The Business Times' Column | Due Diligence: Investing opportunities in the carbon credit market

Puiyan LEUNG | 21 Nov 2022

This column was first published on The Business Times

WHAT does venture capital have to do with saving the environment? A lot, it seems. At COP27 this month, we have seen many calls to action from governments, with some from companies and financial institutions on the sidelines of the event. In the past few weeks, we have seen the launch of the African Carbon Markets Initiative, and the US announcing a voluntary carbon market scheme to boost investment in developing nations. On the flip side, regulators are planning to heighten their scrutiny of voluntary carbon markets to prevent greenwashing. But, to begin with, what are carbon markets?

In the race towards net zero, one area of immense interest for venture capitalists (VCs) like us is the carbon market and the solutions enabling carbon trading. 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 billion .

VCMs have experienced strong momentum in recent times and, many companies – even in hard-to-abate industries like oil and aviation – have started or been relying on them to offset their carbon footprint. Carbon offset projects reduce greenhouse gas (GHG) emissions, resulting in the creation of carbon credits. Examples of such projects include forestry, conservation/ restoration, renewable energy, community projects, and waste-to-energy amongst others. In the voluntary market, any corporate or individual can then buy these tradable credits to offset the carbon emissions from their operations and consumption.

We see significant opportunities for VCM within the South-east Asia region, which comprises six of the world’s 25 biodiversity hotspots and harbours one of the world’s most extensive seagrass beds, coral reefs, and mangrove mass. Perfect for generating a steady supply of carbon credits, right?

The reality of the situation is slightly different.

What’s the potential of carbon markets and nature-based solutions?

With carbon markets scaling globally, the potential offsets generated in the region may offer as much as US$10 billion in economic activity annually by 2030. But, for all intents and purposes, the market does not exist today. On one hand, there is no mandatory carbon market in the region, with Singapore being the only nation with a carbon tax regime currently. On the other hand, the voluntary market is in its infancy and faces many challenges ahead, including a lack of capabilities to scale the supply of offsets, wide variations in credit quality, immature carbon market infrastructure, and a lack of regulatory support.

Despite limitations, demand for VCM credits is expected to grow, driven by national-level net zero commitments, corporate pledges, and shifting consumer sentiments. We feel encouraged to see that eight of ten South-east Asian nations have set net-zero targets and more large regional corporations have stepped up to make climate pledges.

It remains true that carbon offsetting should not be the first line of defence. However, while it is important to invest in decarbonisation levers, it may simply not be enough due to various factors such as technology readiness, economics, and investor interest, regulatory incentives, and enabling infrastructure. Carbon offsetting is therefore an essential piece of the puzzle in attaining our goal of achieving net zero. The VCM market, including the nature-based segment, holds significant promise despite its infancy and the cloud of uncertainty shrouding it.

Investing in climate tech: Where do the opportunities lie?

Similar to any other type of marketplace, the carbon credit market operates on two ends – demand and supply, with market mechanisms and credit registries underpinning the process. A key driver for carbon credit supply is nature-based climate solutions. These projects focus on natural ecosystems such as rainforests or wetlands to do good to the environment to offset the “bad” done by carbon emissions. Projects may focus on improving biodiversity, conducting reforestation programs, or even using soil to sequester carbon dioxide emissions from the environment.

As a South-east Asia-focused VC, we are particularly interested in seeing solutions that can tackle issues in carbon credits projects from both a demand and supply perspective. For example, we have just invested in Fairatmos, a carbon technology platform that enables communities as project developers to develop carbon sequestration projects and companies that want to offset their carbon footprint. Broadly, we see that VC investment opportunities can arise from various parts of the “carbon tech stack” as illustrated below:

From the supply perspective, natural climate solutions (NCS) carbon credit projects typically originate from large and smallholder landowners and communities. Tech-enabled solutions broadly fall into two main categories:

  • Project development: Currently, the process of developing a carbon credit project is typically manual and undertaken by consulting agencies, resulting in barriers to time and cost. Startups in this space can leverage digital tools and third-party data sets to increase efficiency, and transparency and reduce costs. Unique access to supply, ease of workflow tools as well as good domain expertise are critical success factors that will potentially set great startups apart from others in this segment.
  • Measurement, reporting, and verification (MRV) of mitigation actions: According to the World Bank, MRV refers to the measurement of the amount of greenhouse gas emissions reduced by a specific activity over a period of time. MRV seeks to verify the authenticity of carbon removal claims from projects so that these actions (for example, planting a tree) can be converted into credits that can be purchased. Through the use of sensors, satellite imagery, and workflow tools, MRV startups can enhance the level of transparency and information integrity of the carbon credits market. To scale well, companies in this space must find the right balance between data resolution and coverage.

A solution like Fairatmos would fall into the supply side. On the demand side, startups have the opportunity to address private sector demand from both enterprises and consumers.

  • Institutions: To develop sound net zero strategies, enterprises must first take stock of their carbon emissions across their supply chains. Startups in this space may inform enterprises of their carbon emission posture by identifying, harmonising and analysing a complex range of internal and external data sources. Others can make actionable recommendations on possible mitigation strategies, as well as provide carbon offsetting options to the enterprises. Carbon accounting startups can develop a strong value proposition by positioning themselves as leading specialists for certain sectors, use cases or geographies. Those offering carbon offsetting options must be ready to curate a wide variety of projects to suit the different types of enterprise net zero strategies, needs and narratives.
  • Individuals: Climate-conscious individuals may be interested to track, reduce and offset their carbon footprint. In addition, they may also choose to support brands that are perceived to be climate-neutral or climate positive so startups could find opportunities in helping brands to develop and showcase their contribution to protecting the environment. Similar to other consumer-facing businesses, startups in this space must develop cost-efficient and extensive distribution channels as quickly as possible to scale sustainably.

Lastly, underpinning the carbon markets are:

  • Carbon registries: Carbon offset registries issue credits based on defined certification protocols, keep track of available offsets in the marketplace, and are responsible for tracking the retirement of credits after purchase so that two purchasers cannot claim the same verified carbon reduction. While the voluntary market is currently dominated by carbon standard providers such as the likes of Verra and Gold Standard, startups that aspire to bring disruption to this segment can potentially do so by focusing on methodologies, project categories, and geographies that are not well-covered by existing standards.
  • Market mechanisms: By connecting the supply and demand drivers, carbon credit marketplaces, trading and auction platforms as well as brokers ensure that there is liquidity to the carbon market, in turn encouraging funding for the carbon project. A variety of players – from traditional agents to tech-enabled platforms – already exist globally. Scale and reputation will be key success factors for startups in this segment.

Climate tech is certainly not a silver bullet in our fight against climate change – we not only need technological innovations but also concerted efforts and decisive actions across society and the economy. Similarly, as mentioned, carbon offsetting should not be the first line of defence in our efforts to drive decarbonisation.

However, just as climate tech solutions can potentially move the needle in reversing the rising global GHG emissions, the carbon credit market holds significant promise as a critical tool kit in this fight.

As tech investors, we remain optimistic that our collective journey toward a greener economy offers interesting opportunities for innovative climate tech and carbon market companies, including those from South-east Asia.

Leung Pui Yan is a partner, and Khush Topandasani is a senior investment associate, at Vertex Ventures South-east Asia and India, an early stage VC firm.

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