Liability shift for forestry credits expected to have minimal market effect
As part of the regulatory amendments approved by the Air Resources Board (ARB) at the end of last month, a discrepancy in the way stakeholders are held responsible for replacing invalidated credits was ironed out. Previously, this responsibility had rested with the holders of the offset credit (i.e. the compliance entity that retired it) for all project types except forestry. Starting with credits issued on or after July 1 this year, buyers of forestry credits will also be subject to this ‘buyer liability’ provision.
Invalidation and its causes
Under the foregoing regulations, holders of the credit are liable to replace any credit that is invalidated for one of the following three reasons:
- A gross materiality error (i.e. in the calculation of the volume of reduced emissions occurring through a project activity)
- Fraud (the crediting of the same project activity, or the usage of credits generated through the same project activity, under a separate emission reduction program)
- Regulatory non-compliance (if the project activity is found to breach any other regulation which may be in force)
Forestry has sometimes been perceived to be a ‘risky’ project type, because unlike with Ozone Depleting Substances (ODS) or agricultural methane projects, there is no final act of carbon destruction. With credits being awarded for carbon that is stored in the forest, there is always the possibility that any loss in forest area would also lead to credit reversals.
Forestry-specific reversal risks?
However, there are already other provisions in the regulation for credits that are reversed for reasons apart from the three listed above. In the event of an unintentional reversal or act of god, such as a natural or biological disaster that causes a reduction in the quantity of onsite carbon in the project area, credits reversed are replaced from the buffer pool. The buffer pool is a ‘bank’ of credits to which project operators submit some 10 to 20 percent of their credits (based on a determination of how susceptible the project activity in question is to the aforementioned triggers of unintentional reversal), a portion which cannot be sold on the market. There are presently 600,970 credits held in the buffer pool, while 3,056,532 forestry ARBOCs have been transferred to project operators. Credits in the buffer pool account for some 16.4% of all credits issued to forestry projects so far.
In the event of intentional reversal, such as when a landowner harvests more forest than is grown, or when a project is wilfully terminated, the seller of the credit is liable for the replacement instruments. As forest carbon developer Sean Carney of Finite Carbon reminds us, ‘Aside from the usual causes of invalidation (fraud, miscalculations, etc.), nothing the forest owner does in its everyday management affects buyers.’
Since forestry credits present no theoretical added risk to the buyer, it is unlikely that the shift to buyer liability will see forestry credits being priced below what the market would be willing to pay for ODS, livestock, or mine methane credits.
Two breeds of forestry credits?
The other apparent effect of the regulatory amendment is the creation of two distinct strains of forestry ARBOC. Credits issued before July 1, 2014, continue to be ‘seller liability’ credits. As mentioned earlier, just over 3 million forestry ARBOCs have already been issued (39.5% of all ARBOCs), while the Climate Action Reserve compliance projects database also reflects that the Bishop Improved Forest Management Project (a collaborative between the Forestland Fund and Blue Source LLC) was awarded 2,190,134 CRTs on Apr 25, meaning the 60-day window for ARB to issue and transfer ARBOCs will lapse just before Jul 1. Over 5 million forestry ARBOCs may carry a default seller liability.
By definition, a ‘seller liability’ credit is a Golden CCO, and so a price decrease could be expected for post-July 1 credits. In our previous publications, we have documented a steady range of 8-11% as the spread between Golden CCO and CCO prices (translating into $0.80 to $1.10 per credit). Market consultant Ben Massie of K Carpenter Associates remarked earlier this week, ‘Compliance entities seem to be willing to pay a small premium for the forestry offsets that will be issued before July 1, 2014. After that, once the compliance entity wears the invalidation risk, they are willing to pay a bit less.’
Even so, it should be considered that the present market price for forestry CCOs already builds in the reality that many stakeholders are already transacting these as standard ‘buyer liability’ credits, perhaps in part because the market has long known the regulatory amendment was coming. ‘The majority of people were already operating this way,’ Carney stated, ‘Everyone has known about this change for a very long time, [so] I don’t expect this to have any impact on the way forestry offsets are bought and sold.’
Another explanation for why the market has auto-adjusted for buyer liability might be the reticence on the part of larger compliance entities to accept guarantees from sellers with inferior credit ratings. ‘My opinion is that compliance buyers, such as oil and gas entities and speculators, will simply deem non-investment grade counterparties (i.e. most of the offset supply market) as a credit risk, and work for a discounted or better price. Thus compliance buyers will accept and live with the risk, and replace the compliance instrument if it is later invalidated,’ explains Dick Kempka of the Climate Trust, a mission-driven non-profit that specializes in climate solutions for the market.
Julian Richardson of Parhelion Underwriting, whose firm provides insurance against the invalidation of credits, has confirmed that his product will be available to the market for forestry credits. ‘We do cover forestry projects and each project is underwritten on its own merits. The coverage is the same for all protocols,’ he said.
In other words, it appears as if only the smaller and medium-sized compliance entities – those who thus far are reported to have been less involved in the offset market, and who are naturally drawn towards the Golden product should they participate – may find an incentive in snapping up pre-July 1 forestry ARBOCs. It remains to be seen how much of an impact seekers of such incentives will make on the market price.
It should also be borne in mind that, should they wish to keep liability with the sellers for post-July 1 credits, such buyers may simply write such a provision into their Emission Reduction Purchase Agreements (ERPAs). The California Emissions Trading Master Agreement (CETMA) is an example of a contract which stipulates that the seller retains liability. The option of seller-liability credits certainly does not leave the marketplace either.