President Trump’s State of the Union speech committing U.S. support to the Trillion Tree Campaign drew a lot of attention to topic of forestry- and land use-related carbon sequestration schemes.

2019 State of the Union Address
2019 State of the Union AddressWHITE HOUSE

Your correspondent would like to think the president was inspired to mention this topic after reading my last article on this topic, The Premier Technology For Sequestering Carbon – which I published nearly two weeks before he delivered the State of the Union speech…

While President Trump’s election year interest in conservation is dubious – considering that it apparently fails to extend to water and air quality, or even to basic climate science – the ability of forestry and agricultural land-use policy to help mitigate the effects of climate change is genuine.

The topic of land use would not, however, be on anyone’s radar if it were not for the power of financial markets – the markets for carbon credits to be specific.

Many people have heard the term “cap-and-trade,” but have no idea how the carbon credit markets function. They should learn — these markets represent the best chance for humanity’s ability to thrive over the next century and to adapt to the sobering realities of climate change.

Carbon credit markets are a big topic – so big that I’m splitting up my coverage. This article will offer a brief overview of how the markets got started and how they work. The next article looks at the numerous areas in which the carbon markets provide some excellent business opportunities. Next week, I’ll publish an article about an innovative start-up that is applying 21st century technology – AI, LiDAR, and satellite imagery – to preserving forests.

A Brief History of Carbon Markets

Carbon markets were born in the shadow of the 1997 Kyoto Protocol – the first international agreement that sought to operationalize greenhouse gas (GHG) reduction actions agreed to by the signatories of the 1992 United Nations Framework Convention on Climate Change (UNFCCC) treaty.

Kyoto Protocol commitment map
Countries shaded in green are those with firm commitments to cut emissions under the Kyoto Protocol. Those shaded in yellow are participants, but whose commitments are flexible. Red shading indicates non-participants.WIKIPEDIA.ORG

(There are other GHGs the Kyoto Protocol covers, but all emission targets are standardized in terms of units of Carbon Dioxide. This article series uses “carbon” and “GHG” interchangeably.)

The idea behind Kyoto was that a base national emission rate would be determined (for most countries, the base year was set to 1990), then that country would set future emission targets based on that rate. In other words, the Kyoto Protocol set a (theoretical) per-country cap for carbon emissions. Carbon markets arose as the “trade” portion of an overall “cap-and-trade” framework.

Even before Kyoto rules came into force, organizations began creating trading mechanisms for companies wishing to voluntarily participate in carbon emission reductions in advance of the kick-off of the imposition of regulatory mandates.

These markets came to be known as “pre-compliance” or “voluntary” markets. Once the Kyoto Protocol rules came into force, credits started to be traded on markets backed by a regulatory mandate. The markets supervised by governmental regulatory bodies became known as “compliance” markets.

The Kyoto Protocol, as you can see in the image above, was less than a resounding success in terms of participation.

The U.S. famously did not ratify the treaty (Thanks, “W”), Canada pulled out in 2011 (Thanks, Tar Sands), and the countries to which the developing world had decided to outsource low-cost widget production – China and India – were Kyoto signatories but the treaty did not obligate them (or other developing countries) to reduce emissions. In the end, signatories with emission reduction obligations under the Kyoto Protocol only cover about one fifth of global GHG emissions.

Despite lackluster international participation, the Kyoto rules and the carbon trading markets to which they gave birth arguably sparked one of the most important transformations of electrical generation capacity in history – the shift to renewable energy sources.

Renewable Generation Capacity by Source (2000-2017)
Renewable Generation Capacity by Source (2000-2017)IOI CAPITAL

The most important compliance market in the U.S. is that based in California. 80% of the credits transacted in the Californian compliance market are sourced from forestry and land-use related sequestration projects. It’s not too much to say that the Californian compliance market has made material changes to the economics surrounding land management policies in the US.

The Californian compliance market is the second largest in the world, exceeded in value only by Europe’s EU Emissions Trading System (EU ETS).

How Carbon Trading Works

The concept behind carbon trading is simple.

Let’s say Company A is subject to a legally-imposed cap of 100 units but, without implementing new technology to directly reduce the carbon it emits, produces 120 units. Company A knows it will be fined or taxed for every unit of emissions it generates over their cap amount.

Company B has the same cap of 100 units but can quickly and cheaply implement solutions that drive down emissions to 80 units.

In this case, as long as there is a market mechanism by which credits can be recorded, traded, and used, Company A can agree to buy the 20 units’ worth of excess credits Company B does not need. As long as the price of the 20 units of credits is lower than the fine Company A would face if it couldn’t meet its targets, it makes sense for Company A to buy Company B’s excess credits.

Most credits are transacted on an “Over-the-Counter” basis (i.e., privately-negotiated transactions between two parties) though limited trading is available on some public markets.

While this example makes carbon trading sound straightforward, in real life, it is much more complex. Determining allotment levels, verifying that emission reductions are bona fide and persistent, tracking which credits have been issued to which entity then sold to which other entity, etc. – the devil is very much in the details.

This complexity is good news for businesspeople, because complexity breeds opportunities for profit.

In my next article, I will offer some real-life examples of carbon and talk about the various players in the carbon credit value chain. I’m also looking forward to introducing you to Bluesource, the largest carbon offset project developer in North America.

Intelligent investors take note.