In October, insurance broker Howden unveiled a new insurance product for voluntary carbon credits, and back in June, UK-based start-up, Kita, raised seed funding to develop new insurance products for carbon credit transactions. These innovations are part of a growing trend of intermediaries trying to de-risk investments in carbon credit projects. Investors in, and buyers of, carbon credits are often interested but hesitant. If these risks can be mitigated or laid off to third parties, it could unlock a significant expansion of the sector.
State of play
Companies and other organisations looking to offset their carbon emissions have ‘retired’ some 174 MtCO2e of carbon credits in the last twelve months, in transactions estimated by Trove Research at over billion in value. Based on the climate commitments of companies, the market could grow over the next decade to some $10-40 billion by 2030 (see Trove’s Oct-2021 report here).
However, as in any market, there are risks. In financial markets, risks centre on price volatility with a range of tools available to manage and mitigate the downsides. In the voluntary carbon market, exposure to changes in the price of credits certainly matters, but carbon credits also raise additional issues for buyers such as risks of greenwashing, the accuracy of verification, the permanence of the carbon impact, ‘additionality’ (the question of whether projects might have happened anyway), and double counting or double claiming. According to a survey conducted by TSVCM in 2021, credit quality was at the heart of buyer hesitancy, being identified by 45% of buyers as a pain point.
The development of third-party risk management tools should therefore be welcomed by the carbon credit industry. These tools build on the growing use of insurance and reinsurance products for renewable energy project finance in developing economies. For example, project development lenders in Africa and Asia have started using financial instruments to protect default risk on loans. Insurance and reinsurance products can also enhance the credit on project loans or bonds so that they can be sold to risk-averse institutional investors. In both cases, new money becomes available for lending.
The Howden product for the voluntary carbon market, has been created in partnership with carbon finance business Respira International and Nephila Capital, an investment manager specialising in reinsurance risk, and will focus on covering voluntary carbon credits against third-party negligence and fraud. Howden’s statement said: “Capacity came from the Lloyd’s market, with Nephila’s Syndicate 2357 as the lead market.” The insurance will be wrapped around “books of independently-verified, high-quality carbon credits”. Howden was advised by climate risk finance company Parhelion.
The vital principle with insurance is always to check what is covered and what is not. For instance, buildings insurance may exclude flood damage, or war, or even subsidence, or as many businesses have recently discovered business interruption insurance may exclude global pandemics. Similarly, insurance for carbon credits won’t, for now at least, cover all problems that might crop up.
At present Howden’s offering will cover fraud and third-party negligence – “the most damaging things reputationally”. In future, Howden has said it hopes to extend cover to catastrophe risk affecting the underlying projects and may look at offering cover forward-looking credit delivery risk, that is projects not producing what had been hoped.
Insuring against this risk is currently the focus of Kita, with its “Carbon Purchase Protection Cover” which would pay out if the project didn’t deliver as many carbon credits as it intended. The initial product will centre on “removal” credits, a project category which includes technologies such as growing new forests, biochar and, potentially, direct air capture. Nature-based projects could under-deliver for several reasons, for example because of over-estimating the rate of growth of new trees, or the impact of drought, fire, pest or illegal logging.
Trove analysis of 60 nature restoration projects shows that on average they deliver around 100% of the expected volume of carbon credits, but with a higher variance. A good proportion deliver less than 40% of their expected volume, while others exceed planned output by over 50%. Outcomes are seemingly unpredictable when it comes to nature.
However, for the foreseeable future, the most difficult hazard to cover is likely to be political risk. Indonesia, for instance, recently suspended verification of carbon credit issuances, and in the summer India floated the idea of banning credit exports, although he has since rowed back on this. Insurance works by averaging out random risks where probabilities can be quantified and impacts measured. Political risks are difficult to quantify, and although some more general providers do offer products covering risks such as licence revocation, expropriation, and business interruption, political risk in relation to carbon credits seems a step too far for insurers at this time.
Of course, as with any insurance there is a premium to pay and, usually an excess, and it remains to be seen whether there is a sufficient appetite to pay for extra cover. In other emerging risk markets, such as weather derivatives, sometimes the upsides didn’t seem to justify the premiums. Howden and Kita have not disclosed the cost of their cover, however we believe the excess is likely to be between 5% and 10% of the value of the credits. “Buyers need to have skin in the game,” Howden told Trove.
There are also other ways than insurance for buyers and issuers can cover these risks. The most obvious and simplest is to ‘self-insure’, whereby the buyer holds a large enough portfolio to ride the ups and downs of projects in different parts of the world. Another is for project developers to sell forward only part of their volume, leaving them a safety margin.
Intermediaries can also play a role by holding a portfolio of projects with different delivery profiles, so buyers can access a credit stream with guaranteed delivery. Respira, for example, provides this portfolio approach as part of the Howden tie-up, as do several other trading houses.
The advent of insurance for voluntary carbon credits is however, far from the only initiative going on now that may boost confidence in the market. Most prominent is the efforts of the Integrity Council on the Voluntary Carbon Market (IC-VCM), which has recently put out a draft for consultation of its Core Carbon Principles (CCPs) that it hopes will eventually become the de facto benchmark for what is considered a quality credit. Trove summarised the consultation in its recent webinar – available here.
If the carbon credit market is to grow to the levels hoped for, carbon reduction projects certainly need de-risking for both investors and buyers. Insurance products could well be one of the tools used, but most likely as part of a portfolio of approaches.