Aspects to keep in mind for investors
Here’s the second of a three-part series on how NCS has emerged to be a new asset class
Investment funds in the Natural climate solutions (NCS) asset class can be differentiated by different sources of return as well as target investors. Nature+ funds, for example, invest in NCS to provide financial and non-financial returns for long-term investors; sustainable product funds focus on making supply chains greener with higher net-zero and sustainable sourcing commitments and carbon pure-play funds use a broader carbon sequestration portfolio to secure carbon credits from NCS investments.
However, for investors looking to step into the world NCS funds and carbon credits, several considerations need to be kept in mind – such as long development times or a tight inventory of NCS projects; low correlations between quality and price; no consensus on the measurement of price co-benefits, evolving trade infrastructure in voluntary carbon markets and political and regulatory risks.
Considering the looming supply crunch and limited scalability of most NCS projects, and with most projects having either long lead times or indefinite completion schedules; investors need to take several actions in order to improve their chances of obtaining high-quality carbon credits especially given the high degree of competition.
- Preparing a comprehensive origination strategy tailored to local environments is crucial to a solid investment portfolio, and is often better than taking an opportunistic and reactive (rather than proactive) approach. “They should evaluate partnerships based on their track records and their relationships with governments and local communities,” according to Bain & Co.
- Technology to speed up high-quality projects: Comprehensive early-stage registration of projects, along with automated assessment tools to grade carbon projects on co-benefits and potential is crucial.
- Engage the community: Bain& Co. writes: “poor community engagement is the primary reason for project failure. Success is more likely when local communities are properly consulted, participate voluntarily, and receive an equitable share of benefits. Investors that obtain such guarantees from project developers can better mitigate their risks.”
Low price-quality correlation
Since it is in its nascent stages, NCS markets do not yet price risk very well in spite of a general understanding of the four main criteria of quality. Primarily, the quality of carbon credits should be determined by the following factors, according to the US-based non-profit Environmental Defense Fund:
- Environmental and social impact: The project avoids negative externalities or adverse environmental or social impacts on local stakeholders and communities. Instead, it generates benefits beyond the reduction of greenhouse gas production.
- Additionality, or no double counting: These credits represent carbon abatement only for the sake of credits, and not otherwise.
- Permanence: The carbon abatement is more than temporary in nature and does not face major risks of being re-released due to natural disasters, project management or carbon cycles.
- Leakage: Emissions aren’t just moved to another location; i.e. reductions in carbon emissions in one place are not offset by a corresponding increase elsewhere.
The lack of a consensus in deciding consistent standards can lead to the risk of several low-quality credits being chosen over higher quality ones. Bain writes, “as standards coalesce and the risks become clearer, investors can consider several strategies to ensure the quality of credits.” Certain aspects that can be kept in mind are as follows:
- Engaging in large funds: Larger funds give investors greater engagement as well as control over project selection, minimum-standard enforcement (along with setting guidelines for projects) as well as assist with an unbiased selection of implementation partners, as well as provide quality assurance for investors. This becomes especially relevant in a market laden with uncertainty.
- Working with third-party tech providers: Specialised companies using data and technology to get an improved picture of carbon credit quality, and proper assessment of metrics such as additionality, leakage potential and permanence becomes crucial. Bain opines, “using these third-party platforms for due diligence allows for the swift assessment and procurement of reliable projects.”
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