A Game Plan for Funding Carbon Offsets

A Game Plan for Funding Carbon Offsets

Illustration: Edmon de Haro; Baloncici/Getty Images (chimney); Vitalina/Getty Images (butterflies)

In September 2015, a curator from Yale’s Beinecke Rare Book and Manuscript Library traveled to Amsterdam to collect the previous 12 years’ worth of interest on a bond issued on May 15, 1648. At the bond’s issuance, the borrower, an autonomous Dutch water authority, had promised to pay the holder interest in perpetuity. Cash from sale of the bond had been used to pay for an infrastructure project that protected against rising sea levels.

Such perpetual bonds may prove useful in today’s fight against climate change by enabling the funding of projects that will remove and store carbon indefinitely. Carbon removals can be used to offset carbon-emissions liabilities (or E-liabilities), thereby helping businesses and other organizations achieve net-zero goals. Perpetual bonds can also support the development of efficient spot markets in removal offsets, spurring both their production and their use.

Perpetual bonds help resolve a key mismatch between the duration of many carbon offsets and the duration of the E-liabilities they are to be netted against. As we note in our July-August HBR print article, “Accounting for Carbon Offsets,” E-liabilities from greenhouse gas emissions pose a particular challenge to financial markets since emissions produced today are expected to linger in the atmosphere for more than 1,000 years, a duration far longer than typical financial liabilities. Given that, we establish the need for offsetable carbon-emission assets (E-assets) to also have indefinite duration.

Certain E-assets such as carbon capture and storage via subterranean mineralization explicitly meet this criterion, but such E-assets are currently uncommon. Far more widespread today are nature-based offsets (NBOs) such as virgin forestation programs, which typically have shorter durations stemming from the finite (unreplenished) lifetime of forests (potentially less than 100 years). At issue, then, is whether NBOs can be used to net E-liabilities: if they cannot, then most removal offsets being supplied today are only down-payments against long-term emissions liabilities.

For NBOs to have indefinite duration, the issuer must commit to managing the underlying (forest) asset in perpetuity — that is, replanting the forest as its constituent trees naturally decay or are destroyed by disease, fire, etc. To finance this operation, the offset provider needs capital not only to buy the land and plant trees but also to provide for predictable outlays in perpetuity. In other words, they must invest part of any capital raised in an endowment fund, the returns on which can go towards financing the management of the forest so that the carbon remains sequestered indefinitely (defined as, say, 1,000 years, a reasonable scientific estimate of how long carbon emitted today will stay in the atmosphere).

Moreover, given the indefinite commitment, an issuer wanting to qualify some fraction of its presently delivered (or “earned”) removal offsets as being immediately and fully nettable against the purchaser’s E-liabilities will have to set aside a separate (significantly larger) fraction of its available earned offsets against future commitments to sequester carbon.

All this implies that providers of capital to producers of NBO offsets can expect relatively low returns on their investments, albeit distributed in perpetuity. Individual offset buyers (usually for-profit businesses) will not find it attractive to tie up their own capital in this way. But such an investment might well be attractive to institutions that require endowments to cover predictable liabilities far into the future, such as universities and churches. The investment would take the form of a perpetual bond — such as that issued by the Dutch water authority — or of preferred equity with a fixed dividend. Ordinary equity is likely not suitable to finance indefinite-duration removal offsets since investors usually want a guaranteed return for tying up capital in perpetuity with limited upside.

Consider, as a hypothetical example of how a perpetual bond approach can work, an indigenous tribe in Canada that wants to sell nettable E-assets from a virgin forest that it will plant on its land and manage indefinitely. To do so, it must raise capital to develop and maintain the forest. The tribe can issue a perpetual bond and place some of the capital in an everlasting financial endowment. The tribe uses the interest from the endowment to pay for the costs of managing the forest. As offsets from the forest become “earned” — that is, trees mature and sequester carbon — the tribe can sell some portion of these E-assets to pay for expenses, including the interest on the perpetual bond.

Let’s assume that 20 megatons of CO2 equivalent (MtCO2e) of offsets from the forest’s current trees is “captured” this year and will be so for the next 100 years, but the trees will then have to be replanted at least 10 more times to be nettable against a 1,000-year E-liability. To distribute the risks of this commitment, the tribe can sell 2 MtCO2e of this year’s offset as “earned” in perpetuity (i.e., 20 Mt divided by 10).

If there are enough producers of NBO offsets and enough demand for them, the nettable offsets can be sold into a liquid market, which distributes the future risks of the forest across a range of offset purchasers and helps the tribe to meet its interest obligations. Next year’s spot buyers may be different from this year’s, and, indeed, spot buyers hundreds of years thence likely will be very different, but collectively, through contributing to the perpetual bond’s interest costs, they share in the long time-series risks of NBOs. The scheme is profitable for the tribe as long as the proceeds from spot sales of nettable offsets and from endowment returns exceed the bond’s interest expenses and the ongoing forest-management costs.

Very likely, no one 375 years ago expected the Dutch seawall-management bonds would make interest payments in the present day to a New England university library 3,500 miles away. Likewise, we cannot predict how financial markets will develop to meet the needs of emissions liability management. But the pathway set out here suggests a feasible market solution to mitigate the long-term consequences from today’s carbon emissions.