The Broken Yardstick of Carbon Markets

And a better yardstick so carbon markets can live up to their potential

Today’s carbon markets are using a broken yardstick to measure the impact of carbon credits, and it’s inhibiting climate impact. We propose a better yardstick that promises a specific, uniform, and consistent measure of impact across carbon projects.

Published June 26th, 2022

Our broken yardstick

We’re using a broken yardstick to measure the impact of carbon credits. Buyers have no assurance whether the carbon credit they buy today, represents one tonne of carbon stored out of the atmosphere for 20 years, 100 years or 10,000 years, and there’s no guarantee of when the impact occurs, which in some cases can be more than a decade into the future.

Why? Today’s standards for carbon development originate from simpler times when a credit simply meant avoiding an emission of carbon into the atmosphere. As a swelling number of entrepreneurs and innovators discover new ways to avoid emissions and remove carbon already in the atmosphere, the standard definition feels increasingly mismatched with the nature of carbon projects, and so do our standards for certifying them.

In short, we’re using a broken yard stick, and it’s creating a credibility gap that is limiting the growth of carbon markets.

Finding a new yardstick

Finding a new yardstick starts with redefining a carbon credit as a specific, uniform, and consistent unit of measure across projects – in short, a commodity. To create a commodity, we must account for each of the three variables of impact for a carbon project: volume, duration, and timing.

Our current system accounts for volume well, but not so duration and timing. Fortunately, we have the tools to do so: the adoption of tonne-year accounting, coupled with a discount rate representing the social cost of carbon will effectively measure duration and timing, as well as volume.

Including duration and timing in our global carbon standards will remove the onus currently on buyers to understand the impact of each carbon project individually. This will reduce transaction costs, decrease confusion, minimize market manipulation, boost credibility, and ultimately increase climate benefit.

In short, accounting for all three variables – volume, duration, and timing – will create a commodity with credibility that enables carbon markets to reverse rising temperatures most efficiently.

The importance of duration

Most of the today’s the standards and methodologies account for the volume of carbon avoided or removed from the atmosphere but fail to account for the duration of time it is avoided or removed.

Fortunately, tonne-year accounting resolves this issue. To learn more, read What’s Wrong with the Carbon Markets? In short, tonne-year accounting elegantly accounts for both volume (tonnes) and duration (years). And any project – every project – can be measured using tonne-year accounting because every project has both a volume and duration component, whether both components were measured historically or not.

In addition to accounting for both volume and duration, it provides other benefits such as delivering ex-post (rather than ex-ante) impact, eliminating non-permanence risk, and increasing access to carbon markets for a greater variety of projects and participants.

The Climate Action Reserve has led the way by incorporating tonne-year accounting into several project methodologies. However, our standardization bodies need to ensure tonne-year accounting is the norm on every project.

The importance of timing

With volume and duration accounted for, we’re left with timing. Timing matters.

The IPCC estimates we have until 2050 to reach net zero in order to limit Earth’s average temperature increase to 1.5-2.0⁰ Celsius above pre-industrial levels. With any further increase, we hit a tipping point of accelerated temperature rise. 2050 is 28 years away. We’ve got a countdown clock, and the next decade is 35% of the time left before the buzzer sounds.

Time-value of carbon

Because timing matters, we need to measure it, and today’s standards do not.

This concept has been called the “time-value of carbon”[1] and parallels the time-value of money. Simply illustrated, would you prefer $100 today or $100 in 10 years? You’d like it today because it’s worth more in your pocket where you can use it. What about $100 today versus $105 in ten years? That’s tougher, but maybe you’d still prefer $100 today. At some number though, say $1,000, you’d clearly prefer the money in 10 years, because that represents a growth rate above 25% compounded every year for those 10 years. Or said differently, if you discounted the $1,000 back to its present value today, it would be worth more than the offer of $100 today.

The same is true with carbon. Carbon impact in the near-term is more valuable than carbon impact created over the long term – all else equal – because it gives us greater optionality and more time to innovate.

The problem with ignoring the time-value of carbon

The closest mechanism to valuing timing today is the 100-year global warming potential standard – which essentially overvalues the benefit for 100 years (using a 0% discount rate) and then entirely devalues the benefit thereafter (100% discount rate).

The first issue with this binary 100-year approach is that it creates arbitrary incentives for carbon projects. For example, many forestry projects are required to contract with landowners for a period of 100-years, an unrealistic time horizon for most timberland owners, who are not willing to shackle their property or descendants with liabilities for the next century. This barrier to participation excludes willing participants in carbon markets and fails to unlock new sources of climate action.

Moreover, not all carbon projects fit the 100-year convention, and increasingly innovative projects defy it entirely. In the absence of an effective mechanism to value timing, project developers have no greater incentive to create badly needed near-term impacts.

For example, a project that can deliver the same physical impact in a shorter period of time (say 5 tonnes for 20 years compared to a project with 1 tonne for 100 years) is not valued any more in today’s standards, despite delivering the impact entirely before the buzzer sounds in 2050.

In another less obvious example, a direct-air-capture credit, which stores carbon for 10,000 years, can claim to be 100x more impactful than either of the examples above, each worth 100 tonne-years. However, this fails to account for the value of near-term impacts over long-term impacts. In the case of direct-air-capture, 99.7% of that credit’s benefit occurs after the buzzer sounds in 2050. There is certainly considerable value to that tail of benefit, but the value of each year is less beneficial the further the impact is into the future. And if you think 10,000 years is long, some projects claim infinite durations!

In short, we need standards that not only account for volume and duration, but also value timing.

Valuing time (and choosing a discount rate)

There is broad support that a more accurate mechanism to account for the time-value of carbon is a discount rate applied consistently across each year throughout the effective lifetime of the project. [2],[3]

This mechanism is the same used by our most sophisticated financial systems to determine the time-value of money. This is because it accurately reflects the continuous, rather than binary, nature of time.

The largest barrier to adopting this solution is a lack of consensus on the appropriate discount rate. It is, in essence, a question of the value of urgency. A discount rate set too high risks incentivizing urgency too strongly at the expense of long-term benefits. A discount rate set too low risks the opposite, a weak signal for urgency and bias for long-term over near-term impacts.

But should it be 1% or 5% or 50%? Corporate finance experts often use discount rates between 5% and 10%. However, 28 years is also longer than the typical corporate investment horizon, so we may expect the discount rate to be a bit lower, perhaps in the 2-5% range.

Fortunately, others have sought to answer this question. The mathematical equivalent of the binary 100-year global warming potential is a 3.3% discount rate. [4],[5] And the social cost of carbon has been calculated as 3.0% annually[6], which is to say the impact of a credit next year is 3% less valuable than the impact of a credit this year, because the environmental and societal cost has increased.

Sky Harvest recommends the 3.0% discount rate to reflect the environmental and societal cost of rising temperatures. More importantly, we recommend the adoption of any discount rate over the confusion and inefficiency of not accounting for timing of carbon impact. Then, we can collectively refine and tweak this number as needed to reflect the latest research and knowledge.

Conclusion: A better yardstick is born from a marriage of mechanisms

When we couple tonne-year accounting with a uniform discount rate representing the social cost of carbon, we can equate the impact of any project, of any volume, for any duration, across any time period. This powerful marriage of mechanisms is a Rosetta Stone that unlocks the ability to truly compare the impact of different types of carbon credits.

While we still need better standards that normalize other attributes of carbon offsets (such as additionality and co-benefits), this is a major step towards commoditizing carbon credits. By doing so, we remove the onus from consumers to understand each type of carbon credit and facilitate a more efficient, fluid, and liquid market that will increase our ability to combat rising temperatures.

Let’s replace our broken yardstick with a better one. That yardstick marries tonne-year accounting and discounting the time-value of carbon to create a specific, uniform, and consistent unit of measure: the universal carbon credit.

Sky Harvest is a carbon project developer committed to seeking sensible solutions to climate change.

[1] Generation Capital, “Time Value of Carbon” [2] Wigley et al., 1998; Shine et al., 2005; Allen et al., 2016; Edwards et al., 2016 [3] Schmalensee, Richard. 1993."Symposium on Global Climate Change."Journal of Economic Perspectives, 7 (4): 3-10. [4] Mallapragada, D.S., Mignone, B.K. A theoretical basis for the equivalence between physical and economic climate metrics and implications for the choice of Global Warming Potential time horizon. Climatic Change 158, 107–124 (2020). [5] Sarofim, M. C. and Giordano, M. R.: A quantitative approach to evaluating the GWP timescale through implicit discount rates, Earth Syst. Dynam., 9, 1013–1024 [6] IWG Social Cost of GHG