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August 19, 2022

Carbon offsets: Companies not prepared for high prices

Corporates and investors seem to be underestimating the risks of an expected shorter supply and sharp rise in the cost of quality carbon offsets.

By Elizabeth Meager

California burning: wildfires are just one of the growing risks to carbon offset markets. (Photo by Erin Donalson via iStock/Getty Images)
  • New initiatives, such as a set of principles addressing points of contention, are expected to help build confidence in voluntary carbon markets…
  • …and in turn they are seen as likely to drive improvements in the quality of carbon offsets and push up the price of carbon credits.
  • The voluntary carbon market presents big risks and opportunities that most corporates and investors are not properly considering, say market advisers.

This year’s summer has brought unprecedented heat to Europe, with devastating consequences both for the planet and companies’ decarbonisation plans.

In late July, a reforestation firm working for carbon-offsetting company Land Life accidentally caused a 14,000-hectare forest fire in northern Spain. The affected trees had not yet generated any carbon credits, but the incident served another stark warning – with a side of bitter irony – to the offsetting community. Similar events abound in wildfire-prone California.

Over the past decade, corporate buying of carbon offsets to help achieve their emission-reduction goals has grown exponentially in popularity, as environmental concerns become an ever more important component of a company’s social licence to operate. The offset market has quadrupled in size since 2020 to $2bn last year. The most ambitious estimates suggest it could hit $180bn by 2030.

Yet various issues have plagued the market throughout its short life. The growing incidence of natural catastrophes is just another to add to the list, which also includes companies relying on offsets to achieve net-zero plans at the expense of actually cutting emissions, and scepticism over the quality of credits and whether they are achieving what they claim to. That’s not to mention another key obstacle: the lack of a widely agreed carbon price.

carbon offsets
Benedikt von Butler of Evolution Environmental Asset Management says corporates and investors plan to rely on carbon credits in the future with no idea of how much they will cost. (Photo courtesy of Evolution Environmental)

Whether carbon offset markets end up being regulated or simply facing greater scrutiny from investors, the price of carbon credits is widely expected to rise as demand grows for quality offsets. That would pose risks for which many corporates and investors are badly underprepared, say market experts.

“Companies are setting all these net-zero targets today – many heavily reliant on offsets to cover their last-mile emissions, with no idea how much a carbon credit will cost in the future and how many they’ll need,” says Benedikt von Butler, a Berlin-based portfolio manager at Evolution Environmental Asset Management and 20-year carbon markets veteran. “That’s a huge financial risk that isn’t being managed.”

New carbon market initiatives

Yet the offset market needs to build credibility to attract the huge volume of institutional capital needed. Offset volumes will need to grow fifty-fold from its 2020 size of 210 tonnes if 2050 net-zero targets are to be met, wrote Bank of America analysts in an October 2021 research note.

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There are two initiatives under way seeking to boost market confidence and credibility and drive volumes.

For instance, the Core Carbon Principles (CCPs) were published on 27 July by the Integrity Council for the Voluntary Carbon Market (ICVCM), a body created following the 2020 launch of the Mark Carney-driven Taskforce on Scaling Voluntary Carbon Markets. Each of the ten principles, which seek to define what makes for a good-quality carbon offset, address a different controversy, such as additionality, permanence, programme governance or third-party validation.

Chris Leeds, head of carbon markets development at Standard Chartered in London and an elected market representative of the ICVCM, says: “We acknowledge there are limitations within the market and areas that need to be improved, mainly to make credits from different sources more comparable.”

The CCPs are ambitious, forward-looking and intended to signal where the market would like to go rather than to assess the quality of existing carbon credit projects, Leeds adds.

Another venture, separate from the ICVCM, is the Voluntary Carbon Markets Integrity Initiative (VCMI), which launched its integrity code on 8 June. The VCMI encourages responsible corporate use of offsets, such as aligning decarbonisation targets with the Science-Based Targets initiative and having claims verified by an independent third party.

Unanticipated risk

Standards such as these are needed, but over time they will result in a smaller supply of good-quality offsets, thereby pushing up prices, say market participants. Most companies and investors are not adequately prepared for this development, Von Butler says.

The average offset price in 2020 was just $2.50 – which is widely seen as far too low – but by 2030 it could be between $11 and $215 depending on the policy scenario, according to modelling published in January by BloombergNEF (see chart).

“No matter the scenario, corporations and other entities looking to buy carbon offsets shouldn’t expect them to be a get-out-of-jail-free card for much longer,” Kyle Harrison, BloombergNEF’s head of sustainability research, said at the time.

Firms that have not taken the future cost of offsets seriously will face major challenges, Von Butler says. “Companies are going to have to either push their target back a few years, compromise on quality, or just say ‘sorry, we didn’t manage it’, which is reputational suicide.”  

One Malaysian infrastructure company working to implement a responsible business framework is very conscious of the challenges. An executive working on the process says her firm is still in the early stages of establishing its emissions baseline and transition pathway.

The company has not yet given serious thought to how it will use carbon offsets, she adds. “There isn’t a market for us to even go and acquire the credits yet, let alone know how we want to use offsets.

“It will require a lot of early planning and financial resources, and it’s hard to get that commitment today because it’s so far in the future,” the executive says. “It needs to be mainstreamed as a strategic initiative. Right now there isn’t a concerted effort on that.”

Investors unprepared for carbon offsets

Most investors are not taking carbon market risk into account either, Von Butler adds. “Many investors we meet come into the meeting thinking an offset is just a nice forestry project in Brazil that you pay for out of your marketing budget. They leave realising this is much bigger than they thought – and all of them want a second meeting within a few weeks.

“Over the next five years net-zero targets are no longer going to be a ‘nice to have’,” Von Butler says. “Governments, regulators, investors and consumers are demanding it. This needs to be moved out of the marketing department budget and considered a real financial liability, which eventually needs to be hedged like any other commodity exposure.”

Some investors clearly have not thought in any great depth about the risks that carbon pricing poses to their portfolio, agrees Joel Krueger, adviser to London-based carbon finance firm Respira. On the other hand, some “see carbon pricing as critical to both their role as fiduciaries and managing their own balance sheets”.

Krueger is also global chief investment officer for insurance at consultancy Aon, but has recused himself from client discussions involving carbon credits and net zero because of his work for Respira.

Carbon market convergence?

All this being said, some market participants point out that the voluntary carbon markets would not be needed if there were a global compliance market, such as the EU’s emissions trading system (ETS). The voluntary market is a response to a need that has not been fulfilled by governments for various reasons – even though investors, pushing for more policy certainty, have long called for it.

As the voluntary carbon market matures, there is likely to be increasing convergence between it and the regulated markets, says Krueger.

The big corporate polluters subject to the regulated carbon markets will be very interested in a convergence that would put more tools, such as credits bought on compliance markets and offsets, in their arsenal to satisfy regulatory requirements, Krueger says. Initiatives like the CCPs and the VCMI may be a stepping stone in that direction, he adds.

The ICVCM certainly hopes regulators will be comfortable endorsing – or at least voicing support for – the principles.

“People forget that the desire to buy carbon credits is largely voluntary,” says Leeds. “And if you criticise people for doing something, then they start to think maybe they’re better off doing nothing, and that would be a real shame – and a serious own goal for the environmental movement.”

And if corporates and investors get involved in the voluntary carbon markets now, they will be better prepared in the likely event of a mandatory regime eventually being rolled out.

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