Harsh Sanghvi and Sean Locke discuss the inner workings of the rapidly expanding carbon market.
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Cutting emissions to limit the effects of climate change demands a complete transformation in how we produce, consume, and move around – and the financial markets have the potential to be an essential driver of global economic decarbonization by putting a price on carbon and providing an incentive to reduce emissions.
In this two-part episode of Market Points, Harsh Sanghvi, Director, Commodities and ESG Risk Management, and Sean Locke, Associate, Sustainable Finance at Scotiabank discuss the inner workings of the rapidly expanding carbon market, from the way credits and offsets work, to emerging trends and opportunities for businesses and investors in this new economic era of sustainability.
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Announcer: You’re listening to the Scotiabank Market Points podcast. Market Points is part of the Knowledge Capital Series, designed to provide you with timely insights from Scotiabank Global Banking and Markets’ leaders and experts. Cutting emissions to limit the effects of climate change demands a complete transformation in how we produce, consume, and move around. And the financial markets have the potential to be an essential driver of global economic decarbonization by putting a price on carbon and providing an incentive to reduce emissions.
This episode of Market Points is the first of two parts. You’ll hear the first half of a discussion between Harsh Sanghvi, Director, Commodities and ESG Risk Management, and Sean Locke, Associate, Sustainable Finance at Scotiabank. They’ll discuss the inner workings of the rapidly expanding carbon market, from the way credits and offsets work, to emerging trends and opportunities for businesses and investors in this new economic era of sustainability.
Let’s get started. Here’s Sean Locke.
Sean Locke (SL): So, we’ve seen a lot of growth in the carbon markets and with you sitting in your seat as a commodities trader, I’m really interested to hear how you’re seeing this market grow and develop.
Harsh Sanghvi (HS): I mean it’s been exponential, Sean. Just look at the numbers. Last year, the value of the global voluntary carbon market topped a billion dollars. The all-time value now sits roughly about $6.5 billion dollars. When we look at what’s happening in the renewable credit space, the issuances have almost doubled during the pandemic era. Look at the price of most traded environmental markets as well, all of them have steadily increased over the last couple of years. This activity has picked up both from a pricing standpoint, demand standpoint, and supply standpoint, and the markets are maturing each day.
SL: As a commodities market expert, what type of solutions are you seeing developed to help corporations and organizations participate in these markets?
HS: If you think about just how much the world has changed in the last couple of years and look at shareholders and financial institutions – they’re starting to evaluate climate risk as its own risk category for every issuer that they work with. Look at countries and organizations – they’re pledging aggressive decarbonization goals across their entire footprint, both direct and indirect, not just near-term, but for decades to come. With sustainable finance – we’re starting to see almost every single KPI that is being issued at least have one climate-related goal, and companies have to effectively work towards. Look at ratings agencies – they’re starting to assign ESG scores to organizations, which is something that is being used by investors in evaluating which companies that they will work with.
Companies are focusing on this energy transition story a lot more than they ever have. Many fossil focus industry sectors are now investing and repositioning themselves around energy transition. So, what this means is that while the company may be an emitter today, they are creating operations and business lines that will be generating carbon credits. They’re also now thinking about the operational changes required to achieve these carbon objectives that they have on their end. So, as you can imagine, with any change in operation it brings cash flow volatility. Carbon and the broader environmental markets are becoming their own commodity asset classes, and just like any other commodity product, we’re seeing buyers and sellers use these products as a way to effectively manage their ESG goals. So, what would have been, let’s say with a utility, power would have been a risk item. Or an oil and gas producer, where gas or oil would have been the risk item, here for any client – which could be corporate, institutional, buyers, sellers – ESG is the risk item and they’re looking to solve that by using environmental trading markets and hedge that risk going forward. As companies proactively implement more aggressive ESG risk policies, you’re going to start seeing an increasing need for hedging that comes on the back of that as well.
SL: That makes a lot of sense, especially when you think about how companies are really exposed to not only their operational [emissions] but their emissions across their entire value chain, and they’re going to have to be liable for reducing those emissions. Before we dig too much deeper into the carbon markets and specific credits, I think it’s really important to understand the difference between Scope 1, 2 and 3 emissions.
The IPCC (Intergovernmental Panel on Climate Change) and other international bodies state that we have to reduce emissions across the entire economy in order to achieve international climate goals. Scope 1 emissions are really a company’s direct emissions from the facilities that they own and the sources that they control.
HS: Sean, correct me if I’m wrong, but Scope 1 emissions are the easiest to quantify because it’s direct purchases on any type of component that has greenhouse gas emissions. I would assume natural gas for operating manufacturing facilities or diesel for trucks, as an example.
SL: And that’s typically where folks start when they look to emission reduction. And then the other easier to quantify piece are the Scope 2 emissions, which are technically also considered as operational emissions, but they’re indirect emissions from the purchase of electricity and heat to run your operations.
HS: Another one that’s easy to quantify and [there are] a lot of tools available today in terms of the market and how we go about managing that exposure.
SL: And last, but certainly not least, is the Scope 3 emissions. These are emissions across your entire value chain. So, it’s not direct emissions from the company, but it’s the emissions that are associated with the upstream supply chain of their products or even the downstream end use of the products by their consumers or customers.
HS: Which is again the largest category, if you will, because if you think about the pure definition, anything that gives you value is a very broad term to describe something that can be incorporated into your Scope 3 emissions. Because everything may give you value, but you may not be able to control all facets of that value chain. So again, probably the hardest to quantify and work towards because it’s hard to kind of control all those different operations.
SL: Exactly, and it’s more challenging to account for, and as such, companies have only really gotten started quantifying it and implementing strategies to reduce their Scope 3 [emissions] more recently.
So that said Harsh, what are you seeing in your conversations with institutional and corporate clients trying to address this topic?
HS: As you can imagine, in net-zero across all three Scopes is a very, very complex endeavor. Especially Scope 3, being the hardest one of it. I often get asked what examples of Scope 3 emissions are, which is something that in my opinion impacts every single sector. Look at commercial corporations, Scope 3 could mean everything from the emissions from third-party service providers to logistics companies to the products that they buy. How do you forecast forward your Scope 3 and have a plan to eliminate that? Because again, you’re not controlling those activities. I mean, look at just the last two years, if you had to forecast your Scope 3 emissions, it would have been practically impossible because you would not have been able to account for the pandemic or the conflict in Europe.
When you think about Scope 3, for most organizations, they’re just now starting to develop strategies, and that change only comes in a few years from now. For areas where companies can’t reduce their carbon footprint organically, there is a sort of growing need for relying on something else to effectively to offset that. And this is where the environmental credits offsets come in play, where they can be used to complement an organic change. They’re not necessarily used as the only way to reduce your emissions, but they can be used in a way to effectively complement some of the organic changes that are being implemented within the company.
Look at the trends – you’re starting to see some of that as well in the S&P 500. Almost 36% of companies are now starting to use carbon and environmental offsets to complement their net-zero strategies, which is a lot more than what we saw more than five years ago. And I would personally expect the number to continue increasing as well, as companies get more and more aggressive and look at well-rounded Scope 1, 2 and 3 reduction plans versus historically just focusing on Scope 1 or just on Scope 2.
SL: It’s great to see some of these solutions really develop and grow over time. I think it would be really helpful, given your expertise in the market side, to give a bit of a breakdown for folks to understand the different types of environmental products. There’s a lot of different names you hear out there, whether it’s between compliance or voluntary markets or even the different products within those markets. Do you think you could help us understand some of these different products that are out there?
HS: Absolutely. Look, if I were to go through all the different nuances in the market, I think we’d need a very long podcast.
SL: Right [laughs].
HS: I think broadly speaking, the markets can be grouped into two broad camps: compliance markets and the voluntary markets.
Let’s look at the compliance markets first. Certain jurisdictions – and this can be states, countries, or provinces – have implemented a mandatory cap on direct Scope 1 emissions. So, for instance, if you’re in California or Quebec, they have their own program. The EU has their own program. The UK has their own program now as well. Many countries and many states are implementing their new programs in terms of limiting the Scope 1 emissions of companies and entities within these organizations. So, this means that if you’re in one of these geographies, you have to either limit your direct emission by a certain benchmark or purchase allowances for your excess emissions.
Alternatively, if you reduce your exposure below a certain threshold, you have available credits that you can now sell into the market. There are many different types of environmental products that are now being governed by compliance entities. So, for instance, obviously we think about carbon as a big one, but there’s also renewable power energy credits commonly known as RECs (Renewable Energy Certificate), low fuel credits known as RINs (Renewable Identification Numbers) or LCFS (Low Carbon Fuel Standard credits). And many new products are just coming to market today and will be over the next few years. Again, this market is evolving even in the compliance space. But within this compliance camp, it’s all around what is a government mandated activity that you have to reduce below, and above which you have to go and effectively buy your excess allowances in the market.
On the other hand, there are voluntary credits. So, in geographies where there is no compliance requirement, an organization may choose to reduce their direct carbon footprint voluntarily. If they do so, they’re eligible to generate a voluntary carbon offset, which can be either retired for self-benefit or be sold to another entity, which they can then retire for their own benefit.
International agencies have now started putting a lot of strict criteria and methodology where companies have to prove additionality, greenwashing, permanence and other factors before a voluntary offset can be issued or traded. Exchanges like the CME have also added voluntary carbon offsets from a futures standpoint to provide further support and standardization for the market.
Whether in compliance geographies or in voluntary geographies, the voluntary markets can be a good tool to incorporate into your strategy, especially around Scope 3, which is not governed by compliance entities. As you can imagine, during an organization’s transition, they may go from net emitters to net offset generators as their actual consumption changes. So, these tradable markets, whether it be on the compliance side or on the voluntary side, allow companies to balance their net long, net short positions in real time. We’re also in the forward markets where they can now lock in future price for these instruments.
Given the ESG transition is going to be capital intensive, especially when you incorporate Scope 1, 2 and 3, the ability to leverage these markets and use the compliance products and the voluntary products, can be great tools for companies to manage cash flow risk, strategy risk and the broader ESG risks that they have in their business.
SL: Right. And that’s a real complement to what we’re seeing in the sustainable finance space and the explosion in terms of sustainable debt products. Just another tool really in the toolbox for these corporations.
Announcer: You’ll hear the conclusion of this discussion in part two, next episode. Thanks for listening to Scotiabank Market Points. Be sure to follow the show on your favourite podcast platform. And you can find more thought leading content on our website at gbm.scotiabank.com.
Announcer: You’re listening to the Scotiabank Market Points podcast. Market Points is part of the Knowledge Capital Series, designed to provide you with timely insights from Scotiabank Global Banking and Markets’ leaders and experts.
This episode of Market Points is part two of a two-part episode about the rapidly expanding carbon market. You’ll hear the second half of a discussion between Harsh Sanghvi, Scotiabank’s Director of Commodities and ESG Risk Management, and Sean Locke, an Associate in Sustainable Finance at Scotiabank. We pick up the conversation with a question from Harsh Sanghvi about the array of products and options available to clients in the sustainable finance space.
Harsh Sanghvi (HS): Given your focus in sustainable finance, what are you hearing from clients out there as they incorporate some of these tools as part of their broader ESG strategy or financing objectives? Historically, a lot of focus was just in terms of getting the KPIs and the framework in place, now we’re starting to see that change a bit. How are some of these tools trickling into your side of the world as well?
Sean Locke (SL): We’ve seen over the last couple of years, a big focus has been really on companies measuring their footprints, and then setting strategies and measurable KPIs and targets. And we're really seeing the conversation shift – instead of what’s our target, towards how are we going to get there and what tools are we going to use to get there. And in terms of using environmental offsets as a tool, corporations are still primarily focused on achieving organic emissions reductions within their footprint, whether that’s in their operations or their value chain.
HS: That makes sense.
SL: Yeah, exactly. And similarly, investors and other capital providers like lenders, banks, and other insurance providers, et cetera, are also very focused on ensuring their clients are focusing on these operational reductions and organic reductions. The key is once companies, especially in the near term but even further out, have exhausted all possible options for reducing organic emissions, there are still many left over hard to abate emissions. And that’s where we’re seeing companies turn to the offset markets, whether it’s for renewable power or for carbon offsets.
So, in saying that, it’s really critical that corporations are using offsets in a very high-quality manner to avoid any potential greenwashing where they’re more so buying their way out of their emissions rather than focusing on providing real reductions. In that case, it’s really critical to partner with high integrity organizations. There are a number of internationally recognized agencies that we here at Scotiabank work with, that provide robust protocols and methodologies for generating offsets and also have audit and validation requirements to make sure that the projects are real and living up to all the claims they’re making.
SL: There is also companies that are developing preferences in terms of the types of offsets that they will work with, whether it’s preferring an offset that represents a removal of emissions rather than avoided emissions or something that is more in the sectoral or geographical area that is more aligned with the corporate themselves. So, it’s interesting to see the market develop these nuances.
HS: You’ve touched upon a lot of things around ratings agencies providing more comfort around what these companies are doing and how they’re going about it. What would be your guidance as companies look for the best solution in achieving their net-zero goals and investors and external shareholders are also scrutinizing those choices. So how do you sort of balance the two? Obviously, some of these are going to be scrutinized more than others. I’d love to get your perspective in terms of how the corporation effectively balances those pros and cons.
SL: It’s a great point and it’s becoming increasingly important as we see more headlines in the news and examples of concerns around greenwashing, whether it’s in this space or in any sustainability spaces.
I think the first thing to remember about the carbon offset market is that it’s a very heterogeneous market. Every offset project is unique and has its own unique characteristics. We even see this in the trading markets where nature-based solutions might be trading more at something like $15 dollars a metric ton, but then there are credits that are generated by renewable power that could be closer to $5 dollars a metric ton. And then there’s even some really advanced technological solutions, such as direct air capture, that we might see trading in the hundreds of dollars a ton. That kind of gives you an idea of how different these offsets can be, which becomes a bit challenging in terms of evaluating quality. But there are a few key principles I would point to.
The first is something you mentioned briefly – additionality. And this is the concept that the emission reduction or removal that occurred as a result of the project generating the carbon offset wouldn’t have happened otherwise if it wasn’t for the offset and the financing that it provided. And so that’s really the key point and that registries design their methodologies to make sure that project developers do demonstrate additionality.
Another concept that’s a little bit trickier to evaluate and may be more focused on the nature-based and forestry type solutions, is called leakage. And that’s where emissions that might have been prevented due to an offset project – for example, protecting a rainforest that was slated to be deforested for agriculture – it’s ensuring that that project didn’t just sort of shift that demand for deforestation to a new area and it didn’t result in any net benefit.
The last key principle – and this is particularly important for carbon removals where you can think about storing carbon, whether that’s in biomass such as trees or technologically stored and engineered solutions – is what’s called permanence. And that’s the duration of time that a ton of carbon is removed from the atmosphere. Organizations are increasingly looking for a minimum number of years for the carbon to be stored. And there’s premiums put on solutions that are storing carbon for longer periods of time.
Now it may be tricky to evaluate all of these different things, so what’s great is there’s an independent governance body called the Integrity Council for Voluntary Carbon Markets that’s made up of industry experts. They’re putting together what’s called the Core Carbon Principles, which will be released later this year and it should provide the market some key standards for developing a framework to assess the quality.
HS: Sean, it’s interesting that you mention all this, because one of the things that keeps coming up as companies look at science-based targets or other initiatives where they’re looking at organic investments to abate their Scope 3 emissions – when I see that, I look at risks that come on the back of that as well.
If you think about a company that may have to now look at non-core assets, so think about a company that may have to invest in a forestry asset to get the nature-based carbon offsets to reduce their organic footprint, but they may not have any expertise within that space. When you think about all the things you talked about around additionality, permanence, some of the things that we’re starting to see from a principal standpoint – how do organizations manage that? Because in many cases they may not be necessarily the right entities or may not have the right skill set in these alternative investments to do it organically themselves.
SL: Yeah, that’s really the beauty and the function of the offset market. It allows companies who are really focused on achieving these reductions, but don’t have the specific expertise to operate the project, to provide capital and financing in a way, in an alternate form, so that the developers or the experts in these different areas – whether it be nature-based solutions or renewable power or carbon capture – to really develop and successfully operate these projects. And while companies are certainly not always going to want to develop their own projects, there are an interesting set of parameters that they’re evaluating. For example, a food company or grocery chain may want to reduce the emissions associated with their supply chain, but they don’t really have the expertise to develop agricultural offset initiatives themselves. So, they could partner through a carbon offset program with an agricultural company or farmers to provide carbon offsets. We do see some of that in terms of companies focusing on something in their sector or in their home geography, they want the projects to be related to their business, but they really just don’t have the expertise to operate them themselves.
HS: It’s interesting because what you’re effectively saying is you would redirect expertise to the organizations that are experts in developing projects that will yield carbon credits that can be used to abate those Scope 3 and hard to manage components. But at the same time almost take a bit of a mutual fund type exposure profile, if you will, where you’re kind of combining and aligning, syndicating risks out to the parties that are going to be most able to manage that themselves.
SL: Yeah, exactly. And that’s what these market-based solutions are really designed to do, to help develop and ensure growth in the most efficient way for all the parties involved.
HS: I think about all the factors that corporations must go through before they can embark on a net-zero journey and also implement the changes necessary. It seems that there’s a lot that they have to understand and they need banks to opine on as well. So, from your standpoint, as you look at institutional clients or corporate clients all around the world from the lens of sustainable finance, what are some of the changes in terms of how the banks’ roles are evolving – within the space, as well from a traditional blending or debt facility that normally would have been pretty standardized at this point.
SL: It’s definitely something that is evolving in terms of how we, as a bank, work with our clients. A very obvious change in the specific products itself that you alluded to in terms of embedding KPIs that call into facilities and we call them sustainability-linked financing products. These could be loans, bonds, derivatives, or even other products, such as deposits, where the financing rates are linked to KPIs and the most common being the rate of organic GHG emission reductions.
And so that’s a really important way for us as banks to help our clients move the needle on their end and ultimately reduce our own financed emissions, which is something that’s really been evolving. Earlier this year, Scotiabank released its Net-Zero Pathways report and its first targets to reduce our financed emissions from the companies that we lend to. So now that we’re incorporating that as another metric into how we assess our risk and performance, it becomes important for us to work with clients to help them reduce their emissions because in turn, they are Scope 3 emissions. And that’s really where the offset market comes in. It’s been estimated that the energy transition to net-zero will cost upwards of $9 trillion dollars per year so we really need an all of the above approach. And many financial institutions have pledged large commitments, including ourselves, to help promote mobilizing capital towards the green economy. So, it’s key to have a tool like the carbon offset markets, which can provide another source of financing for some of these hard to abate emissions.
SL: With that said, I’m curious to hear how you see banks and financial institutions interacting with the market and where you see things going from here?
HS: When you think about the scale of the emission reduction pledges in 2030 and in 2050, I personally think that we will continue seeing this exponential interest in risk management and financing solutions around the transition as well. Banks and financial institutions will have to get creative in the way we structure the capital for let’s say project finance entities or other types of entities where there is really no other physical collateral asset in place outside of the carbon credit. For instance, when you think about a forestry project or a carbon capture and storage project, the only real output here is an environmental offset. This means that the bank not only has to provide capital against future delivery of environmental credits, but there’s also a greater need to lock in the future price of those credits and bring better certainty around returns and break-even parameters. We’ve already seen a growing interest for prepaid facilities, equity investments, and other ways to fund projects where raising debt might be hard.
This is very different in terms of how we look at traditional project finance, traditional infrastructure financing, because those are going to very mature established markets versus these are becoming something where we’re just starting to scratch the surface and what this world looks like. Financial institutions will have to provide liquidity for this market. Support for physical and financial trading, offer better offtake solutions, both for the buyers and the sellers. This is not just corporates. I mean, even think about institutional investors, right? They’re looking at their carbon portfolio, in terms of the companies that they invest in from an asset management standpoint, companies that they have in their portfolio and they’re now trying to figure out how they decarbonize that across everything that they do in their investment portfolios and how they leverage these tools. In some cases, we’re seeing companies, again from an institutional standpoint, focused on new investments from a green standpoint where they’re focusing more and more investments in the green space. But we’re also starting to see them look at the environmental products, just like another asset class and look at yield strategies or investment strategies from a trading standpoint, like a FICC product, like an equity product, to get additional alternative investments with an ESG component to it.
SL: That’s fascinating. I’m really interested to hear your perspective in terms of seeing all these new products coming out – how does Scotiabank fit in and how can we help our clients in this space?
HS: We at Scotiabank have been focusing our efforts on developing new sustainability-linked products such as these carbon solutions, new indices within the space or looking at even sustainability-linked derivatives or deposits or other products that can be linked to a custom KPI. We have taken a holistic, in some ways product and sector agnostic approach, on how we assist our clients on all facets of their ESG transition.
The goal at the end of the day is to use all these different tools to come up with a customized strategy that links this advisory piece with the financing piece with products like carbon and ESG solutions that we spoke about today and really help our clients align but, more importantly, implement and deliver on their enterprise wide ESG goals, both on a short-term and long-term basis.
I think part of the innovation that we’re working on is how we connect the dots and make it more comprehensive. But at the same time, we will need more tools, more debt, more liquidity, more players in the market, so we can do it in a way that’s scalable and achievable in the timelines that we need in the next two to three decades, from a net-zero standpoint.
SL: Absolutely. I’m really excited to see where the sector goes and see how we can help advance the growth of it and how it can contribute to achieving our global climate goals that are so important.
Announcer: Thanks for listening to Scotiabank Market Points. Be sure to follow the show on your favourite podcast platform. And you can find more thought leading content on our website at gbm.scotiabank.com
Market Points is part of the Knowledge Capital Series, designed to provide you with timely insights from Scotiabank Global Banking and Markets' leaders and experts.
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