The evolving carbon insurance market explored

The voluntary carbon market (VCM) has recently seen rapid growth thanks to its role in achieving net-zero goals.

As many in the insurance industry will know, the VCM enables the offset of greenhouse gas emissions through the trading of carbon credits, which are generated by projects that reduce or remove greenhouse gases. The VCM not only assists in the reduction or removal of greenhouse gases, but also stimulates investment in sustainable development – such as in nature-based solutions or innovative green technologies. However, as the VCM has grown, so too have the questions regarding its evolution and this has had an impact on VCM liquidity in more recent months.

According to Morgan Stanley, by 2050 the VCM is expected to grow to around $250bn, but complex risks threaten its ability to scale rapidly – which is where carbon credit insurance comes in. There is now growing recognition of carbon credit insurance’s fundamental role in the VCM. Tailored insurance products that use parametric – or index-based – solutions, blockchain and artificial intelligence (AI) have emerged to meet the unique requirements of the VCM.

There are two main types of carbon market: the regulated compliance markets – such as the EU Emissions Trading Scheme – and the VCM. The VCM is unregulated and driven by corporates and non-governmental organisations seeking to achieve climate-related objectives.

Carbon market risks

Unlike the compliance markets, where the number of credits are strictly controlled, the number of credits that can be generated through carbon projects is directly linked to the metric tonnes of reduced, avoided or removed CO2 or equivalent greenhouse gases and the prices are determined based on supply and demand in the open market. This gives rise to a variety of low-frequency and high-severity risks, which can materialise at any stage of a carbon project’s lifecycle and can lead to financial losses for investors, potential reputational harm and reduced market participation. Consequently, these risks can undermine the credibility and impact of the VCM.

Investors are more likely to participate in the VCM when they are assured their investments are protected against unforeseen risks, particularly where they are contracting for carbon credits in advance – including through development funding or pre-payment. Such participation is a critical element in establishing a liquid and well-functioning market.

There is now growing recognition of carbon credit insurance’s fundamental role in the voluntary carbon market. Tailored insurance products that use parametric – or index-based – solutions, blockchain and artificial intelligence have emerged to meet the market’s unique requirements

Carbon credit insurance can assist in filling gaps in the risk allocation of carbon credit offtake arrangements, which in turn strengthens confidence among market participants, encourages investment and ensures stability through reducing the uncertainty associated with the delivery of credits generated by carbon projects.

This is achieved by covering financial losses that arise through projects that do not generate the expected amount of carbon credits; providing quick financial relief for projects that are affected by natural force majeure, enabling project recovery and continuity; and covering losses resulting from regulatory shifts or political risk events arising, which in turn helps market participants navigate the changes without substantial financial setbacks.

Carbon credit insurance also ensures buyers are compensated when invalid or fraudulent credits are purchased, maintaining trust and market integrity. It provides coverage against the price volatility of carbon credits, creating a more predictable revenue stream for market participants. It thus provides a safety net for all market participants.

Parametric products

Parametric insurance has evolved as a novel approach to managing the risks associated with carbon projects and is a type of insurance that is triggered by a pre-defined loss event occurring.

As mentioned by Swiss Re Corporate Solutions in its article on parametric insurance, the insurance cover is triggered when pre-defined event parameters are met or exceeded, which is measured by an objective parameter or index. In practice, this event could be wildfires or floods, for instance, where the parameter or index is the level of precipitation or fire intensity. Once the threshold is met or exceeded, an agreed payout is made regardless of actual physical loss suffered and without the need for lengthy loss assessments.

Parametric insurance is crucial for carbon projects as it provides swift financial support and liquidity, which is needed for the recovery and continuation of carbon projects. Policyholders also have more certainty regarding the coverage. When combined with blockchain and AI, parametric insurance enables insurers to assess the associated risks and adjust the pricing more accurately. This allows market participants to better manage their financial exposure to events that could undermine the effectiveness and profitability of their investments.

The integration of blockchain technology and AI into carbon credit insurance has the potential to transform the market. Blockchain technology provides a decentralised and immutable ledger that records all transactions relating to carbon credits. This transparency helps prevent issues like double-counting and fraud, ensuring each carbon credit is of good quality and verifiable.

The use of blockchain can streamline the verification process by making it easier to monitor the progress and impact of carbon projects. Blockchain also enables digital contracts and transactions to be executed in a secure, transparent and auditable way. By establishing trusted relationships among all participants, blockchain has the potential to provide a consistent and automatic execution environment, which in turn reduces the administrative workload and ensures prompt payouts without the need for intermediaries.

AI can be used by insurers to assess the performance risks relating to carbon projects by analysing large datasets to predict risks. By leveraging machine learning, insurers can better understand the factors that affect the generation of carbon credits and identify anomalies that are indicative of fraud. This assists in maintaining the integrity of the VCM by ensuring genuine, high-quality credits are traded and priced appropriately.

The integration of parametric insurance, AI and blockchain solutions in the carbon insurance market not only assists insurers by increasing the accuracy of risk assessments and pricing models, but it also protects all market participants through the provision of certainty, credibility, assurance, financial support and liquidity, all of which promote the success of the VCM and its ability to channel much-needed funding into nature-based and innovative technology carbon projects.

This synergy improves market stability, bolsters investor confidence and ultimately paves the way for the growth of the VCM and global movements towards achieving climate-related goals.

James Bateson, Laura Kiwelu and Nicholas Berry are partners and Jess Bruneau is an associate of Norton Rose Fulbright