The price of offsets varies depending on the delivery terms. Guaranteed offsets are usually more expensive than intended emission reductions, even if the offered offsets are of the same quality. Guaranteed reductions have either already occurred (prompt delivery) or will occur in the near future and are guaranteed to be delivered (forward delivery). In the latter case, the provider is held liable for contract default if it fails to deliver the agreed-upon number of emission reductions. In cases where buyers donate toward intended emission reductions, project shortfall or failure has no consequences for the offset provider. Such intended emission reductions are referred to as ex-ante credits; the process is referred to as forward crediting.
Not all offset providers clearly distinguish between non-guaranteed ex-ante credits and guaranteed offset purchases. For example, a provider could advertise to sell Gold Standard offsets from projects that have not yet produced verified emission reductions. If this is not clearly communicated to the buyers, they may be unaware of the risk they are undertaking. It is therefore vital that the buyer reads the general terms and conditions of the contract and determines whether the purchased amount of offsets is backed by real emission reductions or not. The following sections describe the three levels of delivery risk in broad terms. Though specific contracts may deviate from this scheme, the underlying principles generally hold true.
Low Transaction Risk: Prompt Delivery of Existing Offsets
Prompt delivery in the carbon markets typically means delivery within a few days of contract signature. This delay allows for administration of the actual transaction, but not for the generation of offsets, which would be impossible in such a short time. In such cases, the provider assumes all project and price risks and generates the carbon offsets prior to selling them. The provider invests in the necessary technology, oversees project implementation, covers the operational project expenses, and pays the costs for validation, registration and verification of the project activity. The provider does so without knowing for certain how large a volume of offsets the project will ultimately generate, nor at what price these offsets may be sold. However, after successful project operation, having the carbon offsets in stock enables the provider to offer risk-free deliveries, and to achieve a higher nominal sales price than could be set for high risk (non-guaranteed) offsets. Since providers of promptly delivered offsets can specify and easily guarantee the exact amount, quality and parameters of their products, buyers of such offsets carry no project-related risks. Thus, this type of contract is suitable for buyers that wish to receive risk-free emission reductions quickly.
Medium Transaction Risk: Forward Delivery of Future Offsets
A forward contract constitutes a binding agreement in which the offset provider commits to deliver emission reductions to the buyer at a pre-defined time and price. The provider may have access to future emission reductions from a certain project or portfolio of projects, or may have existing emission reductions available in stock. For both the provider and the buyer, a forward contract is a way to eliminate market price risks and secure a desired transaction price, even though delivery may not occur for months or years. Such an arrangement protects the provider from falling market prices, and the buyer from rising market prices. Forward contracts may specify a fixed or proportional amount of offsets to be delivered.
A fixed delivery quantity specifies the exact amount of offsets to be delivered, while a proportional amount typically refers to the project’s overall success (e.g. buyer agrees to buy 50% of all generated offsets each year for 3 years). In fixed volume transactions, the seller carries the risk if the project produces fewer offsets than expected. In case of an offset shortfall, the seller must make up the missing offsets by delivering offsets from other projects at the same price.
A forward contract can be executed only if both parties still exist at the time of delivery (i.e. have not suffered bankruptcy). If the seller is unable to meet its contractual obligation, the buyer faces the risk of having to pay the current market price for offsets, which may be more than they had originally settled on in the forward contract. The risk of a party not being able to fulfill its contractual commitment is referred to as credit risk. Before signing a forward contract, each party typically assesses the credit risk of the other party.
While organizations applying professional risk management strategies may prefer forward deliveries to eliminate market price risks, such arrangements are less suitable for consumers who do not know how to assess credit risk. Forward contracts are most suitable for buyers who want to secure a price ahead of actual delivery and payment date (e.g. buyers who expect market prices to increase in the future).
High Transaction Risk: Forward Crediting of Ex-ante Offsets
Forward crediting – the sale of ex-ante credits – is the most complicated type of transaction for the buyer to understand. Typically, at contract closure, the buyer pays the purchase price for a certain number of offsets that have yet to be produced, and the provider delivers a certificate confirming the purchase. The successful generation of the agreed number of emission reductions is uncertain. Unless the contract contains an ex-post adjustment of the purchase price corresponding to any shortfall in offset generation, the customer carries the risk that some or all of the purchase price may be lost, given that offsets might not be delivered. Transparency in such transactions is likely to be limited because providers are unlikely to inform buyers of any shortfall in the number of emissions ultimately achieved. This is especially true for projects that are not expected to deliver the emission reductions for several decades, as is the case with certain forestry projects. Because buyers must pay upfront with no guarantee of the fulfillment of delivery, such transactions carry the highest risk for the buyer.
Forward crediting is similar to forward purchasing (see above) and the same principles of price-risk hedging and credit risk assessment apply. But there is a substantial difference in the degree of risk associated with the two types of transactions: in forward crediting contracts, the purchase price is paid upfront and is not repaid in case of delivery shortfalls. The seller is not obligated to replace delivery shortfalls with offsets from other projects. Because of this, forward crediting might be more suitable for donors who do not depend on exact emission reductions than for buyers who are looking to offset a precise amount.
How Providers Can Reduce Delivery Risk
Risk management techniques can substantially reduce the risk of project under-performance and consequent delivery failure. One key technique is the portfolio approach: by contracting / developing not just one or a few projects but a large number (e.g. with differing technologies or locations), the provider can diffuse the risk of catastrophic project failure. Restricting sales to the expected delivered volume based on the probability of project failure can significantly reduce the risk of over-selling. Providers with a substantial portfolio of projects are thus able to guarantee the amount, quality, and parameters of the carbon offset delivery to the buyer at contract signature, prior to generation and delivery. Active risk management can also be applied on a technical and operational level. By hiring technical experts to oversee the job site and perform quality control, and by consulting with local representatives, providers ensure that they will react in a timely manner to technical failure, shortfalls and errors in project documentation, changes in laws and regulations, etc. Although such measures raise project costs for the provider, they also ensure a lower project failure rate. A third way for the provider to avoid delivery default is to compensate for offset generation shortfalls with emission reductions purchased from other providers. Since all forms of risk management require an investment of resources, not all providers are able to offer an optimal delivery guarantee when contracting to generate offsets.