Carbon offsets: pragmatic solution or unwelcome distraction?

At 2021’s COP26 United Nations climate conference an agreement was struck to establish an international carbon market, enabling countries to trade certified carbon offsets.

The goal is to facilitate the transfer of emission reductions between countries to support the implementation of their Nationally Determined Contributions (NDCs), and to incentivise companies to adopt offsets.

But will carbon offsets be part of the solution to the climate crisis, or are they just a distraction? Below I offer a brief summary of the debate, which is the focus of a huge amount of research and analysis here at LGIM.

Offset theory

The idea behind offsets is appealing. A carbon offset represents one tonne of carbon emissions, which can be used to compensate organisations for financing projects that avoid greenhouse gas (GHG) emissions or projects which remove GHGs from the atmosphere.

Offsets can be used in hard-to-decarbonise industries to offset part of the carbon footprint while technology that delivers real-world emission reductions catches up. Once an offset is created, it can be retained by the organisation that financed the project, or it may be traded in a voluntary carbon market.

The United Nations (UN) is clear that it believes carbon offsets have a role to play, with the UN Intergovernmental Panel on Climate Change stating in its April 2022 report¹ that “the deployment of carbon dioxide removals to counterbalance hard-to-abate residual emissions is unavoidable if net zero… emissions are to be achieved”.

Theory meets reality

Proponents of carbon offsets claim they offer a way to channel investment to conservation and sustainable development – ‘nature-based solutions’ (NBS) such as re-forestation – while reducing climate emissions. Critics, meanwhile, say they are a form of greenwashing that will delay real action.  

A key consideration is the principle of ‘additionality’. Does the activity that produces the offset result in emissions reductions that would not have occurred without the carbon finance? For example, if you purchased an offset to prevent rainforest deforestation, was that part of forest actually in danger of being cut down?

A counterfactual world where a carbon project did not take place is not observable, so we must use assumptions. Project developers are incentivised to maximise credits by exaggerating the expected emissions in the baseline (unobserved) scenario.

Closely linked to this is ‘leakage’. Let’s suppose that the offset you purchased was indeed ‘additional’, but the logging activity has merely been displaced to another area of the forest. If this were the case, the real-world outcome would be unchanged.

Devil in the detail

Carbon offsets are also heterogeneous. One offset equals one tonne of carbon. However, offsets are backed by a variety of projects such as land use and reforestation, renewable energy projects, and improving energy efficiency, meaning one credit is not exactly equal to another.

Permanence of carbon avoidance or removal varies by project: some may only deliver carbon reduction or avoidance for 10 years, whereas atmospheric CO2 emissions influence the climate for thousands of years. Few carbon offsets have an identical impact on the climate to one tonne of carbon emissions.

Usually, the climate benefit of offsets is significantly below one tonne.

Practical and ethical issues

Closely linked to this is the fact that the offset market is voluntary – a point we’ll explore in the next blog. With unregulated markets, there is a wide variety of verification methodologies.

This means offset quality and prices vary widely. For example, Microsoft* paid, on average, $15 per ton in 2020.² But Delta Air Lines* paid $30 million to buy 13 million offsets in 2020³ in support of its claim to be carbon neutral, meaning it paid only $2.30 per ton.

Finally, there are some thorny ethical issues to contend with. Do offsets legitimise richer developed countries continuing to produce emissions without benefitting poorer countries? And are offsets effectively a licence to pollute as they are cheaper than meaningful emission-reductions capital expenditure, extending the life of the fossil fuel industry?

Assessment principles

The World Resources Institute provides two overarching principles⁴ to assess offsets and their use:

1. Credits must ensure environmental integrity and represent NBS that respect the rights and livelihoods of indigenous and local communities while safeguarding biodiversity
2. An organisation should be on a mitigation pathway aligned with limiting warming to 1.5°C, and its use of NBS credits must supplement, not reduce, the pace of emissions reductions in its own operations and value chain

To be effective, carbon offsets need to represent a reduction that is real, additional, permanent and traceable – meaning if a company purchases a carbon offset from a developer, that same offset cannot be sold to anyone else.

With the need to deploy capital at a rapid pace, around $5 trillion per year by 2030 (a point I made in my previous blog), a sizable liquid voluntary carbon market is likely to develop.

The challenge for this sector is governance. Integrity is key in our view to a functioning voluntary offset market.

*Key risk: For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

1. Source: https://www.ipcc.ch/report/ar6/wg3/

2. Source: https://blogs.microsoft.com/blog/2020/01/16/microsoft-will-be-carbon-negative-by-2030/

3. Source: https://www.reuters.com/business/sustainable-business/delta-spend-30-mln-neutralize-most-its-2020-climate-impact-2021-03-04/

4. Source: https://www.wri.org/technical-perspectives/guidance-voluntary-use-nature-based-solution-carbon-credits-through-2040