As concerns about climate change and the need for sustainable development grows, carbon credits are becoming increasingly attractive to institutional investors.

Carbon credits are a form of tradable permit that allows companies or governments to offset their greenhouse gas emissions. They work by supporting initiatives that reduce carbon dioxide and other harmful pollutants in the atmosphere.

Traditionally, investments in carbon credits have been used by institutional investors to align portfolios with environmental, social and governance objectives. By supporting initiatives that reduce carbon emissions, institutional investors can demonstrate their commitment to sustainability and contribute to the global effort to combat climate change.

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This isn’t the only value carbon credits could bring to portfolios. Like any security, the credits are traded on various exchanges, with prices determined by market demand and supply. As governments introduce or consider introducing carbon pricing mechanisms, such as carbon taxes and cap-and-trade systems, demand for carbon credits is expected to rise. According to figures from the World Bank, the percentage of global GHG emissions covered by carbon pricing schemes grew from 22 per cent in 2020 to 23 per cent in 2021, with revenues growing from $60 billion to $84 billion during the period.

Investing in carbon credits can also help institutional investors manage the risks associated with climate change. As the impacts of climate change become more severe, there’s a growing risk that certain investments, such as those in fossil fuels, may become stranded assets. By diversifying portfolios and investing in carbon credits, institutional investors can reduce their exposure to these risks and protect their investments.

Of course, there are risks attached to carbon credit schemes. The main ones relate to regulatory uncertainty and the potential for fraud or mismanagement in carbon credit projects.

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The regulatory uncertainty isn’t likely to abate in the short term. By the middle of 2022, the World Bank registered 36 carbon tax schemes and 32 cap-and-trade schemes operating in 46 nations. It also noted a number of major economies were considering establishing national carbon schemes. If they do, it’s likely to have a significant impact on the carbon credit universe.

As for risks related to fraud or mismanagement: imagine that an institutional investor selects a carbon credit project that promises to capture methane, a potent GHG, at a landfill site. It pays a significant sum of money for the credits and receives a certificate indicating the number of tonnes of methane that will be destroyed through the project. After a few years, it becomes clear the project isn’t reducing methane emissions as expected. As a result, the investment hasn’t achieved the desired environmental benefits and the value of the credits is reduced.

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