Rapid changes in demand for offsets can create turmoil in carbon markets.
GOVERNMENTS around the world are battling to reduce emissions and increase biodiversity.
One solution is the use of environmental markets, which to work will require the participation of landholders.
Environmental markets are considered one of the solutions to reducing emissions (carbon markets) and reversing biodiversity decline (biodiversity markets). These markets are an opportunity for agricultural enterprises within Australia.
While they are an opportunity, they are not without risk for Australian farmers.
As emissions targets around the world increase, there will be continued demand by the world’s polluters to purchase offsets to continue emitting into the atmosphere. There may also be demand for biodiversity services from private enterprises and the government.
Environmental markets operate differently from pure markets as they have a large element of government intervention to ensure that they operate. The demand for offsets can change by the stroke of a pen and cause large upward (or downward) swings in pricing.
The current structure of environmental markets remains in its infancy. This is especially the case for biodiversity markets.
There remains a range of risks for participants within the marketplace, from sovereign risk to default risk. While most are discussing the positives of entering into carbon pricing contracts, I thought it was important to outline some (not all) of the risks faced by farmers.
Inset or offset
Agricultural enterprises that generate credits have a choice about whether they sell or retain the credits.
The demand for carbon credits is currently largely driven by government purchases or government policy forcing emitters to purchase credits.
Agricultural enterprises are not currently required to account for their emissions. While there are no policy movements to include agricultural enterprises, there is no guarantee these won’t be included.
Sovereign risk applies to carbon contracts and there is the potential for government policy to change and require agricultural enterprises to account for their emissions.
Government change to decrease emissions through an additional focus on agriculture is currently being discussed in New Zealand, Europe and Canada.
We recommend seeking advice prior to selling carbon credits and considering whether retention of credits for future on-farm requirements is an option.
Early adopters
There are many agricultural producers in Australia who have conducted environmental activities within their enterprises, such as planting trees.
Over the course of many years and decades, these activities have been conducted voluntarily and many times through the support of local Landcare organisations. While these activities have a positive outcome for the environment, they are unlikely to be financially rewarded.
These early adopters – who have introduced activities that would reduce emissions in many cases – have not created a baseline.
In these instances, the early adopters, when carrying out their assessment of their baseline, will likely have a reduced opportunity to add additional carbon sequestration.
Those who have conducted the most in terms of reductions will therefore have less to add to their operations, reducing any financial incentive.
Sovereign risk
In the developed world, sovereign risk is a much lower risk. However, it is not a zero risk. Sovereign risk is the risk that a government changes policies and defaults on previously created agreements.
The largest demand driver for carbon credits in Australia and Europe is through government compliance schemes. Therefore, any change in policy can have far-reaching consequences for environmental markets.
A recent example of government intervention in environmental markets occurred during March 2022. During early March, Australian Carbon Credit Units (ACCUs) were trading at $47/t, close to record levels.
The government of the time decided to change the rules to allow project developers to break long-term agreements and add extra supply to the market. The extra supply resulted in a 38 per cent fall in the price of ACCUs.
The high exposure that environmental markets have to government demand is an inherent risk. As governments change, this can produce policy changes that can be positive or negative to environmental markets.
Many environmental market contracts can have time frames stretching over more than six parliamentary terms. A contract period of this span can lead to an increased likelihood of policy changes, both negative and positive.
Our advice to farmers is to think very carefully before selling any carbon credits you have, especially for longer time frames.
- Andrew Whitelaw is co-founder and director of Episode 3 (EP3)
