Insights
Navigating the green tightrope: Carbon offsets, decarbonization and risk
We analyze the reliance on carbon offsets for decarbonization, any risks associated with them and factors that affect the prices of these offsets.
October 2024
Many companies view the purchase of credits in carbon reduction or removal projects, such as reforestation or renewable energy initiatives, as an effective way to offset their greenhouse emissions. However, critics argue that offset reliance is a temporary solution that allows for continued emissions rather than addressing the root cause.
In this paper, we investigate firm reliance on carbon offsets and find that companies tend to use carbon offsets as a complement to their decarbonization activities rather than a substitute. Moreover, we find little evidence that market-based or analyst-derived risk measures reflect the inherent risk associated with offset reliance. Finally, we explore key factors, such as project type and geography, that explain carbon offset quality and prices.
Key highlights
As the urgency to decarbonize intensifies, carbon markets, both mandatory and voluntary, have become a key tool for achieving a long-term net-zero goal. Firms trade emissions via standardized carbon markets, such as the European Union Emissions Trading System (EU ETS), which regulate carbon emissions through a cap-and-trade mechanism, or through carbon offsets in the voluntary market.
Offsets can play a critical role in the transition to a low-carbon economy, but they are not without controversy. Do firms simply rely on offsets to avoid the potentially harder task of sustainably decarbonizing their operations, or do they use offsets in a truly additive fashion to reduce their carbon footprints? Are some offsets better than others? In this paper, we investigate whether firms rely on carbon offsets as a substitute or a complement to their own decarbonization activities, whether risk measures reflect a firm’s reliance on offsets, and the factors that explain variation in offset prices.
We find that:
- Firms that decarbonize more also use more offsets, implying that firms rely on carbon offsets as a complement to their decarbonization activities rather than a substitute.
- Organizations with higher emissions rely less on offsets, suggesting that organizations that have “more room” to reduce emissions use fewer offsets.
- There is little evidence that market-based and analyst-driven measures of risk reflect the inherent risk in different decarbonization and offset reliance strategies.
- We can explain roughly two-thirds of the variation in offset prices with a simple model and find higher prices for: removal versus reduction, European and North American offsets versus the rest of the world, and for forestry, land and household/community-based (e.g., clean cooking) projects versus other types.
Investors can use these results to understand offset markets and thereby better identify companies that are likely to use offsets effectively, as well as to understand which offsets themselves are the best vehicles for efficiently funding real reductions in carbon emissions.
