Moving Beyond the Buffer Pool

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By David Diaz

By their very nature, forest carbon offsets suffer a deficiency shared only by other biological sequestration projects. The inevitability of the biological carbon cycle means that carbon stored in forests is transient. Over time, the risk of stored carbon unexpectedly returning to the atmosphere must be accommodated by these projects in order to maintain parity with offsets from other project types (such as capturing and combusting landfill methane).

In the carbon market, this risk has been a major hurdle to project development, tying up the well-recognized potential for forestry activities to achieve real emissions reductions. But while the so-called “reversal” risks may have originally seemed an unmanageable tangle akin to the mythical Gordian Knot, over recent years, several policy innovations are helping to unravel the mess.

 

How the Snag Turned into a Knot

In younger days of forest offsetting, the Kyoto Protocol’s Clean Development Mechanism took serious compromises to deal with reversal risks.

Apart from restricting the types of forest projects to only those involving new forest planting, the CDM also utilizes temporary offset credits from forest projects. It is currently the only emissions trading program to use this approach. Credits from these projects “expire” after a 20 or 30-year term, and must be replaced with other temporary credits by any buyers using them for compliance purposes.

Although using temporary credits for temporary carbon storage may have seemed like a reasonable compromise at the outset, the effect of this policy choice has been the relegation of forest projects under the Kyoto Protocol to a distant second-tier of emissions credits.

Under this arrangement, the risk of reversal is borne primarily by the buyer, who must replace expiring credits, or the project developer who must submit to regular field verifications. At the same time, the policy also translates in a lower price for credits, cutting down the value of new projects that are often in need of critical financing early on in a project’s life. At the end of the day, these policy choices reflect a clear obstacle to any risk-averse investors.

In the wake of these choices under Kyoto, every forest offset standard to emerge since has sought alternative policies to define and compartmentalize this risk in order to move it further away from buyers and investors.

 

Starting to Untie the Knot

The first major step to untangling this reversal risk began when several US-based offset standards such as the Chicago Climate Exchange (CCX), American Carbon Registry (ACR), Voluntary Carbon Standard (VCS), and Climate Action Reserve (CAR) moved away from temporary credits to employ a buffer pool based on a project-level risk assessment which holds some portion of a project’s credits in reserve to draw from in the event of an unexpected disturbance.

Although this approach represents a clear step towards leveling the playing field between forest-based offsets and other project types, the buffer pool still presents a substantial hurdle for many projects.

Buffer pool withholdings can take up as much as half of a project’s credits. Tying up such large shares of the primary revenue stream for many projects undeniably maintains the comparative disadvantage of forest project developers seeking to attract investors to the project pipeline.

And yet, despite explicit interest from many standards organizations in moving beyond it, the buffer pool nevertheless remains the dominant paradigm for offset standards dealing with forest carbon reversal risks.

That is, perhaps until today.

 

A Strong New Pull on a Loose Thread

This morning, the American Carbon Registry and forest project developers Finite Carbon have announced a milestone in the management of reversal risks for forest projects. In the first step towards private insurance for projects since the advent of the buffer pool, Finite Carbon is unveiling a new “risk mitigation product” that they are hoping will finally overtake the buffer pool as the preferred option for dealing with reversals.

In a nutshell, a new subsidiary of Finite Carbon, the Carbon Reduction Corporation will offer complete coverage for all reversal risks—including so-called “intentional” reversals—to any forest carbon project around the world registered under ACR. This is in contrast to most buffer pool policies which only cover unexpected natural disturbances such as wildfire, pest, or storm damage.

In exchange, project developers have the option of paying for this coverage with credits from their project or with cash.

Scott Nissenbaum, President of Finite Carbon helped explain the new payment scheme with an analogy to life insurance.

“Let’s say the first year premium for life insurance is $1,000 for $100,000 of death benefit. The insurance company needs $100,000 on their balance sheet in case the person dies in the first year,” he says.

“The economics for the insurance company at the beginning are poor,” he continues. “But as the number of people insured grows and the years of premium from each person grows, the economics get better. The same principals apply to the forest carbon market.”

But there’s also an extra silver lining Nissenbaum sees for insuring forest projects. “Fortunately, unlike life insurance, forest projects get less risky as they mature because they have a fewer number of years that a reversal can happen.”

Nissenbaum is still waiting for a longer history of forest projects to feed into a reliable actuarial model to more accurately predict the reversal risks for individual projects. In the meantime, ACR and Finite Carbon came to an understanding that the risk mitigation product should hold a 1:1 reserve for all insured tons. That is, for every ton of offsets covered under this plan, the Carbon Reduction Corporation will hold in reserve a ton from forest or other project types.

 

So What’s the Big Deal?

If you’re scratching your head and wondering how this set of arrangements moves beyond the current buffer pool arrangement, consider a few key distinctions.

ACR’s Chief Technical Officer Nick Martin puts it plainly. “Once the proponent of a forest carbon project decides to use this product, they take all the future unknowns—of the magnitude of reversals as well as of the price of carbon—they take all that out of their project and it turns into a cost they can manage up front.”

Having an agreed-upon dollar value written down on a page at the outset of a project means that project developers can deal with this cost up front if they so choose, an option not available under buffer pools which continue siphoning a portion of credits throughout a project’s lifetime.

This reduced uncertainty may help make the overall risk of investing in a forest project a bit more palatable to cautious investors.

For Martin, who is seeing credits from ACR’s REDD projects at a premium to other project types such as destruction of ozone-depleting substances, this latter option may be particularly valuable for REDD project developers under ACR.

“For REDD Projects in ACR’s pipeline,” Martin predicts, “this product will be really attractive because they tend to be ‘front-loaded’ or deliver a lot of credits up front. They’re also very desirable and therefore higher priced credits in the market.”

“If you find a way for those projects to not take 20-30% of the offsets and put them aside in a buffer,” Martin continues, “it’s going to hopefully drive more registration of REDD projects.”

Ultimately, this product means that REDD projects can free up their entire pool of credits to sell while their offsets can be backed by cheaper (and permanent) tons from other projects.

 

Finally Unbound?

For many standards, the light at the end of the tunnel appears to be an eventual shift towards private insurance policies to handle these risks. The basic belief underlying this movement is that these reversal risks are inherently knowable and manageable, even if we’re not quite there yet.

These first steps being taken by ACR and Finite Carbon represent a watershed in the transference of reversal risk away from the project developer, past the standard organization, and eventually to a private entity.

The Climate Action Reserve, Voluntary Carbon Standard, and Chicago Climate Exchange, all of which have explicitly opened the door to these policies also have yet to find any innovative insurers to take on this risk.

Although Nissenbaum wouldn’t speculate about whether this new risk mitigation product paves the way for more general insurance policies for project investors, buyers, or developers across the project cycle, he remains bullish about their new work.

“We certainly think this is income-positive for the landowner, it makes sense to use it in all situations over the buffer pool,” he said. “It makes it easier to get into a project and we should see more landowners enroll.”



David Diaz is a Forest Carbon Associate with Ecosystem Marketplace. He manages the Forest Carbon Portal, and can be reached at ddiaz@ecosystemmarketplace.com


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