Carbon Offsets 101: Big Gains (and Some Growing Pains) in Forest Carbon Offset Markets
Companies looking to reduce their climate impacts and greenhouse gas (GHG) emissions use a variety of tools to do so: buying renewable electricity (especially solar and wind); improving the efficiency of energy-hungry infrastructure; and generally trying to lower the "carbon footprint" associated with the goods and services that their employees use each day. But the methods available today cannot eliminate most emissions.
Many energy-intensive industries like airlines, manufacturers, and tech firms have tremendous 24/7 electricity and capacity demands that currently cannot be met with only renewable resources. To that end, voluntary carbon offset transactions are an increasingly popular alternative, allowing a company to indirectly reduce its climate impact.
What Are Carbon Offsets?
Carbon offsets are not new, but have quickly gained popularity (and scrutiny) around the world as the consequences of climate change become more apparent. In the early years of voluntary carbon offset markets, demand was driven by public institutions such as the World Bank. But as private companies take on far-reaching net zero or neutrality commitments, they are likely to become the major driver of demand for offsets. Recent reports suggest that over 450 large companies have pledged to go net zero or carbon neutral by 2050 or earlier, and these companies account for annual revenues of more than US$16 trillion per year.1
To date, timber and agricultural landowners generate most carbon offsets by deferring or modifying the harvest of trees or the disturbance of soil so as to sequester more carbon. For a fee, the landowner makes a legally binding commitment to defer or modify its activities for some period of time. Typically, each carbon credit represents one metric ton of CO2 (or its equivalent in other GHGs) kept out of the atmosphere.
Yet, while the demand for carbon offsets has never been greater, the supply side faces hurdles in generating enough high-quality timber and agricultural offsets to satisfy demand.
Scaling the Forest Carbon Offset Market
Historically, creating carbon credits through U.S. forest offsets has been difficult for timberland owners because it has required (a) very large tracts of land—thousands of acres at least—to create enough credits to justify the process; (b) 50- to 100-year commitments not to harvest; and (c) the money to pay significant transaction costs, both to create the credits and for on-the-ground project monitoring over decades.
These factors greatly inhibit the scalability of forest carbon offset programs. Given the intensifying and widespread effects of climate change, and the appetite for carbon offset transactions, there is an urgent need to greatly expand this market without compromising the scientific integrity of the emission reductions behind the credits.
One promising new option is to match small-scale timberland owners—who may only have 10, 50, or 500 acres of timberland, but would rather sell GHG reductions than logs—with large corporate buyers that want to purchase a lot of carbon credits.
The Natural Capital Exchange (NCX) is a recently-launched market designed to facilitate and expand the connection between small timberland owners and large corporate buyers, thereby dramatically increasing the size of the forest carbon offset market. NCX has pioneered a new paradigm to make it feasible for those small owners to generate credits.
NCX helps to pool the carbon on the timberlands of many property owners by using satellite imagery and AI technology to inventory the size and type of individual trees, substantially reducing the cost of measuring timber volumes and monitoring compliance. As NCX scales, its approach can dramatically increase the size of the forest carbon offset market by tapping into the vast areas collectively held by small owners.2
To translate its innovative technology into a robust market, NCX removes the timberland owner from the role of creating the carbon credits and focuses on deferring harvests one year at a time—a length of commitment feasible for most timberland owners. This greatly increases both the number of timberland owners able to participate in the market and the amount of forestland available for carbon offset projects.
In addition, NCX serves as a third party "market maker" by contracting with the timberland owners, obtaining verification of the resulting credits, and selling the credits to corporate buyers. The NCX program allows interested timberland owners to enroll their land by sharing their entire timberland boundaries with NCX, which in turn assesses the potential carbon sequestration available from deferring harvest on that property. Timberland owners then express the prices at which they are willing to defer harvest for a year and, to address "leakage" concerns, they also make commitments not to shift their harvest to other properties.
During its quarterly auction process, NCX "clears" the market, anonymizing bids, assessing the bid characteristics (e.g., geographic location and size), and then accepting the lowest-priced bids for the procurement quantity needed.
Through its auction in the summer of 2021, NCX has accepted bids from over 570 timberland owners in 16 states at an average price of $12 per "Harvest Deferral Credit." NCX is also working to obtain third-party verification of the carbon offsets such transactions create, which will be a critical step to expand the market and attract buyers.
Carbon Offset Market Improvements on the Horizon
Challenges remain on how to best structure this new marketplace in a way that maximizes the benefit to both landowner sellers and carbon credit buyers. Sellers and buyers often have different perspectives, motives, and incentives—which can delay the "meeting of the minds" in contracting.
Greater Understanding of Markets
Because carbon offset transactions are novel and most landowners have little experience with them, the transaction costs can be high. In crafting new carbon offset agreements, it is important to provide flexibility and transparency for landowner sellers while also keeping the terms of the agreement simple (i.e., minimizing dense or confusing legal terminology). Using clear and simple language helps to reduce the concerns of landowners, who often have limited knowledge of carbon credit terminology. Yet those landowner agreements must still ensure the integrity of the resulting GHG reductions so that the resulting credits meet the needs of large, sophisticated buyers (and potentially even regulators). Contracting in this space requires deep understanding of the relationship between the carbon credit as a tradeable instrument and the actual land management that credit represents.
Property Encumbrances
Deferral agreements with landowners must also be structured with consideration given to the impact of encumbrances on the real property. Many landowners have mortgages that limit their flexibility to encumber or restrict the use of the property.
For instance, a typical commercial mortgage will require the lender's written consent to any further encumbrance. A carbon credit program that requires maintaining property in a specific manner might violate such mortgage covenants, so harvest deferral agreements with timberland owners need to be carefully drafted to minimize this risk.
In addition, many timberland owners may want the flexibility to sell their timberland or a portion of it during the deferral period, so the deferral agreements should provide for an assignment or other process that ensures that carbon credits remain valid even if the underlying property is sold to a third party.
Scaling Forest Carbon Offsets
There are still challenges associated with having smaller timberland owners participate in commercial carbon offset transactions. It can often be difficult for small timberland owners to commit the time and resources (including outside legal counsel) needed to consider entering into harvest deferral agreements.
Small-acreage timberland can also be held in trust or owned by family businesses in a manner that complicates the ability of the timberland owner to enter into a deferral agreement. Without the help of third-party market makers like NCX, companies needing large amounts of credits tend to enter into transactions with many different landowners in different jurisdictions, which can result in delays and significant transaction costs.
The further growth of NCX and other carbon marketplaces should help provide small timberland owners and corporate offset buyers with meaningful access to carbon offset markets going forward.
Impacts of Climate Change on Forest Carbon Offsets
Timberland owners, buyers, and other carbon market participants will have to remain flexible to address new factors and risks associated with these transactions. For example, contracts and crediting methods will need to anticipate and account for wildfire risks and other weather-related events as climate change increases the occurrence and intensity of those events.
And as climate change accelerates, climate regulation and carbon markets will too—requiring all parties to carbon transactions to work to maintain alignment with evolving legal requirements and technical standards.
Moving Forward
Adapting to climate change and mitigating its impacts requires the development and scaling up of a full set of tools so companies can select GHG reduction projects most suited to a particular location or set of issues.
Carbon offset transactions are an increasingly efficient way to offset a company's emissions and carbon footprint, especially for those that cannot immediately be eliminated by purchasing renewable energy or reducing demand or direct emissions. DWT is already at the forefront of this emerging and fast-moving market to help clients meet their diverse climate goals with efficiency and integrity.
FOOTNOTES
1 Nicolas Kreibich & Lukas Hermwille (2021) Caught in between: credibility and feasibility of the voluntary carbon market post-2020, Climate Policy, 21:7, 939-957, DOI: 10.1080/14693062.2021.1948384; https://doi.org/10.1080/14693062.2021.1948384
2 Note that NCX is a DWT client, and DWT is proud to have helped NCX design and develop the commercial contracts necessary to facilitate the NCX carbon offset marketplace.