Market Analysis

Analysis

Forest finance for climate change mitigation has been long-discussed but only recently advanced in the international policy arena. As a result, entities wishing to support climate-smart forestry and agriculture have voluntarily purchased carbon offsets to channel their support to forest carbon mitigation projects.

With the exception of a few large pilot projects launched in the mid-1990s, it wasn’t until 2010 that practitioners began translating theoretical methodologies for estimating emission reductions and carbon sequestration from forests into actual offset projects. For transactions prior to 2010, buyers often paid projects in advance to support carbon sequestration that was not verified until years later when these methodologies became available.

However, some early actors’ bets paid off: between 2012 and 2013, the State of the Forest Carbon Markets report found that the volume of forestry offsets transacted (i.e. contracted for immediate or future delivery) tripled and forestry became the most sought-after project type among those tracked in the State of the Voluntary Carbon Markets report in 2014.

It’s not hard to imagine why voluntary demand for forestry carbon offsets retains its popularity: with charismatic “co-benefits” that safeguard biodiversity, improve health, employ communities and more, investing in these projects is ideal for companies that want to meet their corporate social responsibility (CSR) goals or to demonstrate climate leadership among their peers. In 2013 alone, the market saw hundreds of private sector companies voluntarily mobilize $140 million for forests.

Yet even with this financing, project developers said that sales failed to meet the levels necessary to sustain these projects – falling short of their immediate aggregate need of $249 to $450 million across all existing projects, which have the potential to reduce 20-36 MtCO2e annually. To achieve the global reach needed to save the world’s forests, a dramatic new scale of investment is necessary.

The contribution from voluntary offset project investment and credit demand is and will remain highly variable, but historical market data can inform potential future scenarios. The responsive charts on this page depict how both supply and demand might play out under eight scenarios that consider various offset price and carbon emissions policy signals, which Ecosystem Marketplace[1] has determined to be the most impactful variables determining market growth or stagnation. Despite the presumably positive influence of discretionary income on corporate impact investing and philanthropy-like activities, economic variables were omitted after initial analysis revealed that domestic economic performance had little bearing on demand from the top ten buyer countries.   

Assumptions

STANDARDS AND LOCATIONS

Only forestry projects in developing countries were considered for this analysis. This analysis only includes offset supplies and historical demand from voluntary projects developed according to guidance from the Verified Carbon Standard (VCS), the Gold Standard (including CarbonFix standard historical data), Plan Vivo and the Clean Development Mechanism (CDM – when attributed to voluntary buyers) as these programs exhibit fairly regular market activity. Collected data stems from the online public registries (APX, Markit) for those standards, as well as from the confidential information collected for Ecosystem Marketplace’s State of the Forest Carbon Market reports.

The analysis omits historical and projected offset supply and demand related to REDD+ offsets or other emissions reductions generated and contracted at the “jurisdictional” (e.g. state, provincial, regional, national) scale, as these emissions reductions are expected to be bilaterally contracted between public agencies for purposes unrelated to voluntary market demand.  

ISSUED SUPPLY AND PROJECT FAILURE

Supply is determined according to the volume of offsets issued on a registry system to enable trade of carbon assets. This issued supply excludes both ex ante and ex post transacted and retired volumes in order to reflect the current state of offset availability.

Within the market, projects launch and some recede depending on the friendliness of market conditions, project resources, revenue mix and financial stability, positive or negative market signals, favorable or unfavorable policy conditions, and many other factors. This analysis assumes that if a project intends to discontinue, its absence from the market will not be apparent until it surpasses the maximum allowable time period between audits without actually undergoing an audit. In most cases this maximum allowed time between audits is 5 years. If a project does not undertake a mandatory audit within 5 years, it is considered to have ceased operating as a carbon offset project. Rates calculated from the State of the Voluntary Carbon Markets report data set indicate an 8% project cessation rate – and associated decrease in available future supply – for every major verification period (2011-2013; 2016-2018; 2021-2023).

PROJECT DEVELOPER RESPONSIVENESS TO MARKET SIGNALS

Ecosystem Marketplace data also reveals that the growth rate of supply doubles that of demand in response to favorable market occurrences by a ratio of 3:1.5. Due to the time requirements of project implementation and validation and/or certification, project developers responding to positive market signals are delayed in their response. Thus fluctuations in offset supply and project numbers are related to market conditions in the previous year. Calculations of supply responsiveness are calculated as such, even if the current year presents less favorable market conditions.  

DEMAND-SIDE INFLUENCE

On the demand side, the two major influences are policy and price. Based on historical data, the effect of positive forestry policies such as discussion of REDD+ in the US Waxman-Markey Bill (the 2009 American Clean Energy and Security Act), can as much as triple demand. Negative events such as the failure of the same bill typically halve demand for the relevant market subset. Of course, no two events are the same and some have greater impact than others. Discrete disruptive events (i.e. the UNFCCC Kyoto Protocol’s end, or approval of the first VCS REDD project methodology) happen on average every 2.5 years and add an additional 50% change to voluntary demand in the relevant market subset (e.g. demand in the United States, or for REDD+, VCS and Climate, Community and Biodiversity standard-certified offsets).

Forest offset pricing is highly elastic – in other words, exceedingly responsive to fluctuations in price. Increased prices lead to quickly shrinking demand, while lower prices raise it. Conversely, cheaper offsets have less impact on the supply: instead of selling less, project developers often try to make up for the discrepancy by selling larger volumes. An exception to demand-side pricing trends, too, is seen in demand for Gold Standard forestry and land use offsets, for which higher prices drive marginally greater demand due to the perception of Gold Standard offsets as a luxury good.  

DIFFERENTIATED PRODUCT MARKET AND HISTORICAL BASELINE

The voluntary offset market behaves more like a retail fashion market than a hard commodities market. Unlike compliance offset markets, where buyers prioritize price over offset characteristics in their purchase decisions, voluntary offset markets are driven by companies’ desire to differentiate their corporate offset programs, take “ownership” of unique projects, and support innovation and experimentation.

As a result, it is impossible to project demand at the level of standards, project type, and/or geographic preference as these factors are in constant flux and highly susceptible to disruptive new project approaches (e.g., new project locations, “charismatic” co-benefits, scale of intervention) that cannot be anticipated. Thus this research only estimates future demand based on the more generic variables of policy, price, and with historical demand as a baseline.

All estimations in the graph above utilize historical growth rates as their “baseline”. The characteristic absence of any reliable demand driver for voluntary action (such as emissions market caps, “tax-and-trade” offset-inclusive regulations as those found in compliance markets) and a lack of transparent mechanisms for determining real-time pricing (e.g. auctions, formal exchanges) means that actors in the voluntary market must rely entirely on historical price and transaction volume trends to estimate future market behaviors. The same is true of this research, which nonetheless excludes major singular outliers and early market performance (pre-2005) which is less reflective of current market size and dynamics.   

POLICY INFLUENCE ON VOLUNTARY DEMAND 

Fluctuations can occur as a result of the consideration of potential climate change regulations or the passage of new policies, as buyers and project developers seek to prepare for compliance markets that may or may not ever appear. In addition to pre-compliance activities, even larger fluctuations could occur at the international level depending on international climate change agreements/protocols.

Though the voluntary offset market is not driven by regulation, buyers nonetheless take their cues from regulators and public opinion regarding the legitimacy of offsetting as an emissions reductions and carbon management strategy. Thus even seemingly unrelated policy developments can heavily impact corporate awareness of and demand for voluntary carbon offsetting.

Methodology

To determine factors that are likely to positively or negatively impact voluntary offset demand, Ecosystem Marketplace analyzed nine years-worth of proprietary market data to identify the statistical significance of attributes related to both project design and external policy and economic environments.

Variables that were subjected to multivariate statistical significance tests and determined to be insignificant contributors to demand (by volume purchased) included:

• Project stage
• Project age
• Project type
• Project location
• Buyer location
• Standard and/or certification type
• Land tenure
• Project size (important determinant of price but not demand by volume)
• Economic performance (measured in GDP in buyer countries)

Variables that were subjected to multivariate statistical significance tests and determined to be significant contributors to demand (by volume purchased) included:

• Pre-compliance status (potential or perceived eligibility for use in domestic carbon markets)
• Offset price

Fluctuations in supply and demand were estimated based on:

1. Historical average proportionate price sensitivity of both supply and demand; and
2. Historical proportionate increases and decreases in demand (by volume) and new project development or cessation of project activities (and thus supply) in response to “major” (e.g. very positive/very negative) and “minor” (positive/negative) policy developments.

The latter multipliers were determined by evaluating the historical increase or decrease in offset demand based on the projects’ external context. Examples of “major” events included:

• Introduction of formal offset-inclusive cap-and-trade legislation in the United States and Australia;
• Failed passage of the same;
• Emergence of widely available REDD+ methodologies under the Verified Carbon Standard and first ever REDD+ offset sales;

Examples of “Minor” (or more regional than international) events included: 

• Positive or negative news related to regional carbon trading programs in the United States (Western Climate Initiative, Midwest Greenhouse Gas Regional Accord, Costa Rica Carbon Program, Japan-VER, Chicago Climate Exchange; US Regional Greenhouse Gas Initiative)
• Demand-related news items (UK-based REDD+ broker scams, New Zealand government communications restrictions on offsetting claims, Australia’s acknowledgement of REDD+ credits under national corporate carbon offset standard);
• Project-level uncertainty created by introduction of jurisdiction-scale REDD+ program.  

Other assumptions include a 28% average annual increase in supply which accounts for both historical annual additions to REDD+ offset supply and an anticipated 8%/year decrease in available supply in major verification renewal years (2016-2018 and 2021-2023, occurring every five years according to maximum allowed gaps between verifications according to VCS) in which project developers might choose to forgo project renewal in response to negative market signals.

Historical growth in demand is an estimated +9%/year, based on relevant project transactions in market years 2007 to 2014.   

Findings

Ironically for a “purely voluntary” market, policy is the most impactful determinant of market behaviors – on both the supply and demand sides. Theoretical “positive” or “very positive” policy developments result in a projected minimum of 100 MtCO2e demanded by 2025, while “negative” or “very negative” developments  ensure that demand won’t reach more than 52 MtCO2e below the business as usual scenario based on historical trends (83 MtCO2e).

An example of a very positive policy development is the U.S. House of Representatives’ passage of the American Clean Energy and Security Act of 2009 (H.R. 2454 of the 111th Congress) on June 26, 2009 – with mention of potential demand for international REDD+ offsets as a compliance instrument. A mere “positive” event includes policies with a more limited scope and/or unclear implementation timelines such as the nascent talks of a carbon market policy in the North American state of Oregon.

Most importantly, policy gradients such as “very positive” versus “very negative” are highly dependent on the temporal backdrop in which they were introduced: for example, a very negative event is the U.S. Senates’ failed passage of the same clean energy bill that passed in the U.S. House of Representatives one year earlier. Other negative events include decisions that limit (but not prohibit) the scope for offset demand within possible carbon tax or carbon market policies.     

Though the minimum of positive policies and maximum of negative policies have nearly equal range from the historical baseline, they diverge when it comes to extremes. The most positive scenario, “lower price, very positive signals” predicts demand increasing by 354% between now and 2025, while the most negative scenario only experiences a 72% drop, which brings us to our first finding: positive policies have a disproportionate effect on the market compared to negative policies. In general, positive policies drive a 3x increase in demand, while negative policy scenarios only depress the market by half.

Yet even with favorable politics playing out on the world stage, only two situations end with demand exceeding supply: the “higher price, very positive signals” scenario and the “lower price, very positive signals” scenario. The shared characteristic between these two scenarios (the “very positive events”) has a far greater impact on demand than negative events or even price fluctuations. In these two cases, it is likely that the proposed policy – such as the prospect of an offset-inclusive cap-and-trade program in the US or Australia; or the actual launch of such a program in California – seems so imminent or important as to spur voluntary demand through “pre-compliance” activities; that is, businesses carry out transactions with the expectation of and in preparation for a compliance market.

This leads us to the second finding, which is: project developers are more responsive to positive market developments than are buyers. This is most likely related to a lack of transparency regarding the actual size and scope of offset demand in a policy’s infancy – when project developers are seen developing projects quickly in an effort to target early market actors for pre-compliance.

Regardless of the policy situation, buyers prefer lower prices, which is why the “lower price, very positive” scenario results in the highest supply and demand estimates. A rung below, the potential for a massive forest-favorable policy still pushes voluntary demand above supply despite higher offset prices, while a more average positive policy scenario coupled with lower prices results in nearly equal amounts of supply and demand.

The rest of the scenarios feature higher supply estimates, as project developers remain more optimistic than their corporate buyers. Coming off of those highs, the worst case scenario reflects the opposite: a high price and a very negative policy environment.

[1] The Ecosystem Marketplace, a project of Forest Trends, is a leading source of news, data, and analytics on markets and payments for ecosystem services (such as water quality, carbon sequestration, and biodiversity).