Understanding Carbon Offsets

Contract Terms

The price of offsets varies depending on the delivery terms. Guaranteed reductions are usually more expensive than intended emission reductions, even if the offered offset credits are of the same quality. Guaranteed reductions have either already occurred (prompt delivery) or will occur in the near future and are guaranteed to be delivered (forward delivery). In the latter case, the provider is held liable for contract default if it fails to deliver the agreed-upon number of emission reduction credits. In cases where buyers donate toward intended emission reductions, project shortfall or failure has no consequences for the offset provider. Such intended emission reductions are referred to as ex-ante credits; the process is referred to as forward crediting.

Not all offset providers clearly distinguish between non-guaranteed ex-ante credits and guaranteed offset purchases. For example, a provider could advertise to sell Gold Standard offsets from projects that have not yet produced verified emission reductions. If this is not clearly communicated to the buyers, they may be unaware of the risk they are undertaking. It is therefore vital that the buyer reads the general terms and conditions of the contract and determines whether the purchased amount of offsets is backed by guaranteed emission reductions or not. The following sections describe the three methods of offset credit delivery in broad terms. Though specific contracts may deviate from this scheme, the underlying principles generally hold true.

Prompt Delivery of Existing Offsets

Prompt delivery in the carbon markets typically means delivery within a few days of contract signature. This delay allows for administration of the actual transaction, but not for the generation of offset credits, which would be impossible in such a short time. In such cases, the provider sells carbon offsets it has in stock and assumes all project and price risks prior to selling the offset credits. The provider can offer risk-free deliveries, and achieve a higher nominal sales price than could be set for higher risk (non-guaranteed) offsets. Thus, this type of contract is suitable for buyers that wish to receive risk-free emission reductions quickly.

Medium Transaction Risk: Forward Delivery of Future Offsets

A forward contract constitutes a binding agreement in which the offset provider commits to deliver emission reductions to the buyer at a pre-defined time and price. The provider may have access to future emission reductions from a certain project or portfolio of projects, or may have existing emission reductions available. For both the provider and the buyer, a forward contract is a way to eliminate market price risks and secure a desired transaction price, even though delivery may not occur for months or years. Such an arrangement protects the provider from falling market prices, and the buyer from rising market prices. Forward contracts may specify a fixed or proportional amount of offsets to be delivered.

A fixed delivery quantity specifies the exact amount of offsets to be delivered, while a proportional amount typically refers to the project’s overall success (e.g., buyer agrees to buy 50% of all generated offsets each year for 3 years). In fixed volume transactions, the seller carries the risk if the project produces fewer offsets than expected. In case of an offset shortfall, the seller must typically make up the missing offsets by delivering offsets from other projects at the same price.

A forward contract can be executed only if both parties still exist at the time of delivery (i.e. have not suffered bankruptcy). If the seller is unable to meet its contractual obligation, the buyer faces the risk of having to pay the current market price for offsets, which may be more than they had originally settled on in the forward contract. The risk of a party not being able to fulfill its contractual commitment is referred to as credit risk. Before signing a forward contract, each party typically assesses the credit risk of the other party.

While organizations applying professional risk management strategies may prefer forward deliveries to eliminate market price risks, such arrangements are less suitable for consumers who do not know how to assess credit risk. Forward contracts are most suitable for buyers who want to secure a price ahead of actual delivery and payment date (e.g. buyers who expect market prices to increase in the future).

High Transaction Risk: Forward Crediting of Ex-ante Offsets

Forward crediting – the sale of ex-ante credits – is the most complicated type of transaction for the buyer to understand. Typically, at contract closure, the buyer pays the purchase price for a certain number of offsets that have yet to be produced, and the provider delivers a certificate confirming the purchase. The successful generation of the agreed number of emission reductions is uncertain. Unless the contract contains an ex-post adjustment of the purchase price corresponding to any shortfall in offset generation, the customer carries the risk that some or all of the purchase price may be lost, given that offsets might not be delivered. Transparency in such transactions is likely to be limited because providers are unlikely to inform buyers of any shortfall in the number of emissions ultimately achieved. This is especially true for projects that are not expected to deliver the emission reductions for several decades, as is the case with certain forestry projects. Because buyers must pay upfront with no guarantee of the fulfillment of delivery, such transactions carry the highest risk for the buyer.

Forward crediting is similar to forward purchasing (see above) and the same principles of price-risk hedging and credit risk assessment apply. But there is a substantial difference in the degree of risk associated with the two types of transactions: in forward crediting contracts, the purchase price is paid upfront and is not repaid in case of delivery shortfalls. The seller is not obligated to replace delivery shortfalls with offsets from other projects. Because of this, forward crediting might be more suitable for donors who do not depend on exact emission reductions than for buyers who are looking to offset a precise amount.