Companies continue their attempts to mitigate their environmental impact. But are some merely buying their way out of the problem using carbon offsets? Global Head of Sustainability Research Stephen Byrd and Head of ESG Fixed-Income Research Carolyn Campbell discuss.

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Stephen Byrd: Welcome to Thoughts on the Market. I'm Stephen Byrd, Morgan Stanley's Global Head of Sustainability Research.

Carolyn Campbell: And I'm Carolyn Campbell, Head of Morgan Stanley's ESG Fixed-Income Research.

Stephen Byrd: On this special episode of the podcast, we'll discuss the voluntary carbon offset market and the role carbon offsets play in achieving companies' decarbonization goals. It's Thursday, February 23rd at 10 a.m. in New York.

Stephen Byrd: As extreme weather becomes the new normal, and sustainability rises in importance on investors' agendas, many companies are working towards mitigating their environmental impact. But even so, there's persistent public concern that some companies claiming to be carbon neutral may in fact be "greenwashing" by purchasing so-called carbon offsets. So, Carolyn, let's start with the basics. What exactly are carbon offsets and why should investors care?

Carolyn Campbell: So a carbon offset represents one ton of carbon dioxide equivalent removed, reduced or avoided in the atmosphere. Companies are buying offsets to neutralize their own emissions. They essentially subtract the amount of carbon offsets purchased from their total emissions, from their operations and supply chain. These offsets are useful because it allows a company to take action against their emissions now, while implementing longer term decarbonization strategies. However, there's concern that these companies are just buying their way out of the problem and are using these offsets that do not actually do anything with respect to actually limiting global warming. So, Stephen, some of these offsets focus on reducing carbon dioxide emissions, while others aim to directly remove these emissions from the atmosphere. Between these so-called avoidance and removal offsets, how do you see the market evolving for each over the next 5 to 10 years, let's say?

Stephen Byrd: Yeah, Carolyn, I think the balance is set to shift in favor of removal over the coming decade. So we developed an assessment of the potential mix shift from carbon avoidance to carbon removal projects, which shows the long term importance of removal projects as well as the near-term to medium term need for avoidance projects. We're bullish that over the long term removal projects, and think of these projects as projects that demonstrably and permanently take carbon dioxide out of the atmosphere, as generating enough carbon offset credits to reach company's net zero targets, again in the long term. However, over the near to medium term, call it the next 5 to 10 years, we expect the volume of removal projects to fall short. As a result, we think carbon avoidance projects, and these would be projects that avoid new atmospheric emissions of carbon dioxide. These will play an important role as offset purchasers shift their mix of carbon offsets towards removal over the course of this decade. Carolyn, one of the big debates in the market around voluntary carbon offsets involves nature based projects versus technology based projects. Could you give us some examples of each and just talk through, is one type significantly better than the other? And which one do you think will likely gain the most traction?

Carolyn Campbell: Sure. So on the one side, we've got these nature based projects which include things like reforestation, afforestation and avoided deforestation projects. In essence planting trees and protecting forests that are already there. There's also other projects related to grasslands and coastal conservation. On the other side, we've got these tech based projects which are actually quite wide ranging. This includes things like deploying new renewable technology or capping oil wells to prevent methane leakage, substituting wood burning stove for clean cookstoves, everything up to direct air capture and carbon capture, so on and so forth. So in our view, these tech based offsets will eventually dominate the market, but they face some scaling and cost hurdles over in the near term. Tech based offsets have some key advantages. They're highly measurable and they have a high probability of permanence, both disadvantages on the nature based side. Nature based sides, like I said, have measurement hurdles, but we think they represent an important interim solution until either geographic limits are reached because there's no more area left to reforest, or legislative conservation takes over. Removal technologies, like direct air capture and carbon capture, yield highly quantifiable results. And that drives a value in a market where the lack of confidence is a major obstacle to growth. So we think that's where the market's heading, but we're not really there yet. Now, one thing we haven't discussed is why even buy carbon offsets at all? Should companies be spending their limited sustainability budgets on carbon offsets, or is that money better served on research and development that might get us closer to absolute zero in the long term?

Stephen Byrd: Yeah, we are seeing signs that companies are increasingly looking to spend more of their sustainability budgets on research and development of long term decarbonization solutions, in lieu of buying carbon offsets. Now we support that trend, given the need for new technologies to really bend the curve on carbon emissions. And we do believe that offsets should not substitute for viable permanent decarbonization projects. Now, that said, offsets are a complimentary approach that enables action to be taken today against emissions that corporates currently cannot eliminate. We also believe the magnitude of consumer interest in carbon neutral products is underappreciated. Survey work from our alpha wise colleagues, really focused on consumer preferences and carbon neutral goods and services, shows that consumers are willing to pay about a 2% premium for carbon neutrality. Now, that may not sound like much, but it's actually a very significant number when you translate that into a price on carbon. Let's take sneakers as an example. Our math would indicate that consumers would be willing to price carbon offsets at a value above $150 a ton of carbon dioxide. That prices about 15 times the weighted average price of offsets in 2022. So consumer preferences may well play an important role in the evolution of the carbon offset market throughout the course of this decade and beyond. And we do think that this dynamic could provide the support needed to move the market towards higher quality offsets, and also drive companies to develop their own innovative decarbonization solutions. Carolyn, how big do you think the carbon offsets market could get over the next 5 to 10 years and even longer term?

Carolyn Campbell: Okay, so right now the market's around 1 to 2 billion in size, but we think there is a sizable growth opportunity between now and 2030, which is when many of the interim targets are set. And also longer term out to 2050, by which point we're trying to be net zero. So we estimate that the market could grow to around 100 billion by the end of this decade, and that will swell to around 250 billion by mid-century. And we've done this analysis based on our median expectation for progress on a few different decarbonization technologies like decarbonizing cement, decarbonizing manufacturing, and increasing the zero carbon energy penetration in the grid. When we look at that technological progress versus where we need to be in terms of our ambition to keep warming to one and a half or two degrees Celsius, that's how we arrive at the shortfall to make up that size of the market.

Stephen Byrd: Finally, Carolyn, one of the criticisms of carbon offsets is that they aren't regulated. So could you give us a quick glimpse into the policies and regulations around carbon offsets that potentially lie ahead?

Carolyn Campbell: Yeah, so you're right. Right now the market is largely unregulated and that creates the risk of fraud and manipulation. However, we don't expect imminent action, and it's just not a priority in the U.S. for Congress. That being said, if regulation does occur, we have an idea of what it could look like. We would expect to be led by the CFTC, which regulates the commodities markets. And we think that it would be focused on ensuring integrity in the market, creating a registration framework for the offsets and pursuing individual cases of fraud. Now, without formal regulation, there are few voluntary initiatives that have continued to set the standards in the industry. These organizations focus on the integrity of the market, they set principles to ensure that offsets are high quality, and they're even looking at labeling to mark credits as high integrity. So there's a lot of guidance out there, and it's constantly adapting to this evolving landscape.

Stephen Byrd: Carolyn, thanks for taking the time to talk.

Carolyn Campbell: Great speaking with you today, Stephen.

Stephen Byrd: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

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