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June 12, 2023

Carbon Pricing - Where the Market Currently Is and Where It Must Go

TIME CO2 Portfolios

When looking to purchase carbon credits, companies may find themselves overwhelmed by the diversity of options -- and the corresponding variance in price. The problem is, simply resorting to purchasing the lowest-cost credits is not only ineffective for climate mitigation, but also subjects the buyer to reputational risk. Here's what science has to say on carbon pricing (including tools like shadow pricing and the social cost of carbon), and how we approach our own pricing at TIME CO2.

Carbon credit pricing in voluntary carbon markets can be mind-boggling. On one hand, credits from renewable energy or reduced deforestation projects can cost less than $5/ton. On the other hand, companies whose sole focus is to directly pull carbon dioxide from the air are selling credits for $250-600/ton or more

Yet in theory, the carbon credits being offered are equivalent - a ton of carbon is (supposed to be) a ton. What is driving such huge price variation, and how should companies think about carbon prices as they plan their climate strategy? 

Drivers of Carbon Prices

The wide range of carbon credit prices can largely be explained by a number of factors and historical trends:

1. Project diversity: Carbon credits in the voluntary carbon market (VCM) are currently issued from industries as wide-ranging as agriculture, chemical production, forestry, and waste management. This means that projects will inherently differ in cost structure, with capital-intensive projects like carbon capture and sequestration (CCS) requiring much more upfront investment, while labor-intensive projects like mangrove restoration will incur more significant maintenance costs.

This also means that project models used to generate credits vary dramatically in their impact, implying that the credit price may have multiple values bundled in, far beyond the carbon itself. Some projects share revenues or provide material support to surrounding communities that are affected by project operations. Some projects generate a range of environmental and social co-benefits, be it improved local biodiversity, reduced air pollution, increased employment opportunities, and more. Adding to the complexity, the geographical location of projects can affect prices, as projects in certain regions may have different cost structures, regulatory requirements, or market conditions.

2. Carbon Market Decentralization: Compared to other markets, carbon markets are still nascent: the first carbon market emerged less than three decades ago, with the advent of the Kyoto Protocol in 1997. Since then, both regulated (compliance) and voluntary carbon markets have seen an explosion of stakeholders, including project developers, brokers & intermediaries, certification programs, registries, rating agencies, insurance providers, and more. With each of these stakeholders creating their own frameworks, standards, and rules, trying to fully understand carbon credit products and pricing structures is a dizzying affair, with prices fluctuating as a result.

Carbon Prices in Regulated Markets

The heterogeneity of carbon markets isn’t limited to voluntary markets. With an increasing number of regional, national, and international emission trading schemes emerging - which each have their own rules, regulations, and pricing mechanisms - regulatory compliance markets are similarly exhibiting significant variations in price.

For example, the European Union Emissions Trading System (ETS), which covers 40% of EU emissions and is currently the second largest carbon market in the world, is actually a decentralized system consisting of 27 member states’ national allocation plans and regulatory frameworks. Since its inception in 2005, the carbon price in the EU ETS market has witnessed dramatic swings, from near zero in 2007 to over 100EUR/ton in 2023. 

3. Knowledge Requirements for Informed Decision-Making: In part because of the aforementioned issues, making a fully informed purchase of carbon credits can be a herculean task given the many factors affecting project quality and risk. To address this issue, ratings agencies emerged to help make sense of the many options that customers face.

However, this strategy also has its limitations; coverage of carbon projects is spotty, currently only applies to credits that have already been issued, and is subject to the ratings agency’s own quality criteria and biases. Ultimately, the dynamic and layered nature of the VCM complicates understanding a project's carbon credits, making it challenging for buyers to accurately predict and interpret carbon prices.

A Non-Linear Relationship between Quality and Price

No wonder, then, that we are seeing a low correlation between project quality and price. There is wide variation in carbon credit price and quality, with a diverse sample of 50 projects (see Figure 1) showing normalized ratings from Calyx Global, Sylvera, and BeZero (three of the largest credit rating agencies for carbon credits) that are not correlated to price. 

Figure 1: Chart depicting the weak relationship between project rating and price. Sample data were taken from Calyx Global, Sylvera, and BeZero, and standardized for comparability.

Note that this analysis only reflects credits that are readily available today; many projects that expect to issue credits in the future (such as from engineered carbon removals) have higher permanence and in some cases, higher overall carbon integrity, than existing projects. However, these credits are not yet available at meaningful volumes to move the needle on climate in their own at the rate we need to over the next five years. These projects typically have prices above $100/ton. 

Stakeholders like McKinsey and Sylvera have similarly made observations about the heterogeneity of carbon credits - a market tool that was intended to standardize and commodify carbon as a means of accelerating finance to impactful climate initiatives.

Does that mean that VCM pricing is simply pure chaos? Not quite. The cheapest credits in the voluntary carbon market come from forestry and renewable energy, typically priced at $1-$12 per tonne, making up ~75% of the credits issued (see Figure 2). While not always the case, the additionality of these projects (whether the issuance of carbon credits is actually creating more climate benefit than what would otherwise happen) is often suspect, with several high-profile projects recently being called out and heavily criticized. This is exacerbated by the fact that many of the credits on the market date back five years or more. 

This has a chilling effect on climate financing, as new project developers seeking to generate high-quality credits at sustainable prices find themselves competing with antiquated credits of questionable quality being offloaded at lower prices.

Figure 2: Summary of credits issued by scope - as of May 2023 - in the voluntary carbon market. Source: Ivy S. So, Barbara K. Haya, Micah Elias. (2023, May). Voluntary Registry Offsets Database, Berkeley Carbon Trading Project, University of California, Berkeley.

This trend has important implications for the VCM’s ability to lead to an overall reduction in global emissions. In setting the expectation of paying no more than $5/ton - a standard met by credits of highly variable, often dubious quality - companies may be inadvertently contributing to the erosion of trust in the carbon market and a race to the bottom. Studies have shown that higher carbon prices can lead to steeper emissions cuts. In other words, companies cannot reasonably expect to solve climate change while paying rock-bottom prices for carbon credits. 

The True Price of Carbon

So what should companies do if they’re serious about fighting climate change? Being comfortable with higher carbon prices would be a good start. As Figure 3 illustrates, even as natural climate solutions are an important piece of the climate puzzle, offering low-cost, immediately available options for climate mitigation, they alone are insufficient in addressing climate change. 

Companies cannot reasonably expect to solve climate change while paying rock-bottom prices for carbon credits.

In contrast, engineered removals have greater potential for scale, but are limited by their cost while the technology is still relatively nascent, having been able to remove less than 0.001% of global annual emissions to date. Companies should be willing to strike a balance between short- and long-term solutions, investing in higher-cost engineered removal technologies to bring their cost down even as they fund lower-cost natural climate solutions that are immediately available.

Figure 3: Diagram depicting array of solutions needed for sufficient climate mitigation, with corresponding range in price. Source: IPCC, Global CCS Institute, Goldman Sachs Global Investment Research.

There are a number of benchmarks that companies can use to guide their expectations on price. A report from the World Bank found that global carbon prices need to reach $40-80/tCO2e to have meaningful impact.

Shadow Pricing

Similarly, increasing numbers of companies are incorporating shadow carbon pricing into their internal operations; in the absence of formal regulations or consistent market signals, they are assigning a monetary value to carbon in their cost-benefit analyses, which influences their funding decisions and channels more investments into low-carbon projects. With this metric, the UN Global Compact has called on companies to set a shadow price of at least $100/tCO2e over time.

The Social Cost of Carbon

Another useful framework is the “social cost of carbon,” or an estimate of the economic damages associated with each ton of carbon dioxide and other greenhouse gases emitted into the atmosphere; this represents the minimum amount that companies should be paying in the longer term. The latest US Environmental Protection Agency estimate of the social cost of carbon is $120-$340/t for 2020 (it’s even higher for later years and more potent gases like methane). Recent scientific studies recommend a carbon price of at least $185/t.

While these figures may create sticker shock for companies that are used to low-cost carbon credits, they pale in comparison to the trillions of dollars we have already lost to hurricanes, wildfires, flooding, droughts, and other climate-induced natural disasters, and which we will see more of in the decades to come.

How TIME CO2 Approaches Carbon Pricing

Here at TIME CO2, project quality, financial best practices of diversification, and planetary needs dictate how we allocate funding to projects. CO2's portfolio of high-quality credits includes permanent carbon removals that cost between $150 and $1200 per ton (such as biochar, direct air capture and storage, and bio-oil) blended with high-quality emissions reductions projects and nature-based removals projects, all of which are necessary for achieving climate impact at the scale we need globally. 

As such, our portfolios typically cost $45-$65 per ton of carbon removed or reduced, a price range that reflects a broad range of high-quality, blended solutions. This is still less than the social cost of carbon, with the added benefit of providing catalytic funding for new technologies and ecopreneurs that need the support of carbon markets to grow.

As a company that places quality first, we stand behind the projects in our portfolios and their associated prices, because that is what the planet needs.

Want to learn more about TIME CO2?

Andrew Wu and Isabella Akker

Andrew and Isabella are portfolio managers at TIME CO2.