Introduction to Ecosystems Services Markets - How Do Ecosystem Services Markets Function? (Part 2 of 2)
The Soil and Water Outcomes Fund is one of several programs leveraging ecosystem services markets to pay farmers to implement conservation agriculture practices and to offer the resulting outcome credits (e.g., carbon sequestration and water quality improvement) to corporate and government entities to meet their supply chain or regional jurisdiction ecosystem targets.
This is part 2 of a two-part series to shed light on why ecosystem services markets exist, how they function, and how to engage in these markets. (See Part 1: Why do ecosystem services markets exist?)
We have received a number of questions about ecosystem services and intend this series, and the related terminology glossary at the bottom of this article, to serve as a useful resource for agricultural operators and organizations.
Regulatory (Compliance) vs. Voluntary Environmental Markets
While both carbon and water can be traded in regulatory or voluntary markets, there are key distinctions in carbon or water credit trading between the two regimens. The major differences are driven by scope, targets, and enforcement.
Regulatory markets take a top-down approach. In a regulatory or compliance market, the scope is often well defined, limited to certain industries / companies / types of pollution, and focused on the biggest offenders contributing to the underlying environmental issue. Targets in regulated markets are usually set by policy with severe penalties for non-compliance as well as a prescribed set of qualifying pathways that entities can use to achieve reductions and compliance. Enforcement by a national, regional, or international body which has legal authority and jurisdiction to enforce the rules of the regimen is what makes regulatory markets “regulated.”
Take for example the European Union Emissions Trading System (EU ETS), regulated by the European Commission and its Environment Agency, and was until 2021, the largest cap-and-trade program in existence. In terms of scope, the EU ETS covers all 27 member states (excluding UK), over 5,000 companies, and includes the power, refining, metals, mineral production, pulp and paper, and aviation sectors of the economy. It regulates (or caps) the total amount of GHG emissions that can be emitted annually by economic actors covered in these sectors in line with the EU’s 2030 target which is 40% below 1990 levels, equating to an approximate 2% reduction target each year. Penalties for non-compliance are steep, as much as €100 per missing allowance (i.e. €100 per metric ton of carbon). In 2021, the EU ETS issued approximately 1.6 billion allowances, equating to a 43 million mt CO2e reduction of GHG emissions compared to 2020. To date, it has been wildly successful and estimated to have reduced well over 1 billion tons of CO2 compared to a world without the EU ETS.
Given their built-in predictability, standardization, and enforcement mechanisms, a regulated carbon or water credit will often trade at multiples of the voluntary market value. For example, in February 2022, the regulated EU ETS Carbon Allowance was trading roughly $100/mt carbon dioxide equivalent (CO2e) versus the voluntary Nature-Based Global Emission Offset (N-GEO) trading at $15/mt CO2e.
Figure 1. EU ETS (Regulated) vs CME Group N-GEO (Voluntary) Price
Source: CME Group & Bloomberg
Regulatory ecosystem services markets include:
Carbon: California Cap-and-Trade Program, Regional Greenhouse Gas Initiative (RGGI), European Union Emissions Trading System (~ 90% global volume), China’s National ETS
Water: Pennsylvania Nutrient Credit Trading Program (Chesapeake Bay) and Wisconsin Water Quality Trading
Alternatively, voluntary markets function outside of the regulatory regimens and are catered toward corporate entities, countries, or even individuals looking to offset their environmental footprint outside of legal mandates. In the absence of regulatory pressure, corporate action in voluntary markets is heavily driven by investor and shareholder expectations and the evolving Environmental, Social, Governance (ESG) ratings space. For example, Climate Action 100+, the world’s largest investor lead climate change initiative with $55 trillion in assets under management, recently released a set of investor expectations for the food and beverage sector which include requests to:
Deploy strong governance and accountability frameworks that addresses climate change risks
Reduce GHG emissions across the value chain in line with the Paris Agreement – this infers the need to target Net Zero emissions by 2050 or sooner; and
Provide corporate disclosures in line with the Task Force on Climate-related Financial Disclosures (TCFD) and other sector specific guidelines when applicable
Targets in voluntary regimens are often made along the lines of a percent reduction from a historic baseline, rather than a hard cap of pollution allowed. In response to investor pressure, many companies are making pledges aligned with certain climate change initiatives such as SBTi’s Net-Zero – which, to date, includes commitments from more than 2,200 companies across 70 countries that represent approximately one third ($38 trillion USD) of global market capitalization. In the agricultural food and beverage sector, the companies below have each committed to reaching net zero emissions by 2040 or 2050, including scope 3 emissions that reside in the supply chain. Cumulatively, these commitments represent an emission reduction target of approximately 1.7 billion metric tons CO2e per year - the rough equivalent of decommissioning 481 coal-fired power plants per year.
Figure 2. Food and Beverage Companies with Net Zero Science-based Targets
While voluntary markets scope is impressive and adoption is growing, participation is almost entirely optional with little consequence or repercussion for non-compliance. Today, the majority of voluntary markets and climate commitments are self-governed, with various standards bodies and affiliated NGOs acting as the police force. However, there is ever increasing demand and action geared towards treating climate-related disclosures similarly to financial disclosures, which fall under the regulation of various government agencies. For example, the EU recently passed the Sustainable Finance Disclosures Regulation (SFDR) which sets exact standards, methods, and increases transparency when it comes to a broad range of ESG metrics reported by financial market participants. Similarly in the U.S., the Securities and Exchange Commission (SEC) recently put forth rules for public comment which seek to enhance and standardized climate-related disclosures. The proposed rules include the disclosure of GHG emissions, which have become a commonly used metric used to assess exposure to climate-related transition risks.
Voluntary ecosystem services markets include:
Carbon: Bi-Lateral trading (Soil and Water Outcomes Fund, ESMC, Pachama, Nori, Regen Network), CBL Markets, AirCarbon Exchange, CTX
Water: Bi-lateral trading (Soil and Water Outcomes Fund, EPRI Ohio River Basin Trading Project)
The Role of Registries
Both voluntary and regulatory ecosystem services use registries to track, verify, and account for certified credits tied to qualified projects. Similar to GAAP (generally accepted accounting principles) which offer a collection of commonly followed accounting rules and standards for financial reporting, registries act as a system of record for credible accounting and tracking of a supply of credits from origin to retirement. When a credit is retired it is removed from the market in perpetuity – this occurs after it is purchased and taken onto the balance sheet of a specific entity to be used against their reduction target. A retired credit can no longer be traded – this ensures the reduction is only claimed once and avoids double counting.
While today’s registries and credits are 100% digital, we can draw a comparison to a county grain elevator from agricultural cash grain markets. Like a producer would deliver grain to an elevator, as seen in Figure 3 below, project developers in ecosystem services markets deliver verified environmental outcomes generated by their projects to a registry where they are “registered” as environmental credits under a prescribed registry protocol. These environmental credits are then purchased by ecosystem services market participants to offset their environmental footprint. Money flows back to the project developers through the registry. Like ownership of grain in a county elevator bin can exchange hands multiple times without ever moving, so can ownership of credits within a registry until they are removed from the registry and retired.
Figure 3. Ecosystem Services Market with Registry
In contrast to county elevators, which in the U.S. are all governed by the same National Grain and Feed Association rules and USDA oversight, each registry has its own rulebook which is often complex and may not be fungible with other registry standards. So, while a bushel of #2 yellow corn could be delivered to a county elevator in Iowa or across the river to another in Illinois, the same cannot be said for a metric ton of carbon delivered to a registry. This inherent lack of standards and interoperability between registries is a major issue to scaling ecosystem services markets and impacts market fundamentals, including price discovery.
Recently, as seen in Figure 4, a concept has emerged in ecosystem services markets very similar to ethanol plants or livestock producers contracting directly with farmers to source high-quality feedstock (and thus cutting out the county elevator / registry). Seeking to meet their reduction goals effectively and efficiently, some market participants are opting to contract directly and entering into bi-lateral trading agreements with project developers with their own private registries or “programs” to generate a stream of high-quality credits that are specific to their needs and supply chain, a concept known as insetting. Compared to offsets, which generate environmental outcomes anywhere, insets generate environmental outcomes within an organization’s supply chain. In agriculture, this is primarily done at the farm level through implementation of regenerative agricultural practices which increase soil carbon sequestration, reduce nitrogen, and build up biodiversity.
Figure 4. Ecosystem Services Market without Registry
The Soil and Water Outcomes Fund is one of these programs producing high-quality, independently-verified carbon sequestration and water quality insets and engaging in bi-lateral contracts.
The current unregulated nature of the voluntary market environment is leading to a proliferation of programs with a wide variance of definitions, terms, calculations, and measurement.
Please contact us to discuss how to decipher, qualify, and quantify the value of these programs and the ecosystem services-linked assets they are generating.
Appendix II: Glossary of Ecosystem Services Terminology
Bi-Lateral Trade – this term is used to describe trade directly between two counterparties without using any intermediaries or central exchange.
Credible Accounting – accounting related to quantification, ownership, methodologies, and verification should all be transparent, truthful, convincing, and reliable while disclosing and communicating any limitations, constraints, or conflicts of interest that would preclude ethical judgment or performance of an activity.
Double Counting – double counting refers to the situation where two parties claim the same ecosystem services credit.
ESG Ratings – ESG ratings are designed to measure and quantify a company’s resilience and exposure to long-term, industry material environmental, social, and governance-related risks.
Inset – As opposed to offsets, which generate ecological benefits anywhere in the world. Insets are tied to improvements and outcomes specifically within organizations’ supply chains. Insetting often comes with a multitude of co-benefits, including increased climate resiliency of the entire upstream/downstream value chain.
Net Zero – a systems-based approach to the conservation of natural resources which encourages a sustainable balance between the impacts on the ecosystem and the public goods produced by it. In the context of carbon sequestration and emissions, Net Zero refers to a state in which the greenhouse gases going into the atmosphere are balanced by removal out of the atmosphere.
Registry – a system of record for tracking, verifying, and accounting of certified ecosystem service credits tied to qualified projects.
Retirement – retiring an offset or any ecosystem services credit occurs when an entity or individual purchases a credit and uses it to offset their environmental footprint. This effectively removes the credit from circulation and reduces the available supply.
SBTi – the Science Based Targets initiative (SBTi) is a collaboration between several NGOs that works with organizations to define and promote best practices in emission reductions and net-zero targets in line with climate science.
Regulatory Market – compliance markets use regulatory oversight and market-based mechanisms through the issuance of allowances (permits) and offsets to meet predetermined regulatory targets. Rules are enforced by a regional, national, or international body with legal authority and jurisdiction.
Task Force on Climate-Related Financial Disclosure (TCFD) – A taskforce created by the Financial Stability Board (FSB) to develop a set of recommendations for voluntary climate-related financial disclosures. These are aimed at all financial actors, from companies and investors to asset owners and managers, as the goal is to provide consistent and transparent information to global markets.
Voluntary Markets – markets that enable private investors, governments, NGOs, and corporations to voluntarily purchase ecosystem services credits to offset their unavoidable environmental impacts.
