i.e., having purchased 1 durable carbon credit with today’s budget of $500. However, the buyer believes that the price of durable CDR will come down to $145 per tonne in 10 years. If that prediction is correct, the buyer can buy 4 credits for $580 in 10 years. If the price does come down to $145, by using the “option” of the SOC credit today, the buyer quadruples the amount of CDR they can purchase for today’s $500 budget, with about $30 left over.
It is also worth noting for the SOC credit that if the farmer continues the regenerative practices, the carbon may remain sequestered for well past the 10 years of the credit, adding to the positive impact. The trade-off is that the buyer can make only a qualified, long-term emissions offset claim until the durable CDR is purchased, and there is always a risk that the price of the durable CDR will increase in the future.
Critics of this framing may argue that by using the “option”, buyers are transferring the burden of the immediate demand required for durable CDR to achieve the scale that will bring the price down to $150 onto others —a sort of “freeriding” problem. This may be true in absolute terms but the reality is that many companies do not have the budget for durable CDR at current prices. The alternative is even less desirable from a climate perspective: companies doing nothing until the price of durable CDR eventually comes down. The “SOC option” enables companies with tighter budgets that want to take positive climate action to act today while potentially amplifying their overall impact. With the urgency for immediate action to prevent climate tipping points, that seems a very good option.
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.