KAMPALA – Carbon markets turn CO2?emissions (CO2e) into a commodity by giving it a price. These emissions fall into one of two categories: carbon credits or carbon offsets which can be bought and sold on a carbon market. Carbon markets exist under both mandatory (compliance) markets and voluntary markets. Because carbon credits are issued by the government or regulators to entities in certain sectors who trade among themselves and this market is often referred to as the compliance market. Voluntary markets, however, consist of individual organizations or businesses trading carbon offsets. Compliance markets are created and regulated by national, regional, or sub-regional governments and laws and credits are frequently issued under what is known as a “cap-and-trade” program in compliance markets. Here, regulators set a limit on carbon emissions – the cap. These can be likened to permission slips that allow a company to emit up to a certain set amount of CO2e that year. The cap-and-trade program exists in developed countries around the world and this exists as the Emissions Trading Scheme (ETS) program.
Voluntary carbon markets function outside compliance markets and let businesses buy and sell carbon offsets to achieve their own goals. Offsets for carbon operate slightly differently. Companies that engage in activities that lessen the amount of carbon already present in the environment, such as increasing tree planting or utilizing renewable energy sources, have the option to offer carbon offsets. These markets are termed voluntary because the purchase of these offsets is optional. However, businesses may mitigate measurably the amount of CO2e they generate even further by purchasing these carbon offsets. Many businesses currently purchase carbon offsetting to counterbalance the CO2e they generate, and this can be leveraged to enable such entities achieve a “carbon neutral” status. While the voluntary carbon market is largely unregulated and challenging to quantify, analysts concur that participation in the voluntary carbon market is expanding quickly. According to Refinitiv (2022) the voluntary carbon offset market globally is worth around $1 billion. However, the voluntary carbon market would still fall well short of the amount of investment needed for the world to completely reach the targets set by the Paris Agreement.
Why should bankers care? Understanding the role of banks in carbon markets
There is increasing pressure to develop carbon markets. It is generally understood that these markets play a crucial role in driving the net-zero transition within various jurisdictions, and of course, for the world. Banks typically play a significant role in the compliance markets by offering a liquid market with price certainty and transparency to companies governed by cap-and-trade programs. Banks also play a key role in voluntary carbon markets. The banks can develop a strong develop a strong ecosystem to support the offset market and increase the delivery of high-quality carbon offset projects, among other things. In order to give access to a wider range of investors, there are also prospects for other capital market solutions, such as repackaging carbon credits from regulated markets into structured notes. Some banks are also looking into capital market instruments that include voluntary carbon credits into sustainability-linked loans, bonds and derivatives.
Some of the major ways in which banks can add value to the carbon market include, Financing project development as Banks should be bold and offer debt financing or blended financing to the project developers creating carbon offsets i.e, to a greater extent or scale than they do today. Many carbon projects are relatively capital intensive and small-scale – with values merely in the hundreds of thousands or low millions of dollars – and so would need to grow quickly to meet demand ++ Financing capacity development as some market experts feel that the market is not ready for financing due to lack of regulation and what is needed are more on-the-ground project developers. Beyond financing projects, more capital should be channeled into training people to develop projects ++ Bridging the information gap as Banks play an intermediary role between project developers accessing financial support and the market (businesses, corporates, individuals they transact with in their daily operations), as such they could help manage the information asymmetry between project developers who look to sell their offsets and the market which constantly seeks more understanding and information about carbon offsets.
Although the point on whether the market is sufficiently developed for banks to efficiently engage remains debatable, clearly banks can play crucial roles in developing the current state of the market through core and transformative services. Commercial banks can still provide capital to a variety of enterprises, including those pursuing carbon projects. Commercial banks typically provide loans, but they can also make equity investments or other forms of investments to support carbon projects. Commercial banks can also play a role in the structuring and management of other financial entities such as carbon finance funds. In the future, banks will even function as aggregators of carbon credits for smaller enterprises, but this concept has yet to be explored. By and large Commercial banks can finance all stages of the life cycle of a carbon project, assuming the enterprise pursuing the project can provide sufficient collateral. When financing the earlier stages of project development, commercial banks require a higher return than when financing the later stages of project development or implementation. This is due to the longer repayment period and the higher risk of the project not reaching completion. Most Ugandan banks are still at a nascent stage of considering carbon credits as part of their business model but are gradually providing funding toward projects that could potentially generate carbon credits in the future. Despite the benefits of carbon markets (credits and offsets), it is important to recognize that it should not be entirely relied upon to achieving ‘carbon neutrality.’ More effort from individuals and entities, however, should be geared towards investing in and promoting efficient processes and technologies that can reduce emissions.
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The author, Denis Tukahikaho Ph.D. is the Ag. President -The Society for Environment & Climate Finance Professionals.
denningyoung@gmailcom.
