Welcome back, everybody. My name is Freddie Fuller and I'm the product specialist on the RBC European Equity Team. We return for this latest episode of our sustainability podcast to discuss that most ubiquitous of topics, carbon and specifically the topic of voluntary carbon offsetting. We're going to explore where they should sit within the broader journey to net-zero and ask whether investors should be asking more of companies in this regard. To discuss this, I'm joined by Lukas Harrison, Senior Analyst on the desk.

Thanks for having me. Hello, everyone.

Lukas, this is an area that has sparked a fair amount of debate over the years perhaps because it's so often touted by companies front and centre, as part of their net-zero efforts. It's also extremely visible to consumers as well. Recently the fact that the TV host and comedian, John Oliver, hosted a segment on this topic during his very popular late-night talk show is demonstrative, I suppose, that the topic is becoming far more visible and less niche. A recent report from the UK Climate Change Committee has also highlighted that while voluntary carbon markets can play a small but important role in the transition to net-zero, there needs to be improvement. They're saying stronger guidance, stronger regulation and standards in order to avoid carbon credits being utilised, rather than direct emissions reductions in targets. Perhaps we could start with your view of the voluntary carbon market more generally.

Yes, thanks. The voluntary carbon market enables companies and individuals who emit carbon in their operations to offset these emissions by purchasing carbon credits in projects to either reduce such a void or remove carbon emissions from the atmosphere. There are over 4,000 projects globally and these projects can be either technological or nature-based projects. Reduction and avoidance projects can decrease emissions that would've otherwise been produced from pre-existing activity by technological means, such as converting from fossil fuel to renewable energy sources or through nature-based solutions, such as preservation of forest and wetlands. Alternatively, removal projects remove emissions in the atmosphere through technological developments like direct air carbon capture in storage, or through nature-based solutions such as afforestation and reforestation.

Okay. The market for this has grown at a pretty extraordinary rate over the last decade, hasn't it?

Yes, definitely. The market has been growing at quite a rapid pace. Looking at the numbers, the amount of carbon credits issued increased by nearly 400% just from 2016 to 2020. With the total transactional value nearing USD2 billion in 2021, that's around 0.8% of the global GHG emissions. According to a McKinsey report, this could be worth upwards of USD50 billion by 2030. Geographically, Europe is currently the biggest buyer of carbon offsets; they accounted for around 63% of offsets purchased in 2019. Although, Asia is a leader in terms of where the projects are based.

Okay. Interesting. One thing that's held pretty constant, I suppose, over that time period is pricing. It's an interesting point to note that it continues to be far cheaper to voluntarily offset for companies than to use the EU emissions trading scheme, which for those not aware is a regulatory cap and trade scheme. The price per ton of CO2 for the ETS is hovering around USD80 a ton. For voluntary carbon offsetting, this ranges from USD1 to USD6 per ton. Clearly, there are big differences between the two schemes, who can use them, who will use them, but this difference is pretty stark.

It is. It will be interesting to see which market is influenced more as there is a move to more of an equilibrium.

Yes. It's one to keep an eye on. There are a number of criticisms aimed at voluntary carbon markets and predominantly around this issue of quality. Do you think the criticisms of offset quality are justified or perhaps less justified than they once were?

I think some of the criticism is fair. You often see media reports of big corporations claiming to be net-zero through the use of carbon offsets but when digging deeper into the credits they're purchasing, then you realise they're paying to preserve forests that weren't really at risk of deforestation in the first place. That being said, the voluntary carbon market is still relatively new. As it matures, we continue to see advancements in the auditing and verification of carbon credits.

There are organisations such as the Integrity Council for Voluntary Carbon Markets which work to ensure that every carbon credit in the market are true emission reductions or removals. Some of the issues that still persist around quality relate to how much of an impact they really have, as it's hard to compare it to a scenario in which the project didn't occur.

There are also questions around the longevity of the positive impacts from the projects and also the risks of reversal or leakage. Nature-based projects like reforestation will only have decades-long impact, whereas a tech-based solution, such as carbon capture and storage are more longer term but could risk leakage in the future from abandoned or faulty storage wells. The biggest concerns around quality relate to additionality.

That's an interesting topic, additionality, which we have touched on before. By this, we mean that it can be demonstrated that carbon removed from the atmosphere by a project would not have happened without the carbon offsetting finance being in place. For example, a full-scale reforestation project on previously unused land with the large upfront investment required from offsetting would be considered additional. While a power plant that was built with carbon capture or efficiency technologies from the outset may be viewed as un-additional, I suppose. Much of this as you mentioned, should really be viewed through the counterfactual lens. If it hadn't been for the financing through offsetting, would carbon sequestration have occurred anyway?

Yes. This really leads us to the difficult area of whether tech or nature-based solutions are preferable at this stage. As always, there's no easy answers especially when you bring the financing aspect into the equation. At the moment, nature-based credits tend to be seen as higher quality and traded at a premium to technological projects. They account for only 21% of the projects, but 45% of the credits based on tons of CO2.

It is important to try to look at it at the longer term as well. The progress made in renewable technologies, such as solar and wind, clearly demonstrated just how quickly the cost curves of nascent technologies can come down and indeed undercut more traditional technologies. The corresponding picture with the ‘technological versus nature’ debate may ultimately mirror this, with the technology cost curve on this accelerating downward trend in the nature-based solutions often needing replenishing, proving to be more expensive perhaps than initially thought. However, these are very long time scales we're talking about here.

That's a good point. What is increasingly pertinent, I suppose, is to look at how corporate behaviour is changing with regards to offsetting routes and methodologies. People may have recently seen that EasyJet have announced that they will be scrapping their carbon offsetting scheme launched back in 2019. The company has instead decided to focus on investing in other technologies, but to cut emissions directly. These include more efficient aircraft, more efficient fuels, all the way through to untested technologies such as hydrogen-fueled planes.

According to Easyjet, this will reduce emissions by 78% by 2050 with the rest of its emissions offset using carbon capture technology that's not currently operating at a large scale or at a scale at all. I'm quoting directly from them here, they say, "Our carbon offsetting program has been the right thing to do, but you need to deal with your own operations. You cannot rely on out-of-sector initiatives." I think at a high level that's a fair point. With airlines likely to rely on offsets to decarbonise over 95% of their operations still by 2025, the short term looks pretty bereft of solutions, I suppose.

This is a big statement from EasyJet, given they are in such a carbon-intensive industry like you said. The cynics will say it's just a cost-cutting plan after the struggles they faced during the pandemic. This isn't necessarily fair, depending on just how much they're investing in the carbon reduction initiatives. I think it's one we’ve got to continue to track, as they are very ambitious reduction targets based on future technology. We need to see the progression over the medium term. Just so you know, Fred, I should note that they still will allow customers to purchase voluntary offsets when they fly with the airline.

A fair point to note as well. Lukas, in your view, how should investors treat offsetting at a corporate level or even as an asset management level, I suppose?

For me, carbon offset should basically be used as a last resort for companies to reach their net-zero ambitions. First and foremost, they should be exploring and investing in solutions that will help reduce their emissions on an absolute basis. Realistically, many companies won't be able to get to zero emissions in their operations. These are the situations where we see offsets serving a purpose.

Trying to analyse the actual financial impact on balance sheets, it's a pretty complex exercise. According to Bernstein, purchasing voluntary credits is currently only likely to be reaching around 2% of companies' adjusted EBITDA for the highest end of the scale, so that we're looking at the transportation and infrastructure industries that are most likely to be impacted by higher prices in the longer term. I mean, right now with corporate profitability coming under pressure, it will be interesting to see whether voluntary offsetting falls down management's priority list.

That's a good point. Do you think this changes the way that investors should engage with companies?

Well, I mean, investors should already be engaging with corporations in terms of what actions they're taking to reduce their emissions. If companies are making net-zero claims, ask them how much of this is coming through the use of offsets. Ask them about what voluntary carbon credits they're purchasing, and how they're ensuring they are high quality. At the end of the day, the goal is to reduce overall emissions on the planet. What we don't want is a situation where carbon offsets are being used as license for corporations to continue to pollute without consequence.

That really seems to be the nub of the issue – striking the balance between the use of preferably measurable, high quality and additional offsets and ensuring that this isn't a smokescreen for direct emissions reduction, which is the most important and vital route to actual decarbonisation. Well, unfortunately, that's all we have time for. Thank you very much, Lucas, for joining us and for our listeners for tuning in again.

Thanks for having me, Fred.