by , 21 December 2010
Ecosystem Marketplace posted an interesting document today on Global Forest Carbon Financial Risk Management Best Practices. Produced as part of a workshop of forest investors and lawyers, it outlines the risks in the forest carbon offset market and practices to manage these risks. Given the growth potential of forest carbon offset markets (not to mention other ecosystem service markets), the risk management tools for offset transactions are underdeveloped.
The authors document 25 different categories of risk that need to be addressed in order to develop the market. These include regulatory risks, currency risks, legal risks, etc. I am most interested in biophysicial risks, described here as “Unintentional Reversal” - the likelihood that an event such as fire or pest outbreak will kill off a forest and cause a loss of sequestered carbon. The authors suggest that these risks need to be underwritten financially.
Right now most programs for carbon offsets require project developers to set aside some portion of their offsets in order to create a “buffer pool” of offsets to mitigate risk of a forest failure. However, as one of the authors, Gabriel Thoumi, points out elsewhere, the registries are not the best party to manage these buffer pools because it leaves them exposed to huge risks better handled by insurance companies.
One topic I don’t see called out here is simple performance risk. Catastrophic events such as fires and floods are not the only reason a forest might not take up as much carbon as planned. Subtler ecological and climate stresses could reduce the rates of carbon uptake below what would be projected using standard models for tree growth. Forest systems are more complex and less predictable than, say, agricultural crops, for which one has a pretty good idea of what yields will be absent frosts, droughts, and other disasters. So a forward contract on carbon offsets from a forest would have considerably more uncertainty than one for a bushel of corn. The buffer pools might be able to handle this, but I wonder how well this risk has been incorporated in their design.