Carbon credits and the energy transition: An Investor Perspective
By Dr. Amar Inamdar, Managing Director, KawiSafi Ventures Fund | November 7, 2022
Asymmetries between rich and poor are at the heart of the idea of a Just Climate Transition. At KawiSafi, we envision Africa to be at the forefront of the climate transition in the next decade, building an inclusive energy ecosystem that build pathways out of poverty and toward prosperity on the continent. The role of carbon markets in addressing some of these asymmetries is gaining policy traction. COP27 will see the launch of the Africa Carbon Markets Initiative at COP on 8 November, with many on the continent, including SE4All, voicing their call for action.
As we speak to companies that are leading the energy revolution, it is apparent that many are considering, or have already been, leveraging the potential of carbon markets and unlocking new growth opportunities. What does the current carbon market boom mean to energy startups in Africa? How should venture capital funds and impact investors evaluate these businesses? We see an opportunity that has the potential to radically transform the economics of low-carbon businesses and improve affordability for hard-to-serve markets everywhere.
Carbon market: the basics
Carbon credits are created from activities that avoid, reduce, or remove emissions. More than 95 percent of carbon credits in the market fall under the first two categories, meaning that the projects result in fewer units of carbon in the system as compared to the baseline “business-as-usual” scenario. This represents the type of carbon credits – such as renewable energy installation, clean cooking stoves, or e-mobility credits – sold by energy startups that aim to displace the dirty alternatives that emit greenhouse gases. The remaining 5 percent are carbon removal offsets, including nature-based solutions (such as afforestation and reforestation projects) or technology activities that take the carbon out of the system by permanently storing them underground or elsewhere (such as direct air capture).
The demand for carbon credits is expected to increase exponentially, especially driven by the surge of corporate climate pledges that will boost activities in the voluntary market. As of November 2022, over one-third of the world’s largest publicly traded companies have announced net-zero targets. These companies are set to use carbon credits they purchase to offset emissions that are hard to completely abate, alongside actions to decarbonize their emission activities. The voluntary market has already topped $1 billion in 2021, and the global demand for voluntary credits is forecasted to increase by a factor of fifteen by 2030, reaching1.5 to 2 gigatons per year.
Carbon credits for an equitable energy transition
For the 6.1 billion people, or 80 percent of the world’s population, living in the developing markets, carbon offsets mean more than a market instrument to drive global climate actions. They are also an important tool to facilitate an equitable and just energy transition for at-risk communities in emerging and frontier markets.
Perhaps most importantly, carbon credits help subsidize the cost of clean energy alternatives and make them more affordable for low-income households. At the current price point, scaling clean technologies, such as solar mini-grids and clean cooking stoves, to low-income households at the scale required for a net-zero future is nearly impossible. Carbon credits could be used to drive down prices of these clean products, enabling a far greater product reach to households that would otherwise not be able to enjoy these products. For companies that have successfully tapped into this business model, the carbon credits served as additional revenue streams to serve lower-tier markets without compressing margins.
Additionally, projects that generate carbon credits in the developing world, if executed successfully, would typically be associated with co-benefits supporting the local community. For example, clean cooking stove projects are usually associated with upskilling and improving the cooking conditions of women, who take on the domestic role in many families across Africa. There are also public health benefits, such as reducing black carbon and particulate matter, which will translate into better long-term social and economic development outcomes.
However, despite significant potential as a carbon sink and needs for clean technology, Africa remains marginalized in the global carbon market trades. Analysis shows that Africa accounts for only 2 percent of carbon trading globally, most of which occurred in just five countries.
Challenges to executing carbon strategies
While, in theory, the carbon credit is a promising market mechanism for companies to drive revenue growth and climate impact simultaneously, it is not at all easy for early and growth-stage start-ups to implement and realize their aspirations. We can share direct experiences from companies we have invested in – including Biolite and SistemaBio – both of whom have developed innovative carbon transactions to reduce the cost of their products to consumers, thereby accelerating sales in lower income markets.
There are no ‘typical’ carbon trades. But here is one example that works:
First, getting a carbon project accredited and validated is a cumbersome and expensive process, which is often tough for start-ups with no prior experience and limited capacity to navigate. Deciding on the carbon offset standard associated with the project – such as Gold Standard and Verra for the voluntary market, or a compliance market that accepts international credits, like Korea’s – is a decision that requires much planning and expertise.
Second, cash flow and liquidity could be a challenge for businesses that are looking to use carbon credits to lower product pricing. Oftentimes, credits are only recognized when the associated product has been sold for at least a year with verifiable data on performances. That translates into a time gap where the product is sold (at a discount) and when the carbon credit revenue is finally realized. Companies typically resolve this through pre-financing agreements with financing partners, who take on the project risks and receive returns in the form of carbon credit revenue sharing or other arrangements. This adds another layer of uncertainty to companies looking to develop carbon projects.
Lastly, finding the buyers who would purchase the credits at desirable prices could also be a challenge. The carbon markets have long attracted strong criticisms for their opaqueness, where most transactions occur through brokers and middlemen instead of an open exchange. While we are excited to see the recent enthusiasm and developments in improving the efficiency of the market, it is still relatively difficult for new companies to navigate the space and build their sales pipeline directly with end users.
Implications for investors
So, how should clean energy ecosystem investors respond to the (exciting) disruption brought by the carbon markets? Here are our three key takeaways.
First, evaluate companies that promise a strong carbon revenue with caution. Does the company have a clear execution plan and timeline to realize its carbon credit strategy? Or, at the very least, understand the structure of the market and can speak to the potential challenges and risks they might face? How reliant is the company’s financial forecast on carbon credit sales, and is the basic product value proposition robust enough beyond the credits? What are the pricing, quantity, and timing assumptions of the company’s carbon credit sales? These are important questions to consider, as more start-ups across the energy ecosystem jump on the carbon credit bandwagon.
Second, support portfolio companies in developing their carbon strategies. Are there opportunities for the portfolio companies to increase their addressable markets through carbon credit sales? What sort of guidance could the investors provide to support them in developing high-quality carbon credit projects? Should the companies launch a project, would the investors be able to connect portfolio companies with buyers who are willing to purchase them? Understanding the type of activities that would qualify as carbon credits would be an important first step in this process.
Third, explore the potential of investing in carbon pre-financing deals. As discussed before, many project developers would need upfront capital to launch the projects and manage the delay of carbon revenue carefully. For investors, these deals could be attractive and potentially generate an upside return of over 20 percent, if project risks are deemed to be low. However, traditional venture capital investors might find themselves entering unfamiliar territory and must carefully assess whether these projects are good investments within their fund’s mandate.
KawiSafi believes that catalyzing the energy transition in Africa requires innovative solutions that are tailored to low-income and underserved markets. If executed well, we see carbon credits as an important tool to transform the lives of Africans, which account for over 55 percent of the world’s poor. We are excited about the opportunity it brings to the continent, and we look forward to hearing from and partnering with innovative companies that share the same vision along our journey.
Top 5 questions on the carbon market: our view
- How confident are we that the carbon market would not crash again like it did in the 2000s?
The EU ETS carbon market crash in 2007 – resulting in a near-zero carbon price – was widely attributed to the over-allocation of permits and the unfavourable system design in its early years. The EU ETS has since conducted rounds of reform, while the 34 regional ETSs and the voluntary market helped diversify the market, further reducing pricing risks. Just like any other market, carbon prices will have short-term fluctuations, but we are confident about the long-term prospect of the market, given the promising commitments to decarbonize from both the public and private sectors globally.
- Some investors have expressed a preference for removal credits over avoidance or reduction credits, claiming that the latter is not truly “additional”. What is KawiSafi’s take on this debate?
We echo the concern regarding the insufficient supply of removal credits. The current 100,000 tons of high-quality removal credits is far from enough, as compared to the 5-16 billion tons needed by 2050 to achieve a net-zero climate goal, according to the IPCC. As such, we are excited to see the enthusiasm in the carbon removal space. Nevertheless, as seasoned investors in emerging markets, we also witnessed the dual role of reduction credits in accelerating clean technology adoption and improving the livelihoods of low-income communities. We believe that these credits are valuable and necessary to build the right incentives, such that funding could be directed to those that would otherwise not be able to afford the investments required for a clean transition.
- How do you address the concerns of “greenwashing” when companies and countries can continue polluting while claiming the reputational benefits from the carbon credits?
We believe that carbon credits are complementary to – but not a replacement of – decarbonization actions by emitters. Referencing the net-zero standard developed by the Science Based Targets initiative (SBTi), the net-zero end goal is for emitters to reduce emissions from their value chain as much as possible, and use carbon credits to offset the residual emissions that are truly hard to abate. Yet, we acknowledge that decarbonization actions take time to implement; meanwhile, accelerating climate actions does require an “all-hands-on-deck” approach. Therefore, we believe that, in the meantime, carbon credits, if implemented well, could be a good market-based solution to accelerate carbon actions.
- What are the key criteria you are looking for in a carbon credit project?
For the carbon market to maximize its impact, we believe that buyers must prioritize quality over price and eventually increase the overall standards of the carbon credits available in the market. Simply speaking, a high-quality credit is additional, permanent, accurately estimated, not claimed by another entity, and does not result in other social or environmental harms. Admittedly, there is an abundance of cheap, low-quality credits that allow buyers to claim the carbon benefits at the lowest cost possible. We are supportive of the various efforts (such as the Integrity Council for the Voluntary Carbon Market) to improve the overall quality of carbon credits in the market, and we are keen to support companies that create high-quality carbon projects with strong co-benefits to local communities.
- How resilient is the carbon market in an economic downturn, like the one we are seeing now?
An economic downturn or a recession will impact the carbon market in several ways. First, companies might decide to prioritize other initiatives (such as cost cutting) over their climate commitments. Hence, there might be a drop in demand for credits in the voluntary market. Second, a recession will reduce consumptions and lower the demand for emissions allowances in the compliance markets. However, prices in the compliance markets are ultimately driven mainly by the supply of allowances, which is controlled by regulators. The EU ETS’s Market Stability Reserve mechanism is an example of how regulators can remove oversupply of carbon allowances to provide price stability. Meanwhile, high-quality offsets are generally more resilient, as the current supply of quality offsets is still far from enough to meet the needs.