Still buffering…Why insurance is the solution for Buffer Pools 2.0
It's COP29, aka the “finance COP”, and Kita is discussing how carbon insurance is helping drive finance to scale high integrity carbon markets. In this blog, we highlight how insurance can better support Carbon Standards and buffers, to mitigate solvency risk and increase certainty and trust for stakeholders (while reducing the onus on project developers). We believe this is core to the wider integrity of Carbon Standards, building trust in outcomes, and enabling financial strength for project developers (including at the Article 6 level).
At Kita, we have always believed that carbon market buffers and insurance are complementary. As we wrote in our report Buffers and Insurance in the Voluntary Carbon Market: A Comprehensive Overview, “As the VCM evolves, there is potential for insurance and buffers to interlink more deeply.” We are delighted this interlinking is now happening in practice, with a great example being Kita’s Buffer Depletion Protection Cover (“Buffer Insurance”) policy, which is now live in the market.
Insurance is a familiar, highly regulated risk management mechanism common in most high-value markets. It exists both as a safety net when things go wrong and to outline paths to scale via proactive risk management. As noted by Kita’s CEO in this post, Carbon Standard buffers are often discussed as a structure that “acts as an insurance policy” and/or performs as an “insurance mechanism.” However, as we all know, acting as something is different than being something, and an insurance mechanism is different than a regulated insurance policy. Despite the integral role of buffer pools in scaling the markets and increasing trust, there is widespread recognition that integrating insurance as a tool to strengthen buffer pool safeguards - particularly in the face of increasing climate-related reversal risks - is not only prudent, but necessary.
This isn’t specific to just the VCM. A core development during COP29 has been the CMA adopting the decision on Article 6.4 to ‘take note’ of the standards developed by the Article 6.4 Supervisory Body – including the “Requirements for activities involving removals under the Article 6.4 mechanism”. The objective of this standard is to set out the requirements for activities involving removals under the Article 6.4 mechanism, and noted in a previous blog, a buffer mechanism is included and insurance is referenced.
By working in partnership with Carbon Standards, insurance can build trust in the integrity and resilience of buffers, by providing:
A creditworthy protective wrap against depletion of the buffer pool
A backstop against unexpected loss and security to counterparties
Clarity for end buyers as to how losses are addressed and compensated – outlined in a legally binding and regulated contract
Efficiencies of scale around risk modelling, data analysis and MRV
Benefit to project developers in the form of risk-adjusted contributions that respond to ongoing performance, thus rewarding high performers
The result enables greater flows of investment into underlying carbon projects.
Read on to find out more about (1) what buffer insurance does; and (2) why it matters.
What does Buffer Insurance do?
Buffers work in a broadly similar way across Standards:
Carbon project applies to Carbon Standard.
Via some form of risk assessment, or pre-set percentage, the project contributes a certain percentage of their carbon credits to the buffer.
The credits in the buffer pool cannot be sold.
If the project subsequently has a loss event exceeding the buffer contribution, according to the type of loss and terms and conditions of the Carbon Standard, the project developer may be obligated to ‘make good’ and replenish its contribution to the buffer.
If this ‘make good’ cannot occur, then buffer credits will be cancelled as a form of compensation to the buyers of those carbon credits who might be impacted.
There are two key points here that emphasise the benefit of Buffer Insurance:
All buffers face a risk of outlier loss that diminishes their solvency and ability to meet outlined expectations for buyers of carbon credits. It is possible an extreme number of losses could deplete the buffer past its ability to perform its function.
A lack of transparency from the perspective of the carbon buyer at the point of the ‘make good’ leads to confusion and mistrust as to the function of buffers, and thus integrity of resulting carbon credits.
Buffer Insurance therefore plays a very simple but important role:
Buffer Insurance operates as a creditworthy wrapper, protecting the buffer in the instance of unexpectedly high loss levels, leading to buffer depletion past comfortable levels. The insurance tops the buffer back up, leading to increased clarity and certainty for stakeholders of the Carbon Standard.
The provision of Buffer Insurance – as a regulated insurance policy – provides the ability for the Carbon Standard to provide a certificate of insurance to end buyers and report on losses/performance on a frequent basis, thus increasing certainty and trust in how any losses are covered.
Why does Buffer Insurance matter?
Buffer insurance matters because it can help increase certainty of function, and thus trust in output, of Carbon Standard buffers. This should help address market concerns that can limit investment.
To elaborate, let’s look briefly at Pros and Con(cern)s of VCM Buffers:
Pros:
Cover a key risk and play a needed risk transfer role
Started out of necessity and Carbon Standards evolving to meet market requirements
Provide some aspect of certainty on liquidity that would otherwise be lacking
Con(cern)s:
‘Over buffering’ leading to reduced liquidity in the market
The ‘weakest link’ risk within projects within the Buffer
Onus on the project developer – compliance; financial; liability
Market confusion around process and function, plus lack of clarity on 'like for like'
Questions around suitability for potential future regulation
Overall
There have not been many instances where the buffers have been significantly drawn upon.
both a pro (structured as a last line of defence)...
and a concern (unclear as to their overall ability to withstand catastrophic loss)
A key role of Buffer Insurance is helping mitigate these concerns to emphasise the positive aspects of VCM buffers.
Help market stakeholders feel reassured
Creditworthy backer that takes on legally binding risk
A protective wrapper to increase financial resilience - backstop to catastrophic loss
Certainty of expectation for stakeholders - legally-binding regulated contract
Reduce potential conflict of interests for the Carbon Standard
Insurance reduces potential conflict of interest via third party risk assessment, loss assessment and insurance claim payment
Reduce cost to project developers
Insurance wrap for buffer itself manages risk and cost for all stakeholders
Over time, helps reward project developers who build and maintain higher integrity carbon projects
Better manage a long-term and evolving liability
Insurance can play a staged role to reduce the “permanence” liability Carbon Standards and project developers currently hold
Insurance enables cost efficiencies in sharing / outsourcing aspects of MRV, due diligence and scenario analysis for loss events
Conclusion
We believe insurance and buffers are complementary, and together address key risks more effectively than each in isolation.
For any Carbon Standards who wish to speak with the Kita team about Buffer Depletion Protection Cover, please don’t hesitate to get in touch.
Please see earlier articles written on how Insurance can be incorporated into the carbon markets in collaboration with Carbon Standards here: