Insurers ask whether their policy pays out cash or carbon

Insurers want to help get carbon out of the atmosphere: the physical dangers alone pose an alarming challenge for carriers and both they and their clients want to be environmentally conscious and responsible.

One of the most visible ways to tackle climate change is to participate in carbon markets. While many large polluters must participate in mandatory governmental emissions trading systems (ETSs), anyone can buy carbon credits in the smaller – but growing – voluntary carbon market.

The novelty of the carbon market has posed challenges for insurance, which is only now beginning to insure carbon credits on a significant scale. The market is changing at speed, but not every peril in the carbon market can be covered by existing insurance products or systems. Because markets effectively have their own internal currencies – carbon credits – some firms are offering policies that pay out in those credits, rather than cash.

Origins of carbon markets

ETSs originated in the US as a measure to reduce sulphur dioxide emissions, which are a cause of acid rain. Global carbon ETSs emerged following the signing of the 1997 Kyoto Protocol, which launched global efforts to control greenhouse gas emissions.

Carbon credits take two forms. The first are permits issued by governments and traded on government-backed ETSs, sometimes called the compliance market. The EU’s ETS dates from 2005 and China launched its own in 2021. In the US, the state of California has operated an ETS since 2006. The World Bank reported revenue from ETSs and carbon taxation came to nearly $95bn in 2022.

In addition to state-backed ETSs, there are also private sector voluntary carbon markets. Voluntary markets trade credits, rather than permits. Removal credits, seen as the most reputable form of voluntary credit, are tied to projects that remove a certain amount of carbon dioxide from the atmosphere.

The voluntary exchanges are much smaller than the ETSs; German energy company E.on cited figures claiming carbon offsets worth €1.5bn ($1.6bn) were traded in 2021. Deloitte reported as of 2022, total issuance of carbon credits came to close to $1.3bn.

In November 2022, the European Commission proposed a regulation to create “a Union certification framework for carbon removals”. Any accredited instrument must produce a “net carbon removal benefit”, which is quantifiable net the carbon generated by whatever activity is providing the offset.

The EU’s carbon market regulation also mentions insurance, calling for “appropriate liability mechanisms” to provide for cases when sequestered carbon leaks, among them “up-front insurance mechanisms”.

Coenraad Vrolijk, chief executive of CarbonPool, a new insurer that plans to offer carbon market insurance, says the voluntary and compliance markets are gradually converging. This is because official ETSs are starting to accept some removal credits as equivalent in carbon value to an official emissions permit.

George Beattie, head of innovation at managing general agent CFC, says the 2015 Paris Agreement could grant legal status to voluntary carbon market credits, which would make them valid for regulatory compliance. The Paris Agreement established a goal of “holding the increase in the global average temperature to well below 2°C above pre-industrial levels and [pursuing] efforts to limit the temperature increase to 1.5°C above pre-industrial levels”.

Vrolijk says photosynthesis – that is, forests – will be the main tool for drawing carbon from the atmosphere over the next decade. There are other methods, including carbon capture devices, which are very expensive, Vrolijk adds. Maynard mentions converting biomass into charcoal, called “biochar”, and spreading carbon-absorbing rock over fields.

Slow progress

Natalia Dorfman, chief executive of carbon insurance specialist Kita, says some “nascent” insurance initiatives emerged in the compliance market around 2005 and 2006, but these largely faded away as a result of the start of the global financial crisis two years later. The line revived again with the Paris Agreement.

Beattie places the market’s revival a bit later, saying: “Only since 2022 have things really picked up, probably due to the growing sophistication and size of the voluntary carbon market.”

Coenraad Vrolijk, chief executive, CarbonPool

Hayley Maynard, head of innovation at specialty re/insurer Chaucer, which has partnered with Kita and provides its underwriting sponsorship, says “when we first started working with Kita… you had existing carriers dabbling in this space”, but now the market has “carbon-specific entities” specialising in these fast-moving markets.

Kita is among these new entrants: a Lloyd’s coverholder, it partnered with Chaucer to offer carbon market insurance in early 2023. The two companies began working together via the Lloyd’s Lab. “Lloyd’s has been very, very supportive to us, as has Chaucer,” Dorfman says. Lloyd’s provided access to both capital and experienced insurance professionals, she adds.

“We take carbon liabilities and we charge people premiums in dollars or in [other] cash, but we invest that cash in our carbon removal projects. The core of our business model, of course, sits around the fact carbon is its own distinct currency in this climate space and it is acutely scarce”
_{Coenraad Vrolijk
CarbonPool}

Maynard stresses Kita gives Chaucer vital insight into a rapidly changing market, to which it can add its “insurance expertise”. Dorfman sees Kita as “the bridge between the carbon markets and the insurance markets”, which is important because not all carbon risks can be insured. She points out carbon sequestration is supposed to last for a century, meaning clients will seek infeasible 100-year policies.

CarbonPool has not started offering policies yet and is in the process of seeking a licence from the Swiss Financial Market Supervisory Authority. In the interim, Vrolijk says the company is “pre-assessing” potential clients, building up capital reserves and researching potential carbon-offsetting projects.

CFC unveiled its “carbon delivery insurance” in March but Beattie says market volume remains quite small. Though there are no exact figures, he says there may be fewer than $5m in gross written premiums for carbon insurance. “This is like the cyber market in the year 2000,” he adds.

Categories of risk

There are a number of participants in the carbon market. There are corporates purchasing credits or permissions, but also firms that offer carbon offset projects and their investors.

But they all essentially need insurance for either the failure of the carbon project – for example, because a forest burns down or suffers stunted growth – or because an actor has polluted more than it was allowed or had committed to.

CarbonPool plans coverage against three categories of risk: excess emissions beyond what is provided by a policyholder’s carbon credits; accidental release of sequestered carbon; and a failure of purchased offsets to absorb sufficient carbon. Vrolijk says most of the insurance perils that could cause a shortfall in offsets can be accurately modelled and insured against, with some exceptions – mainly large-scale political risk.

George Beattie, head of innovation, CFC Underwriting

Dorfman says Kita covers “delivery risk”, focusing on the earlier phases of carbon abatement projects before the new facility is producing carbon credits and undergoing auditing. “We’re looking at the investment into those projects to enable them to scale up and protecting the investor against the risk the project fails to meet its performance expectations,” Dorfman says.

Relevant risks include natural disasters; counterparty risks like bankruptcy, fraud and negligence; or “the carbon standard or its methodology being invalidated”, Dorfman says.

“I would be concerned, as an insured, about having my claim paid in carbon credits from projects I don’t know about and whose value I can’t easily deduce and that may be worth less than the credits I’ve lost… We believe, right now, purchasers of carbon credits would rather have a cash payment”
_{George Beattie
CFC}

Beattie says CFC’s product does cover political risks: “CFC’s carbon delivery insurance protects forward purchasers of voluntary carbon credits against non-delivery arising from any cause and we are the first to combine coverage for natural perils and political risks under one coverage.”

In cash or in kind

What makes CarbonPool and Kita unusual is they plan to pay out on their insurance policies in carbon credits rather than in cash. Vrolijk points out paying out in kind is not unprecedented – motor insurance policies, for example, sometimes provide roadside services instead of cash cover.

Vrolijk argues that, because carbon markets are not very liquid, it would be difficult simply to buy replacement credits with cash – much as a stranded motorist cannot simply buy a mechanic in the middle of nowhere. In most cases, “cash can make you good” – but emissions markets use “this currency of carbon, which is completely illiquid and scarce”.

CarbonPool deals with this peculiar market “by basically running a carbon balance sheet. We take carbon liabilities and we charge people premiums in dollars or in [other] cash, but we invest that cash in our carbon removal projects”, Vrolijk says.

Natalia Dorfman, chief executive, Kita

“The core of our business model, of course, sits around the fact carbon is its own distinct currency in this climate space and it is acutely scarce,” Vrolijk says, adding “carbon is the currency of net zero”.

Kita also offers cover in carbon credits, although it will also pay out in cash. “We feel it’s very important to have flexibility in how we pay a claim, because what a client wants is going to be based on how and why it’s engaging in the carbon market,” Dorfman says.

Dorfman gives two examples: one company might be insuring against a failure to meet a net-zero target, which means it needs carbon credits. On the other hand, a bank that loans funding to a failed carbon offset project will need cash.

“We’re looking at the investment into [carbon abatement] projects to enable them to scale up and protecting the investor against the risk the project fails… We feel it’s very important to have flexibility in how we pay a claim, because what a client wants is going to be based on how and why it’s engaging in the carbon market”
_{Natalia Dorfman
Kita}

One challenge for insurers is carbon credits are not necessarily fungible. Dorfman says some clients want their carbon removals attached to specific projects or locations. She gives the example of a South American forest project – should it burn down, the client might not want credits from a different operation in south-east Asia. Kita uses a “best match” model to match credit demand with potential substitutes.

Beattie is sceptical of this business model: “I would be concerned, as an insured, about having my claim paid in carbon credits from projects I don’t know about and whose value I can’t easily deduce and that may be worth less than the credits I’ve lost.” Beattie adds carbon credits may all nominally equal one tonne of carbon dioxide, but the projects that produce that credit “can be very different, so it’s felt voluntary carbon credits are in fact quite non-fungible”.

“We believe, right now, purchasers of carbon credits would rather have a cash payment that allows them to rectify a non-delivery in a way that suits them,” Beattie concludes.

Kita and CarbonPool develop portfolios of carbon offset projects to provide them with the necessary carbon credits. Kita has a “carbon supplier pool, which are carbon project developers we have vetted and that have the right type of carbon credits available”. Since January, CarbonPool has been “building a pipeline of investments ourselves in these carbon removal projects”, so it can start buying or reserving removal credits before the end of 2024.

Certain growth

Beattie expects the carbon market and the demand for carbon credit insurance will continue to grow. He cites estimates the voluntary market will be worth $30bn by 2030.

Dorfman says as the market adopts standard contractual language and definitions of key terms – something Kita is actively involved in crafting – it will be able to attract more capacity. She sees a large number of deals in the carbon market reaching completion towards the end of 2024 and start of 2025.

The Kita chief executive cites a report from Oxbow Partners that predicts carbon credit insurance could account for $1bn in gross written premiums by 2030 and between $10bn and $30bn in 2050.

Vrolijk also expects very rapid growth in the voluntary market, as increasing numbers of large corporations purchase carbon credits – “it will be billions spent this year on carbon removals”.

The CarbonPool chief adds the number of major corporations buying carbon credit appears to be doubling annually. “It’s going very, very fast right now and the amounts people are spending on this is also not less than $100m each a year,” he says.

“Right now, these credits are not covered, but once these big players face an unexpected shortage of carbon credits in a new market, the demand for insurance will swell,” he adds.

Although “the climate deniers obviously slow down this process” of decarbonisation, Vrolijk does not expect them to stop the expansion of carbon markets, since the obvious effects of climate change are worsening.

“The urgency will go exponential,” he says, until “there’s a complete panic moment”. That is when the world will need an insurer with a long balance sheet in carbon credits, he adds.

“I don’t think we’ll be overwhelmed,” Vrolijk concludes. “We may not be able to reach the goals we set… but that’s not going to be because we are overwhelmed and insurance can’t handle it.”