13 April 2022
The VCM needs ratings agencies
Mani Gangadharan Venketachalam
The history of credit ratings agencies is almost as old as the industrial era itself. A few businesses began publishing financial information on companies and opinions on railroads (who were borrowing money via bonds), sowing the seeds of the global credit rating and information services industry.
They helped usher in an era in which capital markets provided the liquidity and fossil fuels provided the energy to build the modern world. All of this started with a few forward thinking entrepreneurs. Individuals who believed that standardised data, structured information and independent analysis were essential for the orderly development and scalability of markets.
Today, the accepted benefits of credit ratings are ubiquitous. Ratings underpin everything from credit derivatives to fixed income indices, credit assessment tools to credit information services, and the distribution and support infrastructure around these businesses.
Ratings agencies play an equally crucial role in market structure by acting as the keystone of transparency. They scrupulously ensure their ratings criteria and methodologies, as well as the headline ratings views, are public. This is how they establish their credibility and are accepted by market participants.
Capital markets are all about information and price, or questions and risks. The more information able to circulate in a market in a structured way, from credible sources, the better all market participants can assess risks associated with the trading assets.
Amidst decades of market peaks and troughs, ratings agencies have performed this vital function. They have facilitated and accelerated the growth of the global fixed income market to ~$123 trillion of outstanding securities in 2021. A market larger than the combined market capitalisation of all equity markets (around $106 trillion). Without fixed income markets, countries, corporations, and communities would struggle to function as we know them. Ratings agencies, such as Standard & Poors, are now household names and are Fortune 500 companies with robust business models and high operating margins.
The only problem is that the old formula for economic growth has stopped working. Two centuries of unprecedented expansion has given birth to what’s known as the Anthropocene Epoch – the era of human activity having a significant impact on the planet’s climate and ecosystems. Capital markets now have a new role. To help the global economy wean itself off carbon intensive fossil fuels. One of the many great opportunities this presents is how to leverage the market building power of ratings agencies to support transition to a more sustainable economic model.
The first order is climate change, the path to net zero, and the role of the voluntary carbon market (VCM) in scaling climate action. Unlike the more established regulated cap-and-trade markets, the VCM is at a similar state of evolution as the bond markets were in the early 20th century. Demand for credits is driving rapid growth; transactions are mostly off market or “over-the-counter”; exchange-based trading is in its infancy; there is no independent risk-based pricing mechanism; and the information infrastructure is conspicuous by its absence.
The biggest perceived issue with the VCM is an inability of market actors to assess “quality”. The VCM market structure today relies on a well recognised approach to issuing carbon credits through accreditors. This is not the problem. Their role is extremely important, essential to the future operations of the market and akin to financial auditors. Efforts to relitigate this space are only seeking to replace one truth with another. This is not useful.
The key shortcoming is that the market lacks the information infrastructure it needs to price and manage risk, not the number of accreditors it has. The objective for market structure is to move beyond binaries, where “a tonne is a tonne”, to something probabilistic. But with the knowledge that outcomes naturally vary between projects and accreditation, it’s a necessary, but imperfect, science.
This is where ratings agencies have historically proven their mettle. The VCM needs an independent rating agency, or agencies, to assess the quality of carbon credits beyond accreditation. Such agencies are just as relevant here as they are in financial markets. An approach to ratings that treats a carbon credit like a financial instrument, i.e. that it is a contract to deliver a tonne of carbon between two counterparties. Price may reflect other things, such as social impacts, but this carbon component is the primary driver of value and is the only truly fungible metric common to all projects.
BeZero Carbon has taken up the initiative to set up the world’s first full service, global carbon rating agency. Our vision is to build for ecosystem assets what S&P or Moody’s built for financial markets, starting with carbon markets. The BeZero Carbon Rating assesses the probability that any given carbon credit delivers a tonne of avoided or removed carbon. It is a carbon-only rating. As such it is not the only determinant of quality, but it is a vital component of that equation. Our criteria and methodology are available in the public domain and open to interrogation and feedback. Our assigned ratings are available on our website, with additional information and assessments live on our platform. We rate projects across all sectors, countries, and accreditation agencies subject to our qualifying criteria.
Over the coming years, we believe carbon ratings will increasingly rebuild the correlation between price and quality, allowing the VCM to support the industrial scaling of capital flows into climate positive projects. Understanding the benefits, and limitations, of ratings will create the demand for more projects to be rated. Over time, carbon offsets will be difficult to trade without a rating, creating positive momentum for greater transparency and overall market development; or more money going to better climatic outcomes.
Risk-driven pricing will make the traded prices more reliable and consistent and facilitate the development of pricing benchmarks, indices, driving further investments. Exchange traded contracts, ETFs, and derivative instruments all underpinned by ratings will emerge and become an integral and potentially large part of the carbon markets.
The demand for ratings will create the demand for underlying data on projects, developers, investors, brokers and buyers; data on project performance, key operational metrics (including time series data and benchmarks) for each project, sector and country will be sought and from there will emerge a range of sectoral and country ratings and scoring products.
With rising net zero commitments, carbon credits will become integral to the day to day operations of a large number of stakeholders, fuelling the demand for risk models, portfolio analytics and workflow tools for users to assess their carbon reduction requirements, identify credits to purchase, manage their portfolios, retire credits and report on these activities to internal and external stakeholders. Accounting and reporting standards will be developed and an ecosystem of service providers will support the implementation and reporting of this information. Each of these components will contribute to the development and strengthening of the information infrastructure around the VCM, facilitating its orderly growth and development, catalysed by independent credit ratings.
This article originally appeared in Carbon Pulse on 13/04/22, it can be found here.