Work program 1: Sound and Accountable Markets for Carbon Assets (Removals)

In its recent work SFI has made important contributions to the development of E-Ledgers accounting, working with colleagues at Oxford and Harvard Business Schools through the E-Ledgers Institute (ELI). One important result of this collaboration has been SFI’s contribution to a rule book that establishes coherent E-Ledgers accounting that would properly recognize carbon balance sheet liabilities which incorporate the principles and practices of generally recognized financial accounting. E-Ledgers is increasingly recognized as an alternative system for carbon management that contrasts in multiple ways with predominant practices of emissions reporting under the Greenhouse Gas Protocols (GHG)) n(GHG—practices which have been subjected to sustained academic and practical criticism. Now, agreement on a comparable E-Asset accounting rule book is a critical step toward sharpening the confused lines of carbon asset management and trading that currently create perverse outcomes in carbon finance. We anticipate definitions of carbon accounting standards and conventions will include both economy-wide rule books for environmental assets and more specific use cases of sector-wide consequence, such as multi-product (food crop) or multi-user (data center) allocations of carbon emissions.

The principal lines of distinction between E-Ledgers consistent asset accounting and GHG emission reporting may be summarized under three lines of critique.

Established non-carbon accounting practices (GAAP) demand that units of account be counted comprehensively, but only once; that recognized liabilities be matched by assets of comparable duration and quality; that liabilities are not tradable as assets, and that authoritative auditing be transparently completed at the close of each performance period. While GHG reporting deviates from all of these tenets, E-Ledgers has developed faithful applications of these principles for carbon liabilities; SFI has and continues to complement these with similar analysis of carbon assets.
GHG protocol reporting standards for emissions inventories underlie carbon trading in voluntary, compliance and removals markets. However, while E-Ledgers accounted carbon removals require atmospheric carbon be captured and stored to match each unit of carbon emitted, voluntary markets (VCM) overwhelmingly trade offsets for actual emissions against carbon reductions or avoided emissions defined by counter-narratives of what would have occurred but for the transaction. The widely used VCM qualitative screens of additionality, permanence and leakage are inadequate asset matches for properly accounted emissions liabilities because stories of what emissions would have occurred later, elsewhere or under different policies or prices, proliferate and often loosen, with each new standard setting body. As these agencies (registries, ex ante validators) multiply, supplies of offsets increase apace, prices fall, and the gaming of politically agreed carbon budgets is inevitable.
While substantial public and private human and financial resources are devoted to GHG reporting of supply chain and downstream emissions with problematic data -- and to offsetting them with frequently unaudited and mismatched carbon credits--, funds and priorities are deflected from both transitions away from carbon-intensive production (decarbonization) and from innovation around effective carbon removals, which together define Net Zero commitments. In the latter case, the gaming dynamics to gain market share of avoided emissions transactions undercut the prices of compliance permits or true removals. In a Net Zero/E-Ledgers world of stable carbon, the price of compliance for emitting carbon must equal the price of capturing and storing carbon of equal duration and quality. In the GHG world we occupy, available low-priced avoided emissions and poorly matched removals claims undercut the demand for higher priced compliance permits and the development of true removals at scale to which compliance prices must in a Net Zero future must ultimately converge.
In support of its E-Asset commitments, SFI in its work program 2 will work up from its published analyses to deliver a prototype removals transaction between two globally influential sovereigns that exemplifies through transparent practice the rules of E-asset definition and trading. At the same time, the parallel drafting of the E-Asset rule book will be conducted in ongoing consultation with the E-Ledgers Institute, as was done with the liability side rules. Reflecting both the financial theory background and the extensive experience in asset management and regulation that Marc Roston brings to the SFI E-Asset work program, this work program is well placed to take a recognized lead in drafting the structure and content of a credible E-Asset rule book. Several recent political commitments provide further weight to the sense that the drafting and diffusion of such an E-asset rule book may be well timed and received beyond the conceptual and policy malperformance of GHG reporting and carbon markets.
- The prevalent and acknowledged controversies about the centrality and sensitivities of an effective process for putting a sound accounting system under various applications of carbon action have been recognized in various forums, including the proposed COP 30 action agenda. The simplest and proper path to this goal is through a dedicated Commission, integral to the COP 30 process, that incorporates professional expertise in established and familiar accounting principles and practices (“Plan A”). On November 25, in commenting publicly on the political difficulties of climate action reforms that had precluded priority goals during the UNFCCC process, COP 30 President Andre do Lago emphasized (Financial Times,11/25) the greater potential for the formation of coalitions of commercial and public actors to overcome hold-up behavior in areas like deforestation and fossil fuel roadmaps and in their complementary accounting and carbon finance practices. In either case, SFI is engaged with and well recognized by the relevant Brazilian and COP 30 authorities to participate, consult and diffuse its E-asset work, whether commissioned through or around the COP 30 action agenda.
- At the same time, political uncertainties suggest the formulation of a backup “Plan B” that could offer a close substitute for the substantive characteristics and likely outputs of the ideal, but perhaps problematic, Plan A. Plan B, in which leading private firms with ambitious carbon commitments could play a driving role, could take off from two recently held workshops— an E-Ledgers sponsored Amsterdam event 13-14 October and an SFI/Climate Leadership Council sponsored Washington event, coincident with the IMF/WBG 16-17 October. In each case, there has been significant engagement of academic and financial/accounting professional experts, as well as COP 30 officials. In this same vein, significant line of parallel forum development is likely to be the newly chartered Carbon Measures Alliance (CMA) created and announced at COP 30 by major corporates in the commodities, financial, accounting and chemicals sectors. SFI should have particular opportunities via CMA to play a formative role in the development of the E-Asset side of carbon balance sheets and associated carbon markets for removals and carbon budget consistent volumes of avoided emissions in which these assets can credibly trade.

Carbon accounting and carbon work program related SFI research papers in preparation:

Three Authorities: The paper explains why qualitatively distinct “assets” such as physical carbon removals; carbon compliance permits and avoided carbon emissions cannot be traded in unified markets without perverse outcomes for carbon effective management.
Market that won’t Trade: To correct the well-documented problems of fraud, gaming, volatile levels of liquidity, and mismatched asset-liability quality in carbon markets, the paper argues that financial markets theory and empirical studies of financial institutions suggest an architecture that incorporates trading only carbon removals, duration-termed assets, risk-driven pricing, audited carbon, and long-term portfolio construction.
Carbon ecosystems: Analysis of effective financial markets suggest an ecosystem of specialized firms that supply and manage assets that are credible, credit worthy and liquidly traded (alienability, custody, fungibility). The paper explores options for innovative carbon market firms that can offer scalable services for carbon delivery portfolios, carbon re(insurance), and regulatory supervision.