Innovative insurance products could be an effective tool to reduce carbon offset risk and limit potential losses, experts say
The use of carbon offsets to control companies’ greenhouse gas emissions remains controversial – a clear example of this is the recent furore when the emissions standard setter proposed the Science Based Targets initiative to allow companies to use carbon offsets to reduce their Scope 3 emissions to decrease.
The risks associated with carbon offset transactions are numerous and range from physical – such as forest fires and floods – to political – including a change in government policy, as well as negligence and insolvency on the part of the carbon project developer. Any of these events could potentially lead to the cancellation of a carbon offset project.
Another risk is accusations of greenwashing; climate activists often criticize offsets for allowing companies to continue polluting rather than reducing their own emissions.
To address these concerns, a niche part of the insurance industry is offering tools to mitigate risks affecting carbon markets and increase the feasibility and credibility of offset projects.
“The universe of risks is enormous as buyers of carbon credits have no certainty about their obligations, while supply risk remains largely unprotected,” said Nandini Wilcke, co-founder and Chief Operating Officer of CarbonPool. The company aims to offer insurance solutions through a carbon-based balance sheet, although it has not yet received an insurance license from the Swiss regulator.
Lack of rules
A lack of regulation is another major issue underlying the controversy surrounding carbon offsets, experts say.
Agreement on the “clear rules of the game,” including the contentious Article 6 negotiations, must be reached before the market can successfully scale, says Kyoo-Won Oh, senior underwriter at the World Bank’s Multilateral Investment Guarantee Agency, which has specific insurance protections in its internal carbon projects.
Article 6 of the Paris Agreement consists of nine paragraphs detailing the principles for establishing international carbon markets. However, these have yet to be translated into a practical, rules-based framework, as countries disagree on how to structure and govern a global carbon rulebook.
The “MIGA Guarantee” provides protection against losses arising from a government’s withdrawal or repudiation of its binding obligations in areas such as the right to own, sell, export and dispose of carbon credits, Oh says.
MIGA also monitors a carbon project’s impact on a host country’s economy, such as revenue sharing with local communities, emissions reductions, job creation, gender equality and tax revenues.
Immature markets
Currently, carbon credits are accessible in the voluntary and compliance markets.
Compliance markets, such as the EU emissions trading system, rely on a cap-and-trade mechanism where the price of carbon depends on supply and demand. However, the voluntary market remains largely unregulated. It has been to contract in value and volume over the past 18 months, partly due to transparency and quality issues related to the carbon offset projects offered.
Although compliance markets are not unified globally, they are generally less prone to controversy and risk because the rules are better defined. The voluntary market has a greater need for insurance, despite being much smaller in size, says Natalia Dorfman, CEO and co-founder of carbon insurance company Kita.
The types of companies interested in taking out carbon insurance include large companies with ambitious net-zero strategies that anticipate a credit crunch and want to be ahead of the curve, as well as financial institutions investing in projects and specialized carbon players, says Dorfman .
According to Oh at MIGA, innovative insurance products are designed to address the various challenges within carbon offset transactions, from regulatory risks at the project level to market level and country level.
“Insurance products are one of the most effective tools to help limit risks, increase the confidence of investors and buyers in the project, increase the bankability of the projects and contribute to the continuation of activities in the event of adverse events,” adds he added.
More difficult risks
However, there are certain types of risks that will remain difficult to insure even in the long term, experts say.
While insurance against reputational risk in carbon markets is in high demand, Dorfman says, it is not something her company offers. “Once a reputation is damaged, you can’t magically restore it,” she adds.
Kita’s ‘all risks’ policy cover lasts an average of five years and includes protection against natural disasters, fraud and negligence, insolvency, neglect and changing carbon standards. It will also soon launch a political risk solution, intended to insure against potential disruptions at the national level, such as nationalization, civil unrest or breach of contract.
CEO and co-founder of CarbonPool Coenraad Vrolijk applies the golden rule: “If we can’t measure it, we can’t insure it either.” Currently, CarbonPool focuses on insurance that addresses natural disasters, weather impacts and machine failures that result in excess emissions.
Future payouts
Carbon insurance is a relatively new area, the value of which has not yet been tested as no payouts have been made to date. Kita co-founder Tom Merriman told Sustainable Views on the sidelines of London Climate Action Week in June that he expects the first payout to come from insolvency, not wildfire.
In addition, insurers take different approaches to payouts. With MIGA, compensation is always paid in cash, while CarbonPool only plans to provide replacement carbon credits, and Kita offers both solutions for flexibility.
CarbonPool’s founders argue that the rationale behind a carbon credit payout is to maintain alignment with a customer’s net-zero strategy, rather than to compensate them for their failure to achieve it.
However, Oh is skeptical of this approach, saying: “Due to the lack of fungibility between carbon credits and the low liquidity of fungible carbon credits on the market, it is still a challenge to structure an insurance mechanism of in-kind compensation with ‘identical’ or ‘interchangeable’ carbon credits.
CarbonPool believes that as long as the replacement credits are not subject to accumulation risks, where a single event could affect all projects simultaneously, the carbon credit payout is valid.
Due diligence also varies between carbon insurers. Kita carries out a full developer audit check, taking into account a country’s risk profile and potential disputes with local communities, but does not do on-site due diligence. Instead, this often happens because the customer buys the insurance, Dorfman says.
Conversely, CarbonPool generally uses its own team to conduct site visits and ‘sense-check’ local dynamics. However, if a project is very small, it would rely on a third party or satellite imagery.
It’s too early to say whether insurance will ultimately help make carbon markets less prone to controversy and give buyers more certainty, but Dorfman suggests it’s a step in the right direction.
“Insurance cannot stop a scandal, but it can help demonstrate that, as in any market, systems can be put in place to identify and mitigate risk if something goes wrong, if something goes wrong,” she says.
