Carbon Offsetting - Offset Transactions

In the absence of predominant market standards, the variety of offset prices, qualities, delivery conditions and contract terms makes it difficult to get a clear overview of the voluntary offset market. The following clarifies pricing, costs, risks and delivery terms within the market mechanisms.

Pricing of Offsets

A complete and correct assessment of the production costs of an offset requires extensive knowledge of investment costs, operational costs, past, present and future project performance, corporate finance, and risk management, among other factors, and is extremely time-consuming. Few consumers have the time and know-how to conduct such extensive analyses. Even those that do may find it extremely difficult to factor all cost components correctly.

Project Costs

Offset providers must cover costs incurred at many different stages of project implementation before the emission reduction can be sold as an offset. The main cost factors can be divided into:

• Project cycle-related costs: investment for technological implementation, financing of investment capital, costs for technical project operation, maintenance, administration, etc., and
• Delivery process-related costs: costs for the management of project failure risk, quality control, administration, legal, printing costs, etc.

These costs have an indirect influence on the market price of offsets: in a functioning market where rigorous and transparent standards are available, prices are set by supply and demand. Offset providers whose efficient projects and internal processes enable them to generate offsets below market prices will be most successful. Providers whose generation costs exceed market prices, on the other hand, will need to increase their prices, which may result in decreased sales.

The cost of each aspect of production varies from project to project, so no rule of thumb exists for predicting the generation cost of an offset. The cost can be as low as two Euros per offset (typically in projects at large chemical plants), but has no upper limit. Some projects incur costs of € 20 per offset and more, not including delivery process-related costs. The generation costs for some offsets exceed resale prices as early as in the planning stage. Other projects reach equivalent cost levels due to technical failure or generation shortfall.

Since no for-profit organisation can sell offsets below production costs over the long term, less costefficient projects are typically implemented with funds donated to non-profit organizations. Such projects may in turn have high co-benefits which have no assigned monetary value in the current carbon markets, in which the traded commodity is a CO₂e reduction.

A Common Misunderstanding: The “Project Share Pitfall”

Buyers of offsets are inclined to pay the lowest possible price for offsets of a given quality, and are not willing to pay for a provider’s unreasonable profit or other unwanted expenditures (e.g. project administration or taxes). In comparing different offset purchase offers, buyers often try to invest in projects with high project share – that is, the proportion of the investment that goes toward direct implementation costs as opposed to overhead and organizational costs. Many buyers prefer offsets with a high project share because they believe this indicates a more significant contribution to climate protection.

But the project share measure can be manipulated, and is subject to individual assumptions and definitions:

• There is no agreed-upon method for calculating project share, so different providers may include various costs in their calculations. Internal administration costs to the provider, for example. may or may not be included in the administration costs for a specific project.
• Purchasing offsets with a high project share that are significantly more expensive than other offsets may not be the most effective use of available funds, since the same funds could be used to achieve more emissions reductions at a lower price.
• Even if two projects have the same project share in the planning stage, the projects’ generation success (and, therefore, climate impact) may differ significantly. The overall project share may be known only after successful long-term project operation.
• Some projects are easily constructed but difficult to administer, while the opposite is true for others.

Most buyers aim to maximize the emissions reductions they are funding. But project share is often an unreliable measure for evaluating and comparing the quality and effectiveness of offset projects.

Offset Market Prices

It is nearly impossible to give a precise overview of current offset market prices, as the market is considerably fragmented due to the variety of available standards, project types and locations, offset qualities, delivery guarantees, contract terms and conditions, etc. That said, the main price drivers are an offset’s standard and origin (i.e. project type).

In a competitive market, offset prices are a function of supply and demand. The attractiveness of a project depends on the buyer’s objectives. These are different for a compliance buyer than for a voluntary buyer:

• Compliance buyers are interested in obtaining credits reliably and cheaply in order to fulfil their regulatory requirements.
• Most institutions that voluntarily use offsets for their climate neutralization efforts want to communicate that effort to the public and choose projects that are well-received by the target group.
• In Europe, voluntary buyers are especially interested in biomass, renewable energy and enduser energy efficiency projects from less developed countries. Other emissions reduction projects such as industrial gas projects at chemical plants are less attractive to these buyers because, despite their emission reducing capability, such projects deliver very limited cobenefits such as job creation and protection of local ecosystems.
• In the US, voluntary buyers prefer offsets generated by domestic projects, and are less focused on project type or sustainable development components.

Carbon markets are still in their infancy. As public opinion and understanding of the markets increase, different project attributes may become more attractive to buyers. The following market prices¹ are only approximations, and do not reflect the full variety of the purchase and sale preferences of all market participants.

Pricing of Offsets for Each Standard

Standard	Pricing
CDM	The wholesale market price for CERs is at around € 18.2 A seller therefore has the possibility to sell the CER to a compliance customer at that price using a standardized and cost efficient process and will sell to other buyers only, if any additional administration costs are covered by additional revenues. Additional costs apply for marketing expenses, certificate management, administration, value added tax etc. Therefore, CERs are sold in the area of € 14 to € 30.
GS	GS CER or GS VERs are sold on average at a premium to regular CERs or comparable VERs of 5-25% of the market price. The premium varies depending on a number of factors: the project itself (its attractiveness for communication for example), project location (projects in so called least-developedcountries for example, are much sought after), whether a trade happens in the wholesale or in the retail market, vintage etc
VCS	VCU prices depend to a large extend on the project type. VCS version 1 VCUs are traded at € 5 to € 15
VER+	VER+ offset prices depend to a large extend on the project type and are traded at € 5 to € 15.
VOS	GS VER: see above Other VOS VERs: prices depend to a large extent on the project type. They trade at a premium compared to other VERs, but at a lower level than GS VER levels.
CCX	CCX offsets are traded at €1.2–3.1.3 Additional costs apply for exchange fees, marketing expenses, certificate management, administration, providers profit, value added tax etc. and resale prices will usually be higher than the price listed on the exchange.
CCBS	Offsets from CCB projects are traded at €5 - €10.
Plan Vivo	The price of Plan Vivo Certificates depends on the volume of the purchase and the project. Plan Vivo certificates are traded at €2.30 - €9.50 / tCO2
GHG Protocol	N/A
ISO 14064-2	N/A

Choosing the Right Contract Terms

In the offset market, as in most other markets, participants compete to secure market shares. In order to do so, providers of a certain offset quality (e.g. Gold Standard CERs) must set prices at competitive levels. This requires efficient project operation on the part of the provider, as well as limited profit margins. A provider of offsets with profitability expectations substantially above the competition will set their prices too high and as a consequence lose market share. On the other hand, a provider pricing offsets too low without looking at all of the applicable risk and cost components runs the risk of bankruptcy – especially in case of project shortfall or failure.

Yet the market can only function successfully if reliable information is available about the quality of offsets. Otherwise, the markets will fail to ensure quality and efficiency. For example, if nonadditional offsets enter the market and are indistinguishable from additional offsets, a market driven race-to-the-bottom will occur, since the non-additional offsets will by definition be cheaper than the additional ones. Standards must fulfill the role of ensuring quality and providing transparent information to buyers and sellers. If reliable standards are available to distinguish the different types and qualities of offsets, buyers can take advantage of the competition in the offset market by comparing prices for products of a desired quality.

Comparing offsets is no simple task. Buyers must take into consideration project type, offset standard, delivery guarantee, and other factors. Ideally, by choosing offsets offering the best value among those of similar type and quality, the consumer fuels market competition, which in turn results in more efficient emission reduction activities.

Among the most important contract parameters are the delivery provisions, which are specified in the contract between buyer and seller. In order to choose the product that best fits their needs, it is crucial that buyers understand the terms of the contract and the delivery terms and risks involved.

The cost of purchasing guaranteed offsets, for example, may be more than that of buying intended emission reductions, even if the offered offsets are of the same quality. Guaranteed reductions have either already occurred (prompt delivery) or will occur in the near future and are guaranteed to be delivered (forward delivery). In the latter case, the provider is held liable for contract default if they fail to deliver the agreed-upon number of emissions reductions. In cases where buyers donate toward intended emission reductions, project shortfall or failure has no consequences for the offset provider. Such intended emission reductions are referred to as forward crediting or ex-ante credits.

Some buyers may prefer to make a donation toward intended reductions based on personal preferences, especially if a project delivers high co-benefits. Others may prefer the certainty of achieved emission reductions associated with purchasing guaranteed offsets.

All but one of the reviewed full-fledged standards verify exclusively ex-post emissions. For such offsets, it is up to the buyer and seller to choose between prompt delivery and forward delivery. Plan Vivo is the only standard that verifies ex-ante credits. But not all providers clearly distinguish between non-guaranteed ex-ante credits and guaranteed offset purchases. For example, a provider could advertise to sell Gold Standard offsets from projects that have not yet produced verified emissions reductions. If this is not clearly communicated to the buyers, they might be unaware of the risk they are taking. It is therefore vital that the buyer reads the general terms and conditions of the contract and identifies if the purchased amount of offsets is backed by real emission reductions or not. The following sections describe the three levels of delivery risk in broad terms. Though single contracts may deviate from this scheme, the underlying principles generally hold true.

Low Transaction Risk: Prompt Delivery of Existing Offsets

Prompt delivery in the carbon markets typically means delivery within a few days of contract signature. This delay allows for administration of the actual transaction, but not for the generation of offsets, which would be impossible in such a short time.

In such cases, the provider assumes all project and price risks and generates the carbon offsets prior to selling them. The provider invests in the necessary technology, oversees project implementation, covers the operational project expenses, and pays the costs for the validation, registration and verification of the project activity. The provider does so without knowing for certain how large a volume of offsets the project will ultimately generate, nor at what price these offsets may be sold. However, after successful project operation, having the carbon offsets in stock enables the provider to offer risk-free deliveries, and to achieve a higher nominal sales price than could be set for highrisk (non-guaranteed) offsets.

Since providers of promptly delivered offsets can specify and easily guarantee the exact amount, quality and parameters of their products, buyers of such offsets carry no project-related risks. Thus, this type of contract is suitable for buyers that wish to receive risk-free emission reductions quickly.

Medium Transaction Risk: Forward Delivery of Future Offsets

A forward contract constitutes a binding agreement between the offset provider and the buyer to deliver emission reductions at a pre-defined time and price. The provider may have access to future emission reductions from a certain project or portfolio of projects or may have existing emission reductions available in stock.

For both the provider and the buyer, a forward contract is a way to eliminate market price risks and secure a desired transaction price, even though delivery may not occur for months or years. Such an arrangement protects the provider from falling market prices, and the buyer from rising market prices.

Forward contracts may specify a fixed or proportional amount of offsets to be delivered. A fixed delivery quantity specifies the exact amount of offsets to be delivered, while a relative number typically refers to the project’s overall success (e.g. buyer agrees to buy 50% of all generated offsets each year for 3 years).

In fixed volume transactions, the seller carries the risk if the project produces fewer offsets than expected. In case of an offset shortfall, the seller must make up the missing offsets by delivering offsets from other projects at the same price.

A forward contract can be executed only if both parties still exist at the time of delivery (i.e. have not suffered bankruptcy). If the seller is unable to meet their contractual obligation, the buyer faces the risk of having to pay the current market price for offsets, which may be more than they had originally settled on with the forward contract. The risk of a party not being able to fulfill its contractual commitment is referred to as credit risk. Before signing a forward contract, each party typically assesses the credit risk of the other party.

While organizations applying professional risk management strategies may prefer forward deliveries to eliminate market price risks, such arrangements are less suitable for consumers who do not know how to assess credit risk. Forward contracts are most suitable for buyers who want to secure a price ahead of actual delivery and payment date (e.g. buyers who expect market prices to increase in the future).

High Transaction Risk: Forward Crediting of Ex-ante Offsets

Forward crediting – the sale of ex-ante credits – is the most complicated type of transaction for the buyer to understand. Typically, at contract closure, the buyer pays the purchase price for a certain number of offsets that have yet to be produced, and the provider delivers a certificate confirming the purchase. However, these offsets do not yet exist, and the successful generation of the agreed number of emission reductions is uncertain.

Unless the contract contains an ex-post adjustment of the purchase price corresponding to any shortfall in offset generation, the customer carries the risk that some or all of the purchase price may be lost, given that offsets might not be delivered. Transparency in such transactions is likely to be limited because providers are unlikely to inform buyers of any shortfall in the number of emissions ultimately achieved. This is especially true for projects that are not expected to deliver the emissions reductions for several decades, as is the case with certain forestry projects. Because buyers must pay upfront with no guarantee of the fulfillment of delivery, such transactions carry the highest risk for the buyer.

Forward crediting is similar to forward purchasing (see above) and the same principles of price-risk hedging and credit risk assessment apply. But there is a substantial difference in risk associated with the two types of transactions: In forward crediting contracts, the purchase price is paid upfront and is not repaid in case of delivery shortfalls. The seller is not obligated to replace delivery shortfalls with offsets from other projects. Because of this, forward crediting might be more suitable for donors who do not depend on exact emissions reductions than for buyers who are looking to offset a precise amount.

How Providers Can Reduce Delivery Risk

Risk management techniques can substantially reduce the risk of project under-performance and consequent delivery failure. One key technique is the portfolio approach: by contracting / developing not just one or a few projects but a large number (e.g. with differing technologies or locations), the provider can diffuse the risk of catastrophic project failure. Restricting sales to the expected delivered volume based on the probability of project failure can significantly reduce the risk of over-selling. Providers with a substantial portfolio of projects are thus able to guarantee the amount, quality, and parameters of the carbon offset delivery to the buyer at contract signature, prior to generation and delivery.

Active risk management can also be applied on a technical and operational level. By hiring technical experts to oversee the job site and perform quality control, and by consulting with local representatives, providers ensure that they will react in a timely manner to technical failure, shortfalls and errors in project documentation, changes in laws and regulations, etc. Although such measures raise project costs for the provider, they also ensure a lower project failure rate.

A third way for the provider to avoid delivery default is to compensate for generation shortfalls with emission reductions purchased from other providers.

Since all forms of risk management require an investment of resources, not all providers are able to offer an optimal delivery guarantee when contracting to generate offsets.

1	“State of the Voluntary Carbon Market 2007 – Picking Up Steam“, Ecosystem Marketplace & New Carbon Finance, 17th July 2007 and Tricorona, November 2007
2	Nordpool price, 14th November 2007: € 17.70
3	Pricing data from October 07-February 08; http://www.chicagoclimateexchange.com/market/data/summary.jsf