As Fund I starts generating cash flow, we take a look at the drivers of return.
Climate Trust’s pilot carbon offset fund (Fund I) has started to generate cash flow. Of the Fund’s seven investments, one has already produced carbon offset revenue and five more are expected to do so over the next two months. Demand for the offsets has been strong and we have sold 100% of this year’s expected compliance offsets. Currently, the Fund’s return is projected to be 14%.
What drives that return projection? At its simplest, the Fund I model projects carbon offset prices, multiplies that expected price by projected offset volumes and subtracts expenses to arrive at net cash flow. As we assess each factor’s effects on the return, we are seeing that about 60% of it comes from offset price appreciation and 40% from estimating offset volumes correctly and managing expenses well. Why is this the case? Is that breakdown a good thing? What does it tell us about the offset markets?
To review, the Fund invests in carbon offset projects upfront, takes title to the carbon offsets for a period of ten years, and after it has been paid back its initial investment, the Fund then shares revenues with the project owner. If the carbon project does not produce the volume we expect, we don’t ‘claw back’ our investment from the project owner. So we must be fairly certain the volume of offsets we estimate during due diligence are actually issued, and that we can sell those offsets in the market for a good price.
So, yes, we think deriving 60% of the return from price appreciation is a good thing because the Fund’s investment thesis is carbon offsets are undervalued relative to their risk. The trend line for offset prices is tied closely to allowance prices. Remember, in the California compliance market, offsets can be used to meet up to 8% of regulated entities’ GHG targets. Allowance prices are mandated by law to increase annually by 5% plus inflation. Offsets historically trade at about a 20% discount to allowances, so it stands to reason that if allowance prices go up, so will offset prices, because regulated entities recognize that offsets are a cost-effective way to meet their targets. To be clear, however, unlike allowances which have a price floor, offsets have none. Even so, with allowances increasing in price each year we believe offset prices will continue to track upwards even if the discount between them widens over time.
Deriving 40% of the return from volume estimates and expense control is also a good thing. Developing carbon offset projects is highly technical, can be costly, and can take up to 18 months or more to develop. Climate Trust spends months conducting due diligence and modeling expected carbon offset generation and the costs to develop a project. When we invest our goal is not to grossly underestimate offset volume as a way to increase returns. We would rather work closely with our partners to ensure volume projections are conservative, but not overly so. Why? Because the Fund’s investment thesis is that carbon offsets are undervalued, not that we can arbitrarily underestimate volume as a way to upside. We value our partnerships with project owners and work in good faith to estimate future volumes as accurately as we are able.
We also carefully manage project development expenses. With our long track record of managing offset projects, we do as much work in-house as we can to optimize project design, and then contract with the highest quality third parties to conduct work that we cannot do in-house. That eye on managing expenses also has a positive impact on returns.
As we look toward the future of carbon offsets, we feel bullish. We plan to launch a second fund in 2020 that will again be predicated on the notion that carbon offset prices are currently undervalued. As before, we will seek high quality partners and offset projects, rely on our expert team to fully vet each investment, and tap into Climate Trust’s 22-year history in the offset markets to further prove the concept that carbon offsets are an investable asset.