Bringing risk-adjusted returns to carbon - what the VCM can learn from Harry Markowitz
At BeZero Carbon, we are working on bringing a similar revolution to carbon markets by fusing Markowitz’s risk-adjusted return thinking with our carbon ratings.
The Voluntary Carbon Market (VCM) is in a pre-Markowitz state akin to the 1930s or 1940s.
It lacks a formalised concept of risk and remains stuck in a basic commodity paradigm, i.e. that a credit must equal an exact tonne of carbon dioxide equivalent. But as we’ve been arguing, carbon isn’t just another commodity market.
Recent industry initiatives, namely the Voluntary Carbon Markets Initiative and Integrity Council for the Voluntary Carbon Market, have brought an improved framework for the demand and supply side of the market.
Both are essential building blocks for a market-based approach, but neither tackles this key issue of how to make a credible claim that accounts for the risk inherent in carbon returns of a credit.
Unlike in financial markets, where historic returns can be observed, the VCM faces the challenge of not being able to fully measure the carbon achieved by a given credit. Factors such as additionality and baselines are constructed using a ‘counterfactual’, or an alternative scenario that cannot be observed.
Consequently, while investors can see how their investments perform versus their target over time, the carbon return on a credit can only be estimated against the one tonne it aims to achieve.
This is problematic when users of carbon credits try to make accounting style claims in a balance sheet format; matching an asset, the carbon credits retired, to a liability, an emission. Indeed, the credibility of claims is one of the leading causes of reputational concerns across the VCM today.
The introduction of ratings-linked discount rates, similar to default rates used in bond markets, poses a solution.
It involves attaching an estimated return to a credit for each ratings notch that can be used to construct an improved accounting outcome: i.e. X% discount to the assumed one tonne subject to whether the credit is rated AAA through to D.
This approach would not seek to re-accredit carbon projects by providing just another point estimate, i.e. this credit is 0.8tCO2e rather than 1tCO2e. Instead, it would build on the accreditation process, which must deliver a whole unit by design, by providing carbon credit users a way to take a risk-adjusted approach to making claims.
At present, our carbon ratings imply a subjective level of risk based on our holistic assessment of the drivers of carbon efficacy. While the same is true of financial markets ratings, the risk of default can be derived for different ratings buckets based on historical default performance data.
At BeZero Carbon, we are working to use data available to attach return estimates or ranges to our carbon credit ratings. As we continue to build richer datasets, these estimates will improve over time. For example, while baseline performance is unobservable, techniques such as dynamic baselining enable us to build ever better proxy estimates.
In order to minimise the risk of making claims backed by carbon credits, users need to be able to build diversified portfolios. Which brings us back to Markowitz’s risk-adjusted return, and why it’s such an important part of the puzzle for carbon markets. The risks to a credit not achieving a tonne may not be precisely quantifiable, but they can be classified.
Examples of this include sector type. For instance, forestry projects differentially face a spectrum of similar natural risks such as the exposure of different types of forest to pests or disease. Likewise geography. Projects in the same country face similar political risks and projects in close proximity are exposed to similar natural or anthropological risks, such as wildfires.
In the same way that modern portfolio theory enables users to maximise risk-adjusted returns by diversifying their risk, classifying the risk to a credit’s carbon returns and what drives this risk would enable the creation of a diversified portfolio of credits.
While this looks like a huge challenge, we are deep in the weeds of collecting the data and building the models to start providing this solution to the market.
The upside is worth it. Providing the market with discount rates and a risk classification system through the BeZero Carbon Rating will facilitate construction of the diversified portfolios needed to make robust claims. It will unlock the next stage of growth in the carbon market.