Insurance Helping to Open Up Carbon Credit Markets

Tony Dowding  

October 7, 2024

A recent report, Gross Written Carbon: Are carbon credits the next billion-dollar insurance market?, by Oxbow and Kita Earth, concluded that the carbon markets present a significant opportunity for the insurance industry, and described it as ‘the next cyber’. And a report by Gallagher found that nearly two-thirds (63%) of all sustainability targets set by large businesses in the UK will be achieved by the purchase of carbon credits, but more than a quarter (27%) of large UK businesses do not have a back-up plan in case their credits fail.

So what are the main risks around carbon credits? James Bosley, head of climate strategy, carbon insurance & parametric solutions, Gallagher, says that the voluntary market is “unregulated and complex, exposing clients to challenging loss scenarios”.

He goes on: “From a buyer’s perspective, non-delivery represents a key concern as providers may be unable to deliver the reductions purchased, leaving businesses needing to find another solution at short notice, and higher cost, to meet their environmental commitments. For sellers of carbon credits, protecting the underlying means of carbon sequestration from natural catastrophes or weather events can be a significant concern.”

Bosley notes that insurance can help mitigate against such risks including non-delivery, reversal events or the risk of credit invalidation. “Currently, the purchase of carbon credits is largely voluntary, however the pressure on businesses to find ways to reduce their carbon footprint is growing, and it is likely that for certain sectors this will be mandated in the near future as a way of reducing their environmental footprint,” he says.

Eilis O’Keefe, carbon markets & partnerships analyst, Kita, says they have identified six key risks associated with carbon credits:

• Non-Delivery: Forecasted credits from a project are not fully delivered;
• Price: Carbon credit price changes, thus increasing your exposure and/or negatively impacting your asset value;
• Reversal: Carbon captured re-released into the atmosphere;
• Counterparty: Parties within the transaction act in a manner such that they become unable or unwilling to fulfil their obligations;
• Invalidation: Carbon project invalidated by the Carbon Standard;
• Political: Host country implementing a change of law or regulation that impacts a carbon project or carbon credit transaction.

Chris Slater, founder & CEO at Oka, The Carbon Insurance Company, says the chief risks are project failure (and associated credit reversal or invalidation) and credit fraud (e.g. when credits are sold to and claimed by more than one buyer, or even by both a company and state [to meet compliance targets and nationally defined contributions, respectively]). Geopolitical risk is another concern (e.g. government expropriation of land, or rescinded Article 6 approval).

“Due to growing scrutiny on their credit purchasing programs – with voluntary buyers accountable primarily to shareholders, and compliance buyers, to regulators – companies must address those risks to avoid serious financial and reputational repercussions,” says Slater.

George Beattie, head of innovation at CFC, says: “Because carbon credits are essentially synthetic certificates that represent carbon capture, the process of generating a carbon credit, getting it to the buyer and then maintaining the fidelity of that credit is fraught with danger. At the start of the logistical process, assuming a project makes it onto a registry and is allowed to sell credits, a project may not capture enough carbon to issue the credits they expected it to. This means they face a financial risk, but so do entities that have ‘bought forward’ from them.”

He explains that the reason a project may not capture enough carbon could be scientific non-performance i.e. less carbon was captured than predicted, natural catastrophe, political risk, crime or legal challenges. He says that in most cases, the contracts between counter parties may not have sufficient protections for counter parties, particularly buyers facing ‘force majeure’ provisions that limit pursuit options in the event of the precipitation of extraneous and fortuitous risks.

“Even issued credits can be cancelled as a result of reversal e.g. the project is destroyed, which releases the sequestered carbon, or invalidated, such as a change in how carbon credits are accounted for within the issuing standard, meaning a raft of credits are wiped out. This means that despite taking delivery of a credit and potentially using it (called ‘retirement’) against a net-zero aspiration, that credit can still be destroyed, leaving the retiring party with a financial loss,” says Beattie.

He adds: “Lastly, there are bad actors in the carbon market, like any other market, who would do tremendous harm to the heroic efforts of a gallant minority to show the world what a high-fidelity carbon market can do. However, spotting the bad guys isn’t always easy, and if an entity buys from an initiative that turns out to be a ‘bad project’, that can cause them reputational harm.”

Insurance solutions

There are a growing number of insurance solutions available in the market. As Beattie points out: “The carbon market is not just open to insurance but clamouring for insurance to play a role.” He says insurance can play a key role in building trust, identifying risks and helping manage their impact.

“The buyer of a carbon credit doesn’t really care why their credit was cancelled, only that it was cancelled. So a traditional named perils approach to the problem will never work at scale. We need to design products where the trigger is the net inconvenience being experienced by the user,” he says.

There are now solutions available across the entire value chain/lifecycle of a carbon credit, says O’Keefe, adding that there remains a significant opportunity for insurers in this space. “The carbon markets are complex and carry a plethora of risks. As with any market, you need multiple insurers and products to have comprehensive risk mitigation. For example, emerging CDR (carbon dioxide removal) projects like direct air capture or marine CDR present unexplored risks. Also, the impacts of climate change on these projects are unpredictable and are rising in frequency and severity,” she says.

Slater points out that because the insurance industry has been slow to enter the space, there are a limited number of providers offering dedicated policies. “This has resulted in an insurance shortfall, with fewer than 1% of corporate buyers protected by carbon insurance. It represents a major missed opportunity, in our view: not only does insurance protect buyers against balance sheet risk – reducing any potential financial and reputational pitfalls – but it also alleviates the burden on companies to conduct their own due diligence.” He adds that the problem is one of volume rather than innovation.

The data issue

As with many areas around net zero and sustainability, there is an issue around data. As Slater points out, data is the chief barrier to entry for insurance companies. In more mature markets, expertise and data are widely available, but because the voluntary carbon market (VCM) is relatively new, lenders and insurers may have neither the capacity nor the volume of historical risk data required to model specific market risks, he says. “Compounding the challenge, carbon markets suffer from a lack of price transparency and liquidity – and even project and methodological uniformity – which makes it hard to assess the risk-adjusted value of projects and their credits,” adds Slater.

As an evolving market, historical data for the carbon market is scarce and a lack of regulation has led to limited data transparency, according to O’Keefe. But she says the data within the market is improving, particularly with emerging monitoring, reporting and verification techniques.

Beattie says the problem in the carbon market isn’t necessarily data, but the rules used to interpret that data. “The science of carbon capture is changing all the time, by necessity as we learn more about how it all works. However, as a result of that, what’s true today in the market may not be true, in part or in whole, in five years’ time. This makes underwriting carbon risk quite interesting, because we have to try to predict which risks are going to present over the timeframe we are writing the business.”

Slater believes there is a sizable environmental and financial opportunity for insurance policies that protect investors and lenders at the earliest stages of project development. “Carbon and climate projects are key to mitigating the worst effects of climate change, but many – even, if not especially, those employing new technologies – struggle to access financing. Their business models are often new by design, and innovative technologies are inherently high cost and high risk. On the other side of the equation (or table), would-be financers are relatively risk averse,” he explains.

“Policies that lower costs and de-risk investments may move the needle for institutions that would have otherwise shied away from unfamiliar business models. By reducing equity- and debt-related risk, insurance makes projects more attractive to investors and lenders, respectively. It’s a win-win: developers gain access to large-scale institutional capital; asset managers and banks, to a new source of high-yielding, ESG-positive opportunities,” he says.

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