The Critical Role of Insurance in Ensuring the Integrity of Carbon Credits in the VCM 2.0

As climate change and its impacts accelerate, the twin aims of reducing global emissions and reaching net zero are increasingly essential and also increasingly challenging.

Olafur Pall Torfason
COO
Published: 1:03 PM 27 Jun 2024

Achieving climate targets requires deep emissions cuts across all sectors. However, there will always be some sectors where such cuts are difficult, due to factors such as cost, control, or available technology. These ‘hard-to-abate’ areas make up around 30% of global emissions.

The carbon markets (and within this blog, we will focus on the Voluntary Carbon Market or “VCM”) are a means to help. VCMs do not replace significant emissions reductions but instead work in tandem by driving capital towards carbon removal, reduction, and avoidance projects.

VCMs have multiple uses and benefits, such as helping offset hard-to-abate, residual emissions; providing climate revenue streams for emerging and developing economies; scaling financing to climate solutions such as carbon removal technologies and nature-based solutions; and enabling significant co-benefits aligned with the UN Sustainable Development Goals.

However, as with any market, there are challenges and risks that need to be managed effectively. For example:

  • How do you accurately quantify, monitor, and audit the effectiveness of a climate project’s performance, and thus the ensuing quality (and permanence) of its carbon credits?
  • How can stakeholders protect themselves against project underperformance – for example due to insolvency, fraud/negligence, natural catastrophe, or political/regulatory change?
  • What safeguards exist in the market to monitor and mitigate these risks and provide security when risks lead to losses?

While there are many in the market who act with high-integrity, the well-publicised actions of a few risk the entire VCM being tainted by association.

How do we work together to increase confidence?

One answer is greater collaboration between Greenhouse gas (GHG) programmes and Insurance; both of which are focused on ensuring quality, risk assessment, and risk management.

Within this blog we elaborate on this point, covering:

  • How GHG programmes and insurance, alongside other “Risk Stakeholders”, are complementary in providing rigorous scrutiny and frameworks by which quality projects can be assessed and monitored over time.
  • The specific risks that insurance companies assess and protect against, and how the addition of insurance to the VCM can provide greater security to market stakeholders.
  • How Kita, a specialist carbon insurance company, and International Carbon Registry, a high-integrity GHG programme, are working together and the benefit this brings to VCM stakeholders.
  • How GHG programmes and insurance companies can collaborate to deploy insurance policies more widely within the VCM.

For further information, please don’t hesitate to get in touch with the authors.

The building blocks of a climate project and why we need the different roles:

A climate project is based on the notion that it contributes to mitigating climate change in various ways. Broadly, these projects are categorised as either carbon removal or avoidance/reduction initiatives. Due to the diversity of methods available, each with unique characteristics, standardising these approaches is crucial. This need for standardisation explains why an increasing number of stakeholders become involved over time

The development of a basic project begins with a concept; a simple idea that a specific action - such as planting trees - can facilitate carbon removal. However, different types of trees vary in their ability to absorb CO2. For example, it is necessary to estimate the baseline scenario (which is essentially a snapshot of the existing conditions before the project starts as well as the most likely future performance of the project assuming a ‘business-as-usual’ progression). This helps determine the additional benefits that the project is expected to provide i.e., additionality.

Once a developer of a climate project has established a concept, a methodology must be selected. A methodology essentially serves as the recipe for the project's goals and demonstrates its benefits.

As projects progress, a multitude of potential issues can arise. Historical events show that forests can burn down, be cut down, or be sold, and baseline scenarios can be manipulated and the additionality exaggerated. These, and other factors, introduce risks to potential buyers, deterring participation and undermining confidence in the overall market.

Due to these challenges, specific new roles have emerged, with the primary focus on reducing risks, enhancing transparency, and ensuring accountability. Collectively, these roles can be described as key Risk Stakeholders.

In the VCM, the introduction of insurance companies to key “Risk Stakeholders”, i.e. those entities that assess, mitigate and manage risks related to climate projects, is a positive development for all market stakeholders.

The cumulative impact of these Risk Stakeholders, each with a distinct role to play, helps contribute to the quality of the climate project.

KEY RISK STAKEHOLDERS IN THE VOLUNTARY CARBON MARKET

Insurance Carbon Standards

Risk Stakeholders - Project Level

Standards and GHG Programmes: The foundation of quality assurance.

Standards and GHG (Greenhouse Gas) programmes act as the cornerstone of carbon credit quality. These frameworks establish benchmarks for quality, transparency, sustainability, and additionality. By doing so, they foster market trust, enabling stakeholders to discern the true value of carbon credits.

Validation and Verification Bodies: The inspectors and auditors.

Validation and verification bodies (VVBs) serve as meticulous examiners of climate projects and the impacts they deliver. They scrutinise the methodologies, project designs and actual impacts of climate initiatives, ensuring that the carbon credits reflect genuine, quantifiable and additional emission reductions or removals. Their critical role underpins the integrity and trust in the VCM.

Insurance: The regulated safeguard.

Insurance is a familiar, highly-regulated risk management mechanism common in most high-value markets. Insurance acts both as a safety net when things go wrong and to outline paths to scale via proactive risk management – for example, providing standardised risk assessment frameworks and legally binding contractual structures that are core to enabling institutional investment. In a voluntary market, insurance companies are amongst the few entities that must abide by regulations across multiple aspects of the business, thereby enhancing trust and integrity within the wider market.

By working in partnership with other risk stakeholders, insurance can help proactively identify and mitigate risks; provide safeguards when projects underperform; and build trust in the integrity and resilience of other risk mitigation mechanisms (such as Buffers), enabling greater flows of investment into underlying climate projects. 

Ratings: The shorthand signal

Ratings offer a concise evaluation of a carbon credit's integrity, assisting investors and buyers in making informed decisions swiftly, by providing an independent review. From the perspective of the buyer, they interpret and assess the quality of the climate project. Their primary objective is to support the buyer's side of the market, serving as their advisors and delivering an easy-to-understand message based on expert opinion.

Digital Monitoring and Reporting: The modern toolmaker

The advancement of digital technologies in monitoring and reporting enhances transparency and traceability of climate projects and carbon credits. Digital tools allow for real-time, accurate tracking of emissions reductions or removals, ensuring that each carbon credit reflects a real impact.

Risk Stakeholders - Industry Level

GHG Programme Endorsements: The gatekeepers of integrity.

Independent parties such as the International Carbon Reduction and Offsetting Alliance (ICROA), the Integrity Council for the Voluntary Carbon Market (ICVCM), and the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) act as the guardians of the VCM. These entities establish rigorous criteria and benchmarks that GHG programmes need to meet to be recognised and endorsed, providing an additional layer of assurance that climate projects and carbon credits genuinely contribute to mitigating climate change.

Accreditation Bodies: Ensuring competence and reliability.

Accreditation bodies, members of the International Accreditation Forum (IAF), ensure that VVBs operate with competence and impartiality. This accreditation guarantees that validation and verification bodies adhere to international standards, building trust among stakeholders and facilitating the global trade of carbon credits. Their role ensures that VVBs make uniform assessments of projects. Commonly validation and verification bodies need to be accredited for ISO 14065.

THE ROLE OF INSURANCE: DEEP DIVE INTO RISK MANAGEMENT

Currently, investing into carbon is niche and risky. It typically combines project financing, long term horizons, emerging markets, young companies, nuanced processes, unproven technologies and all the while taking in societal and environmental considerations. These factors make investment a tricky path to navigate. Insurance enables participants to transfer those risks to a qualified third party. This clears the path and opens up the VCM to a wider range of investors.

There are a range of risks associated with the VCM, split between counterparty, physical assets and intangible assets. Risks can occur at various stages during a climate project lifecycle and can impact multiple market participants.

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Insurance presents an effective risk mitigation tool, which can be used to pass on high-severity, low-frequency risks.

Insurance companies bring a unique and critical perspective to the VCMs. They evaluate specific risks associated with carbon credits and projects, offering targeted risk management and mitigation that complements the broader evaluations conducted by VVBs and rating agencies, as well as the GHG programmes themselves.

Key benefits of insurance companies include:

  • A creditworthy financial backstop, offering resilience in the face of outlier loss and protecting against default.
  • A protective wrapper to increase financial resilience - backstop to catastrophic loss.
  • Certainty of expectation for stakeholders and security to counterparties - legally-binding regulated contract. 
  • Efficiencies of scale around risk modeling, data analysis,monitoring and reporting .
  • Increased liquidity and third-party assessment of fungibility between credits by providing additional management of risk-assessed buffer contributions

Here’s a closer look at the distinct risk profiles that insurance companies assess and the advantages of integrating risk management across the VCM:

  1. What is being insured?: The focus of risk assessment will vary based on what is being insured. For example, Political Risk Insurance will focus on country risk, including land ownership rights, community engagement and benefit sharing, fraud and corruption indices, and wider political and regulatory risk considerations, namely across expropriation, confiscation, export license cancellation, contract frustration (including those leading to issues like revocation of Corresponding Adjustments), war/terror/civil unrest. On the other hand, insurance for delivery or invalidation risk will cover a wider range of risk factors, including considerations across track record of the project developer; financial and KYC assessment of the project developer and implementation partners; natural catastrophe risk modeling; supply chain disruption; technical risks related to the underlying project; and science/methodology risks.
  2. Signal of quality: Insurers and reinsurers provide a second pair of eyes to assess underlying risk and how it is being managed. It isn’t that insurers assess completely different risks – on the contrary, most insurers will aim to enable a smooth transaction via assessing documents that most projects will already have available for other stakeholders, leaning on collaboration with the other Risk Stakeholders listed above. The key differences are that (i) insurers dive deep into the specific risk they are insuring; and (ii) insurers use actuarial science, which is core to insurance policies, to assess statistical probabilities of risk.
  3. Increased liquidity: An insurance company has a vested interest in working only with projects believed to be high-quality. This is because, in addition to assessing risk, the insurance company takes that risk onto its balance sheet and is thus responsible if the risk(s) assessed occur, leading to an insurance claim. Therefore, if a project is able to get insurance, this should provide an indication of trust in the underlying project. On this basis, insurance can drive liquidity into those projects which are of higher quality and highlight to the market the principles which enabled that project to become insured. In addition, insurance companies have an interest in projects performing well, and as such many insurance companies have risk mitigation advisory services alongside their insurance policies.
  4. Tried, tested and familiar: Insurance is an essential mechanism in managing risk and has been tried and tested in other markets successfully. This means that insurance is familiar to, and expected by, many in-house risk and finance teams for large-scale transactions. The introduction of insurance to the VCM can therefore be a catalyst in scaling institutional investment by providing a familiar safety net, enabling investors and buyers to take action in the carbon markets with confidence.
  5. Accountability: Insurance plays a crucial role in enhancing accountability within the VCM. By investing in market risks over the long term, insurance companies adopt a distinct approach to projects. They have "skin in the game" and are highly motivated to reduce risks. Insurance companies encourage projects to proactively manage and mitigate risks by using a combination of incentives and penalties. Developers are rewarded with lower premiums and enhanced reputational benefits, while facing increased scrutiny and potential penalties if a project fails due to misconduct. This increases accountability and reduces overall risk.

A CASE STUDY: KITA AND THE INTERNATIONAL CARBON REGISTRY

The partnership between Kita and the International Carbon Registry (ICR) highlights the importance of insurance in the VCM.

As per standard practice within the VCM, ICR manages a 'buffer’, a central pool of carbon credits to which each project developer is required to individually contribute. Buffers are intended to ensure permanence and performance. However, risk per project can be variable and buffers face a risk of outlier loss that diminishes their solvency and ability to meet outlined expectations for buyers of carbon credits. 

Kita provides Buffer as a Service (BaaS), an independent risk management approach for ICR's buffer pool of carbon credits, employing active risk controls, asset management best practices, and project-specific risk assessment based on insurance underwriting criteria.

This service involves:

  • Active Risk Controls: Implementing measures to identify and mitigate key risks. Kita’s risk assessment process measures and tracks risks at a project level but also how the risks combine to present systemic risks at the standard’s buffer level.
  • Asset Management Best Practices: Ensuring effective management of the buffer pool, advising on how to adjust asset weighting in relation to changing risk profile and project performance.
  • Project-Specific Risk Assessments: Conducting detailed evaluations based on Kita’s proprietary insurance underwriting model and performing due diligence checks on all data and information provided. As a regulated financial company, Kita has strict obligations to check and substantiate all information.
  • Advice on where further incorporation of insurance could be beneficial for ICR and/or its stakeholders. 

By leveraging these risk management strategies, Kita helps ICR proactively manage and mitigate risks, increasing the buffer’s ability to achieve positive climate outcomes. This partnership underscores how insurance-driven services can strengthen the overall quality assurance of carbon credits.

GHG programmes and Insurance: Collaboration

As per the above section, ICR and Kita are working together on Buffer as a Service. However, we see further opportunity to collaborate to demonstrate how together GHG Programmes and Insurance can help reduce and manage risk, and provide protection, resilience, and adaptation – thus scaling up investment. Insurance also enables cost efficiencies in sharing / outsourcing aspects of MRV, due diligence and scenario analysis for loss events. 

To some extent, GHG programmes have already incorporated one of the core principles of insurance via the Buffer mechanism. This is the principle of “risk transfer”, by which high-severity, low frequency risks are transferred off the balance sheet of an individual company and onto the balance sheet of a central entity (i.e. an insurer or GHG programme). This central entity holds a pool of risk from multiple companies, and as such is able to spread a risk that is unsustainable for one across the shoulders of many, thus enabling that risk to be managed.

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There are more ways however that GHG programmes and Insurance can collaborate to increase the standardisation and incorporation of insurance in the VCM in order to scale investment into high-quality projects.

For example, the ability for projects to utilise insurance as a form of risk mitigation is outlined in various GHG programmes (including ICR, see here). One clear way that GHG programmes could enable the risk mitigation and management services to be applied more widely would be to more clearly outline the requirements of the insurance providers and policies that are eligible under their programme.

For example, requirements for the insurance provider itself could be:

  • The Insurer must have an investment grade credit rating.
  • The Insurer must have a valid license to operate.

Requirements for the insurance policy itself could outline, for example:

  • The key risks that must be insured at a minimum.
  • The projected loss “triggers” that can commence the start of an insurance claims process (for example, a verification report by an approved VVB).
  • Who is eligible as the Insured party and Loss Payee.

There is a balance to strike between being too prescriptive and inadvertently limiting the scale of eligible insurance, versus being too vague and as a result not having any policies eligible.

Given the technical nature of both insurance and carbon, and also the fact that insurance is best incorporated into projects and deals at early stages, it is important that insurance companies and GHG programme work together to set this criteria.

Examples of insurance options for different stakeholders include:

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IN CONCLUSION

Insurance plays a vital role in the VCM by introducing a layer of rigorous risk assessment that enhances the evaluations performed by existing Risk Stakeholders, with a particular complementary nature with GHG programmes.

By focusing on specific risks such as project performance, market and regulatory changes, operational disruptions, legal challenges, and financial stability, insurance companies help ensure the integrity and effectiveness of carbon credits. This comprehensive risk management approach is crucial for building trust and efficacy in the VCMs, ultimately supporting global efforts to mitigate climate change.

Ultimately, the presence of insurance in the VCMs does more than protect investments; it enhances the credibility and efficiency of the market by ensuring that each credit represents a genuine and quantifiable contribution to climate action, which makes the market more attractive to investors and more effective in its environmental goals. In this way, it drives broader participation and enables more substantial and impactful global climate action.

Glossary

  • GHG programme (UK) / GHG program (US): means a voluntary or mandatory international, national, or subnational system or scheme that registers, accounts or manages GHG emissions mitigation activities or climate projects.
  • ISO 14065 means ISO 14065 General principles and requirements for bodies validating and verifying environmental information.

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Upcoming Webinar: Integrity and Trust, The Role of Insurance and Registries in the VCM 2.0

Join us for an upcoming webinar that delves into how insurance bolsters the integrity and credibility of carbon credits in the Voluntary Carbon Market (VCM 2.0).

Hosts: International Carbon Registry and Kita, this event will uncover the vital synergy between insurance mechanisms and registry standards to fortify carbon credits.

Speakers: Kita’s founder and CEO Natalia Dorfman and ICR’s COO Oli Torfason will discuss targeted risk assessments and risk management strategies essential for validating and securing carbon credits.

This session is key for VCM stakeholders eager to understand how insurance safeguards investments and enhances market efficiency. It will provide a deep dive into how integrating robust risk management can establish trust and integrity, fundamental for the market’s effectiveness.

Please register your interest here to join this crucial conversation and receive updates on the webinar's schedule and speakers.

Published: 1:03 PM 27 Jun 2024