Why carbon insurance: Decarbonization meets risk management

Our industry is engaged in an important dialogue to improve sustainability through ESG transparency and industry collaboration. This article is a contribution to this larger conversation and does not necessarily reflect GRESB’s position.

Over the past four years, we have seen a rapid uptick in net-zero claims and voluntary climate pledges. These pledges are (or should be) backed by robust decarbonization plans that detail how and when the organization will avoid, reduce, and replace sources of emissions. Increasingly, these plans are expanding to include a fourth mitigation measure: compensation through investments in the carbon market.

While transactions on the voluntary carbon market (VCM) slowed in 2023 due to corporate buyer concerns over credit quality and reputational risk, the market is clearly trending upward. In the past year at Stok, we have held many conversations with our clients about carbon credits as a component of a larger corporate climate strategy. Many of our clients are asset managers who have quickly begun asking questions about investing in carbon as an asset class and about the risks and benefits of forward-looking investment contracts.

Their mindset is common. While carbon credit issuance has historically been dominated by avoided deforestation projects (in fact, out of all credits issued to date, 77 percent come from avoided emissions, and 23 percent come from removals), we are seeing an uptick in emphasis on removal credits. Through the new buyers’ club called Frontier, Meta, JPMorgan Chase, Stripe, McKinsey, and others signed forward-looking offtake deals in 2023 with direct air capture (DAC) and bioenergy with capture and storage startups, targeting USD 1 billion in removals by 2030. This is part of a larger, forward-looking trend among corporates. Of the 5.26 million carbon removal credits sold to date, more than 95 percent are for forward-looking credits based on estimated removals in the future.

This means that today’s buyers are already taking risks in their investments, and many more are interested in investing. The question, then, is how to manage this risk.

We know three things to be true:

1. Immediate carbon reduction and removal at scale is required to mitigate the worst impacts of climate change and give us a chance at a below 2°C future (1.5°C would be even more preferable). For a sense of scale, it is estimated that carbon removal technologies need to grow by a factor of 1,300 on average by 2050 to meet global climate targets.
2. Most companies are now relying on or will have to rely at some level on carbon credits to supplement emissions reduction initiatives to achieve their ambitious climate claims and pledges. This means that the question of investment is not a question of ‘if’ but a question of ‘when.’ The ‘when’ is now or soon; companies are encouraged to buy credits early when they are available and not wait. If they wait, they will compete with more companies to buy credits later, driving up prices or pushing delivery even further into the future.
3. The VCM is nascent, unregulated, and rapidly evolving. Data transparency, standardization, and safeguards are critical to mitigating risk, and their absence in the current market will continue to stifle investment.

As it pertains to carbon credits, what do we mean when we say “risk”? In the current VCM, there are five key risks associated with transactions:

1. Delivery risk: The risk that a project underperforms regarding carbon credit issuance compared to carbon credits forecasted.
2. Reversal risk: The risk that the carbon is re-released back into the atmosphere.
3. Resilience risk: The risk that events impact the carbon project’s operational capabilities.
4. Regulatory risk: The risk that carbon credits may become inaccessible or unusable due to changes in regulations.
5. Reputational risk: The risk that the carbon credits themselves and the claim they support are perceived as greenwashing, resulting in negative public perception, publicity, or legal action.

The risks listed above are recognized and shared at some level among market participants. For instance, they are recognized and shared through detailed delivery failure clauses in carbon contracts between a project developer and a corporate credit buyer. Failure to deliver carbon credits can happen for many reasons, some of which the project developer can control, others not.

Consider a not-so-uncommon scenario where the project developer completed its full responsibilities to complete the next credit issuance, with final approval sitting with the carbon standard or verification body. What if that verification body or standard is understaffed, causing a delay in the issuance beyond what is stated in the carbon contract? Is the project developer at fault even though the circumstance is beyond their control? In many carbon contracts, the answer is yes. However, this burdens the project developer unnecessarily and provides no recourse for them or the buyer. This type of risk allocation is not comprehensive or efficient.

One alternative solution is insurance — a common risk management mechanism across standardized markets, such as financial securities. While insurance applied to carbon is a relatively new concept, the development of novel insurance products to address specific risks is not new. Think travel insurance, for example. Insurance transfers risk to a specialized third party — an insurance company — who distributes the risk amongst a larger pool of market participants. This enables parties such as buyers and investors to mitigate risks that otherwise could not be sufficiently managed. In this way, insurance can help reduce barriers to entry and enable the transactions and capital flows vital for carbon projects to scale.

In the VCM, insurance can provide four key benefits:

1. Providing a balance between traditional risk management practices and innovation.
2. Yielding a stamp of confidence: The insurance industry has a long history of risk management and regulatory expertise, which can bring confidence to the VCM and its participants. This is necessary in the VCM, which currently lacks trust.
3. Producing a detailed assessment of carbon project risk: To bind an insurance policy, the insurer must do a thorough analysis of the carbon project, carbon contract, and project developer, covering numerous data points. This can bring to light risky areas of a project, developer, or transaction, helping the insured to make more informed decisions.
4. Encouraging market participants to take risks: Insurers take on responsibility when things go wrong, giving market actors the freedom to take the risks necessary to release capital and scale carbon projects and their associated benefits.

The carbon insurance sector is beginning to grow, with many stakeholders across both the supply and demand of the VCM calling for increased access. At COP28, there were several mentions about the insurance industry’s burgeoning role in the carbon market from the likes of King Charles III, many carbon standards, and the International Organization of Securities Commissions. Several organizations are working in carbon insurance now. Some examples include Kita, Oka, MIGA, AXA XL, and Howden, each offering different variations of carbon insurance products. However, product development is continuously taking place.

As companies increasingly demand means to manage risk in their investments in the carbon market, we can only expect carbon insurance to become more sophisticated and commonplace in decarbonization plans, a key piece of the path to net zero.

This article was written by Colette Crouse, Director of Carbon Services, at Stok, and Racheal Notto, Director of Carbon Markets Engagement, at Kita.

References

“Carbon insurance receives the attention it deserves at COP28.” Kita News. December 19, 2023.

“CDR.fyi.” CDR.fyi. Accessed February 12, 2024.

“Discover the first comprehensive global assessment of the current state of Carbon Dioxide Removal.” The State of Carbon Dioxide Removal. Accessed February 12, 2024.

“Frontier.” Frontier Climate. Accessed February 12, 2024.

“The Voluntary Carbon Market Dashboard.” Climate Focus. Accessed February 12, 2024.