Fungibility refers to the property of a good or asset where individual units are interchangeable and indistinguishable. In other words, each unit of a fungible asset is considered identical and can be exchanged or replaced with another unit of the same asset without any loss of value or change in quality. Examples of fungible assets include money, commodities, and certain financial instruments. In the case of money, a specific unit of currency, such as a dollar bill or a digital currency unit, is fungible because any unit of the same denomination is equal in value and can be used interchangeably. Similarly, commodities like gold or oil are often considered fungible because each unit of the same type and grade is interchangeable with any other unit of the same type and grade.
Fungibility is a key concept in economics and finance, as it simplifies transactions and facilitates the liquidity and trade of assets in markets. Non-fungible assets, on the other hand, are unique and not interchangeable with other units. Real estate, collectibles, and certain types of intellectual property are examples of non-fungible assets. Fungibility is lacking in the carbon markets, even across compliance exchanges. For the carbon market to move to next level, and be a distinct commodity to be traded and consumed, this is a necessity. Just like in the commodities market, for it to function, the market must have confidence that all producers are working within the same regulatory framework, to the same standard, such that the market can reliably value all carbon credits of the same category to the same value, regardless of geographic origin. There must also be enough of the market for there to be liquidity.
The basis of the market is a carbon offset credit, or simply a carbon credit. A carbon offset credit is a tradable certificate representing the reduction, the removal, or the avoidance of production, of one metric ton of carbon dioxide (CO2) or its equivalent in other greenhouse gas emissions. It is called CO2e. The intent is to mitigate climate change by incentivising and by financing projects that reduce or offset greenhouse gas emissions. There are, broadly, two kinds of markets: the voluntary and the compliance. Voluntary carbon credits do not meet the verification and validation requirements to be considered a financial instrument. The key to the commodification of carbon credits is found in the compliance market.
While I may refer to carbon credits as a commodity and a financial instrument, a financial instrument and a commodity are distinct concepts, but there can be overlap in certain situations. A financial instrument is a broad term that refers to various contracts or assets whose value is derived from an underlying asset, index, rate, or instrument. It represents a tradable asset that has monetary value. Examples of financial instruments include stocks, bonds, derivatives such as options and futures contracts, currencies, and various investment funds.
A commodity, on the other hand, is a raw material or primary agricultural product that is traded on an exchange. Commodities are typically standardised and interchangeable with other goods of the same type. Examples of commodities include gold, silver, oil, natural gas, agricultural products, and base metals.
Financial instruments can be linked to commodities in certain cases. For instance, financial instruments like futures and options contracts can be based on the value of commodities. Traders and investors use these derivatives to speculate on or hedge against price movements in commodities. Some financial instruments are specifically designed to track the performance of a commodity or a basket of commodities. Exchange-traded funds (ETFs) and commodity-linked notes are examples of such instruments.
A financial instrument is a broader category that encompasses various tradable assets, while a commodity specifically refers to raw materials or primary agricultural products. However, financial instruments can be created based on the value of commodities, allowing investors to gain exposure to commodity price movements or manage related risks. In the case of carbon credits, it can become a commodity, and because of the nature of the contracts, and the possible derivatives, it can become a financial instrument.
At the moment, however, there are key differences between the commodities markets and the carbon markets. For example, commodities have defined rules on standards and regulations that must be adhered to. The carbon markets lack that. The standards are evolving, and there are different levels of credibility in the different markets. This explains why the EU ETS alone takes up more than 90% of all the compliance carbon markets, despite there being around 30 such markets.
Commodities are abundant enough that while changes in supply and demand will influence price, there is still liquidity in the market. That is not the reality with carbon credits. In fact, as we push towards a more stringent compliance regime, to pave the way for rated carbon credits, we will face an initial shortage oof such carbon credits because there are not enough compliance credits to meet the expected exponential rise in demand due to the implementation of the carbon tax globally.
While we may refer to carbon credits a commodity, commodities are generally raw materials that may be consumed to produce finished products. The commodity itself is a physical product. That product may be tested, assessed, and validated, which creates confidence in its fungibility. Carbon credits are smart contracts, sometimes on a blockchain. They are intangible products based on a physical asset, the carbon sink. It is because of this intangibility that the market confidence for carbon credits can only be based on the stringent compliance standards and regulatory framework. It is this point that precludes voluntary credits from being considered either a viable commodity or a financial instrument.
The intangibility of carbon credits is what feeds the inherent uncertainty of the product. This is what needs to be addressed. Analysts, experts, and market observers have advanced the idea that carbon credits are like bonds. This is a conceptual comparison, an analogy used to highlight certain financial characteristics that carbon credits and bonds may share, such as tradability, market value, and the potential for generating returns.
Like bonds, carbon credits can be bought and sold in markets, and their value can be influenced by supply and demand dynamics. Both financial instruments have the potential to provide financial benefits, although the mechanisms through which they do so differ. This leads to the debate whether carbon credits should be treated more like bonds. This implies that market underpinnings such as ratings, compliance standards, regulatory audits, and insurance drive pricing and risk scoring. They differ in significant areas. Bonds represent debt issued by governments, municipalities, or corporations. When an investor buys a bond, they are essentially lending money to the issuer in exchange for periodic interest payments and the return of the principal amount at maturity.
Investors in bonds receive periodic interest payments as income, and they are typically repaid the principal amount at maturity. Carbon credits do not generate periodic income. Their value is associated with their ability to offset or reduce greenhouse gas emissions. Bonds are issued by governments, municipalities, or corporations to raise capital. The issuer has an obligation to repay the principal amount and make interest payments according to the bond’s terms. Carbon credits are generated by projects that reduce or offset emissions. The entities undertaking these projects may sell the credits to generate revenue, but there is not a direct obligation to repay a principal amount as with bonds.
In any case, whether we consider carbon credits a commodity or financial instrument or both, a key contention is the lack of trust in the quality of the carbon credits, and the associated reputational risk for buyers and investors. Buyers and investors are forced to conduct extensive amounts of due diligence prior to executing any carbon credit transaction, which adds to cost. Because of this variance in due diligence in the absence o framework, there is no fungibility. There is also the challenge for buyers to align their due diligence requirements to wider message on net zero strategies, and Sustainable Development Goals (SDGs). In the course of this, there is a lack of understanding, in many quarters, on the differences between reduction carbon credits, avoidance carbon credits and removal carbon credits.
There are specific areas that need to be addressed, as we work towards fungibility in the carbon market. We cannot achieve fungibility for all compliance carbon offset credits, but we can have fungibility within classes. That means we have to class them according to type of project. These include cookstove offsets, renewables, afforestation, reforestation, biochar, peatland, direct air capture, and green and blue sequestration, among others. Some of these types are not suitable for the compliance market. For example, cookstove offset projects are responsible for millions of junk credits.
As part of the verification and validation process, we need to consider location, because that has a direct correlation to credibility. From location, we can consider political risk, regulatory risk, local community engagement, benefit-sharing, relevance to buyer’s business; geological risk such as natural disaster, corruption, and even project viability. This is especially important when we see this in light of the SSGs.
In summary, we need to identify the types of carbon credits for the
compliance market before we create a regulatory framework that encompasses the
points of contention to be addressed. We
need to identify, qualify and quantify the risks. We need a wide variety of strategic partners
from regulators to central banks to project owners to buyers before traction
can be achieved. From this, we need to
work towards a rating system for carbon credits, so that they can be rated, and
eventually made investment-grade. When
we have that, we can apply for carbon credits to be recognised as financial
instruments by elect central banks, and made fungible.
