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Integrated North American offset market would be useful, but may not be a realistic prospect yet

Published: June 25, 2014 by Editorial Team

The Climate Trust has the unique position of trying to build offset credit supply as a non-profit organization, and this allows it to take a wide-angled approach to the fragmented North American offset market. caught up with its VP of Business Development, Dick Kempka, to discuss the landscape for offsets in light of recent developments in carbon policy. While California’s rigorous program has plenty of positives, it may restrict its own credit supply, and pose challenges to the integration of parallel offset markets. How would you describe the Climate Trust’s involvement in the carbon market?

Dick Kempka: We’ve been trading carbon probably longer than most in the US, since an Oregon law in 1997 capped carbon dioxide emissions from fossil fuels used by power companies. It gave them a choice between mitigating their own greenhouse gas output, and paying a third party trust to find projects that create emission reductions elsewhere. We are a qualified trust that has actively been finding projects and retiring credits for a long time in a compliance market. Our experience in carbon asset management allows us to identify high-quality projects. We helped develop the Offset Quality Initiative along with some partners in the NGO world, which defined what a high-quality offset is. We’ve worked in the voluntary and now the compliance market for quite a long time, both in building up supply and in sales. We call that carbon asset management.

Typically, we work with developers to find high-quality projects, and then we identify them for a particular program that we think is the best fit. The Oregon program, for example, expanded to Washington as well, while a few other states like Montana and Massachusetts have had mitigation measures where we’ve duplicated the delivery of these systems. We also run the Colorado Carbon Fund, and each of these programs required us to build supply. If you boil it down, we find these projects and we basically either sell their credits or just retire them on behalf of the programs we are entrusted to manage.

We’ve done a lot of consulting work on climate action plans and low-carbon fuel standards, and while we also are a non-profit that would accept foundation grants because of a tax status that would allow us to build new methods for carbon, we have a staff of a dozen, and it has become challenging to be good at a diverse set of roles. We think our new strategy will look to make us more of a Carbon Investment Management Organization (CIMO – similar to a Timber Investment Management Organization, or TIMO), and keep us building supply and trading credits by adding value to offset projects in unique ways.

For example, livestock digester projects usually require the operator to have a bank loan for the digester, possibly worth well over a million dollars. It’s hard to collateralise that asset because you can’t move it, and risk-averse financiers would need to see steady and protracted revenue streams before approving loans. Typically, livestock operators set up power purchase agreements, REC agreements, and carbon credit agreements to support their case. We are able to offer a ten-year revenue stream from the credits that these projects generate. The developer can take this as a guaranteed purchase to the bank. There may be others with equity backing who would do this for three- or five year periods, but I think we are unique in offering this guarantee for ten years.

Another example would be how we help with the management of risk in the compliance market, where you have to be willing and able to replace your tons or to provide the cash to do the same. The agreements written in the compliance market basically pass on the burden to the owner of the credit (i.e. the landowner), and we have ways to help mitigate that with our pool of credits. We try to clarify the risk early on in the project’s development, so that when we get to the ERPA stage, operators are aware of these risks. How integral is carbon trading to what you describe as carbon asset management? Would you call your approach unique?

DK: Our programmatic needs mean we do conduct late-stage transactions to obtain credits for retirement, but we are increasingly looking to a ‘fund model’. We get involved more in the early stages, then take a percentage fee or a percentage of the credits, which some of the others in the market are also doing. Furthermore, if a landowner has their own foresters and staff do the work involved in a project, they may also just pay us as a consultant to help them, while they retain control of the credits. Some aren’t comfortable with the models used by other firms, which involve ceding control of the credits. We have some flexibility and haven’t settled yet on any one term structure, just because we have a unique need in the way of our own programs which we need to retire credits for.

I think we will continue to be unique, because of the need to provide credits for our programs. Anyone in the market now has to have the view that the market will grow in the future. If prices are going to rise in the future it’s that early-stage stake in the fund that will deliver benefit. We see this as a situation in which we can gain returns on funds we input now, and channel these returns into furthering our climate goals in the future. Because we are not a private fund, my sense is that our return-on-investment hurdles will not be as steep, and we will be able to do many more project types that our competitors may not be able to. While our competitors are solely focused on the compliance market, we do voluntary projects (VCS, ACR, CAR or our projects) as well and thus have a unique position in the market.

Our approach is to focus on land-based offsets, so agriculture (including livestock methane) and forestry types are our bailiwick. We also have new methods in agricultural nutrient management and wetlands management, and pilots in avoided grassland conversion and a new biochar method. We’re trying to pick ‘winners’ that are going to be scalable and to contribute great volume to the voluntary and compliance markets.

What sets us apart from everyone else is this fund-based model that is not singularly focused on the California market. How does your status as a non-profit influence your approach to trading?

DK: I’ve worked in the non-profit NGO sector for many years, and I think one of the misconceptions with NGOs is that you can’t make money. I want to make sure I put this the right way, but you can make money on projects as long as it goes back into your conservation mission. Although we don’t make profits, we try to build funds that go into more emission reduction projects. Being a not-for-profit, we don’t try to make the large twenty-to-thirty percent margins over the life of the fund that the private sector players typically demand. We’re a bit different because we don’t have such a high hurdle. We do try to operate as a business – all successful NGOs do. So we apply business practices, including covering our costs for all projects, and any additional dollars are put right back into our mission. As a sustainable business, we can be good partners to everyone from the oil and gas sector to the other NGOs that we work with. How has participation in California’s offset market affected your strategy?

DK: California’s offset program is one that is managed super-cautiously. This has an upside of making sure the offsets are of a very high quality. The downside is that there are not a lot of offset types allowable, while a lot of projects are kept from hitting the market. Our view is shaped by our climate mission, and we have refocused our strategy to be a CIMO (Carbon Investment Management Organization), similar to what a TIMO (Timber Investment Management Organization) is.

Our focus now is to build supply for the market from high-quality projects. We view the downturn in the market, or the lack of price growth in the last couple of years, as a positive thing for our business, as it gives us the ability to find projects now to supply quality offsets in the future. To be effective, this model requires the price of carbon to go up at some point. From a supply perspective, we really like what California has done, because it allows us to build supply while there is some uncertainty in the market.

Besides our projects, we also work with covered entities on procurement, and from the sales side it has been discouraging to see prices go from nearly $11 down to the $8s. We would love to see that go up steadily and constantly to a point where we can bring many more project types in. Even so, because our modus operandi is to build early-stage projects and look at new project types that are going to fit in the market, we are not overly discouraged by that right now. A rigorous program has many benefits. Is there also a flipside? 

DK: Absolutely yes, no doubt about it. I think the long engagement period for forestry projects is a heavy hurdle for many forest owners at the price that carbon is nowat. I’ve just been to a Forest Landowners Association meeting in New Orleans, where I met a lot of folks who are very aware of what went on with the Chicago Climate Exchange, and have a very negative opinion of the carbon market. Many don’t know the California program in depth, because they have totally written off carbon.

The next step for many of these landowners would be to look at projections of carbon and timber prices, and see where those lines are expected to cross. It is challenging for them to get into the market when they know they will have to tie up their land for a hundred years, and write off the other benefits they gain from a timber sale, in order to make the carbon project work.

For several project types in California’s market, including livestock and forestry, the cost and rigor of verification, and the lack of qualified verifiers, can inherently drive prices up. There is not much expertise in this area, and service providers aren’t showing too much interest. Even though it appears the market eventually will be a big one, not many are prepared to design a business model around that right now.

While rigor on one hand is a strength (just think of the many groups, including NGOs, out there that don’t like emissions trading), I think there is also a weakness because it drives up the cost of carbon to the point people question whether it will ever be viable to do these projects. If we knew the price of carbon was going to rise to $15 or $20, there would be a lot more people jumping into this, so we have really just scratched the surface of the market.

Uncertainties in livestock methane over eligible feedstocks and possible state regulation of the industry have recently also created a lot of apprehension. So we like the rigor of the methods, but in some cases this rigor combined with policy uncertainties just hampers the development of the offset market. How do you see EPA’s Clean Power Plan influencing the offset market?

DK: A lot of this is still unsettled; we’ve spent a lot of time reviewing the 111 (d) language, and we understand the emphasis is on reducing the use of power. Our understanding is that EPA is not sanctioning the use of offsets, but we hope they might be allowable once the power issue is addressed, and we believe there is room for offsets in cap and trade in all of these states. I may not entirely understand how it will work in

California where there is an existing program that is larger than just the power sector, but certainly in Washington and Oregon we feel there is an opportunity for offsets to be part of the holistic solution. We are of course a proponent of that, but it’s a very complex issue and it will take time for clarity to emerge on possible solutions. We’re certainly trying very hard to promote the use of cap and trade and the use of offsets as a cost containment mechanism. Allowing offsets for 111 (d) compliance would greatly enlarge the offset market in the US. Do you see greater integration across the North American offset markets as a good thing, or are there more benefits to fragmentation?

DK: While we assume the market is going to remain fragmented, I think anything that would allow the growth and development of more offset projects in an integrated system would be useful. So much time and energy goes into developing project types, for instance, so if we have a way to share particular project types between states, it would mean less development costs and expanded offset volumes. A huge amount of time went into the development of project types currently approved in California, and we should benefit from those by applying them to other states.

We run the risk of parochialism if we develop programs state-by-state, each of which gives preference to types that they can themselves implement locally. In California we see forestry and rice cultivation for instance, while other states may have other project types, like mine methane, that they will push more than others. We aren’t sure how we’re going to get over that parochialism, but we would love to see Washington and Oregon implement a system that can be integrated for offset transactions throughout the old WCI. We think it would be a good solution. Is it realistic? I don’t know. Differences in state regulations and laws may make it difficult to define protocols that keep projects additional in several jurisdictions…

DK: I think it’s going to be cumbersome because each state has a different way of viewing and regulating each industry. It will be challenging to navigate those in an efficient manner and effectively build supply. While applying a project type in multiple states would increase supply and be good for the market, I think the process is likely to be cumbersome. The sheer amount of bureaucracy and technical expertise that will be involved is the scary part of the state-by-state approach. Given that you aren’t heavily involved in ODS projects, how firmly has the Clean Harbors affair been on your radar?

DK: At least in our view, those involved in land-based offsets haven’t really had it that firmly on their radars. The fact that I’m not really aware of it perhaps is indicative. Because we work less closely with ODS, we have largely not been tracking that issue. Among the developers that I’ve talked to, no one has really mentioned this issue as something which could also happen to a forestry project.

In a nutshell, our view would be that forest conservation practices have been established for over a hundred years. Everything about the process is known, well-vetted, and tied to Forest Stewardship Council standards and sustainability goals. Projects involving the destruction of GHGs, because they are new, may have implications that we don’t know about. We think there are fewer issues that could emerge from forestry, than there might be when dealing with industrial or hazardous waste. We hope this makes forestry look all that much better.