Carbon Markets - Nascent and Faced with Growing Pains, Why Should VCs Care? (Part 1/2)

Puiyan LEUNG | 08 Nov 2022

This is part 1 of a 2-part series covering our views on the carbon credits market. The articles are co-authored with Khushbu Topandasani.

The Planet Does Not Wait

The Covid-19 pandemic has turned the world and our lives upside down. The World Health Organization (WHO) estimated that the death toll associated with the Covid-19 pandemic between 2020 and 2021 alone was 14.9 million [1]. Beyond the massive loss of lives, we witnessed how the pandemic had wreaked chaos - school closures affected almost half of the world’s students and business closures led to hundreds of millions full time job losses, in turn threatening to undo decades of progress on economic progress [2].

If the Covid-19 pandemic has taught us anything, it is that the planet does not wait for us to be ready.

For decades, scientists have long warned that the world was not ready for the next pandemic [3][4], after various outbreaks such as H7N9, Ebola, Zika and MERS viruses in different parts of the world. Covid-19 proved just how ill-prepared we were.

If there was any silver lining that came out of the Covid-19 experience, for me,  it would have been the fact that global carbon dioxide (CO2) emissions fell sharply early in the pandemic in 2020 and for a moment it looked like the world could accelerate its pace towards achieving net zero. accelerated pace to achieve net zero. [5]. Yet, this was not the case. The unfortunate fact is that global CO2 emissions decline in 2020 were not only less than what scientists had expected [6], they have rebounded to their highest level in history, in 2021. According to IEA, global energy-related carbon dioxide emissions rose by 6% in 2021 to 36.3 billion tonnes, more than offsetting the pandemic-induced drop from a year ago [7]. All glimmers of hope seemed to be dashed as the Covid-19 fiscal rescue and recovery spending dished out to stimulate the economy did not help too— most businesses are single mindedly focused on reviving or maintaining their business in the short term, missing the opportunity to adopt low carbon measures for the long term [8].

At our current rate of global greenhouse gas emissions, we will miss the Paris Agreement target to limit temperature increase in this century to 1.5˚C above pre-industrial levels by the early 2050s. Instead, we are hurtling towards a 2.7˚C rise in temperature [9]. The potential consequences of rising temperatures is expected to be dire, ranging from risks related to health, livelihoods, food security, water supply, human security and economic growth. Insurance giant Swiss Re estimates that climate change could cut the world economy by a staggering US$23 trillion in 2050 [10].

Despite the headwinds, let’s not lose hope just yet?

We believe there is light at the end of the tunnel. We have started seeing positive signs as countries and businesses around the world start to recognise the importance of becoming net zero.

Working together towards Net Zero

Net zero refers to a state in which the greenhouse gases (GHG) going into the atmosphere are balanced by removal from the atmosphere [11]. This is the state at which global warming stops. As of July 2022, globally 137 countries have made net zero pledges, with over 90% of them having set a target of 2050 for reaching carbon neutrality [12].

Beyond state actors, net-zero pledges amongst private-sector organisations are also gaining momentum, driven both by investor and public pressure for corporations to demonstrate clear climate actions. Industries have been increasingly adopting climate disclosure frameworks to disclose climate related risks and opportunities in their businesses.

At the individual level, increasingly, protecting the environment is becoming a top priority for the younger generations, Gen Zs and Millennials. According to Deloitte's 2022 Gen Z and Millennial Survey, which polled over 23,000 Gen Zs and Millennials from 46 countries, 75% of respondents believe the world is at a tipping point in responding to climate change, with 64% of Gen Zs being willing to pay more for sustainable products. Gen Zs and Millennials also expect businesses, including their own employers, to do more to prioritise climate action [13].

How then, do we become net zero?

First and foremost, the world’s focus should first be placed on decarbonising and minimising carbon emissions. This can be achieved through a range of decarbonisation levers across various sectors - such as transport and mobility, energy, agri, forestry and land use, manufacturing and industry, as well as the built environment. These levers are at varying degrees of tech maturity - ranging from proven technology such as solar to emerging ones such as green hydrogen. I have previously discussed some of these decarbonisation levers in Part 3 of my “Demystifying ClimateTech Investment in the Context of Southeast Asia” series [14].

While it is important to invest in decarbonisation levers, it may simply be not enough.

This is due to various factors such as technology readiness, economics and investor interest, regulatory incentives and enabling infrastructures [15]. Hence the second, but equally important, net zero implementation strategy would be to offset emission via projects that remove, or sequester, carbon from the atmosphere via the carbon markets.

Carbon Markets, Carbon Offset and Carbon Credits

A carbon offset is a reduction in emissions of CO2 or other GHG made in order to compensate for an emission made elsewhere, according to the Intergovernmental Panel on Climate Change (IPCC)[16]. Essentially, carbon offsets represent the production of a certain amount of sustainable energy to counterbalance the use of fossil fuels. A carbon credit is a tradable instrument representing the reduction, avoidance or sequestration of one metric tonne of CO2 or GHG equivalent (mtCO2e) [17].

As the name suggests, carbon markets are simply trading systems in which carbon credits are sold and bought. There are various types of carbon markets. The compliance carbon markets (CCMs) are created and regulated by national, regional or international carbon reduction regimes, while voluntary carbon markets (VCMs) function outside of compliance markets and refer to the issuance, buying and selling of carbon credits by businesses and individuals on a voluntary basis.

Today, CCMs are the more mature and larger of the two markets, with an annual trading turnover of more than US$261 B [18]. However, VCMs have experienced strong momentum in recent times and we believe they hold significant promise.

Voluntary Carbon Market’s role in our Fight Against Climate Change

Voluntary carbon markets (VCM), as the word rightly suggests are “self-governed” in nature, i.e enables stakeholders such as individuals, companies or governments to voluntarily purchase carbon offsets from projects to neutralise their hard-to-abate emissions. VCM has grown significantly in recent years with trading volumes exceeding US$2 B globally in 2021 [19]. Today, Asia contributes around 60%, a significant percentage of the carbon credits traded [20].

The significance and more importantly, growth of VCM, is attributed to many factors.

Firstly, many companies are now making net zero commitments and pledges. The United Nations Framework Convention on Climate Change (UNFCCC)’s race to zero initiative reported 5,235 companies making such commitments and pledges by global fortune 500 companies grew 17% between 2020 and 2021 [21].

Secondly, the existence and growing acceptance of emission reporting and disclosure frameworks such as Task Force on Climate-Related Financial Disclosure (TCFD) and CDP (formerly known as the Carbon Disclosure Project) will push companies to make climate related disclosures and, consequently, take relevant actions.

Thirdly, unlike compliance markets that are legally mandated, the credits generated by VCM are generally more fluid and not restricted by boundaries set by nation states, political unions etc. It is accessible by every sector of the economy, including enterprises and individuals, instead of the limited number of industries mandated by compliance markets.

While VCM is currently experiencing increasing awareness and momentum, it is still a nascent and evolving market and has been a subject of widely differing opinions.

Some concerns revolve around the transparency and additionality of projects, i.e for some initiatives, the emissions would have been reduced or avoided anyway without even having a project in place. Furthermore, due to unestablished governance, there could be potential reversals and / or leakages encountered affecting the permanence of projects. Lastly, the absence of a carbon registry for international carbon trading - though many are optimistic that it will be addressed by  Article 6 of the Paris Agreement - may potentially result in double counting of credits.

Despite all this, we are encouraged by the efforts made by stakeholders in both the private and public sector to scale and standardise operations on the demand and supply side of carbon markets to meet the Paris Climate Agreement goals. This represents significant economic opportunities for the stakeholders involved as the VCM market is poised to reach US$25 B by 2030 [22].

Not all Carbon Credits are Created Equal

In the quest for promoting the worlds’ green economy, various decarbonisation levers exist, including forest conservation, renewables, sustainable farming, electric vehicles and others.

However, not all decarbonisation strategies are equal when it comes to the carbon credits market.

Different decarbonisation pathways come with different carbon abatement potentials. In addition, solutions that offer strong co-benefits beyond carbon offsetting, such as biodiversity and community involvement, can command higher monetisation potential. Natural Climatic Solution (NCS) is one such category with a large carbon abatement potential and has the potential to command high carbon credit prices [23].

What are Natural Climate Solutions?

NCS refer to the conservation, improved land management, and restoration actions that increase carbon storage and remove greenhouse gas emissions from the air [24]. The reason they are called nature-based is simply because it uses natural resources such as trees or soil amongst others to remove and capture carbon.

GHG emissions from agriculture, forestry, and other land uses (AFOLU) contribute a quarter of total global GHG emissions and investments in nature could potentially deliver one third of the emissions reductions needed to align with the Paris Agreement between now and 2030 [25]. Examples of Agri, Forestry and Land Use (AFOLU) decarbonisation projects include afforestation and reforestation projects, rehabilitation of degraded forests, improved grazing, peat restoration etc.

Beyond offsetting carbon emissions, nature based solutions also offer co-benefits like biodiversity and community involvement that could potentially meet certain United Nations Sustainable Development Goals (SDGs). Such co-benefits have been a major factor in boosting the prices of AFOLU credits issued by global standardisation bodies such as Verra, Gold Standard, Plan Vivo etc.

The attractiveness of AFOLU NCS credits is elegantly summarised by the data published by Ecosystem Marketplace’s State of the Voluntary Carbon Markets 2021 report. Between Jan - Aug 2021, AFOLU projects contributed the highest quantity of carbon offset across the various categories of carbon offset projects, contributing to 80% of VCM traded globally. In addition, AFOLU credits traded over 4x higher than the next most traded type of credits [26].

While NCS solutions promise high carbon abatement potential, many uncertainties remain.

Globally, NCS solutions such as AFOLU has the potential to abate 7 gigatonnes of CO2e per year, and this is where Southeast Asian countries can play a big role. Indonesia alone can abate up to a significant 20% [27]. While this makes the country a leader in this space, taking a step back, the reality is that there are still challenges faced with NCS projects with regards to low awareness, significant knowledge gaps revolving its application and impact, lack of understanding and process to measure costs and associated benefits (leading to incorrect monitoring, fraud), and lastly, limited policy from stakeholders such as the government adding a layer of uncertainty [28].

Summing it up (for now)

We believe that despite some barriers and the nascent state of voluntary carbon markets, they have the potential to significantly support governments and companies in their mission to decarbonise. The target year that some have set to reach Net Zero - 2030 - is just around the corner, and such solutions require the support of investors and financial institutions to scale operations.

If you enjoyed reading our explainer and found it insightful, do stay tuned for the second part of this series coming out 21 Nov 2022, where we will discuss investment opportunities in the carbon markets space from a VC perspective. We will also delve into our investment thesis for Fairatmos, a carbon technology platform which enables communities as project developers to develop carbon sequestration projects, and companies which want to offset their carbon footprint.

Meanwhile, if you would like to catch up on my previous articles demystifying the climate tech space in the context of Southeast Asia, you can find them here:

Part 1: Sharing the broad global context of ClimateTech investment trends

Part 2: What are the unique climate challenges facing SEA and what are regional stakeholders doing to address them?

Part 3: Specific ClimateTech areas with great potential in Southeast Asia, and a VC investment framework for evaluating such opportunities

What’s Next?

At Vertex Ventures Southeast Asia and India, we believe that Southeast Asia’s transformation toward a greener economy offers interesting investment opportunities, and it would be a missed opportunity to ignore or dismiss the ClimateTech category in our region, even though the space is still nascent. If you are a company with an innovative business model or technology in the ClimateTech space, feel free to reach out to us at helloasia@vertexventures.com and we would love to hear your pitch.

Glossary

AFOLU: Agri, Forestry and Land Use

CCM: Compliance carbon markets

CDP: Carbon Disclosure Project

CO2: Carbon dioxide

GHG: Greenhouse Gases

IEA: International Energy Agency

IPCC: Intergovernmental Panel on Climate Change

mtCO2E: Metric tonne of CO2 or GHG equivalent

NCS: Natural Climatic Solution

SDG: Sustainable Development Goals

TCFD: Task Force on Climate-Related Financial Disclosure

UNFCCC: United Nations Framework Convention on Climate Change

VCM: Voluntary carbon markets

WHO: World Health Organisation

Definitions

Hard to Abate: In some sectors, decarbonising is particularly difficult because of prohibitive costs associated with introducing and adopting new technologies. These sectors are called hard-to-abate, and include oil and gas, cement, steel, chemicals, aviation and transport among others.

References

[1] https://www.who.int/news/item/05-05-2022-14.9-million-excess-deaths-were-associated-with-the-covid-19-pandemic-in-2020-and-2021

[2] https://wellcome.org/news/equality-global-poverty-how-covid-19-affecting-societies-and-economies

[3] https://time.com/magazine/us/4766607/may-15th-2017-vol-189-no-18-u-s/

[4] https://www.nationalgeographic.com/science/article/experts-warned-pandemic-decades-ago-why-not-ready-for-coronavirus

[5] https://www.smartcitiesdive.com/news/coronavirus-impact-cities-climate-change-efforts/574450/

[6] https://www.nature.com/articles/d41586-021-00090-3

[7] https://www.iea.org/news/global-co2-emissions-rebounded-to-their-highest-level-in-history-in-2021

[8] https://www.oecd.org/coronavirus/policy-responses/key-findings-from-the-update-of-the-oecd-green-recovery-database-55b8abba/

[9] https://www.reuters.com/business/cop/un-warns-world-set-27c-rise-todays-emissions-pledges-2021-10-26/

[10] https://www.nytimes.com/2021/04/22/climate/climate-change-economy.html

[11] https://netzeroclimate.org/what-is-net-zero/

[12] https://www.visualcapitalist.com/sp/race-to-net-zero-carbon-neutral-goals-by-country/

[13] The Deloitte Global 2022 Gen Z and Millennial Survey

[14] https://medium.com/vertexventures/demystifying-climatetech-investment-in-the-context-of-southeast-asia-part-3-a1ada766be3f

[15] [23] [31] [39] Bain, Temasek, Microsoft Green Economy Report 2022

[16] https://www.ipcc.ch/2018/06/15/ipcc-meetings-go-carbon-neutral/

[17] https://www.ecosystemmarketplace.com/marketwatch/carbon/

[18] https://darcypartners.com/research/voluntary-vs-compliance-carbon-markets

[19] https://www.ecosystemmarketplace.com/articles/the-art-of-integrity-state-of-the-voluntary-carbon-markets-q3-2022/

[20] https://carboncredits.com/the-ultimate-guide-to-understanding-carbon-credits/

[21] [26] Ecosystem Marketplace’s State of the Voluntary Carbon Markets 2021

[22] Goldman Sachs Sustain Report, 2020

[24] WBCSD - Natural Climate Solutions: The Business Perspective

[25] The Business Case for Natural Climate Solutions

[27] https://www.eco-business.com/events/nature-based-solutions-in-indonesia-the-power-of-nature/

[28] https://www.sciencedirect.com/science/article/pii/S1877343520300750

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