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The Role of Insurance in Ensuring Trust and Stability in Carbon Markets

The Role of Insurance in Ensuring Trust and Stability in Carbon Markets

As a risk management tool, insurance is an essential pillar of mature carbon markets.

Insurance serves as a fundamental risk management tool for most mature markets, with specialized insurance companies offering protection to customers seeking to hedge their exposure by distributing individual risks among a larger pool. Despite compliance markets and the voluntary carbon market (VCM) existing for several decades now, they have not seen a universal take-up of tailored insurance products that mitigate common climate investment risks. Factors driving this gap include the historically small size of environmental asset markets, data limitations, volatile pricing, long-dated risks beyond standard policy periods, and continual market structure shifts. 

This situation is rapidly changing and insurance is being recognized as central to the future growth and stability of carbon markets. In his opening address to COP28, the UK’s King Charles III commented on how the insurance sector will play “a vital role in incentivizing more sustainable approaches and providing an invaluable source of investment to reduce the risks [carbon markets] face”. Similarly, in their recent collaboration announcement, the registries Gold Standard, Verra, ACR, CAR, GCC, and ART explicitly mentioned “innovative insurance mechanisms” as a means to extend the durability of carbon stocks. Meanwhile, Stephanie Betts, Head of Alliances, Coalitions & Reporting at Aon Climate, thinks that insurance for carbon projects will be “one of the fastest moving segments of the market for the next few years”.

What is driving this new recognition of the importance of insurance? Simply put, an interest in risk-adjusted investments driven by general quality concerns and news coverage deteriorating the value of specific environmental assets. In its GHG Market Sentiment Survey 2023 report, coauthored with PwC, IETA found that public perception and negative press coverage were the two most significant challenges facing the VCM, underlining the necessity for safety nets in the market. Respondents also identified the quality of carbon credits and uncertainty around corporate claims as major challenges dampening corporations’ enthusiasm. Undoubtedly, insurance directly helps bolster the credibility of the VCM and its assets as it is a trusted mechanism for underwriting claims of climate impact even in high-risk environments.

Source: IETA's 2023 GHG Sentiment Survey, figure 19

Relatedly, a recent report from rating agency BeZero Carbon and carbon insurance startup Kita sets out three pillars of integrity in the carbon markets: 1) monitoring, reporting, and verification (MRV), which is equivalent to accountancy and auditing in more traditional markets; 2) carbon credit ratings (as covered in our article from July 2023); and 3) carbon insurance. 

The report finds that improvements in these three arenas would significantly de-risk climate-related investments. In particular, insurance would increase both supply- and demand-side actors’ trust in the space, with the goal of enabling more investment, leading to more carbon removal projects, and resulting in less CO2 in the atmosphere.

The mechanism by which carbon insurance facilitates this virtuous circle is worth underscoring. Insurance works by transferring risk exposures to a specialized third party (an insurer) that has the capacity to aggregate and absorb losses on a scale most individuals, companies, and, in some cases, sectors cannot shoulder alone. Beyond financial protection, the insurance sector also provides inherent due diligence, with providers incentivized to assess asset quality and risk factors during underwriting. Most interested parties would likely see a project being deemed uninsurable as a clear signal regarding its impact and investment worthiness. For insured projects, the transfer of key climate risks to the insurer can also unlock lower costs of capital.

These dynamics explain the benefits insurance offers both project developers and corporate credit buyers. It enables the mitigation of risks otherwise too challenging or expensive to self-manage, from weathering volatile pricing to offering compensation for disruptions. Such protection provides vital certainty in budgeting and cash flows. For example, in markets like marine transport tailored coverage has long enabled growth unhindered by fears of massive losses of cargoes at sea. We anticipate that robust insurance tailored to address unique climate investment risks will soon become a similar prerequisite for properly functioning carbon markets, helping accelerate sustainable capital inflows.

A good example of this is Kita’s recent MoU with PYREG. Through its PYREG Climate Finance Solutions (PCFS) initiative, PYREG plans to deploy biochar production systems to 150 agricultural partners by 2040. This first-of-its-kind program will be financed by forward contracts for verified biochar carbon removal credits. Participants can then lease PYREG’s novel carbonization machinery through the revenue generated. Kita’s tailored Carbon Purchase Protection Cover product underpins this model, offering protection against under-delivery risk. By de-risking the ambitious scale-up, Kita’s underwriting increases the confidence of prospective corporate buyers in their investment. This multi-party partnership facilitated by tailored insurance demonstrates how mature risk management solutions can unlock financing for impactful carbon removal models that would otherwise face barriers to growth.

Kita’s bespoke coverage of the PCFS initiative is also an example of a particular type of risk that is especially pertinent in the carbon dioxide removal (CDR) arena (the focus of Kita’s Carbon Purchase Protection Cover offering): delivery risk. Delivery risk refers to the chance that contracted carbon credits fail to materialize as expected and is a key barrier to investment in the nascent CDR space (see our recent article for an overview). Addressing delivery risk is critical for carbon removals given that the asset class is still in its early stages, with transactions overwhelmingly conducted in forward contracts. Policies that protect against non-delivery can therefore help corporations confidently make the upfront investments into pioneering CDR projects needed to scale climate impact.

Another risk affecting credit integrity is validation risk. This refers to the chance that issued carbon credits end up failing verification down the line and being declared invalid by supervising registries. As methodologies and scientific understanding rapidly evolve, registries may amend criteria in ways that mean previously approved credits now fall short. 

Startup Oka is an innovative provider in this space that recognizes the severity of invalidation, and the associated elimination of a credit’s carbon mitigation value. Their ‘Carbon Protect’ coverage pays out when invalidations occur post-issuance, helping safeguard buyers against revocations threatening their climate strategies.

Quality risk is another category intrinsically related to the validation of carbon credits, but does not refer to the likelihood that a project is validated but rather whether a validated project was validated credibly. Fundamentally, it relates to factors that undermine credits' ability to truly offset a tonne of CO2 emissions. Again, triggers range from projects overestimating their carbon removal impacts to methodological flaws in baselines and additionality assessments. To mitigate this, specialized quality assurance coverage can audit underlying projects and provide replacements for any credits subsequently deemed to be low quality. 

Another category closely related to invalidation is reversal risk, i.e. the potential for a validated project’s removed carbon to be released back into the atmosphere, compromising the permanence of emissions reductions and resulting in the credits being expunged. Triggers range from deliberate activities such as land use changes, illegal logging, or natural events like floods or wildfires destroying carbon-storing assets. The growing frequency and severity of climate change-exacerbated natural catastrophes makes this an acute concern and the total value destruction that reversal events represent has made designing insurance around them complex. However, insurance policies based on triggering criteria like acres burned in protected areas offer new methods to swiftly compensate for reversals, with Oka again being a first-mover in this space.

Beyond the credit integrity risks covered above are a host of other exogenous threats in the carbon markets that tailored insurance could help mitigate, including:

  • Counterparty risks: Risks created by third-party actions, ranging from defaults to fraud to reputational damages from the credits transacted. 
  • Geopolitical risks: Country-specific interference like expropriation or loss of ownership rights that could invalidate credits. 

While complex to cover, these risks all have precedents in traditional insurance markets—including political risk, cyber crime, and fraud liability, or business interruption—and interconnect with the credit-specific risks that Kita and Oka’s first policies are designed to address. 

All of the above risks are not mutually exclusive and several of them could combine to undermine a project initially regarded as credible, potentially resulting in all its credits or at least certain vintages being rejected by the market. The key here will be a relentless, multi-pronged drive toward increasing credits’ quality and managing the full range of risks. For carbon insurance to fulfill its promise and play a key role in scaling carbon markets, then, its risk frameworks have to be fit for this developing market. 

Risk models are foundational in pricing policies and determining coverage eligibility. As Stephanie Betts from Aon highlights, rigorous data analysis is enabling more accurate underwriting for climate risks. Partnerships also allow for the leveraging of cross-domain expertise, as seen in the example of Kita co-developing a biochar assessment methodology in collaboration with emissions quantification consultancy GECA Environment to be used for Puro-certified credits. This joint development of a tailored risk methodology aims to quantify likelihoods and severities across factors from operational risks to climate impacts. At launch, Puro's VP of Funding Solutions commented on how "Kita's delivery risk insurance product for biochar is providing a powerful de-risking mechanism, needed for buyers to increase their contributions to Net Zero." By enabling investors to confidently scale high-integrity CDR efforts, then, these robust risk frameworks can unlock capital flows into pioneering carbon removal models.

Such frameworks also need to evaluate factors ranging from technology readiness, monitoring robustness, and operator financials to location hazards and climate model projections—quantifying both likelihoods and severities across identified risks. Coupling holistic risk appraisal with emerging parametric triggers can enable finely tuned products. Refining frameworks as new datasets arise further strengthens reliability, while the digitalization of MRV and the carbon credit trading infrastructure also yields more reliable data in a space in which historical claims data is non-existent. Naturally, different insurers think differently about risk. Natalia Dorfman, CEO and Co-Founder of Kita, in an interview with CTVC explains how her company’s framework focuses on de-risking investments at the early stages:

… risk profiles differ depending on the type of carbon project. Nature-based projects like forestry have more familiarity for some investors, for example due to wider timber investment portfolios. However, they might have concerns regarding political, counterparty, and climate risks—particularly in areas prone to natural disasters. Engineered carbon removal projects are more capex-heavy and face technology and scale-up risks, but once up and running can offer investors a risk profile that feels familiar in terms of other infrastructure assets. The major hurdle across all forms of carbon removal projects is that there isn’t enough financing coming in. It’s a chicken and egg situation – all projects will be high risk until they hit key milestones – but insurance can act as the unlock to provide the risk protection to enable financing to help scale high quality projects.

For his part, Oka’s Founder and CEO Chris Slater in the same interview underlines the risks all along the timeline:

When you start a project, from day one to its end, there's always uncertainty whether it'll kick off as planned and actually start sequestering carbon. It's not just about getting it off the ground; even after we issue credits, there's this ongoing challenge to make sure they keep their value and do their part in meeting Net Zero goals. Insurance becomes essential across the board, so we’re juggling risks throughout the project lifecycle like reputation, finance, and staying on top of regulations.

Although the insurance industry’s behemoths are waking up to the growing importance of climate risk, these more nimble startups—which themselves use heavyweights like Lloyd’s of London as a re-insurer—are leading the way in structuring bespoke products to empower rapid scaling of high-integrity carbon markets. Traditionally, insurance claims are settled in cash. However, Kita is also offering clients in-kind payouts through their Carbon Supplier Pool. This means paying out claims in replacement credits rather than cash, which is appropriate in the carbon market due to the underlying asset often being valued for its utility (i.e. as an offsetting instrument) rather than solely as an investment. 

The challenge this presents is determining which credits serve as suitable replacements that align with clients' purchasing standards and priorities. In other words, the semi-fungible nature of environmental assets and the resulting difficulty in creating liquidity instruments also poses challenges when creating such insurance products. We touched on this in the following post: 

Kita's novel Best Match Method seeks to bridge this gap by working with advisory partners and carbon suppliers to define key attributes for comparison. Their framework analyzes factors ranging from project type, location, permanence, and more to quantify similarity and identify best matches for in-kind payouts.

As 2024 begins, a mature, trusted VCM underpinned by consistent rules and transparent pricing seems within reach. To fulfill this vision, specialist insurers are needed to assume and minimize carbon credit risks. Insurance will in itself also increase the value of those credits, as insurability acts as a signal of the value of the underlying asset relative to less robust credits. As the market matures, the portfolio of insurance products available will expand to cover more and more types of risk. The Taskforce on Nature-related Financial Disclosures (TNFD) has developed a set of disclosure recommendations and guidance for organizations to report and act on evolving nature-related dependencies, impacts, risks, and opportunities. When TNFD comes into effect, the need for comprehensive insurance products will become apparent across the board. Structured risk transfer instruments from a range of insurance providers promise to unlock transformational possibilities for carbon markets.

Neutral
About Neutral

Neutral is an exchange for environmental assets. We combine tokenized carbon credits, renewable energy credits, and carbon forwards with specialized market infrastructure to deliver efficiency, transparency, and trust in these markets.

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