Our Head of Research, Jan Ahrens, explains the differences between carbon offsets and carbon allowances and assesses their suitability as Paris-aligned investments.
Carbon offsets are renowned as an important tool in the fight against global warming. However, although most offset projects prevent the increase of emissions, they do not decrease emissions overall. They do not, therefore, impact the infrastructure around how we pollute, they simply try to amend how much we pollute already. They cure the symptoms of Climate Change, but do not address the underlying issue.
Furthermore, the offsets market is largely unregulated, fragmented and lacks transparency, resulting in a range of quality and standards that leave a question mark over their environmental integrity.
In contrast, carbon allowances (‘permits to pollute’) are issued by regulators in cap and trade schemes. They exhibit significant differences to offsets. Foremost, since they are created in a regulated market, allowances are highly standardized to allow for liquid trading, and most importantly, the physical withdrawal of one allowance from the market represents a 1 tonne reduction in emissions within the cap and trade scheme.
Furthermore, regulators and industry associations, such as the IIGCC, acknowledge that carbon allowances or carbon removal units (currently trading above $500/tonne) are the only viable instruments to achieve Net Zero alignment strategies.
Introduction to Carbon Offsets and Carbon Allowances
Within the investment community, as awareness of the carbon markets proliferates, there is often confusion between two very different classes of carbon instruments: Carbon Offsets and Carbon Allowances. This paper explains the financial and environmental differences between the two and concludes that – while offsets are an important “bridging technology” in the fight against global warming – only carbon allowances are aligned with Paris Agreement objectives, since they create lasting decarbonization consistent with environmental targets set by regulators.
How offsets work is widely known: The purchaser finances a (cheaper) emissions-reducing activity to mitigate the continued act of polluting elsewhere. For example, offsets can be purchased as part of “green” airline travel, or to reduce or “offset” a carbon footprint. The financing works through the purchase of electronic certificates that are issued when an offset project impacts emissions either through avoidance of emissions increase or a reduction. However, in order to redeem the associated environmental benefit of an offset, it has to be retired at which point its value is reduced to zero.
Carbon allowances are lesser-known: An allowance is a “permit to pollute one tonne of CO2”, issued by a regulator. Entities covered in cap and trade schemes (like the Emissions Trading Scheme in the EU, or the Western Climate Initiate or Regional Greenhouse Gas Initiative in the US) have to buy enough allowances to match their annual emissions. They must then surrender those allowances to the regulator. However, only a finite number of allowances are made available each year – and over time this volume declines in order to drive emissions down and ultimately meet societal environmental targets.
Carbon offsets and carbon allowances are typically purchased for their environmental impact.
Offset credits are created when two criteria are met: i) a project needs to reduce emissions against a business-as-usual scenario, and ii) the project is only economical through the additional revenue from selling offsets (known as "additionality").
For example, suppose a company wants to build a coal-fired power plant, but can opt to build a wind farm instead if the offsets create additional revenue that make the wind farm economical. For every MWh produced by the wind farm, a number of offsets are issued. But, as this example highlights, although no new emissions were created, no existing emissions were actually reduced. (The same principle applies to most kinds of offsets – with the important exemption of carbon removal offsets, which currently trade above $500/tonne1)
The buyer of the offsets can then choose to retire the offset to claim these emission “reductions” to balance his own emissions of, say, a flight. The purchaser believes that their air travel is now “carbon neutral” as he/she avoided emissions somewhere else. What actually happened under most offset systems, is that emissions overall increased: The flight did cause greenhouse gas emissions, and the project just avoided a further increase. So the net emissions in the atmosphere increased.
As well as carbon removal units, which finance activities that capture CO2 from the atmosphere and store it permanently, ‘Forestry and agriculture/ land use’ is another offset class often labelled as “emissions reducing”. The idea is that planting trees or changing land use removes carbon and stores it in soil or wood. The downside is that these reductions are not permanent – if the tree dies/burns/is harvested, emissions are released – and if land use is changed in the future, the same happens.
In a cap-and trade market, every year the regulator issues, via auction or allocation, permits that allow the holder to emit one tonne of carbon dioxide. These permits are called carbon allowances. Each year, the supply of allowances is fixed by regulation and preset to decline. If an investor buys a carbon allowance, this allowance is no longer available to emitters covered by the scheme – thus available supply is reduced and the capacity to pollute is reduced. Consequently, an entity needs to reduce emissions – and the overall emissions go down. As long as the investor holds this instrument, the capacity remains removed. The investor now has three choices:
- If the allowance is issued in cap and trade markets except for the EU ETS: Retire the allowance to make the emission reduction permanent
- If the allowance is issued in the EU ETS: Because of the specifics of the EU ETS (namely the Market Stability Reserve), retiring an allowance is not environmentally beneficial. However, holding the unit creates lasting emission reductions through the MSR itself2
- Selling the allowance again: Outside the EU ETS, the environmental effect will be limited to a delay in emissions (which has benefits on its own), but inside the EU ETS even temporarily holding allowances creates a lasting environmental impact
Critics argue that cap and trade schemes have excess allowances, so that withholding some of them does not make a difference. That is partially true, as some cap and trade schemes have battled with historic excess allowances. However, as the annual inflow of additional allowances declines steadily, at some point this excess is used up. Withholding allowances accelerates this process – until emissions are eventually reduced.
To conclude: Only carbon removal units or carbon allowances can ensure that emissions are actually reduced permanently, and therefore can be used for net zero compliance.
The market for compliance instruments
The markets for buying these two carbon instruments vary significantly.
Around 104m offsets were transacted in 2019, worth $320m3. This market is heavily fragmented across registries, methodologies and types of project, creating a wide range of prices.
There are several attempts to standardize the market to create a liquid derivatives market and to drive scale4, but for now buyers need to curate projects that are acceptable in terms of quality and price, and hope that they avoid later discovery of non-additionality.5
The market for carbon allowances is much larger: The world’s largest cap and trade scheme, the EU ETS, saw €200bn traded across spot and derivatives markets.6
Traded volume in 2020 in major cap and trade markets globally:
Each system has its own characteristics, and while there are ongoing discussions to link them together, this seems fraught with challenging politics in today’s climate. However, within a scheme, there is barely any difference between allowances, allowing for more transparency, standardization and therefore the development of a robust secondary market.
Carbon instruments as part of a Paris-aligned investment portfolio
Similar to offset markets, there is a lack of standardization on “Paris-aligned” investing. Various initiatives set their own standards for measuring, reporting and actions “eligible” to meet reduction targets. Some do allow the use of offsets (with specific quality restrictions), while others do not. As an example, the draft IIGCC net zero investment framework explicitly states that offsets should not be used, but “Credits purchased by participants within regulated carbon markets that are designed to meet the net zero emissions goal can be used.”7
If a cap and trade scheme is enacted to meet a future net zero target (like the EU ETS or WCI), its allowances can be seen as a “net zero” compliant asset – as their only raison d’être is to drive the regulated entities towards net zero emissions.
That is in stark contrast to offsets, which, to a large extent, do not actually reduce emissions but avoid increases, and are not part of a regulated policy towards net zero. Current offsets remain an important tool to transfer technology and support countries and companies to limit emissions increases, particularly in sectors of the economy such as land use and agriculture which are yet to be covered by carbon dioxide regulation. However, their environmental benefit should be assessed under close scrutiny. Until costs for carbon removal units come down significantly, buying emission allowances from regulated cap and trade schemes is the best way to support CO2 reductions.