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How insurance can help build confidence in the voluntary carbon market

Reducing carbon emissions is the top priority for businesses looking to achieve their net-zero ambitions, but the voluntary carbon market (VCM) has the potential to be a valuable auxiliary tool. While there is strong demand for carbon credits, the market is missing a key ingredient: confidence. Sophisticated, innovative, and fit-for-purpose risk solutions could potentially unlock the promise of the VCM and turn a nascent industry into an established financial market.
Person's name and title

By Ryan Bond , 

Head of Climate and Sustainability Insurance Innovation

31/05/2024 · 6 minute read

As the world continues to grapple with the climate crisis, the reduction of carbon emissions remains the top priority. But while the difficult work of decarbonization happens, companies can offset their carbon emissions through the voluntary carbon market (VCM). This decentralized market allows organizations to purchase carbon credits, which support projects that offset emissions to the atmosphere. As a nascent financial market, the VCM can suffer from expected teething issues. Recent discussions on the future of the VCM have raised questions surrounding the validity of carbon credits, market regulation, and ethics, and this highlighted the absence of a key ingredient in any financial market: confidence.

One recurring criticism of the VCM is its lack of regulation and supervision. But it has suffered from another glaring omission: insurance. Today, companies buying carbon credits face a range of risks, including issued credits being invalidated (due to errors in assessing the amount carbon sequestered, for example) or sequestered carbon being released into the atmosphere (as a result of a forest fire, for instance). Insurance brokers have struggled to connect their clients with appropriate coverage simply because the solutions did not exist. But this is changing as new products and services could invigorate and sophisticate the carbon credits space. Combining innovative insurance solutions with traditional coverage could effectively help de-risk carbon credit purchases for investors, provide more support for offsetting projects, and grow confidence in the market.

This could well be doubly potent, considering a recent and significant shift in perspective in the market. Where the VCM has traditionally been the domain of sustainability teams, businesses are increasingly considering its importance from a risk perspective.

From a sustainability mindset to a risk perspective

Most companies look at the VCM solely as a tool for delivering on carbon neutrality commitments – or used to. But growing challenges in the market, such as recent SEC disclosure requirements in the US are beyond the remit of the average sustainability officer and increasingly becoming a focus for risk experts. It is also important to note that the VCM is incentive-based and therefore usually operates in the absence of compliance regimes or regulated markets.

As a result, businesses are increasingly approaching carbon credits with a risk-first mindset. And VCM investment poses several unique risks. One of these is ‘reversal’, which happens when carbon that has been removed or avoided by a project ends up being emitted – for example, if a restored forest is hit by fire. In other words, if a sustainability project fails to make good on its offsetting claims, issued carbon credits lose their integrity and value. To mitigate this loss, carbon projects typically set aside a portion of the credits they generate into a ‘buffer pool’. These credits could then be cancelled in the event of reversal, to ensure the integrity of the previously issued credits. Not only does this place a significant amount of financial pressure on all parties involved, but there are also significant concerns regarding the effectiveness of buffer pools in insuring against risk.

The good news is that risk could one day be transferred away from these buffer pools to insurers like Oka, The Carbon Insurance Company™ (Oka). Primarily focused on addressing the risks associated with nature-based solutions and tech projects, Oka and similar insurers provide coverage for clients’ financial, reputational, regulatory, and climate exposures. These specialized insurers identify the risks facing their clients and compose a matrix of choice for coverage consisting of traditional and more innovative products, thereby reducing financial uncertainty and helping provide peace of mind for companies seeking to make carbon credits a pillar in their climate objectives.

While carbon credits have steadily contributed to global climate goals, better integrated and fit-for-purpose insurance could act as a catalyst for exponential growth in the VCM that could otherwise take years to achieve.

Insurance as a catalyst for growth

Expanded and more sophisticated insurance coverage wouldn’t just benefit investors. For project development partners like Invert, de-risking investments through fit-for-purpose risk-transfer solutions could mean smaller contributions to buffer pools. Currently, organizations like Invert have an obligation to contribute around 20% of all carbon credits generated by projects into buffer pools overseen by registry operators to mitigate potential losses from non-delivery or reversal events. Going forward, by transferring some of these exposures to insurance providers, development partners may benefit from reduced buffer pool contributions and improved project economics. For example, what if instead of contributing 20% of expected credits to buffer pools, project developers contributed just 10%, plus 5% equivalent for the cost of insurance? This would result in a 5% volume increase in credits available for sale. Unlocking this additional capacity would have a considerable impact on the liquidity and scalability of projects like Invert’s Bonos X-Hazil Ruta Sian Ka’an project in Mexico.

In this light, insurance can play a key role in making carbon credits a more powerful and legitimate tool. On the one hand, insurance can facilitate more investment into sustainability projects that can deliver meaningful impact to the environment. Also, risk solutions can make sustainable options more accessible. By offsetting the cost of risk mitigation and taking on the exposure associated with the VCM, insurers can unlock liquidity and capital to be invested in new technology and solutions, helping companies transition towards more environmentally friendly models at scale.

However, the insurance industry can’t turn the VCM into a mature, established financial market alone. Collaboration between insurers, governments, industry bodies, and experts will lead to the development of appropriate regulation, forward-facing governance, intelligent supervision, and enforceable punitive measures for those who undermine the integrity of the VCM.

Unforeseeable events are an unfortunate part of doing business, even more so during a period of climate and economic volatility. But with insurance expertise and the right products, investors can mitigate potential risks and have the confidence they need to invest in new markets and projects. It is important to bear in mind that this goes well beyond the health of companies, their investments and these carbon projects. Ushering the VCM towards a prosperous and sound future could spell worldwide progress on the decarbonization front as companies will be empowered to use carbon credits as a viable support act to their wider sustainability missions.

Companies looking to make carbon credits a viable and effective arm of their sustainability efforts should consider having a conversation with their broker. Giving the right people a seat at the table will ensure the best expertise can guide companies towards a solution that inspires confidence and trust.

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