A world first “Buffer Depletion Protection Insurance” policy, protecting Carbon Standards’ carbon credit buffers against depletion.

At Kita, we’ve always believed that Voluntary Carbon Market buffers and insurance are complementary. As we wrote one year ago in our report Buffers and Insurance in the Voluntary Carbon Market: A Comprehensive Overview - “As the VCM evolves, there is potential for insurance and buffers to interlink more deeply.”

We are delighted this interlinking is now happening in practice, and we can announce that the first Buffer Depletion Protection Insurance (“Buffer Insurance”) policy is live with UK Carbon Standard, Wilder Carbon!

Insurance is a familiar, highly regulated risk management mechanism common in most high-value markets, existing both as a safety net when things go wrong and to outline paths to scale via proactive risk management. By working in partnership with Carbon Standards like Wilder Carbon, insurance can build trust in the integrity and resilience of buffers, enabling greater flows of investment into underlying carbon projects.

In this blog we discuss (1) why this Buffer Insurance policy exists; (2) what it does; and (3) why it matters.

1) Why does Buffer Insurance exist?

Buffers within the Voluntary Carbon Market (VCM) are a topic of much debate, with commentary ranging from confusion as to the function of a buffer, to frustration about the level of contribution from project developers to appreciation for an inbuilt risk management mechanism that is core to the functioning of the VCM.

The buffer is a central pool of carbon credits to which each project developer is required to individually contribute, and these credits are not allowed to be sold. Buffers were created to protect buyers of carbon credits against reversal risk in underlying carbon projects, thus ensuring integrity of climate impact.

As the VCM evolves, Carbon Standards and buffers are evolving as well – from existing buffers incorporating new risk mitigation mechanisms, to new buffers addressing the challenge of getting to critical scale and building market confidence.

There is increasing recognition that integrating insurance as a tool to strengthen buffer pool safeguards - particularly in the face of increasing climate-related reversal risks - is not only prudent, but necessary. 

By incorporating insurance into the Wilder Carbon buffer, our ambition is enabling: 

• a creditworthy financial backstop, offering resilience in the face of outlier loss and protecting against default; 
• efficiencies of scale around risk modelling, data analysis and MRV; 
• increased liquidity and third-party assessment of fungibility between credits by providing additional management of risk-assessed buffer contributions;
• a smoothing strategy to help manage the downside risk of unexpected failure (where actual losses are higher than those modelled);
• confidence that investors (i.e. carbon buyers) will receive expected returns; and
• certainty of contractual expectation for underlying asset owners (i.e. carbon sellers).

Likewise, a key aim is enabling project developers to achieve a benefit of risk-adjusted contributions that could incorporate ongoing performance, thus rewarding those project developers who build and maintain higher performing carbon projects.

As Wilder Carbon continues its growth, we believe insurance will play a supportive role in enabling Wilder Carbon to further demonstrate integrity, respond quickly as risks evolve, and increase the liquidity of high-quality carbon projects to meet buyer and seller demand. 

2) What does Buffer Insurance do?

The quick summary is...

• Insurance as a creditworthy protective wrap against depletion of the buffer pool.
• A backstop against unexpected loss and security to counterparties. 
• Clarity as to how losses are addressed and compensated – outlined in a legally binding and regulated contract.

To provide more detail...

Buffers work in a broadly similar way across the VCM (disclaimer – the below is a simplification; there are many nuances across how different Carbon Standards and their buffers function):

• Carbon project applies to Carbon Standard.
• Via some form of risk assessment, the project contributes a certain percentage of their carbon credits to the buffer.
• The credits in the buffer pool cannot be sold.
• If the project subsequently has a loss event that exceeds the buffer contribution, according to the type of loss and T&Cs of the Carbon Standard, the project developer may be obligated to ‘make good’ and replenish its contribution to the buffer.
• If this ‘make good’ is unable to take place, then buffer credits will be cancelled as a form of compensation to the potential buyers of those carbon credits who might be impacted.

There are two key points here that emphasise the benefit of Buffer Insurance:

1. All buffers face a risk of outlier loss that diminishes their solvency and ability to meet outlined expectations for buyers of carbon credits.  It is possible an extreme number of losses could deplete the buffer past its ability to perform its function.
2. A lack of transparency from the perspective of the carbon buyer at the point of the ‘make good’ leads to confusion and mistrust as to the function of buffers, and thus integrity of resulting carbon credits.

Buffer Insurance therefore plays a very simple but important role:

• Buffer Insurance operates as a creditworthy wrapper, protecting the buffer in the instance of unexpectedly high loss levels that might lead to a buffer depletion past comfortable levels. The insurance tops the buffer back up, leading to increased clarity and certainty for stakeholders of the Carbon Standard.
• For established buffers, this insurance protects against the core risks of reversal and other non-permanence events that could lead to undesirable levels of depletion.
• For establishing buffers, there is the additional risk of not achieving critical mass – where early-stage projects don’t achieve the carbon sequestration projected, thus damaging the buffer’s ability to manage near-term liquidity risk. For these newer buffers, the insurance increases financial resilience and provides a backstop in the case of catastrophic loss, reducing the risk the buffer won’t hit critical scale or could default in the timeframes required for carbon stores to grow. 

3) Why does Buffer Insurance matter?

Buffer insurance matters because it can help increase certainty of function, and thus trust in output, of Carbon Standard buffers. This should help address market concerns that can limit investment.

To elaborate, let’s look briefly at Pros and Con(cern)s of VCM Buffers.

Buffers within the VCM have pros and con(cern)s

Pros:

• Cover a key risk and play a needed risk transfer role. 
• Started out of necessity and Carbon Standards evolving to meet market requirements.
• Provide some aspect of certainty on liquidity that would otherwise be lacking.

Con(cern)s:

• ‘Over buffering’ leading to reduced liquidity in the market.
• The ‘weakest link’ risk within projects within the Buffer.
• Onus on the project developer – compliance; financial; liability.
• Market confusion around process and function, plus lack of clarity on 'like for like'.
• Questions around suitability for potential future regulation.

Overall

• There have not been many instances where the buffers have been significantly drawn upon. 
• both a pro (structured as a last line of defence)... 
• and a concern (unclear as to their overall ability to withstand catastrophic loss)

A key role of Buffer Insurance will be helping mitigate these concerns to emphasise the positive aspects of VCM buffers.

Help market stakeholders feel reassured

• Creditworthy backer that takes on legally binding risk.
• A protective wrapper to increase financial resilience - backstop to catastrophic loss. 
• Certainty of expectation for stakeholders - legally-binding regulated contract.

Reduce potential conflict of interests for the Carbon Standard

• Insurance reduces potential conflict of interest via third party risk assessment, loss assessment and insurance claim payment.

Reduce cost to project developers

• Insurance wrap for buffer itself manages risk and cost for all stakeholders
• Over time, helps reward project developers who build and maintain higher integrity carbon projects

Better manage a long-term and evolving liability

• Insurance can play a staged role to reduce the “permanence” liability that Carbon Standards and project developers currently hold.
• Insurance enables cost efficiencies in sharing / outsourcing aspects of MRV, due diligence and scenario analysis for loss events

Conclusion

We are delighted to be working with Wilder Carbon on this market-leading Buffer Insurance policy.

We believe insurance and VCM buffers are complementary, and together address key risks more effectively than each in isolation.  We hope this first policy is one of many, to help increase integrity and function of Carbon Standard buffers within the VCM.

For any Carbon Standards who wish to speak with the Kita team about Buffer Depletion Protection Insurance, please don’t hesitate to get in touch.