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Key phases in the development of the carbon ratings market

  • Mani Gangadharan Venketachalam

  • The Voluntary Carbon Market (VCM) is widely expected to become a new breed of environmental asset class. 

  • Essential to the scale up of any asset class is the availability of independent risk assessments. 

  • For the VCM, this is now available in the form of independent carbon ratings from firms such as BeZero Carbon.

  • The carbon rating industry is expected to follow the pattern typical of any risk assessment service, along five phases of development.

Introductory Phase - Ratings are ‘Interesting’

In the introductory phase a number of firms will launch services with their bespoke criteria and methodologies, rating scales, definitions, sectoral focus, and/or coverage, depending on their respective expertise, capabilities and perspective. 

The same project could be rated very differently by different firms. This does not mean a firm is right and the other is wrong. Each firm has assessed the risk based on its own criteria and methodology and assigned a rating in line with their rating scale and definitions. These variances are an integral part of a market’s early development.

Firms will also differ on public availability of their criteria, methodologies, ratings and rating reports. Some will make them free to access for all, others will restrict access behind paywalls, and some in between.  

Market participants - developers, intermediaries, exchanges and buyers - will invest time to understand the concept of independent carbon ratings, try one or more providers and determine if and how it adds value to their business and operations.

They find carbon ratings ‘interesting’. Most still continue to rely on their existing team and processes, but they start to track providers’ ratings and factor them into their thinking. The more their clients and competitors reference them, the more they need to.

Recognition grows that independent risk assessments are essential for pricing carbon credits and risk management. This is set against a backdrop of limited correlation between carbon credit ratings and pricing. 

This is the crucial phase in market development. Despite potential differences in their assessments, rating agencies should work together in this phase to ensure that the concept of independent credit rating is well understood and established. 

Critiques from the users of ratings is an important feedback loop. But exaggerating or characterising the differences in rating agencies’ criteria, methodologies or ratings as right or wrong risks adversely affecting the credibility of the industry they serve.

Familiarisation Phase - Ratings are ‘Useful’

In this phase, rating agencies will start to align on rating scales and definitions. This alignment is the next important step in the orderly development of the market as differing rating symbologies and differing definitions will confuse market participants and delay adoption. 

While each rating agency will continue to present its unique perspective based on its understanding of and assessment of risk, there will be a general convergence on high level aspects of carbon credit risk assessment. Firms focussed on a particular sector or geography will expand their coverage and the techniques used to assess different types of projects. Material differences in ratings (greater than one notch) will increasingly be rare, though a single notch difference may remain in many instances. This is an acceptable level of differentiation and also exists in financial market ratings. 

The rating industry will also evolve to a common standard of transparency and disclosure. All criteria and rating methodologies will be published and freely available, along with headline ratings with summary rationales. Information vendors will start porting this information as part of their services.

Market participants will have a better understanding of ratings and consider this as a ‘useful’ input in their decision making. Some may even adjust their internal processes to integrate independent ratings as part of their decision processes. 

The market will also witness emerging correlation between ratings and pricing - this is the first step in market adoption of ratings.

Market debate will shift from criteria/methodologies to demand for expansion of ratings coverage. Rating agencies will set out and lead stakeholder education campaigns explaining the relevance of ratings, criteria, methodologies and their interpretation. There will also be an increasing demand for common standards for validating and reporting information on projects, further strengthening the information rails for the VCM.

The growing market interest in ratings will attract new entrants to the ratings industry, though most will soon realise that it is not an easy business to operate. 

The rating industry is presently at this state of development.

Adoption Phase - Ratings are Important

With increasing demand for and use of ratings, there will be a strengthening correlation between ratings and pricing. This will further precipitate the demand for ratings’ coverage, creating a positive momentum and accelerating market scale up. 

Rating agencies will rapidly expand their coverage, develop new risk assessment products and services to rate ex-ante credits, assess upcoming projects, develop sector and country risk scores, and variants thereof. ‘Developer pay’ and ‘investor pay’ models will emerge as demand for ratings will outstrip the stock of rated projects. 

Opportunistic entrants into the ratings industry will continue to economically struggle, driven by the long economic gestation period of ratings businesses. 

Ratings will become an ‘important’ input into decision making by all market participants. Project developers will require risk assessments for the upcoming projects and for new vintages to be issued. Project investors will request for ratings before investing in projects. Intermediaries - brokers, marketplaces, exchanges, consultancies etc. - will request for projects to be rated to facilitate pricing and marketing them. Buyers will request for ratings to assess the likely impact of the VCM credits they purchase and retire. 

The firming up of correlation between ratings and price will create a market for pricing benchmarks, indices and other derivative products, further accelerating the scale-up of the VCM. 

Rapidly expanding transactions will necessitate the development of common identifiers equivalent to ISIN/GICS (International Securities Identification Number / Global Industry Classification Standard) in the financial markets. Increasing standardisation of data and information will further strengthen the information rails of the VCM, providing further impetus to its growth and expansion. 

Ratings will increasingly become the primary determinant to price and trade carbon credits.

Proliferation Phase - Ratings are ‘Essential’

The extensive adoption of ratings and its use in pricing carbon credits will further strengthen the correlation between pricing and ratings. Rating agencies will publish ‘ratings performance reports’ in the form of ‘rating transition studies’ highlighting the strength of their analytical processes. 

The ratings industry will attract regulatory attention. A regulator will be nominated to provide oversight over ratings agencies which will publish basic guidelines regarding transparency, disclosure, monitoring standards etc. Ratings agencies will invest time in educating the regulators and regulatory relations will emerge as an important function. 

Growing regulatory attention, increasing costs will challenge near term economic viability of newer entrants in the ratings business. Some firms may discontinue operations, while others may choose to combine with the larger, more established players. 

On the other hand, the growing stature of carbon rating agencies will attract attention from traditional financial sector players, who will seek partnerships and collaborations. 

Market regulators will also prescribe rules for various participants in the market covering an ever growing number of aspects from operations, risk management, reporting etc. 

Ratings will become an ‘essential’ element in the VCM. Akin to financial markets, where it is difficult to issue bonds without a credit rating, VCM participants will need a rating for all issuances. 

Embedded - Ratings are ‘Critical’

At ‘steady-state’, carbon credit ratings will become a critical part of large and still rapidly growing VCM. The availability of ratings and risk analytics tools, standardised data and information, an active derivative market, well accepted identifiers and regulatory oversight will all facilitate the VCM operating like any other asset class.

Rating agencies will develop sophisticated mechanisms to track and report on the equivalent of ‘default studies’ prevalent in the financial markets. This will enable market participants to compute the ‘risk adjusted quantity’ of carbon issued, traded or retired by them, respectively. 

The ratings industry will likely consolidate around a small number of leading agencies with some alternatives operating in specific niche segments and geographies. 

Established financial sector rating agencies will actively seek to acquire the larger players, or formally associate themselves with one of them. 

Carbon credit rating agencies will provide full coverage of ratings services along with risk analytics tools. They are likely to acquire (or have already acquired) players in the data and information services space to further consolidate their position in the market. They will also be a key player facilitating or providing indices, identifiers and other elements of information infrastructure. 

Developers will obtain risk-adjusted pricing for their carbon credit issuances. Intermediaries will focus on facilitating transactions rather than information. Buyers will optimise their offset purchase on a risk adjusted basis, delivering true impact to the environment.

The scaleup of the carbon markets will set the ground for the development and growth of other ecosystem assets and their integration with the financial markets.

Mani Gangadharan Venketachalam is President of BeZero Carbon. He has over 30 years' experience in ratings agencies and risk assessment services, including S&P, Moody's and Crisil.