Carbon Credits and the Risk of Non-Permanence
Carbon credits are exposed to an alarming number of risks, many of which I detailed in my last article. Most fall into two chief categories: reversal and invalidation. Underpinning reversal, in particular, is the market-critical concept of permanence. In other words, how long will the carbon removed or avoided be kept out of the atmosphere?Reversal occurs when the carbon associated with a project is released back into the atmosphere. This happens if a project is destroyed by a flood, fire, storm, drought, or other catastrophic natural event. Alternatively, it might be decimated by human activities such as illegal logging or poor forestry management. If a project goes up in flames, so too does the value of its associated carbon credits.
Reversal is a growing risk because climate change has exacerbated the frequency, length, and severity of catastrophe events.
In geological terms, carbon released into the atmosphere today can remain there for hundreds to thousands of years and can have effects that extend to geologic time scales . Thus, the durability of carbon stored in carbon pools is a crucial dimension to consider when evaluating the efficacy of carbon credits . The definition of “permanent” has been the subject of great debate. Today, for practicality, high-quality projects use a 100-year removal or avoidance benchmark to brand themselves as permanent. Similarly, the California Air Resources Board, responsible for implementing the state’s primary climate law (Assembly Bill 32, Senate Bill 32), has the same 100-year minimum storage requirement.
Though every carbon credit is at risk of impermanence, the degree of exposure depends on the underlying project. Enhanced rock weathering projects, for example, have a lower risk of reversal than deferred timber harvesting. If the developer of the former were to go out of business, there would be no bearing on previously issued credits. If the developer of the latter were to use their land for another purpose, on the other hand, existing credits would be deemed impermanent.
What Are Buffer Pools?
To mitigate reversal risk, registries and some developers allocate a percentage — normally 10-20% — of certified credits to a central buffer pool. Buffer pool contributions are often a mandatory step of the registration process. Unlike regular credits, buffer pool credits cannot be sold in the voluntary carbon market (VCM). Instead, the diversified pool of credits is earmarked to replace issued credits in the event of reversal. In short, the total number of credits the project is permitted to sell is equal to the net emissions avoidance or removals minus the buffer pool contributions. Buffer credits can be canceled from the pool if a “reversal” covered by the registry’s mandate takes place, with the goal of ensuring the integrity of any previously issued credits. Depending on the registry requirements, buffer contributions may be either standardized or adjusted to the particular risk of the underlying project. As of May 2023, Verra’s Verified Carbon Standard (VCS ) program has nearly 70.5 million credits available in its buffer pool, representing 6.3% of the 1.1 billion credits issued.Recent Research on Buffer Pools
Despite a paucity of research on the efficacy of buffer pools, recent articles and reports paint an alarming picture. A recent peer-reviewed article by CarbonPlan, the National Center for Atmospheric Research, and the Institute for Carbon Removal Law and Policy found that within the first 10 years of California’s carbon offset program, estimated carbon losses from wildfires have depleted at least 95% of the buffer pool contributions set aside to protect against project-specific risks over a 100-year period. Another article finds that the 2020 Lionshead Fire in Oregon, for example, eroded 4-11% of the total buffer pool of California’s carbon market. Other catastrophe risks, such as diseases and insects, further threaten the buffer pool. Moreover, the authors remark that they could find no sound scientific analysis that justifies buffer pool risk reversal ratings and credit contributions. Equally, journalists interviewing policymakers who designed the buffer pools concluded that they are based on educated guesswork and meant to be reasonable, not precise (Pontecorvo and Osaka, 2021). While the study is limited exclusively to the California program, findings brought into question the efficacy of buffer pools as a long-term risk mitigation mechanism. In the case of REDD+ projects, a number of papers have questioned whether the baseline scenarios against which credits are issued represent credible counterfactuals . Registries will only draw from their buffer pool if there is a new loss that exceeds the emissions in the baseline scenario. If the baseline is inflated, significant losses can go unaccounted for and undermine the credibility of the VCM as a whole. In short, buffer pool losses will only be accounted for appropriately if the baseline is not inflated. Finally, because not all carbon credits are created equal, buffer credits from low-quality projects can be used to replace credits from high-quality projects. A recent report by Sylvera found that 25% of their rated REDD+ projects fall into their lowest rating category (Tier 3). This indicates that credits generated by these projects have a very low probability of leading to one metric ton of GHG avoidance.The Five Shortcomings of Buffer Pools
Buffer pools were designed to mitigate reversal risks of carbon projects, but we believe they are an inadequate risk mitigation mechanism. Notwithstanding the studies cited above, there is a paucity of actuarial analyses of buffer risks. This is particularly urgent in the case of credits generated from nature-based solutions, as the underlying projects are inherently susceptible to non-permanence risks, such as catastrophe events, land-right disputes, or illegal logging.| Registry | Buffer Pool Contribution Rule | Insurance substitute |
| Verra VCS | Contribution based on project specific risk-assessment and minimum buffer percentage required. | No |
| Gold Standard | Contribution fixed at 20%. | No |
| American Carbon Registry | Contribution based on project specific risk-assessment and minimum buffer percentage required. | Insurance listed as a potential substitute to buffer pool contributions, application onus falls on project developer. |
| Climate Action Reserve | Default risk rating (except if underlying project is located in US public or tribal lands). | No |
| Puro | No buffer pool contribution. | No |
- Risk assessments vary across registries, so buffer pool contributions do not match the risk profile of the project. A recent report by BeZero found a significant gap in buffer pool contribution disclosures. The report notes“only seven of the 36 largest nature-based projects by credits outstanding disclose a non-permanence risk assessment or any justification for their buffer pool contribution.” The report also found a high level of heterogeneity across registries. While non-permanence risk assessments are required by Verra and ACR, only 56% and 13% of projects outline their non-permanence risk assessment respectively. No projects registered by Climate Action Reserve disclose their risk buffer assessment. Finally, Gold Standard’s documentation does not disclose the actuarial rationale behind their 20% contribution. Thus, there is little transparency about how buffer pools are used in the case of reversals, while risk assessments are unclear from public disclosures.
- Buffer pools often only cover unavoidable losses (i.e. catastrophe risks) but this is only one of many risks to which a project is exposed. (For a more in-depth discussion, see my previous article.) These contributions are also not adaptive as climate change intensifies. Data collected by the Institute for Economics and Peace shows an increase in global weather incidents from 39 in 1960 to 396 in 2019.
- From a financial perspective, buffer pools are an inefficient way to mitigate risk as credits are held in kind for the entire period over which they might be subject to reversal risks. Buffer pool credits become a growing liability over time and, unlike insurance premia, cannot be reinvested. This is particularly concerning as carbon credit projects have very long tail risks.
- From a governance perspective, a conflict of interest arises when a registry simultaneously dictates standards and manages the buffer pool. This creates a structural disincentive to develop more stringent standards for registration because, over time, it could increase the burn rate of the buffer pool. In every other developed financial market, these two functions lie with distinct bodies, with independent decision-making processes to guarantee greater integrity.
Drawbacks Are Solved by Insurance
The fact of the matter is that the VCM, like any other developed financial market, requires risk-mitigation mechanisms. Only by addressing reversal risks can participants secure buyer confidence and market integrity. Unfortunately, however, buffer pools are a poor risk mitigation mechanism: the VCM equivalent of a band-aid slapped over a leaking tank. Fortunately, it is not the only solution. Insurance can play a critical role in securitizing and unlocking finance for carbon credits. Unlike buffer pools, sophisticated insurance products are backed by actuarially sound models. They can be used to not only better evaluate and protect buyers against reversal risk, but also, in so doing, incentivize developers to create high-quality projects. If you have followed my articles to date, you will know why insurance and carbon credits have such an important part to play in the fight against climate change, respectively, as well as the key risks to which carbon credits are exposed. Here, I have examined the main defense against said risks and the flaws therein.What’s next?
In my upcoming whitepaper, I will address the final piece of this puzzle: How will insurance provide the risk transference required to evolve the market?
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