A new dawn
Of all the major trends that shape our society at the moment, climate change is probably THE megatrend.
There are plenty climate related markets and assets – from renewable energy to electric vehicles, but there is an asset class, which is still largely unknown despite being around since the late 90s.
Carbon markets started with the Kyoto Protocol and the asset is a carbon credit, which equals 1 ton of CO2 equivalent (meaning not only CO2, but also other greenhouse gases, with their potent factor converted to CO2, eg. 1 tn methane = 84 tons CO2).
There are two types of carbon markets:
- Mandatory (compliance) markets have been “created” by Governments, which basically forced a punitive market on polluting industries like energy, steel and cement via cap-and-trade schemes. The largest one is the EU Emissions Trading Scheme (EU ETS) and is a $300bn market. The tradable asset is called a carbon allowance. A polluter which purchases these credits (one costs ca. $60), buys the right to pollute, they don’t actually save CO2 with the purchase. It’s a penalty. The mandatory markets can easily get to $1 trillion in size.
On the other hand,
- Voluntary markets are based on the goodwill of people and companies. If you buy 1 carbon credit (=1 tn CO2e) for $10, you are supporting a project, which has already saved this 1 ton CO2. If you retire (destroy) carbon credits equal to your carbon footprint, you become carbon neutral. As an investment, voluntary carbon credits are practically non-existent, but my thesis is that they will become an asset class and could go from a $500m market to >$50bn by 2030, likely with the help of crypto. A 100x opportunity and it is very early.
Before digging deeper on both,
A 10,000 foot view on the opportunity
Carbon markets look “non-obvious” as investments. This is a term that Elad Gil coined:
“I think there are three types of non-obvious markets.
- The first type is, it’s a brand new market, but it’s growing really fast and it kind of comes out of nowhere and surprises people. And honestly, that’s actually the rarest market. And that would be things like cryptocurrencies. It just kind of came out of nowhere in terms of hitting the scale that it did so rapidly….”
Supply side: new climate tech will enable new ways to reduce CO2.
- “I think the second type of market that are non-obvious are, every once in a while, you have a market that looks extremely crowded. And so you think there’s tons of activity and it’s game over, but in reality, it’s still the really early days either because the product isn’t quite there yet, or the infrastructure isn’t quite there yet…”
Mandatory carbon markets and the infrastructure layer of the voluntary carbon markets are good examples.
- “The third type of non-obvious market is one where there is an opening from a sales or distribution or channel perspective…”
Demand side: FinTechs and GreenTechs are enabling completely new business models for voluntary credits.
Cap-and-trade schemes use carbon emission allowances (permits), which don’t reduce emissions directly. The polluters buy (hopefully expensive) allowances, which makes their current operations costly and they are incentivized to switch to cleaner tech. This is a major difference between carbon allowances and carbon reductions (offsets). The money that is collected by the government would ideally go into new carbon reduction technologies. There are active emission trading schemes in Europe (covering 30 countries), USA (RGGI, California), New Zealand, South Korea, Kazakhstan and since 2021 — China.
The largest market is the EU ETS, which covers 40% of all EU emissions, started in 2005 and is currently in its 4th phase (2021-2030). The European Commission issues a (declining) number of carbon allowances (called European Union Allowances or EUAs) for free to every one of the 11,000+ fossil fuel burning installations and requires them to return an amount of EUAs corresponding to their actual emissions for the previous year (1 EUA = 1 ton CO2e). A study from 2020 has found that ca 1bn tons have been reduced in Europe since the start of the scheme.
Investing in the EU ETS
The mandatory carbon schemes are a $300+bn market with the EU ETS being 90% of the total and responsible for the trading of 8bn tons CO2e. At a market price of EUR 100 per ton, which many expect in the future (ca 2x the current price) and a 20% increase in volumes, which is in-line with recent years, the EU ETS can become the first trillion dollar market that nobody has ever heard of as early as next year. This is equal to the size of the Bitcoin market.
EU carbon allowances (EUAs): one can trade carbon allowances via futures or ETFs, or OTC (you’d need an account at one of the country registries to store the EUAs). The goal of Governments is to force a reduction in emissions and they need high carbon prices for that. As a typical commodity, EUAs trade based on supply/demand.
Primary spot auctions and futures are traded on ICE (owned by NYSE) and EEX (owned by Deutsche Börse), which handle most of the volume.
Currently, only a limited number of financial investors (specialized commodity / energy hedge funds) are participating in the market as speculators (they don’t need to hold EUAs), but this may change with climate gaining popularity. The main players are the prop desks of large energy and industrial companies, commodity traders and investment banks.
Individual investors are largely absent from this market. But here is a conspiracy thought: imagine if the good people at /r/wallstreetbets decide one day that, instead of punishing GME short sellers, they want to take climate action in their own hands. They start buying up carbon allowances, 10x-ing the price in no time and pretty much bankrupting the entire European energy and industrial sector for being too slow in reducing emissions.
This will create an utter chaos in Europe, where institutions are very slow. The EU will need to release allowances from the Market Stability Reserve, but this may have a limited effect since mass printing carbon allowances will not be very popular politically and would probably require a uniform decision by all 28 Member States, which is close to impossible. The market-based mechanism gives power to the people in the climate fight (although our electricity bills may temporarily 5x as a result).
The voluntary carbon markets have existed since the late 90s with China, India and the USA being dominant. The initial projects to reduce carbon emissions were related to preventing deforestation in South America. In 1997, the World Bank and Formula 1 Association were the first entities to purchase credits for offsetting purposes. This market is still very small ($500m-$1bn) and not investable, but I believe this is about to change dramatically as we are at major inflection points.
How does it work.
A project developer (an investor) identifies regions, suitable for carbon projects due to government policies and technology, possibility for meeting more UN SDGs (Sustainable Development Goals), carbon standard requirements, verification requirements and project viability and scale. This is not easy – they go remote places in Africa, South-East Asia or Latin America and convince the locals that this is good for them, often being the only source of any investments. This is slow and cumbersome and could take months or years to setup and execute. For typical carbon projects, the carbon credits are the only source of cashflow. These credits are then sold to NGOs and corporations for PR/CSR purposes. Almost all of the transactions are OTC with some participations by brokers, but no financial traders. Retail can only buy and immediately retire credits. Opening an account to just keep them is often impossible (e.g. Gold Standard).
From 0 to 1 as an asset class
I believe voluntary will become a viable and investable asset class with the help of tokenization and crypto. This is because of an inflection point in:
- Market structure
- Price structure
- Intrinsic and relative value
- Market history and structure
The voluntary market today is much smaller than the mandatory, but has massive potential. For the past 20 years, the market size has been relatively stable at <$500m.
A throw back to 2008. Things that have not changed in 13 years:
- 35% of buyers bought for resale, most others buy for CSR/PR retirement.
- Project price dispersion similar to today – between $0.5-$50 with large scale renewable energy dominant and offering the lowest prices.
- An old school value chain: project developer – wholesaler – broker – retailer, increasing prices by up to 75%. Still often the case today.
And a few that have:
- Average prices are down 40% driven by a growing carbon credit inventory due to excess issuance vs retirement.
- Market players in 2008 expected to trade 476mn tons volume by 2020, but the market traded 141mn tn last year vs 131mn in 2008.
- There used to be more than 25 standards/registries vs 5-6 today, most have gone out of business.
A market that has gone nowhere
Here is what needs to happen in the next 30 years.
All societal groups are now aligned:
- Governments: every major economy has a Green Deal and doesn’t shy to print trillions for the transition to the new industrial age. Wasn’t the case 5 years ago.
- Consumers: everyone wants environmentally friendly products and climate cautious workplaces (driven by Millenials / GenZ). Wasn’t the case 5 years ago.
- Corporates all want to go carbon neutral. Wasn’t the case 5 years ago.
It should have happened 10-15 years ago, but the timing wasn’t right.
We are starting to see the opening of new distribution channels to a new, price insensitive buyer group – individuals and SMEs, who are entering the market, driven by new tech solutions. This will increase demand dramatically. Many large established companies are beefing up their ESG and their YouTube ads are no longer about their products, but about them going carbon neutral.
In 2021, it’s different. The timing is right.
McKinsey estimates the market to be $5bn-$50bn by 2030 (10x-100x). The money chart!
Finding buyers for the offsets was a big pain 10 years ago. I remember pitching offsets to companies in Europe in 2011 and nobody cared. Finally, things are moving. Green is the new digital. Behavioral change at the individual and company level is real and here to stay.
Startups are building enterprise tech solutions for estimating, analyzing and reducing carbon footprint. These enable completely new distribution channels, one of the characteristics of “non-obvious markets”.
For consumers, there are numerous apps with an embedded footprint calculator and offset marketplace, that either integrate with the bank account or are in the form of a green credit/debt card that plants trees as you spend or investing in ESG assets and offsetting via a monthly subscription.
A back of the envelope calculation confirms McKinsey’s numbers. Let’s assume that only the developed world upper class (ca 20% of households in the USA and 10% in Europe) will be willing to spend money to either voluntary offset their footprint directly by buying credits or via overpaying for carbon neutral products and services that channel the money to the market. The upper class households in USA ($150k+ annual income) represent 23.2mn households with an average carbon footprint of 90 tons CO2 per year equals 2bn tons. The same for Europe gives us 19.5mn households with an average footprint of 53 tons, resulting in 1bn tons.
Potential demand from upper class households in USA and EU at increasing penetration levels (just for the upper class) and average prices.
The numbers show that the $50bn market forecast is completely feasible and could even be conservative.
Historically, there has always been more issuance of carbon credits than retirement (demand), leading to a steadily increasing overhang. The cumulative inventory from 2002 till today is ca 420m tons.
Since 2019, project developers have started to sense the upcoming change in demand and started to issue record amounts of credits with issuance over the past 2.5 years equaling all credits from 2006-2018 combined. What is interesting and telling is that record issuance comes in the face of declining prices and slowly increasing number of retired credits (the measure of demand).
Factors constraining supply
About 100mn tn of the overhang is from Indian and Chinese projects, largely dominated by renewable energy at low prices. It is entirely possible that corporate and retail buyers in the US and Europe would not want those, which would ease the supply glut. Plus, China has kickstarted their national ETS in April 2021.
A lot of low hanging fruit in large-scale renewable or forestry projects has been developed, leading to oversupply and the two leading standards (Gold Standard and Verra) banning the registration of new grid-connected renewable projects. The reason for the large early developments were two Kyoto Protocol mechanisms called Clean Development Mechanism (credits were called CERs) and the Joint Implementation (ERUs), which allowed those offsets to be used by European emitters. Many of these projects were in India and China and were banned from use by 2015 and some of them converted to voluntary credits.
Why were they banned? These mechanisms were established to enable technological, know-how and capital transfer from Europe to less developed countries where the same 1 tn CO2 can be saved much cheaply. Massive reductions came from HFC-23 gases (used in air conditioner / refrigeration), 12,000x more potent greenhouse gases than CO2. Their destruction became a natural source of carbon projects. Everything went well until smart Chinese entrepreneurs started building new plants just to destroy the exhaust HFC-23 and sell the credits. Given the CER prices back in the 2010s, the ROI was 15000%-25000%.
Geographically, most offset projects are in LDCs (Africa, Asia and LatAm), because it is much cheaper to save a ton of CO2e where the economies are less efficient and technologically developed. Carbon projects are often the only type of FDIs. Completing new projects in those regions is slow and often small scale. The US has two regional ETS and has introduced separate credit systems for electric vehicles and renewable energy, thus removing part of the potential for carbon projects. Europe has almost no voluntary market because of its well-developed EU ETS (having both mandatory and voluntary systems can cause double counting).
The new investor-wave
Historically, project developers are specialized environmental companies, well integrated into the supply chain, with good knowledge of the geographies, policies, technologies, standards, validators and registry requirements.
Recently, VCs and tech companies have entered the market. Breakthrough Energy (Bill Gates), Climate Pledge Fund (Amazon) and Lowercarbon (Chris Sacca) are funding crazy deeptech. Stripe and Shopify have both set up their own activist CSR vehicles for funding carbon removal tech giving them access to the carbon credits in the future. At the same time, they are involving their customers into these investments. Startups are developing super trees (Living Carbon), cow pills (Mootral), new concrete (Carbon Cure), methane flare (Frost Methane), new fertilizer (Nitricity), very different from the old-school developers. In a crypto startup, you can get equity and/or tokens. A carbon startup often has a viable business plus it produces carbon offsets, which can later be sold.
Experts believe that if we don’t get a scalable capture tech, we can’t get to net zero emissions. Currently, all 15 prototype plants together capture 10k tons / pa, equivalent to 10 flights from London to New York. For these projects, the only revenue comes from carbon credits, but currently, the implied cost is likely $1,000 per ton. The goal is to bring the cost to <$50 per ton at scale (1bn+ tons captured annually). For example, Elon Musk is sponsoring research in this field with $100m prize money.
- Price structure
On the mandatory market, the price for 1 EUA is always the same, regardless of end-user or seller. Voluntary projects, while still priced for 1 ton CO2e, all have different prices. For example, Gold Standard credits cost more than VCS, because the projects provide additional benefits to the local communities like employment, sustainability or technology transfer. The general rule is: the more UN Sustainable Development Goals a project meets, the higher the price for its credits.
To complicate things further, credits are issued with vintages (year of saving), which are also priced differently. People tend to discount emissions from old vintages and prefer the most recent.
Differentiated prices per standard and type
Retail pricing is highly opaque. Buyers are offered bundles so that cheap and expensive credits can be mixed in order to optimize seller margins.
Prices will have to go up. After a decade of price deflation, the McKinsey forecast implies average prices of $25/tn by 2030, 5x vs. today. An increase makes sense given the new nature of buyers. Volume discounts can show a 3x price difference between 10,000 vs 500,000 tons, let alone for 20-100 credits, which is the average footprint of a top 10% developed market household.
- Intrinsic and relative value
Carbon credits are commodities, driven by supply/demand. The intrinsic value comes from the need to offset the footprint by retiring credits (like burning tokens in crypto). The desire to do good for ourselves, our families and save the planet attributes value and certain price inelasticity, especially for the scarce projects, which a buyer can associate and identify with.
Relative value between mandatory and voluntary carbon prices. Voluntary prices are currently much lower than those on mandatory markets. Which is a bit odd as both are based on 1 ton of CO2e, but one is an actual reduction and costs $5/tn and the other is a penalty and costs $60/tn. The delta reflects the supply/demand differences and the missing linkage between both markets. However, one can imagine a world where social pressure, government policies and pure ideology makes voluntary offsetting less “voluntary” in nature and its market prices start catching up.
With average prices of 5$ and assuming a catch up to half of mandatory target prices of 100$, this is a 10x increase.
There are currently two exchanges – CTX and CBL, which have clunky UX and not used by retail. If these can provide better price discovery, that will help with planning and transaction certainty. Otherwise, projects get abandoned, credits are not verified and issued, and local benefits fail. The value of exchanges dates back to 2006-2010 when half of the volumes were on the Chicago Climate Exchange.
We need new carbon wallets/exchanges similar to crypto, although in the meantime, tokenizing carbon and using the existing crypto infrastructure is a solution.
The chart shows the massive difference in traded volumes / retired credits when there was an exchange.
- Infrastructure: old, slow and expensive
Verifiers (project auditors) are an old and expensive industry, ripe for disruption by new, lean, tech entrants like Pachama, which combine verification and marketplace, massively improving the UX.
Registries / Standards set the rules of the game. Gold Standard and Verra have 90%+ market share. The rest is spread among American Carbon Registry, Climate Action Reserve and Plan Vivo. Registries are clunky, slow and expensive. The admin cost can reach 10–40% of the carbon price. Startups will completely revamp the ecosystem and make it 10–100x faster, cheaper and more convenient.
- Enter crypto
Similar to how crypto has created a market around things where there was no market before, carbon has created a market around CSR. People quickly realized that tokenization is a perfect way to solve many issues around distribution and infrastructure.
A few examples:
MOSS was launched in 2020 and has tokenized 2mn carbon credits by issuing a token MCO2 on Ethereum. Their goal is to allow people to buy the token and burn it to offset their footprint. It started in March 2021 and trades mainly on Mercado Bitcoin (largest exchange in Brazil). The price of $9 corresponds to average retail prices.
Carbongrid rewards blockchain networks and DApps for offsetting their carbon footprint.
Nori works with farmers to remove carbon from the air via sustainable farming practices (e.g. no-till agriculture, planting cover crops, and implementing useful crop rotations). They then verify and tokenize these as NFTs (they call them NRTs — Nori Removal Tokens). Nori acts as a marketplace where the farmers can sell their tokenized carbon credits.
How can Bitcoin help voluntary markets
Digiconomist calculates Bitcoin’s carbon footprint to be ca 50mn tn CO2e based on the electricity consumption and energy mix footprint where miners operate (most are in China and use coal power). The University of Cambridge has estimated Bitcoin mining’s renewable energy share to be 40%. If China really bans miners and they move to a place with a different 24/7 energy mix, the footprint will decrease, even though I really doubt that China will easily forgo cheap USD unhindered by tariffs and sanctions.
A viable option is to offset miner emissions.
Today’s Bitcoin footprint is equivalent to 50% of the total voluntary carbon market. Put in perspective, 50mn tn is the footprint of Bulgaria, or 0.1% of total human emissions, which is not so dramatic for a global value network.
It is a matter of time before someone creates financial products (an ETF for example) containing “green Bitcoin”, i.e. physical BTC and carbon offsets. Furthermore, miners can offset their emissions and sell their Bitcoin at a “green” premium. I think Bitcoin alone can double the current demand for carbon offsets as mining needs to become ESG friendly.
Investing in voluntary carbon
It is very early, the market is still small and far from straight forward, but it is coming. Here are a few ideas on how to express the view in public and private markets:
If you are an institutional LP, Breakthrough Energy Ventures, Lowercarbon and the likes invest in startups, some of which have carbon credits as a business model.
If you are a VC or angel, find startups, developing climate tech with a carbon credit angle. You can then use crypto markets to tokenize these credits for retail investors. Alternatively, the infrastructure layer in voluntary carbon needs a major revamp – exchanges, wallets, marketplaces, registries, standards and verification. Startups developing such tools are a good way to play the market. Especially if they have a crypto angle.
If you are a retail investor, you can invest in a rolling fund like Climate Capital (https://angel.co/v/back/climate-capital) or back the AngelList syndicate (https://angel.co/climate-capital/syndicate).
Lastly, crypto investors can buy tokenized CO2 and hold it in their wallets. Alternatively, open an account on one of the two exchanges and buy some credits there.
Carbon feels like crypto in 2012/2013. Terrible UX, old infrastructure and misunderstood. But it is at its inflection point and it is a land grab.