Carbon Credit Markets Aren’t Working Out as Planned. A Better Alternative.

The private sector’s tools to address nature-related risk haven’t kept up. Voluntary carbon credits were long considered the instrument of choice by many companies keen on addressing their environmental impact. But they may not have sufficient environmental impact, recent international investigative reports show. Carbon-credit markets also don’t fully reflect the value of broader ecosystem and biodiversity health. Furthermore, they were born as a means of compensation as opposed to being an investment instrument.  

That’s why the focus of debate is now shifting from credits to asset management—and, more specifically, the question of how to properly structure markets to facilitate the preservation and enhancement of natural capital.  

This shift could herald a new era of natural-capital value creation—and lead to a corresponding risk reduction for the global economy.  

Why invest in natural capital? Motivations range from value-chain security, insurance and return on investment to compliance and market acceptance. The industries most dependent on nature are agriculture, food and beverages, construction, energy, and mining. But the relevance of natural-capital enhancement does not stop there. 

Given their systemic view on the economy and their focus on risk reduction, debt and equity originators, portfolio managers, and institutional investors are also keenly interested in holding “long” positions in natural capital. In addition, insurers—the entities with perhaps the broadest and most direct exposure to climate-change risk—can reduce their flood, drought and fire risk by funding peatland, mangrove, forest or soil health.

Natural-capital markets exist. Some businesses and cities pay for ecosystem services, from water provision to pollination. And some offset their nature impact through land or emission compensation. But overall, these markets have remained marginal to date. They have been held back by a lack of parity between the quantifiability of primary goods produced (such as timber or wheat) and intangibles such as ecosystem quality, which we might analyze in terms of biodiversity, air, soil and water quality. In that regard, the emergence of adaptive, data-driven systems that can pass information on natural capital through to the market is a significant development.

The degree of improvement in natural capital is becoming more reliably measurable thanks to new data sources, including satellite data, metagenomics testing, fauna-acoustics, ground sensors and imagery. This serves to ensure transparency and comparability and, in turn, forms the basis to price natural capital claims. Machine learning will accelerate our ability to understand biocomplexity while lowering monitoring costs. 

In addition, accounting and disclosure methodologies for natural capital are maturing in both the public and private spheres. That provides an additional basis for the development of markets. 

The U.N.’s System of Environmental-Economic Accounting fuses economic and environmental data and contains internationally agreed standards that facilitate statistical comparability. The Task Force on Nature-Related Financial Disclosures is establishing a framework for corporate and financial-institution reporting on, and assessment of, nature-related risks for companies. For its part, the U.S. government is also laying the groundwork for a system of natural capital accounting.

To qualify claims to natural-capital improvement as an asset, ongoing performance must be monitored and claims must be accessible and valuable to buyers. Custodian banking functions are required to bring together the bundle of verification, issuance, transaction, and settlement of nature claims across diverse value chains. 

Today’s markets for carbon credits are suboptimal. That makes it all the more essential to structure contracts in a manner that makes payment contingent on results over time. In other words, the delivery of actual carbon absorption and natural-capital preservation or enhancement must be validated over time. Project cash flows must be aligned on that basis. 

Financial structuring dynamics will likely play out accordingly, as corporations realize the close connection between natural capital and their value chains and balance sheets. As risk-mitigation efforts grow, natural capital assets will become transferable between third parties, particularly insurers and corporations exposed to value-chain risks. 

Outcome-based nature service agreements come with an advantage. They qualify as investments into critical infrastructure and can be recognized as assets on balance sheets. Ultimately, they may take the form of assets underlying financial products.     

The vitality and regenerative potential of natural capital is the critical resource of the 21st century. Our future prosperity is closely linked to the land-use decisions we make daily, millions of times worldwide. With standards now falling into place and data collection capabilities improving, we will soon be able to attach a value to every square meter of natural capital on our planet. That is a strong basis for trusted and thriving natural-capital markets to develop. As land stewards are rewarded for the preservation and regeneration of natural capital, companies will stand to benefit from investments into verified nature uplift.

Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to ideas@barrons.com.