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Is Forest Carbon Just Another Commodity?

External Reference/Copyright
Issue date: 
August 23, 2011
Publisher Name: 
Climatico
Publisher-Link: 
http://www.climaticoanalysis.org
Author: 
Nick Oakes
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As already discussed on Climatico, using REDD+ as a private sector offsetting mechanism runs the risk of creating perverse incentives, exposing land to market price volatility and causing supply-induced price suppression. However, for the purposes of a deeper exploration into the market-related issues of REDD+, let’s assume these problems are solved and that forest carbon can, in theory, be commoditised and traded. This begs the question of whether forest carbon can be treated and traded like any other commodity.

A report by the Munden Project earlier this year attempts to answer this question. The authors’ conclusion was that forest carbon is not suitable for commodity trading. In response, trade association the Carbon Markets and Investors Association (CMIA) this month issued a response to the report.

Don’t commoditise forest carbon

Turning initially to the findings of the original report, first, the report highlights the risk of creating a monopsony structure, largely due to the limited number of organisations capable of verifying carbon measurements to IPCC standards. This results in the homogenisation of prices offered by the credit buyer to a project developer. More importantly, it also diverts the benefits of REDD+ away from communities and towards the middle men, in contrast to REDD+’s stated developmental objectives, whilst increasing the costs of REDD+.

Second, the high level of complexity and uncertainty surrounding forest carbon greatly increases the delivery risk for buyers. In short: there is no universally agreed process for carbon accounting; the costliness of an accounting method influences its use and consequently the mass of carbon that’s measured; and baselines can be manipulated. This affects the volume of credits that can be used to meet contractual obligations, whilst also leaving traders somewhat befuddled on the exact nature of the underlying physical asset.

Third, the uncertainty arising from the issues highlighted above, combined with the unavoidably high margin of error inherent in carbon measurements, is unacceptably high for commodity trading. If forest carbon transactions are executed on an exchange, they will be cleared by a clearing house, the latter of which takes on the counterparty risk. A clearing house will ensure that it can cover 99% of potential losses on a single day. However, the margin of error in carbon measurements is an order of magnitude higher than the uncertainty tolerated by a clearing house. Therefore, forest carbon will either not be exchange traded or a sub-standard commodity will be created instead.

Do commoditise forest carbon

Turning now to the CMIA’s responses, the CMIA first argue that primary market prices will not be homogeneous since the demand for credits is determined by the size and design of a compliance regime that permits offsetting via REDD+. And since any compliance regime has more than one compliant entity, there will always be more than one buyer. There is ample evidence from existing carbon markets to support this contention.

The Munden report is correct, however, to point out that there are only a limited number of organisations capable of verification to IPCC standards. This will almost certainly lead to higher costs and price manipulation by a limited number of organisations, subsequently diverting money away from communities and inflating the total cost of REDD+.

In response to the Munden report’s conclusion that uncertainty and complexity in verification causes problems meeting contractual obligations, the CMIA stresses this can – and currently is, in existing carbon markets – mitigated by the prices and volumes stipulated in the contract. This is true, but mitigation to the level of accuracy that a clearing house demands, this is unlikely. However, the assumption by the Munden report authors that primary market transactions need to be cleared via a clearing house is incorrect.

Copycatting the CDM

It is far more likely that primary market transactions will be executed in the same way as those in the CDM. This means that the delivery risk will be taken on by the two parties that drew up the contract, and that the transaction is very unlikely to be executed on an exchange and cleared through a clearing house. Meeting the high level of accuracy demanded by a clearing house is therefore immaterial.

This leaves a somewhat more familiar landscape. A compliance market will create demand from multiple buyers and result in price differentiation. The high level of uncertainty regarding the potential volume of issuable credits will be accounted for in the unique structure of each contract, and the transaction will be cleared bilaterally. The secondary markets can then trade a commodity that, crucially, already exists – since it has been issued and contains no delivery risk – on an exchange, using a clearing house.

It seems that the Munden report is correct in highlighting the risk of inflated costs caused by there being only a narrow group of capable verifiers, and the consequent diversion of benefits away from communities and the increased costs of fighting deforestation. It fails, however, to properly appreciate the primary-secondary market distinction that currently exists in the carbon markets, and how this is likely to be replicated in a private sector compliance market for REDD+, should one ever exist.

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Extpub | by Dr. Radut