You just bought carbon credits generated by a REDD+ project at $10 USD/tonne. Have you ever wondered where the money went? With a long value chain, multiple project developers and intermediaries involved, as well as opaque fee structures, it can be difficult to get a full picture of how much funding went to halting deforestation and how much actually went to local communities.
In this article, I set out my thoughts on how we can drive greater transparency in carbon finance flows. Increased transparency can enable users of carbon credits to compare projects of different sizes on key parameters such as community benefits, mitigation measures, as well as to ensure money flows to projects that have the most positive impact “on the ground”.
Executive Summary
- Increased transparency can enable users of carbon credits to compare projects of different sizes on key parameters such as community benefits, mitigation measures, as well as to ensure money flows to projects that have the most positive impact “on the ground”. This is not easy, but one north star may be what we have in equity markets. We are very far from that situation. Secondarily, there is anecdotal evidence suggesting that host governments’ hesitation to open their carbon markets is at least in part, driven by this lack of transparency.
- When visiting a project or learning about it from marketing materials, it is easy to be impressed by images of schooling opportunities offered to children and employment for local community members. These benefits are truly important and should not be dismissed. However, what matters is the percentage of funds that are actually being channelled towards these purposes.
- Market opaqueness is driven by a combination of the lack of transparency in the fee/spreads charged by some intermediaries and project developers. There is no requirement to provide audited financial statements.
- One may speculate why are still lacking transparency. Part of the reason is that developers and intermediaries have little incentives and without requirements for transparency, this can be hard to enforce. Perhaps it would have been helpful if the ICVCM required it under its Core Carbon Principles.
- Not all community benefits are the same. Hence even if we had the relevant data for each project, it would not be easy to compare them. Some rating agencies only accept monetary benefits, whilst others accept non-monetary benefits as long as they are chosen by local communities as part of an FPIC process.
- For blockchain technology to enable true transparency, all parties in the value chain and that receive a part of the price paid by the ultimate end-user must be on the same blockchain that is visible for all to see.
- Looking to equity markets, one may have faith that eventually we will have the transparency we need. This will take significant time – or may never happen – if we expect it to happen voluntarily and under competitive pressure. We need both prudential regulators and quasi-regulators taking decisions to stipulate this requirement if we are to have a chance. In the meantime, my hope is that buyers and financiers will start to ask these challenging questions to the intermediaries and developers.
What we want – the ability to compare across projects
Why is transparency so important? While it is obviously part of good governance over a market, a key benefit it brings is the ability for users of carbon credits to assess two projects of different sizes on comparable variables such as (A) percentage of funds paid to project developers (as opposed to intermediaries); (B) percentage of funds used to stop deforestation versus the size of the deforestation driver; (C) percentage of funds given to local communities; and (D) money spent on other “co benefits”.
When visiting a project or learning about it from marketing materials, it is easy to be impressed by images of schooling opportunities offered to children and employment for local community members. These benefits are truly important and should not be dismissed. However, what matters is the percentage of funds that are actually being channelled towards these purposes.
Of course, the context often varies depending on each project and such a comparison will never be straightforward, but it is certainly an exercise worth undertaking.
An analogy could be drawn to listed equities. Investors in such instruments are used to standard financial metrices like Return on Equity, Net Asset Value, Volatility and Financial Leverage etc., that can be easily compared to companies in different countries and industries.
The problem with opaque prices from intermediaries
Carbon markets are full of marketplaces, exchanges and intermediaries to name a few. The prices (fee and/or spreads) that facilitating intermediaries (e.g. marketplaces, exchanges, brokers) charge can vary significantly. Climate Impact X (CIX) for example has sought to be as transparent about our fees as possible to help reduce market opacity.
The market in general is far from transparent. As one report states: “Intermediaries can convince unaware buyers to purchase low-quality, very cheap carbon credits at hugely inflated prices”. The same report estimates that the fee/spread charge is 15.5% which may be on top of any mark-up from warehousing. Whilst it would seem unlikely that brokers and resellers are able to command such large fee/spreads, there is much anecdotal evidence of very varying prices. Whether 15.5% is an accurate figure is less the point here than the fact that facilitating intermediaries should be transparent in pricing.
A joint investigation by Unearthed and SourceMaterial found that some intermediaries are buying carbon credits from forestry projects in poorer countries and selling them on to consumers and companies, including airlines and oil firms, at inflated prices. Here, the authors cite mark-ups of up to 700-800% (which may include warehousing premium). Again, the point is that even if the figures are anecdotal and perhaps inflated, it is hard to determine for sure. Also, an increase in price can simply be the result of market price movements, or to compensate intermediaries for financing and risk-taking. In fact, for markets to work we do need financiers and intermediaries who are willing to put capital at risk. They need to be rewarded for taking this risk.
It is also my experience that governments of host countries are worried when they see that a price that the developer in the country received is only a fraction of the final selling price. They want transparency and control. Such desire is understandable and to some extent reasonable.
The problem with opaque use of funds by project developers
Project developers are most often the recipients of the carbon credits generated and are therefore in the centre of the distribution chain of the funds generated from the sale.
They may sell the credits directly or arrange for a sales agent; pay any government levies; pay the project proponent and of course the project implementation partner and local communities. Naturally they will keep some profit for themselves. It becomes obvious that without insight into this distribution flow and the efficiency of the developers’ operation (e.g. administration etc.), it is nearly impossible to ascertain the quality and viability of the project. This should concern not only investors but also buyers. It would be like investing into a company without being allowed to see their financial statements.
Some may argue that a buyer does not “invest”, but “buys a product” – similar to how a consumer would buy a chocolate bar for example. As such, the buyer will not always have access to the chocolate bar producer’s financial statement. This analogy though breaks down in two ways. Firstly, I almost always can see the ingredients of that chocolate bar on the package (who does not know what emulsifiers and Thiamine Mononitrate are) and secondly, we are hardly talking about a chocolate bar but the faith of humans and ancient forest when we buy NBS carbon credits.
We should insist that we understand where money is going.
The challenge with community benefits
Community benefits are generally expected as a core to a high-quality project. It fundamentally ensures a level of equity, and that sufficient benefits are delivered to local communities – who depend on forests for their livelihoods – to become partners in preserving that forest.
While this may sound simple, it is far from it and raises several questions such as:
- What is considered “enough” benefits to incentivise the prevention of deforestation? Anybody who saw the documentary The Territorywill know that simply paying a token amount will not stop an industry that pays poor local farmers to slash and burn. I discussed this in my previous post “Are you buying the right carbon credits to maximise impact against climate change?”, and since then we have conducted a small non-scientific analysis of 10+ projects. Our analysis confirms that it is very hard to determine if the level of interventions matches the amount needed to realistically stop deforestation.
- What type of benefits are the right ones? Building a school in the local community won’t help farmers struggling to make a basic living. That is why some rating agencies only accept monetary benefits while others accept non-monetary benefits if they are chosen by local communities as part of a FPIC process. Of course, the FPIC process in itself is complex and may not always create outcomes that stops all deforestation. Even if the majority will help protect an area, it only takes a few people to ignite a fire a start the clearing again.
At the bottom of this topic is a data problem. As a buyer, we rarely have the information to make these evaluations. At best, we are told that around 50% of the sales from carbon credits, for example, will go to local communities. That is an important information but insufficient because it does not tell us whether this amount is “enough”.
I note also that Calyx in a recent blog advocated for increased transparency and conclude that: “We have evaluated more than 500 projects across seven carbon crediting programs, spending significant time digging into registry documentation. No program currently lives up to the ICVCM requirements. In particular, programs can improve their transparency requirements and performance regarding the social and environmental impacts of carbon projects.”
It is worth noting that ICVCM has a workstream on community benefits in its continuous improvement programme. It will be interesting to see how ICVCM addresses the issues outlined above.
Is blockchain the solution?
It is tempting to see blockchain as the solution to transparency and there are several intermediaries and registries that have emphasised that they are blockchain-enabled as some sign of integrity. The reality is far more complex.
For blockchain technology to enable true transparency, all parties in the value change and that receive a part of the price paid by the ultimate end-user for the credits must be on the same blockchain that is visible to all to see. Getting the whole value chain of carbon credit on-chain will be challenging. That means we need all intermediaries, financiers, project developers and governments involved. In addition, we need the project developer to transparently show distribution of the funds received from the primary sale. We are very far from that.
Final thoughts
Looking to equity markets, one may have faith that eventually we will have the transparency we need. This will take significant time – or may never happen – if we expect it to happen voluntarily and under competitive pressure. We need both prudential regulators and quasi-regulators taking decisions to stipulate this requirement if we are to have a chance. In the meantime, my hope is that buyers and financiers will start to ask these challenging questions to the intermediaries and developers.
