Valuing carbon offsets

  • Published: March 2021

Valuing carbon offsets

Dieter Helm

March 15th 2021

Sequestrating carbon is the other half of the climate change problem. Climate change is caused by increasing concentrations of carbon in the atmosphere, the net of emissions and sequestration. Nature kept the balance until the Industrial Revolution, but since then agriculture and other land-use practices have both increased emissions from the soils and peats and reduced the ability to absorb carbon. There is a big opportunity – and a necessity – to reduce the emissions and to put the carbon back. Putting carbon back has multiple other benefits (and potentially costs too). Almost all carbon sequestration impacts on all the other natural capitals.

To date, landowners have not been penalised for carbon emissions or been paid for sequestration. This is changing: the polluter-pays principle is pointing to carbon taxation, and proposals have been floated in the UK for beef and dairy taxes (which I address in a separate paper: Bespoke carbon taxes on food). UK red diesel subsidies have come under challenge.

Worldwide, agricultural subsidies are inconsistent with net zero objectives. This is changing: new markets are emerging in carbon offset credits, and new subsidy regimes, like the Environment Land Management Scheme (ELMS) in England, are targeting soils and carbon more generally.

The voluntary carbon offset market

The carbon offset market is currently voluntary. It is driven on the demand side by companies, investors and other organisations and institutions seeking to offset their emissions, often in the context of setting a unilateral, voluntary carbon net zero target. Energy and aviation businesses, for example, look to offset hard-to-abate emissions so as to present themselves to their investors as on the path to net zero and to protect their social licence to operate. Many of these unilateral net zero targets are ambiguous, and widely different impact and emissions measurements are used to reflect the narrow or wider domains for calculating the impact of the companies.

Environmental, Social and Governance (ESG) criteria confuse the position of the emitters further. There are as yet no credible methodologies for measuring the E, S and G impacts, and ESG funds vary greatly in their approaches. There is inevitably a lot of greenwashing going on. It is likely that net zero targets and net zero compliance will tighten up and increase the demand for carbon offsets.

Landowners, on the supply side of the carbon offset markets, seek to sell offsets and to back these up with investments in, for example, forestry, peat management and soil projects. Ethical investors and ESG-accredited funds can potentially be on the supply side too, with land and forestry asset purchases, and hence the investors and fund owners become landowners.

Carbon offset emissions are typically harder to measure than carbon emissions. Lots of questionable approaches are being marketed. A credible carbon offset valuation for the purposes of contracting and trading is derived through a series of steps, as follows:

-                 The baselines
-                 The counterfactual and additionality
-                 The price of carbon
-                 The discount rate
-                 The end of life/scrappage value
-                 The non-carbon natural capital gains and losses.

All of these steps are necessary for a credible valuation: few if any of the parties complete all of them.

The baseline

The first step is to establish a natural capital baseline. This baseline needs both to ascertain the existing stock of carbon and to relate this to the other existing natural capital stocks. The baseline is necessary: it is against changes in this baseline that additional sequestration can be measured, and it can be determined whether this sequestration brings other natural capital benefits, and whether it does any harm to other natural capitals. To grant subsidies, for example, under England’s ELMS and other public goods subsidies, for carbon sequestration without a baseline is nothing more than a leap of faith, notably in the recipient of the subsidy.

Establishing the baseline and re-running it enables the offsets to be measured and accredited in physical units. There are few if any examples of natural carbon offsetters doing this exercise properly.

The counterfactual and additionality

The baseline describes what exists on the ground at a point in time. The second step is to consider what would happen if there were no offset payments or subsidies. What would the landowner have done, and, in particular, would the carbon offsets be additional to this counterfactual case?

This counterfactual is complicated by the regulatory, taxation and subsidy context. For much of the non-agricultural and the forestry sectors, the polluter-pays principle does not apply – indeed, it is the polluted who pay. The goalposts are moving, and greater pressure is applied to carbon emissions from land, and the carbon-intensive inputs such as fertilisers and pesticides. Technical change matters too. It is widely claimed that “no till” is economically attractive regardless of the reduced carbon emissions and even greater sequestration.

Land use is highly regulated, subject to planning restrictions. Some land has lots of other options; other land has very limited ones. Planting trees to sequestrate carbon on rich lowland loam soils is very different to planting on acidic uplands. In the former case, other options may include increasing carbon in the soils (another form of offsetting with a very different time profile), and continuing with intensive cereal production. In the latter case, the economic returns from much of upland agriculture are poor and getting poorer as new technologies provide alternative ways of producing proteins. Much upland has been used for extensive sheep and game shooting. The former is fundamentally uneconomic, and can be damaging to peat and soil carbon; the latter is an alternative revenue stream which may be high, notably for the intensive pheasant-shooting industry.

These alternatives should – in an efficient market – be captured in the land prices. Upland sheep farming may decline over time, which should in principle drive down the land value, and hence increase the rate of return from other activities against a lower capital valuation of the asset. Inheritance and other tax concessions distort this considerably.

Another alternative is to gain non-carbon offset subsidy payments, like the English ELMS payments. The complexity here is that some ELMS payments may be explicitly for carbon-offsetting (for example, for soils) and some of the biodiversity and other projects may also sequestrate carbon. The commercial issue in a net-present-value (NPV) calculation is to see what difference adding these in might make.

In the case of forestry, where residual material is used to manufacture wood pellets and other biomass inputs, the counterfactuals may be multiple. In the egregious case of the use of palm oil for biofuels, had the palm oil not been planted, rainforests might have endured.

Because the counterfactual cannot be observed, the correct methodology is first to list alternatives, next model the extension of the baseline as if there were no change in the land use, and then model the impacts of changing policies on that baseline, independent of the carbon offset payments.

The current price of carbon

There is no single price for carbon now and for all relevant future periods. It is not a matter of setting a single point price. This is extremely important to recognise. One reason is that there is as yet no deep, liquid and transparent market in offsets. Indeed, there is not one in emissions. (The EUETS, for example, is partial and subject to short-term fluctuations and manipulation of the permits by the European Commission, and the UKETS is still best described as primitive.)

The reasons why there is no such market are several: carbon offsetting is voluntary; the policies are in their infancy; the market is distorted by a host of other interventions in land use and agriculture; the English ELMS subsidies are yet to be properly defined and most other subsidy regimes are in the process of reform; and there is little experience of how successful different options may be in sequestration. It is an infant industry.

As a result, no common trading platforms have yet been established, and most trades are bilateral. These can be external – an energy company does a deal with an estate; or they can be internal – a low-carbon investment fund buys land on which to offset carbon.

The absence of a deep, liquid and transparent market, both now and for the foreseeable future, creates an obvious problem for landowners and for purchasers of offsets – what price should they pay?

The starting point is to look at current carbon prices for emissions. The main one (even post-BREXIT) is the EUETS, though there are a host of others. The right way to think about this is to consider a range of possible prices now. These include: the current EUETS price; the carbon price that equates the social marginal costs and benefits; and a minimum price set in various carbon taxes and floor prices.

This gives three possible current price scenarios against which to negotiate. The “right” answer is going to lie within this range, and all three should be simulated as part of the sequestration project appraisal.

The future price of carbon

Establishing a possible starting price is the easy bit; the hard bit is how to guess at future carbon offset prices. This is a “long distance” exercise for many tree planting and forestry options. It may be less so for payments for ongoing carbon offsets from the protection of existing peat, some soil regeneration projects and some biomass crops. I will concentrate on the trees here, as it is the more difficult case because of the long time periods involved.

Let’s say trees are planted which will really get into serious carbon sequestration in 20 years’ time. What is the carbon offset in year 20 worth now?

The conventional answer is to consider the trees as an investment project and discount the price in say 20 years’ time back to now. The NPV now is: the future price projection multiplied by the amount of carbon sequestrated in each period, minus the costs of planting and maintenance, discounted back to the present.

If the carbon price today requires a range, the future price is much more uncertain. Its value will depend on the alternatives (for example, new lower-emission technologies, and carbon capture and storage, CCS), and public policy (including direct interventions on carbon taxation). It will also depend on the price discovery process in (eventual) liquid and transparent markets, and whether a futures market will emerge against which to hedge the risk.

But this is not impossible to model. The answer is again to choose ranges for future prices. Take three options, let’s call them: pessimism and lack of action on climate change; steady as it goes; and a high-case scenario.

There is no precision here: the scenarios allow the project’s sensitivities to be explored and to discover how sensitive the project’s profitability is to the precise prices in precise future years.

Discounting the future value of carbon offsets

This gets us to the crude carbon price envelopes. The next bit is to address the time dimension. There is no immediate private commercial reason for treating this any differently from any other investment. A discount rate is applied.

What discount rate to use? The problem is that current costs of capital are massively distorted by two decades of extraordinary monetary policy, including quantitative easing (QE). The cost of capital today may be historically unprecedently low, but there are few reasons for believing that this will be the case in 20 years’ time.

Again, there is no obvious right answer. So, the modelling for the investment appraisal should assume, say, three possibilities:

-                 A low number, to reflect low current costs of capital and the low returns on agricultural land.
-                 A mid-range market estimate, to reflect future markets and “normal” rates of return.
-                 A high number, to reflect the possibility of inflation leading to the sorts of monetary policies in the early 1980s.

Other data can help inform this, such as returns on forestry.

The discount rate will vary over the 20 years. In the first couple of years we already can lock in very low rates. 20 years ahead is rather different.

We now have three scenarios for the price of carbon and three scenarios for the discount rate – an investment appraisal matrix.

Given the long time horizon, pure standalone tree planting is likely to be discounted out of commercial consideration. But this is only one part of the economic considerations. We also have to consider whether the investor has a lower discount rate reflecting “special” reasons for their sort of project; whether there are other offsetting revenue gains from this project to the other natural capitals; and what the alternative uses of the land (and the land price) might be.

Polluting companies committed to net zero targets may wish to treat emissions as future liabilities in their accounts, and to set carbon offset assets against these liabilities on their balance sheets. This “certainty” may enhance their ESG credentials and this in turn may push down their costs of capital.

There is some evidence that there are investors willing to accept much lower rates of return for “green” projects. However, this is yet to be demonstrated: in 2020 the sharp fall of the oil price in January fed through in the pandemic to poor performance for conventional equity indexes relative to technology stocks. As ESG funds targeted technology, it was very easy to argue that ESG investing was value-maximising. In 2021 this is not so obvious: commodity prices have risen sharply, whilst technology stocks have taken a hit. The conventional “value” stocks and banking have been hit by ultra-low interest rates and QE in 2020. This may also be changing now.

Scrappage values

Trees sequestrate carbon over their lifetimes. At the end of life there are various “scrappage” options for the fully grown trees. One is to burn them in power stations, and hence their value as a fuel for “biomass”. Wood pellets have a price. Trees could be cut up for timber and therefore their carbon could be locked away. Or they could just stand for a long period at maturity until they eventually fall over and rot into the soils, sequestrating carbon until they die, and boosting biodiversity as they rot.

In all of these end-of-life examples, the problem is that it is a long way off, and discounting therefore bites. It is why the economics of forestry is so poor, and why subsidies and governments have had to repeatedly prop it up.

The serious issue here is the carbon tax that should be applied at end of life to wood pellets and biomass that is burnt, for the complete cycle is carbon-negative – there are net emissions – and the value of temporary sequestration is limited. All emissions should pay a carbon price; all sequestration should be paid that carbon price.

Other natural capital values

Next are the other natural capitals and the other revenues that may arise from the project. These include: biodiversity gain; water management; physical and mental health benefits; and tourism over and above the physical and mental health gains. There may also be improvements to some forms of agriculture itself as soils are improved.

To the NPV calculated as described above, there needs to be a similar exercise for all the other natural capitals, net of the carbon offset values.

The results may lead to very different approaches to the creation of new offsets and to their valuation. It is all about, for example, planting the right trees in the right places. A carbon-only focus could lead to major biodiversity and water quality damage and to limited access, recreation and health benefits. Much plantation timber production has been environmentally damaging.

A multiple natural capital approach focuses on the multiple benefits, the possible multiple costs, and to the revenue streams from each. The carbon offset revenue stream is likely to be the best defined, but neglect of the others not only misses opportunities but could also bring major reputational risk to both the buyer and the seller.

Conclusion

If net zero is to be achieved, carbon sequestration will need to be taken seriously, alongside the reduction of emissions. Agriculture is relatively the largest carbon polluter. In addition to reducing emissions, land will have to become a serious sequestrator. To calculate the opportunities, the key variables are: the future price of carbon, the counterfactuals, the future discount rates, the value of scrappage at end of life, and the value of other natural capital benefits from the sequestration. In due course, a carbon-offsetting market will develop. In the meantime, bilateral deals will predominate. The way to calculate these deals is through a matrix of assumptions. There is no obvious point estimate for either the price of carbon or the cost of capital. In all cases, a baseline is required.

 Valuing-carbon-offsets.pdf

© Dieter Helm. All rights reserved.Copyright & Terms