Voluntary carbon markets (VCMs) enable firms to offset their emissions by purchasing and retiring carbon-offset credits issued by third-party project developers. As nations and corporations increasingly commit to combating climate change, VCMs have emerged as a tool to support global decarbonization efforts. Morgan Stanley forecasts that the global carbon offset market will grow to about $100 billion by 2030 and to around $250 billion by 2050.

However, there is serious skepticism regarding the authenticity of climate claims made by some offset projects and their end users (e.g., West et al., 2023). On May 28, 2024, the U.S. government, including the Treasury, Energy, and Agriculture departments, announced a joint statement of policy and principles to guide participation in VCMs. “Voluntary carbon markets can help unlock the power of private markets to reduce emissions, but that can only happen if we address significant existing challenges,” said Treasury Secretary Janet Yellen. This underscores the importance of understanding companies’ incentives to participate in the carbon offset market and the implications of the lack of transparency and authenticity in VCMs for corporate carbon-transition efforts. There is a big gap in our understanding of these issues.

In a new paper, we aim to fill this gap by providing the first systematic evidence on the landscape of carbon offset projects and the determinants of offset usage by publicly listed firms around the world. We use a novel hand-collected dataset that contains rich information about which entities retire how many carbon credits to offset their greenhouse gas emissions in a given year, and which offset projects those credits originate from.

Our data encompass a variety of offset projects, such as those generating renewable energy, contributing to energy-efficient housing and appliances, and preserving forests and grassland. These projects are geographically dispersed, with the majority of them based in Asia, Africa, and the Americas. About half of all projects issue carbon credits that are purchased and retired by publicly listed firms around the world. Consistent with offsets being a transition tool, larger firms with higher institutional ownership and net-zero commitments are more likely to use offsets to reduce their carbon footprints.

To understand the incentives of firms to use carbon offsets, we consider two non-mutually exclusive economic hypotheses. The first is an “outsourcing hypothesis:” Firms with smaller carbon footprints use offsets more intensively to reduce their carbon emissions indirectly due to lower marginal costs associated with offsetting compared with reducing emissions directly through abatement investments and innovations, while heavy-emission firms are more likely to reduce their emissions in-house. The second is a “certification hypothesis,” under which firms care about their credentials with outside stakeholders and use offsets strategically to signal their commitment to reducing their carbon footprints.

Consistent with the outsourcing hypothesis, we find that low-emission industries such as services and financials are highly intensive in their use of offsets relative to their modest emissions, almost offsetting their direct emissions one-for-one. In contrast, the aggregate share of direct emissions that are offset using carbon credits is close to zero in high-emission industries, such as oil and gas, utilities, and transportation. Also consistent with the certification hypothesis, we find that relatively few offset projects are externally verified as having high quality and that most offset credits used by firms are strikingly cheap (more than 70 percent of retired offsets are priced below $4 per ton).

To facilitate a causal interpretation of the tests regarding our hypotheses, we exploit an exogenous change in companies’ ESG ratings triggered by a sharp rating methodology change at a leading ESG rating agency, Sustainalytics. At the end of 2018, Sustainalytics adopted a new methodology for computing firms’ ESG scores that created an average within-industry ESG rank reshuffle of 20 percentiles. Consistent with the strategic role of carbon offsets, firms offset more of their emissions using carbon credits after experiencing an exogenous ESG rating downgrade. Furthermore, when facing an exogenous shock to their incentives to boost rankings, firms with low emissions in industries with narrow cross-peer emission gaps become more likely to use offsets whereas heavy-emission firms in large-gap industries do not. Moreover, firms that strategically increase the use of offsets do so by retiring credits from low-quality offset projects, which command lower prices and therefore provide a cost-effective way of “transition-washing.”

Overall, our evidence does not support the idea that carbon offsets can be effective at facilitating net-zero transitions by heavy-emission firms. While we find some evidence that heavy-emission firms can be given incentivizes to use high-quality offsets rather than low-quality ones, we do not find evidence that these firms would use such “good” offsets in large enough quantities to meaningfully reduce their net emissions.

Our findings that carbon offsets are often used strategically for certification and ranking purposes have important implications for understanding the current state of VCMs and designing future policies and regulations. Our results suggest that the quality of existing carbon offset projects is generally low and that VCMs are flooded with low-priced offsets due to the lack of integrity guidelines and regulations, which likely discourages the use of high-quality offsets by firms that are motivated to take serious steps to reduce their emissions. This highlights the importance of commonly adoptable rules and regulations to ensure the transparency and authenticity of offset projects. Much future work is needed to understand exactly how to regulate the carbon offset market so that it facilitates an effective transition to a carbon neutral economy.

REFERENCES

West, TAP, S Wunder, EO Sills, J Börner, SW Rifai, AN Neidermeier, and A Kontoleon (2023). Action needed to make carbon offsets from tropical forest conservation work for climate change mitigation. Science 381(6660), 873–877.

This post comes to us from professors Sehoon Kim, Tao Li, and Yanbin Wu at the University of Florida’s Warrington College of Business. It is based on their recent paper, “Carbon Offsets: Decarbonization or Transition-Washing?” available here.