Improving climate outcomes through environmental commodities trading

March 20, 2023

Environmental commodities are environmental instruments that can be traded on markets and used to generate environmental, social, and economic benefits. Various types of environmental instruments exist today, including emissions allowances, carbon offsets and credits, or renewable energy certificates (RECs). These instruments are used to reduce environmental impact and generate environmental, social and economic benefits. In this briefing paper, we review key aspects.

Environmental commodities are produced either by governments for use in meeting particular environmental objectives (i.e., reducing greenhouse gas emissions or controlling emissions that contribute to acid rain or ground-level ozone), or by companies engaging in a specific economic activity (i.e., taking action to emit fewer greenhouse gases or generating electricity from a renewable energy facility). Implied in the act of production of environmental commodities is the need by another party to consume it.

Generally speaking, emissions allowances are environmental instruments that set limits on the amount of a pollutant an entity can emit over a specified period. Carbon credits refer to environmental commodities used in carbon trading for pollution reduction activities that meet certain standards, such as reducing greenhouse gas emissions through clean energy projects. RECs are environmental commodities representing one megawatt-hour (MWh) of electricity generated from renewable energy sources like wind or solar power.

Given their environmental benefits and potential for economic growth, environmental commodities have become an important tool to help governments meet environmental objectives, spur investment from private companies in green technologies, and support renewable energy development. At the same time, there are also risks associated with environmental commodities that must be taken into consideration before investing in them. These include regulatory risk (the risk of new regulations or changes to existing ones) as well as market risk (the risk that demand for environmental commodities will decrease due to decreased government incentives). Additionally, there is a lack of transparency around some environmental commodity markets, which can lead to uncertainty on pricing and outcomes.

Types of environmental commodities

Carbon transactions

Carbon allowances and carbon offset credits are tradable financial instruments that create a market for carbon dioxide emissions reductions. Carbon allowances are government-issued permits that grant the right to emit a certain amount of carbon dioxide. Issued exclusively by government bodies, they authorize an entity to emit one ton of greenhouse gas. The creation, distribution (whether by auction or allocation), ownership and transfer of allowances all takes place on electronic registries operated either by government entities or their private contractors. Failing to provide allowances may subject an entity to penalties.

The other type of carbon-related transaction is the creation and trading of GHG emission reduction offset credits. Offset credits are created when an entity that is not subject to a compliance obligation under a GHG regulation reduces its emissions voluntarily. A common example of a GHG offset project is the destruction of the potent greenhouse gas methane from landfills by flaring it or using it in a turbine to generate electricity.

There are several organizations and programs that sponsor protocols, methodologies and registries under which these GHG reductions can be verified by third parties and electronically issued, including the Climate Action Reserve, Verra and the American Carbon Registry.

Once issued, these tons are generically known as "verified" or "voluntary emission reductions" ("VERs") or simply "offsets," though each organization also has specific terms for their unique brand of VER, including "climate reserve tonne," "verified carbon unit," and "emission reduction ton." Each represent a verified form of voluntary emission reduction equal to one ton of carbon dioxide-equivalent. Each of these voluntary registries also allows for the physical transfer of VERs between two parties.

The terms "primary" and "secondary" are often applied to carbon offset credits. Primary VERs or offsets refer to their creation and initial issuance from a project. Secondary VERs or offsets refer to the credits once they have been issued and are easily transferable. Secondary credits tend to trade at a premium to primary ones, all other things being equal, because primary units carry project, issuance, credit and greater change in law risk. Once the credits have been issued, they carry fewer of these risks, and buyers are willing to pay a higher price for the greater certainty of an issued credit.

Renewable energy certificates (RECs)

RECs are tradable environmental commodities that allow consumers to purchase environmental benefits from renewable energy sources such as solar or wind power. Generally speaking, RECs reflect the environmental attributes or "solarness" of the power that the solar project generates and are verified in conjunction with meters or other mechanisms by which the power is measured. One REC represents proof that one MWh of electricity was generated from an eligible renewable energy resource and delivered to the grid.

In a typical transaction, the owner of a photovoltaic solar project will be issued a REC for each MWh of power that the solar project generates. In advance of construction, the project developer will often seek to enter into a long-term agreement with a purchaser of the solar project's RECs. The purchaser in this forward agreement agrees in advance to purchase all the RECs that are generated by the project for an agreed-upon price per REC. Every month after the power has been generated, RECs will be deposited into the project owner's electronic registry account, which are then transferred into the purchaser's registry account. Payment for the RECs will then be made within an agreed upon number of business days.

Biodiversity certificates

Biodiversity certificates are environmental commodities that allow companies to offset environmental damage caused by activities such as construction and logging, or to protect an area of high environmental value from damage. Certificates are typically issued for a specific project or conservation effort, such as restoring a wetland or establishing a wildlife refuge. Each certificate represents the environmental benefits associated with the project – usually in terms of carbon dioxide saved or habitat protected.

Benefits and risk management

Environmental commodities provide environmental and economic benefits. The use of environmental commodities helps to reduce the price of environmental compliance and encourages environmental improvements. They have helped to create markets that allow entities to meet their environmental obligations in a cost-effective manner, while allowing them to take advantage of available opportunities for environmental improvement.

In addition, environmental commodities have helped provide an incentive for entities to engage in environmentally beneficial activities such as GHG reduction projects or renewable energy generation. This allows entities to monetize their environmental efforts and also helps facilitate investments into green technologies which may otherwise not be economically viable.

Despite many benefits, environmental commodities come with certain risks. These include credit risk which refers to the potential for an environmental project or entity to fail to deliver environmental benefits or to transfer environmental commodities as agreed. In addition, environmental commodity prices can also be volatile due to changes in environmental regulations and market conditions. Lastly, environmental commodity projects may be subject to environmental risks such as extreme weather events or other unforeseen circumstances which could reduce their environmental benefit potential.

Regulations governing environmental commodities in the US and EU

Individual state environmental agencies are empowered to legislate programs on environmental commodities. Generally, environmental commodities must be tracked and reported in accordance with applicable environmental laws and regulations. In addition, environmental commodity transactions often require the prior approval of state environmental regulators. U.S. regional trading programs such as the Regional Greenhouse Gas Initiative (RGGI) in the Northeast and the California Cap and Trade Program have also been established to facilitate environmental commodity trading.

In the European Union, environmental commodity trading is subject to emissions trading schemes such as the EU Emissions Trading System (EU ETS). The ETS program establishes a GHG “cap and trade” system for certain industry sectors, including power generation at some offshore facilities. Total GHG from these sectors is capped, and the cap is reduced over time to achieve GHG reductions from these sectors. In September 2020, the European Commission presented a plan to increase the EU’s GHG reduction target to at least 55% by 2030 in accordance with the European Green Deal. In order to reach this goal, the European Commission has proposed potential revisions and expansions of the EU ETS. One development in this respect is the proposal to set up a European Carbon Border Adjustment Mechanism.

With respect to biodiversity, France recently launched the Organization for Biodiversity Certificates, which seeks develop a methodological framework for the development of an equitable and operational financing mechanism to support the preservation, restoration and sustainable use of ecosystems. A public consultation was open until January 2023.

Looking ahead

Further environmental commodity developments will continue to unfold in the United States, Europe and other jurisdictions, with potential new environmental commodity policies being discussed such as carbon border adjustment mechanisms. With an understanding of environmental commodities and related regulations, entities can take advantage of these markets and help reduce global GHG emissions.

CPM