Understanding Carbon Markets Part 1: Demand Side

Carbon credits are a new commodity that allow companies to offset emissions from one source, say powering a freight ship, by investing in quantifiable carbon reducing activities such as planting a tree.   Photo credit; Unsplash. 

By Ben Veres, CEO Kateri Carbon ( Part 1 of 2) 

Carbon offsets have become integral to our increasingly intricate global economy. Over the past decade, governments and industries have explored a balance of free market mechanisms and direct regulation to mitigate the environmental impact of climate change and excess carbon emissions.

The free market mechanism, often called the voluntary carbon market (“VCM”) is a system where companies with high levels of emissions, such as steel manufacturers, airlines, and energy providers, can purchase carbon credits to offset the impact of their climate footprint. While this market has been around in concept for over two decades (see: Kyoto Protocol), it has significantly accelerated in the last few years and is expected to grow exponentially in the next decade.

Advocates argue that these markets encourage Adam Smith’s specialization, leading to overall efficient economic investment that fosters net emissions reductions.

This specialization may come through industries that can produce carbon capture - a new type of commodity. As such, the demand side of the carbon markets is primarily driven by large corporations and a few aggregators who can purchase credits in huge quantities. 

Most of these large corporations, for reasons noted above, are effectively treating offsets as another material in their supply chain. Like fuel used to power a jet engine, carbon offsets are purchased like a commodity to meet firms’ operating needs (say, a carbon neutral flight). 

One of the benefits of this approach is that there’s a clear, quantifiable future demand. 

Why don’t companies just reduce their emissions internally?

They do! These are often called “insets”. Unfortunately, very few industries can truly get to net zero through internal reductions. Some of the limitations are physical (building cars, even electric ones, requires energy and materials that produce emissions). Other times, it’s just not financially viable - for example steel companies could move from coal burning, basic oxygen furnaces (BOF) to electric arc furnaces (EAF) but it would require billions in equipment and operational changes.

So what’s left to fill the gap is carbon offsets. A balanced climate approach should see companies utilizing both insets and offsets to meet their goals.

How much demand is there for offsets? Is it here to stay?

We know the Fortune 500, barring miraculous changes in technology, will need 2-3 Billion tons of carbon offsets annually by 2030. That equates to roughly $20-60B in offset purchases. If so, these sums allows for real investment & financing in carbon development projects on farms, ranches, and wetlands across the US and beyond.

However, unlike some commodities, there’s a massive range of quality and even types of carbon offsets. Standardization is harder because different types of interventions each produce and store carbon differently. We’ll cover more of this in Part 2.

Unfortunately, the science and complexity behind carbon credits has been evolving faster than most corporate sustainability teams can keep up with.

In addition, many sustainability departments are simply under-funded and under-staffed. They’ve been given a top-down message that they need to achieve a 20-40% emissions reduction but they don’t have the procurement authority to buy different fuels, the marketing authority to change product offerings, nor the budget to buy high quality credits. 

Corporations spent ~$2B on carbon offsets in 2021 – against a profit margin of $1.1 trillion in the Fortune 500 alone. That’s just 0.2% of profit (not revenue!) spent on carbon offsets. The spend has not matched the publicity or the new executive titles doled out for sustainability. 

The result has been a demand for credits that are $1-$5 per ton. It doesn’t take a scientist to realize it should cost more than a Subway sandwich to offset the annual emissions from a Cadillac Escalade. (We’ll cover what makes a bad credit in our next piece).

The result was best summed up by John Oliver – many credits purchased over the last few years were low quality or even worse, fake. But we cannot let bad historical projects stop the progress that carbon markets have made and the opportunities that they will bring to landowners and our climate.

There are fixes that need to be made on the supply side and in the market mechanisms, but ultimately, the market responds to the demand side. 

How does demand evolve by 2030?

We see four distinct groups evolving in the demand landscape.

(1)   The first is the “Box-checker” – these are companies buying $1-2/ton blended portfolio credits today that will continue buying. Their consumers care but not enough to avoid the product or do real research. Perhaps these companies have significant monopoly or monopsony power. These groups are likely to just pass the buck entirely by issuing an upcharge on products sold.

(2)   The second is the “Honor Roll Student”- these are companies that have enough public visibility and pressure that they will need to hire a legitimate Chief Sustainability Officer and sign onto the various SBTi, WWF, and UN guided carbon offsetting programs. They’ll invest in more diversified projects (blue carbon, enhanced weathering, etc.) in the $25-$50 range. This should be true for most consumer companies.

(3)   The third is the “Hedger” – these are companies whose business will be materially impacted by regulation if they do not meet certain standards. Likely to be energy intensive and manufacturing businesses. They’ll invest in trading capacity to buy futures contracts once the market is liquid enough and potentially even develop credits themselves in order to build vertical integration and price control. They’ll play primarily in the $15-$30 range because they’ll have significantly more public & regulatory pressure but need to achieve cost effective volumes. 

(4)   The fourth is the “Carbon Unicorn” – these are the big tech companies that are willing to pay exorbitant prices for high permanence solutions like Direct Air Carbon Capture and are willing to make advanced market commitments at $300+ per ton. An example is the Frontier Fund involving McKinsey, Stripe, Google, and Meta that has outlined ~$1B in an advanced market commitment.

Overall, carbon offsets have become a legitimate mechanism for companies to help reduce their net emissions. The concept has been around for a few decades but only in the last few years have they really taken off. Today, the majority of companies are “Box Checkers”. Over the next 5 years, we’ll see a huge shift into the model of “Honor Roll Students” and “Hedgers”, especially as the 2030 publicly stated commitments come due. Some companies will be leaders of the new frontier and others will follow. 

What does this mean for US ranchers looking to participate in carbon?

Carbon markets have now evolved beyond just planting trees and installing solar panels. Companies are looking to diversify their impacts and also their risks (e.g. wildfires can destroy a lot of forest carbon credits). Over the last few years, we’ve seen an increase in demand for agricultural related carbon credits - both from inset programs by players like Nestle and Cargill and from offset programs by players like Shell and Microsoft.

From a practical standpoint, farmers and ranchers receive payments from carbon buyers through project developers (like Kateri!) in exchange for measurable improvements in soil health and increased organic carbon levels over a set period, often 10-30 years. These improvements can be driven by a number of interventions like rotational grazing, cover cropping, and certain no-till practices.

When newer nature-based carbon programs start, they often launch in more affordable regions like Africa and South America. But as prices rise, we’ll see an increase shift into US-based carbon projects. Companies want to offset where their customers are but also have to balance the cost of labor and materials in their projects. At the end of 2023, there were a few hundred thousand acres of rangelands in carbon programs in the US - we expect this number to exceed 10 million acres by 2030.

Carbon markets can help provide funding and incentives to improve grazing - this has benefits beyond just carbon including improved water holding capacity and the ability to fight erosion on rangeland. 

Kateri is excited to help ranchers navigate the complexities of the carbon markets. We believe strongly in nature-based solutions and helping producers capture more value from their land and operations. If this something you want to learn more about, please get in touch with our team.

Stay tuned for Part 2 where we will explore what makes a good credit and where we believe the price of carbon is headed!