The science is clear: Climate change is predominantly caused by the emission of greenhouse gases into the atmosphere.¹ The atmosphere is composed of many gases, but one, carbon dioxide (CO₂)—at a 0.042% concentration today, up from only 0.031% 50 years ago²—is the main driver of climate change.³ It may seem counterintuitive that such a small amount of CO₂ can warm an entire planet, but it is the most abundant “greenhouse,” or heat-absorbing, gas. While 99% of the atmosphere is nitrogen and oxygen, they do not absorb the Earth’s heat. Much like a tiny virus that can make you sick, CO₂ in the atmosphere is minuscule but mighty.

Zeroing out most emissions—by replacing fossil fuels with clean energy technology, improving energy efficiency and reducing other sources of emissions—will not be enough to halt and reverse climate change.⁴ To keep global warming trends below 2º Celsius (C), the threshold outlined by the 2015 Paris Agreement⁵ and recommended by scientists to avoid major future climatic damages, CO₂ removal technologies, potentially both nature-based and mechanical, will be needed. To reach negative net emissions by 2050, carbon removal (along with other strategies) will be necessary.

Desire for a net-zero world has led to the expansion of the global carbon market—an important investment area

This desire for a net-zero world, in which greenhouse gases emitted are canceled out by those removed from the atmosphere, has led to a significant expansion of the global carbon (shorthand for carbon dioxide, CO₂) market. In a carbon market, technologies that reduce the amount of carbon a company (or an individual) produces—their “footprint”— create units of value called carbon offset credits, along with systems for certifying, registering and trading them.

Furthered by regulation and societal pressure, verified carbon credits have become an emerging investment area for companies and individuals as well as investors who may wish to help solve climate change and also achieve long-term returns. However, the carbon market’s growth has been uneven, with notable national variances. The U.S., for example, has no current federal carbon regulation but does have two regional compliance markets.

Carbon removal technologies include nature-based and mechanical solutions. Both approaches can create carbon offsets that can be held, sold and traded on exchanges by those who want help compensating for carbon emissions occurring elsewhere. Many companies, governments and individuals are more than willing to purchase carbon offsets.

Forestry is the current dominant carbon offset solution. Forests sequester carbon through the growth of trees, which pull CO₂ out of the atmosphere and combine it with soil nutrients and water to grow. The segment remains a particularly appealing removal offset, especially as mounting scrutiny is given to some avoidance offsets (being paid to avoid a CO₂- emitting activity). Forestry also offers the potential for even greater stewardship opportunities.

Carbon market standards are still new and evolving. What exists today may not be right for the future. Here’s some background on the carbon market opportunity, including forestry offsets, as well as some of the standards and limits to consider.

Carbon regulation and market development

Carbon regulation to reach a net-zero emissions world has been in development since 1990, when the first of a series of international reports began showing the growing urgency of action to reverse climate change (EXHIBIT 1). Regulation, by creating a pricing mechanism, incentivizes emissions reductions, carbon offsets and investment in technologies to reduce emissions.

But while the scientific evidence of climate change has strengthened, carbon regulation has not kept pace, developing only slowly. The share of global emissions subject to regulation was roughly stagnant from 2005–11. Recently, however, the share of global emissions covered by regulation has grown sharply, to 22% globally in 2021 from 5% in 2010. Regulatory coverage has risen steadily every year since the 2015 Paris Agreement. New carbon regulations (implemented and scheduled) jumped in 2021 as countries sought to show leadership in advance of November’s U.N. Climate Change Conference 26 (COP26) in Glasgow, where countries will negotiate measures for addressing climate change. Carbon emissions are now subject to regulation worldwide.

Carbon regulation has grown steadily, albeit slowly, over time

EXHIBIT 1: GLOBAL EMISSIONS COVERED BY A CARBON TAX OR EMISSIONS TRADING SYSTEM (%)

Source: World Bank Carbon Tracker, U.N. Intergovernmental Panel on Climate Change; data as of April 1, 2021, and August 9, 2021, respectively.

Global participation in carbon regulation: Growing but uneven adoption The number of countries participating in carbon market regulation has been growing (EXHIBIT 2). As of 2021, China’s national emissions trading scheme (ETS) covers the largest share of global greenhouse gas (GHG) emissions (7%),⁶ followed by the European Union’s (EU’s) ETS (3%) and Japan’s carbon tax (2%). Regulations, including these, don’t necessarily cover all carbon emitters; they may only cover specific sectors and thus have the potential to grow within each jurisdiction. For example, the Chinese regulation market presently covers the power sector, representing 40% of national emissions. But the government has indicated its intention to expand to other sectors in the future.

Global carbon regulation has expanded notably

EXHIBIT 2: COUNTRIES OR REGIONS COVERED BY CARBON REGULATION (TAX OR ETS), 2010 VS. 2021

Source: World Bank Carbon Tracker; data as of April, 1, 2021. Includes initiatives scheduled for implementation (formally adopted through

This global patchwork of regulations has led to a wide range in price per metric ton of CO₂ and equivalents—tCO₂e— around the world (tCO₂e allows all regulated gases to be converted to the same unit for common pricing) (EXHIBIT 3). The tCO₂e price is either set by a carbon tax or varies in response to a market. In some markets, prices vary by individual greenhouse gas, reflecting different costs for their reduction or differences in the desired phase-out date. The primary price for fossil fuel-based CO₂e is called the “tier 1” carbon price. For perspective, an average American emits more than 15 tCO₂e a year; globally, the average is around 4.5 tCO₂e per person.⁷

A global patchwork of regulation created a wide range in price for a ton of carbon or its equivalents (tCO₂e)

EXHIBIT 3: SHARE OF GLOBAL EMISSIONS, CARBON PRICING AND REVENUES

Source: World Bank Carbon Tracker; data as of April 1, 2021 (carbon share and pricing), and December 31, 2020 (carbon tax, ETS revenues). All prices use tier 1 pricing. Chart excludes China because with very recent ETS implementation, data is not currently available.

The latest on carbon pricing: governments and markets, EU and U.S.

Historically, carbon pricing has been higher when calculated by governments for the purposes of a carbon tax than when priced by markets in emissions trading systems. If, in the future, markets were constrained by lower allowable emissions allotments (by governments acting more aggressively to reach net-zero goals), ETS prices would increase. Differences in regional carbon prices, often the outgrowth of more lax emissions standards in some locations, have led the European Commission’s Fit for 55 plan⁸ to include a proposed “carbon border adjustment mechanism,” much like a tax, to prevent carbon leakage: the transfer of carbon-intensive activities to jurisdictions with laxer emissions rules. These constraints are policy decisions, either through the levying of taxes, typically based on a set carbon price, or through emissions caps that set maximum emissions, with carbon prices moving in a trading system.

Of note, there is no current U.S. federal carbon regulation. Despite signing the Paris Agreement in 2015, the U.S. began withdrawal in 2017 and formally dropped out on November 4, 2020. During this time, carbon regulation was stagnant. The U.S. formally rejoined on February 19, 2021, after President Joe Biden signed an executive order.

While there is not a carbon price in the U.S. on which to base regulation, there is a pricing framework to aid policy decisions. In early 2021, the Biden administration revised the federal social cost of carbon, a value per tCO₂e to guide federal cost-benefit analyses of greenhouse gas emissions, to inform planning for setting a carbon tax or an ETS carbon emissions cap.⁹ The estimate was temporarily set to USD 51 per tCO₂e—the prevailing price during the Obama administration.¹⁰ During the Trump administration, carbon was priced as low as USD 1 per tCO₂e. An interagency working group is presently reviewing the latest science and economics to develop a new estimate, due January 2022.¹¹ There is speculation a price could be set above USD 125 per tCO₂e.¹² The UK updated its regulatory pricing guidelines in September 2021, with this year’s ranges between GBP 122 and GBP 367 per tCO₂e.¹³ Debate is growing over the use of social cost of carbon to inform policy,¹⁴ yet the conversation itself highlights the surging interest and focus on the developing carbon market.

Two types of CO₂ removal technologies

In order for carbon, and carbon offsets, to trade on exchanges that carbon pricing has and will continue to foster, carbon removal technologies are a linchpin. Such technologies include:

• Nature-based solutions that manage ecosystems like forests, mangroves, kelp beds and soils that naturally sequester CO₂.
• Mechanical removal of CO₂ from air or the ocean with direct capture technologies that use machines to extract CO₂ to create other carbon-based materials, including plastics, carbon-embedded cements and rocks buried deep underground.

Projects using these technologies to remove or reduce a carbon footprint can be verified for carbon offset credits. Companies and individuals can purchase verified carbon credits to reduce their overall emission counts. Investors can invest in these types of environmental projects or technologies to help provide climate change solutions and for their long-term return potential.

Carbon registries: key for offset verification and certification

Carbon registries help verify, certify and track carbon offset projects to avoid double counting. There are two types of registries: compliance and voluntary. Compliance registries are a market used by entities that are required by law to account for their carbon emissions. Voluntary carbon registries have formed in the last 20 years to meet emerging demand for both carbon offsets and overall carbon management where interest has grown faster than regulation.¹⁵ EXHIBIT 4 describes a number of registries.

Carbon registries can vary in specialization and regional footprint

EXHIBIT 4: CHARACTERISTICS OF COMPLIANCE AND VOLUNTARY REGISTRIES WORLDWIDE

Source: Individual registries; data as of August 11, 2021 (Clean Development Mechanism as of July 2, 2021). Total credits registered are the annual estimated credits (Verra), total lifetime credits issued (ARB, American Carbon Registry, Gold Standard, Climate Action Reserve) and total lifetime credits retired for carbon(plan) and Clean Development Mechanism. ARB credits are also registered in American Carbon Registry, Climate Action Reserve and Verra. UNFCCC: UN Framework Convention on Climate Change.

Types of carbon emission offsets

Offsets can take two main forms:

• Avoidance offsets are generated by activities that reduce future emissions through prevention—for example, by building a wind farm instead of a new natural gas energy plant.
• Removal offsets extract carbon from the atmosphere or ocean by nature—such as forestry—or by mechanical removal.

Of late, avoidance offsets have come under scrutiny, especially as energy from renewables becomes more costcompetitive with fossil fuels. Evolving carbon regulations and verification standards may prompt stricter requirements for offsets, particularly around verification of carbon offset delivery and proof that projects do not result in leakage. Ultimately, carbon markets develop to provide financial incentives to reduce emissions.

Forestry represents the majority of both removal offsets and total offsets, by tCO₂e, across all registries. In 2021, forestry represented 40% of all offsets registered—both those available on the market (called “issued” projects) and those already purchased (called “retired” projects). U.S. registries have significant forestry holdings. For example, at Climate Action Reserve, a major U.S. registry, forests accounted for over 80% of offsets in 2019. Standards and projects are also evolving for other nature-based removal offsets, including mangroves, kelp beds and soils, as early standards did not consistently deliver carbon removal.¹⁶

Technologies to directly capture carbon from the air or oceans are still in early development. Major barriers to adoption relate to their materials and energy requirements,¹⁷ as well as costs (estimated low ranges are from USD 250–USD 600 per tCO₂e) that far exceed the current price of carbon in the compliance or voluntary markets (EXHIBIT 3).¹⁸ The largest facility, recently opened under ideal conditions in Iceland, took 18 months to build and will annually remove the equivalent of only 860 U.S. gasoline-powered cars.^{19, 20}

A forestry case study: Trees’ efficiency in capturing carbon

Forests remove carbon from the atmosphere because trees grow by taking in CO₂ and combining it with soil nutrients and water. Forestry carbon offsets are generated by the growth of forests as trees mature and sequester carbon in their wood. It takes roughly 40 years for a hardwood tree to sequester 1 tCO₂e.

Most offset projects relate to reforestation, where trees are replanted or grown where a forest once stood, or afforestation, where trees are planted where they have not previously stood. These projects are designed to maximize carbon removal, a different approach from that taken with mature forests, which have less sequestration potential. In mature old-growth forests, avoided deforestation offsets have been used to incentivize leaving trees standing, but they have come under scrutiny for fear of leakage.

Varied standards have developed for forestry offset certification to ensure common practices and measure whether they deliver their stated carbon removal targets. However, there is room for improvement (EXHIBIT 5). A review of offsets from available registries has shown that some forestry projects have been overcredited; for these projects, carbon removal assumptions were systematically low because they reflected carbon removal for the wrong tree species.²¹ This highlights the need for making the definitions and methods to calculate carbon removal more robust, to ensure accurate delivery.

How forestry projects are credited could be improved

EXHIBIT 5: STANDARDS FOR FORESTRY CARBON OFFSET CERTIFICATION

Source: J.P. Morgan Asset Management.

A criticism of forest offsets has emerged: that primarily single-species tree farms are being grown rather than developing healthy ecosystems. By contrast, the highest quality forestry carbon offsets could provide forestry stewardship, protecting and expanding forests critical for carbon removal and global forestry health,²² with pricing reflecting the costs to deliver sustainability goals.

This would allow for the bundling of positive outcomes from forestry offsets, including:

• Carbon removal by capturing CO₂ from the atmosphere and transforming it into biomass (i.e., trees, kelp, mangroves).
• This requires planting, watering and potentially fertilizing to “farm” carbon removal.
• Meeting the conservation goal of protecting natural land; this may be of special interest to countries making “30 x 30” pledges in advance of COP26 (protecting 30% of land and ocean for conservation by 2030).
• Meeting the biodiversity goals of planting trees and monitoring wildlife to develop healthy ecosystems and support biodiversity.
• Supporting rural economies by creating jobs and access to forests for tourism and recreation.
• Supporting indigenous populations in maintaining cultural traditions through access to forests and creating an income source in managing land (our analysis to create EXHIBIT 4 found that several U.S. projects are managed by indigenous people).
• Lowering wildfire risk by removing debris and other active fire reduction management strategies. The history of fire suppression activities in certain dry forests (e.g., the western U.S.) with natural wildfire cycles have left excess fuel for fires to burn more intensely once ignited. With increased wildfire risks due to climate change, intentional management may lower the risks of catastrophic, large-scale fires,²³ but this requires careful management, clear standards and scientific research to guide activities.
• Climate adaptation by planting tree species for projected regional climate change conditions to improve long-term forest resilience.

Offsets’ current physical limits, with a likely rise in demand ahead

There is the potential for an offset supply issue, given the likelihood of increased demand as corporations strive to meet their net-zero commitments. This could put substantial pressure on carbon prices.

Consider EXHIBIT 6: In 2019, global emissions from all sources reached 36 billion tCO₂e. The Russell 3000 Index, benchmarking the entire U.S. stock market, emitted 7 billion tCO₂e.

Global forests sequester significant CO₂ from the atmosphere annually. Measuring this removal over the last decades using satellites, scientists estimate that 7.6 gigatons (Gt) of CO₂ e are absorbed by forests annually, as represented by the dotted purple line in the chart.²⁴ But this uptake of carbon is not a global offset to be monetized, as it does not create additional removal to reduce emissions and slow or reverse climate change. For corporations to achieve net-zero emissions by offsetting their total global emissions by forestry alone, the world would have to more than double this natural process. Meeting the annual carbon removal required by the Paris Agreement to reverse climate change and stop further warming (if 2ºC or 1.5ºC targets are the goal) by 2100 would demand a sizable scaling up, as shown by the dotted purple line in Exhibit 6.

Yet we estimate a global offset supply of only 0.5 Gt CO₂e, highlighting the need for significant expansion to reduce emissions and meet net-zero goals in the coming decades. Of course, forestry will not be the only solution, but it is the dominant (40% of offsets in 2019) and only scalable removal method today.

The supply of carbon offsets currently listed on registries is small compared with U.S. corporate emissions

EXHIBIT 6: EMISSIONS DWARF THE SUPPLY OF CARBON OFFSETS

Source: Global Carbon Atlas, Russell 3000, MSCI, carbon registries; data as of December 31, 2019. Offsets are those registered on Climate Action Reserve, American Carbon Registry, Carbon Plan, Gold Standard, Verra and Clean Development Mechanism.

Globally, however, as human activities emit CO₂ beyond what the Earth system can naturally absorb in forests and oceans, ecosystems are likely to become more stressed and oceans warmer, potentially reducing these natural sinks and leaving even more carbon emissions in the atmosphere each year, accelerating climate change. As long as global emissions exceed removal, climate change will follow.

Ultimately, the global climate warms in proportion to the amount of CO₂e left in the atmosphere. Every ton of carbon emissions matters. Solutions need to scale to reduce global emissions; offsets play a part, but they are not the sole solution.

What does this all mean?

To reach a net-zero world, emissions need to decline. To keep global temperature rises below 2ºC, both nature-based and mechanical offsets will need to scale. High quality, nature-based offsets such as forests may provide additional positive economic, natural, cultural and other outcomes. Global coordination, such as the COP26 meeting in Glasgow and private sector efforts led by the Taskforce on Scaling Voluntary Carbon Markets, will bring carbon markets and offset development further into focus.

Investing during a time of climate change

Mitigating and reversing climate change will take significant investment. Up to USD 4 trillion per year will be needed globally through 2050 to achieve a 1.5°C target across various sectors, such as power, iron and steel, cement, chemicals, transport, aviation, shipping, agriculture and buildings.²⁵

This requires:

• Replacing high emission activities, such as fossil fuel energy generation, with clean energy.
• Reducing emissions in all sectors as close to zero as feasible, given technological availability. This means improving energy efficiency where there are no zero-carbon alternatives.
• New technologies, materials and recycling to decarbonize sectors beyond energy production. This includes hard-todecarbonize sectors without clear technological solutions, such as aviation and cement.
• Waste and agriculture management for the reduction of methane, a short-lived greenhouse gas whose main impact lasts a decade.

For processes that cannot be replaced with zero-carbon alternatives now and/or in the future, carbon removal through nature-based or mechanical means will be necessary. Investment today is critical—to deploy existing solutions and develop the technologies of tomorrow needed to combat climate change.

Endnotes

¹ Gases that trap heat in the atmosphere include carbon dioxide (CO₂), methane, nitrous oxide and fluorinated gases. In the U.S., these gases represent 80%, 10%, 7% and 3%, respectively, of 2019 greenhouse gas emissions by tons of CO₂ equivalents. “Overview of Greenhouse Gases,” U.S. Environmental Protection Agency.

² “The Keeling Curve,” Scripps Institution of Oceanography, UC San Diego.

³ There have been six reports by the United Nation’s Intergovernmental Panel on Climate Change (IPCC) (in 1990, 1995, 2001, 2007, 2014 and 2021), which changed in tone from providing a theoretical basis for climate change with some observed changes to later making unequivocal statements on the human influence on the climate and the potential for major changes and extreme events if emissions continue.

⁴ Climate simulations in the sixth IPCC report used models with five main methods to reduce global emissions to net zero/negative: 1) reduce fossil fuel use, 2) reduce energy demand, 3) use nature-based solutions, 4) reduce greenhouse gas emissions besides CO₂, and 5) mechanical removal from the air. Jordan Wilkerson, “Half of the IPCC Scenarios to Limit Warming Don’t Work,” Eos 102, July 7, 2021.

⁵ The Paris Agreement is a legally binding international climate change treaty adopted by 196 countries at U.N. Climate Change Conference 21 (COP21), held in Paris in 2015, with the goal of keeping global warming below 2ºC and preferably below 1.5ºC, compared with preindustrial temperatures (before 1860).

⁶ Developed first for provinces and cities, over the last decade the Chinese ETS was recently implemented nationally.

⁷ “CO₂ emissions (metric tons per capita),” World Bank. 8 See note 7.

⁹ This value quantifies the cost of additional damages caused by CO₂e emissions, including but not limited to: health effects, loss of life, damage to properties, reductions in agricultural productivity and damage to ecosystems.

¹⁰ “A Return to Science: Evidence-Based Estimates of the Benefits of Reducing Climate Pollution,” the White House (blog), February 26, 2021.

¹¹ “Technical Support Document: Social Cost of Carbon, Methane, and Nitrous Oxide: Interim Estimates under Executive Order 13990,” Interagency Working Group on Social Cost of Greenhouse Gases, United States Government, February 2021.

¹² Paul Voosen, “Trump downplayed the costs of carbon pollution. That’s about to change,” Science 371, no. 6528, January 29, 2021.

¹³ “Valuation of greenhouse gas emissions: for policy appraisal and evaluation,” UK Department for Business, Energy & Industrial Strategy, September 2, 2021.

¹⁴ Joseph E. Aldy, Matthew J. Kotchen, Robert N. Stavins, et al., “Keep climate policy focused on the social cost of carbon,” Science 373, no. 6557, August 20, 2021.

¹⁵ A legally binding voluntary greenhouse gas trading system, the Chicago Climate Exchange, operated from 2003–10, covering six greenhouse gas emission sources and offset projects but closing due to inactivity and lack of regulatory development.

¹⁶ Jane Zelikova, Freya Chay, Jeremy Freeman et al., “A buyer’s guide to soil carbon offsets,” (carbon) plan, July 15, 2021.

¹⁷ Sudipta Chatterjee and Huang Kuo-Wei, “Unrealistic energy and materials requirement for direct air capture in deep mitigation pathways,” Nature Communications 11, no. 1, July 3, 2020.

¹⁸ Katie Lebling, Noah McQueen, Max Pisciotta et al., “Direct Air Capture: Resource Considerations and Costs for Carbon Removal,” World Resources Institute, January 6, 2021.

¹⁹ On September 8, 2021, Climeworks announced it had broken ground for its first major direct air carbon capture facility in Iceland. The location was chosen for the site’s abundance of cheap, renewable geothermal power to run the plant and the location’s ideal geology deep underground to convert and store CO₂ as rock.

²⁰ Using 2020 estimates from the U.S. Environmental Protection Agency and the Federal Highway Administration. See “Greenhouse Gases Equivalencies Calculator— Calculations and References,” EPA.

²¹ Grayson Badgley, Jeremy Freeman, Joseph Hamman et al., “Systematic over-crediting of forest offsets,” carbon(plan), April 29, 2021.

²² Johan Rockström, Tim Beringer, David Hole et al., “We need biosphere stewardship that protects carbon sinks and builds resilience,” Proceedings of the National Academy of Sciences of the United States of America 118, no. 38, September 21, 2021.

²³ Paul F. Hessburg, Susan J. Prichard, R. Keala Hagmann et al., “Wildfire and climate change adaptation of western North American forests: a case for intentional management,” Ecological Applications, 2021.

²⁴ Nancy L. Harris, David A. Gibbs, Alessandro Baccini et al., “Global maps of twenty-first century forest carbon fluxes,” Nature Climate Change 11, no. 3, 2021.

²⁵ “Climate Finance Markets and the Real Economy,” Boston Consulting Group and Global Financial Markets Association, December 3, 2020.

²⁶ “Carbon Footprint Calculator,” U.S. Environmental Protection Agency.

²⁷ “Local footprint calculators,” World Wildlife Fund. 28 Net U.S. emissions were 5.8 Gt CO₂e in 2019, according to the EPA. For an estimate of infrastructure package reduction, see John Larsen, Ben King, Hannah Kolus et al., “Pathways to Build Back Better: Nearly a Gigaton on the Table in Congress,” Rhodium Group, September 15, 2021.

²⁸ Net U.S. emissions were 5.8 Gt CO₂e in 2019, according to the EPA. For an estimate of infrastructure package reduction, see John Larsen, Ben King, Hannah Kolus et al., “Pathways to Build Back Better: Nearly a Gigaton on the Table in Congress,” Rhodium Group, September 15, 2021.

Risk Summary

Investing on the basis of sustainability/ESG criteria involves qualitative and subjective analysis. There is no guarantee that the determinations made by the adviser will align with the beliefs or values of a particular investor. Companies identified by an ESG policy may not operate as expected, and adhering to an ESG policy may result in missed opportunities.

*Dr. Sarah Kapnick is a former Managing Director and Senior Climate Scientist and Sustainability Strategist for Asset and Wealth Management (AWM). Following her time at J.P.Morgan, she joined the National Oceanic and Atmospheric Administration (NOAA) as their chief scientist.