An assessment of carbon offset risk: a methodology to determine an offset risk adjustment factor, and considerations for offset procurement

Abstract

ABSTRACTCarbon offset credits can reduce a firm's financial risk associated with GHG compliance, but the credits themselves have inherent risk as they can be invalidated by the program administrator. Mechanisms such as regulatory certification, guaranteed offsets and invalidation insurance can be used to address offset credit risk. In the absence of such mechanisms to standardize credits, an offset risk adjustment factor can be derived and used to inform a market price discount. To begin to understand risk, this study examines characteristics of credits that have been invalidated, using historical data from the Alberta carbon market. Three variables used to characterize invalidated credits include: project type, vintage year and project developer. Variables are then combined using applied risk analysis and probability theory for the union of non-mutually exclusive events. A real options valuation method is then used to determine an offset risk adjustment factor. This methodology can be applied to other offset programs, and the offset risk adjustment factor can be expanded using the inclusion–exclusion principle for any number of variables. In addition to developing a methodology to quantify offset invalidation risk, risks associated with primary offsets and procurement approaches are discussed.