By Ana Haurie, Co-founder and CEO of Respira International, and Joel Krueger, Advisor to Respira.

The overall growth of the VCM market has been striking over the past few years, posting 55% CAGR since 2016. In 2021 alone, the market grew by 190% to just under $1 billion. In IETA’s 2022 survey, respondents linked the main drivers for increased demand to increases in corporate net zero pledges, challenges in reducing GHG emissions across corporate value chains, and demand from compliance obligations (e.g. schemes such as the CORSIA international aviation offsetting mechanism).

But given current acute global inflationary pressures, should we expect this growth to continue?

While higher inflation and slower economic growth may have short term temporary negative impacts on carbon credit prices, there are several structural reasons why we believe VCM credits are likely to remain resistant to long-term price declines and are in fact more likely to continue to rise in the medium to long-term.

Short term, there are a few likely negative price impacts associated with inflation, with pressures at their highest levels around the world in many years and with the likelihood of a global recession also at a high:

1. We expect that corporate profitability will decline in sectors where input price increases are difficult to pass on to consumers and those firms may feel less able to pursue their carbon goals. While we do not expect large multinationals to step back from their climate and decarbonisation commitments, including their purchases of carbon credits, it is possible that their total budgets for purchasing carbon credits will be reduced, thus putting downward pressure on the price per tonne needed to meet the commitment.
2. It is possible that other smaller firms in these sectors may delay the implementation of net zero strategies; although they will still be increasingly obliged to report their Scope 1, 2 and 3 emissions.
3. Retail demand for VCM credits could decline due to the rising cost of living. However, retail purchases of credits are a relatively small part of the market and while it may have an impact, it is likely to be muted as corporate buyers constitute most of the demand.

If the larger corporates were to make a meaningful shift away from purchases of VCM credits and prices fall as a consequence, some potential projects, and nature-based projects in particular, will no longer be feasible.

More worryingly, if carbon credit prices remain under pressure relative to other commodities, the opportunity cost is such that this could act as a disincentive to more environmentally conscious business practices.

However, while there could be some downward shift in demand amongst some end users of VCM credits, we believe that the structure of the market will continue to favour both sustained demand and constrained supply and consequently result in stable to increasing prices.

1. The climate science has not changed, and we face the same carbon issues this year as last, except even more acutely. The impacts of carbon emissions are only becoming more apparent as extreme weather events rise. In this context, net zero and other climate pledges continue to rise. Over 4,000 corporates have now pledged to net zero by 2050 or earlier, and net zero pledges now cover nearly 25% of global CO2 emissions and 50% of GDP. Trove has analysed how these pledges translate into demand for carbon credits, with the latest estimates ranging from 4 to 8 billion tonnes of total VCM demand between 2021 and 2030 and 50 to 100 billion tonnes between 2021 and 2050. Insurers are also actively planning for the impact on climate perils in policies and carbon is becoming a component of these policies.  The litigation risk posed to corporates for inaction has the potential to be as serious as the litigation faced by the tobacco industry.
2. Energy companies are large consumers of VCM credits and are now experiencing record profits. Not only is this large group of buyers more able to afford VCM credits, but they are likely to be under even more intense scrutiny to do what they can to mitigate climate risks. Combined with the impacts of the war in Ukraine forcing some European countries to rely on higher carbon emitting energy sources, we expect a short-term increase in their use of VCM credits. Further, we see another large buying group – airlines through CORSIA – also continuing to maintain demand as travel recovers after the pandemic. Reductions in demand for air travel in the event of deeper economic recession may impact VCM demand from airlines, but we have not seen any evidence to date of this occurring, as airlines are committed to offsetting if demand for travel persists.
3. Ultimately, we believe the specific dynamics of project supply and demand will counter downward price levels. The supply of projects is sensitive to price, particularly in the nature-based sector where commodity price increases are raising the opportunity costs and any price reductions will have a meaningful impact on project development and consequently supply. This will only exacerbate the already tight supply of high-quality projects. It remains challenging to deliver high quality projects, particularly in regions of the world with manifest socioeconomic problems, where we see the most impact. These challenges, and the small number of groups able to deliver high quality projects, remain factors as relevant today as they have been in the past. Further, we see the current inflationary pressures leading to a sustained increase in interest rates. Higher costs of capital for project developers will increasingly put further pressure on the supply of new high-quality projects, particularly if short term pricing remains soft.
4. We observe long-term trends in the financial sector that are likely to continue. Financial services firms are increasingly becoming buyers of carbon credits.  We see firms hedging their exposure to carbon prices through the purchases of credits.  Further, we see more asset managers considering carbon credits as a distinct asset class and that taking a long position in carbon is a natural position. We also see increasing pressure on asset owners to take a leading role in mitigating climate change and to use VCM credits as a tool.
5. We anticipate increasing convergence between the VCM and compliance markets and the ability to use VCM credits in many ETS systems over time. We expect this convergence to take place more broadly in the medium to long term,  as the implications of Article 6 of the Paris Agreement play out, although some markets are already beginning to consider VCM credits such as the Japan ETS market launching later this year. The price differential between VCM credits and compliance market allowances can be significant, with VCM credits consistently below that of the compliance market.  This differential we see converging over time as governments will continue to use the carbon price as a policy tool to reduce emissions even while allowing VCM credits to play a role in their systems.

The next 6-12 months are going to be interesting. On the one hand, we expect that some corporates under financial pressure will buy fewer credits  – conversely some corporates (e.g. energy companies/finance houses) will buy more or enter the market for the first time. This, coupled with a reduction in supply of high quality credits, should support prices. As we have seen with the recent record heatwave across the UK, climate change is upon us –  the bottom line is that we need to do something about it and, as highlighted by Nestle this week, we are not about to row back on our commitments.