Insuring REDD Projects: Questions and Answers

Just a few weeks of actual negotiating time remain before the year-end summit in Cancun, and climate talks are a mess. Sure, most parties agree it’s a good idea to reduce greenhouse gas emissions by saving trees, but that’s about all they agree on. This all highlights the amount of risk that investors take when paying for something today that won’t be delivered for decades – and the role that insurers could play in spreading the risk.
 

19 August, 2010 |Business is about risk, and insurance is about managing that risk. Without it, no sector can grow – and the REDD sector is certainly without it. Twice in the past we have examined the challenge of engaging the insurance sector and the importance of doing so (see “related links”, right), and these efforts have sparked a tremendous number of questions. We’d like to offer a crack at answering them.

Question #1: How important is this discussion when it comes to preparing for compliance adoption and is it premature to talk about regulation in advance of compliance?

This discussion is necessary to make all participants aware of what needs to be done to make the current forest carbon market structures viable. In order to prepare for compliance mechanisms acceptance, there must be steps taken to secure the integrity of the voluntary process, and for that matter, secure the integrity of the compliance process. The current structures would not stand up if challenged in the U.S. Court of Law. Currently, there are few legal documents which hold the forest carbon provider legally obligated to adhere to the requirements set forth by the protocols. There are a number of gaps where the carbon credit purchaser has no recourse in case of involuntary or voluntary reversals, default, malfeasance, and other risks. In addition, the registries are not securely protected from potential legal exposures brought about by authoring and administering the buffer pools.  Unless stricter protocols are implemented, the compliance market would be challenged to accept currently listed projects because projects generally are not secured, insured, or preferred.
 

There are solutions, which use a combination of insurance products and risk structuring to provide viable options for permanence. These have been demonstrated to the voluntary registries, for pre-approval process. The cost to project owners would be less than the value of credit contribution required by registry buffer pools. In addition, the project owners would have the ability to receive returns on their initial costs and have more control over their permanence issues. Finally, this would further provide market assurance since the role of market regulator, market insurer, and market standard would begin to function in a more independent arms-length appropriate manner, to the benefit of all market participants, registries, and standards.

The insurance costs would be in lieu of buffer pool contributions. Because there are different factors involved, part of the cost would be the actual insurance, while some of the costs would be administration costs. Estimations would be less than the current buffer pool contributions, with potential to receive portion back, based on loss experience.

There are a number of issues regarding the fungibility of the credits.  The fact that all credits are derived from forest sequestration does not guaranty that every credit is interchangeable.

Some of the issues that need to be taken into consideration for fungibility in the context of a mechanism for permanence are:

• What is the time requirement?
• What are the requirements for intentional or unintentional reversals?
• Have the projects gone through strict due diligence procedures to ensure viability of the project and viability of the project owner?
• How is counterparty credit risk addressed?
• Have the registries taken all appropriate preventative measures to secure their financial and fiduciary responsibilities?
• What steps have been taken to safeguard the registries from potential defence costs and/or legal challenges?
• Is the mechanism for permanence legally separated from the administering of the registries, so as not to expose the registry to conflict of interest or reversal handling issues?
• How are registering and issuance fee differentials handled between registries and standards?
• Are the same carbon pools with similar or same confidence intervals used when calculating mtCO2e regardless of methodologies and standards applied?
• Is there annual financial audit of the project by a qualified third-party CPA?
• Are all transactions of registered tons accounted for using an international transaction log?

These are some of the key components that need to be addressed in order to begin assessing the potential for fungibility.

Within the US, the most relevant data sources come from the forest project landowners. There are numerous data bases and resources available on public forest land.  Private ownership may provide information on a voluntary basis.

It is important to understand the differences between private and public forestlands. In the United States, there are over 747,000,000 acres of forestland of which less than 340,000,000 acres are public land.

For example, in 2007 which was one of the worst fire years in recent history, the National Interagency Fire Center (NIFI) reported that total acres effected were 9,328,045 or 1.24% of all forestland in the US was impacted by fire during one of the worst fire years ever in the US with only 0.17% of private forestland impacted in the US.

Developers, landowners and investors are currently pushing for insurance alternatives. These insurance alternatives include general liability insurance, errors and omissions insurance, insurance and / or buffer pool combination, and directors and officers’ liability insurance.

Examples include: 

• Insurance would provide financially rated and secured reversal instruments.
• Allow registries to focus on core issues of carbon certification.
• 3rd party administration would remove potential legal and financial exposures brought about by facilitating an internal insurance mechanism.
• The use of actuarial data and insurance methods would provide a more precise measurement for credit contribution or premium costs.

There will be an expected number of requirements. One important factor that must be taken into consideration is the legal climate of the United States. If a project is to be considered as meeting compliance guidelines, there also is the potential that the same project could be subject to suits brought about in U.S. court systems.

Currently, VCS is engaging academics to write up an analysis of financial risk management regarding their buffer pool approach.
ACR will entertain insurance in lieu of their buffer pool, as long as it meet’s their approval.
CAR has stated they are working on reinsurance options for their buffer pool.

Different project types meet different market needs with a multitude of project types assisting to complete part of the market. Registries need to segment their projects in a manner that effectively communicates each project types’ categories and information.

The market, to grow effectively, needs to address the needs of projects at the sub-national level and at the national level given different projects are effective within different frameworks. For example, a national REDD+ would be effective at poverty alleviation within a carbon framework while a sub-national IFM project would be effective at improving carbon sequestration for a specific private landowner. Both types of projects – sub-national and national – are needed while both types have their own unique risk and return characteristics along with their own unique financial risk management needs.

Standards can handle buffer pools and insurance in tandem by segmenting risks appropriately and focusing on how each, whether an insurance product or a buffer pool, may most effectively address the risk mitigation needs of this specific risk – whether the risk is ecological, force majeure, financial, business, political or sovereign.

The answer for insuring permanence is combining insurance products with risk management techniques and third party administration. We are taking existing risk transfer solutions and applying them to the forest carbon sector.

Insurance products and principles are applicable to all business sectors. The forest carbon market will be no different, as long as the structural foundation is put into place.
 

Following Up

At this time, those participating in the forest voluntary carbon market are dependent upon the registry design buffer pools for guaranty of permanence. Issues to be concerned with include:

• The factors used in determining contribution percentages put more emphasis on social risks and less on natural hazards’ risks.
• Buffer pools need to be stand alone financially viable organizations with administration of buffer pools with an arms’ length third-party relationship to determining buffer pools.
• In order to adequately satisfy the credibility of forest carbon credits within existing systems, all participants must provide some form of indemnification in case of errors or omissions. This is one of the biggest potential exposures facing the current registries.

Until the forest carbon market adopts proper business principles, the structure will continue to be abstract. In order to meet compliance requirements and attract investment capital, the infrastructure must be overhauled.

Gabriel Thoumi is a consultant at Forest Carbon Offsets, LLC and a Lecturer at the Ross School of Business at the University of Michigan teaching Strategy 739: Impact Investing.

Augustus (Gus) Kent is president of CO2RS, LLC., which was formed to provide insurance solutions for the carbon offset market. Gus has 22 years of commercial insurance experience, focusing in the environmental, professional, alternative and high-risk disciplines. He has been working with insurance carriers, who will offer coverages specific to those participating in carbon credit and offset areas. He can be reached at gus.kent@co2rs.com or (503) 794-1000.

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