Results-based finance and its role in the voluntary carbon markets

Results-based finance – Its role in the voluntary carbon markets

By Neil Salisbury & Christophe Brulliard

The recent 2013 World Bank report on carbon finance revealed that total global investment in the sector reached approximately US$359 billion in 2012, with the majority of contributions coming from the private sector. Voluntary carbon markets, which make up approximately five percent of the global carbon offset market, are also driven primarily (approximately 90 percent) by the private sector with corporate social responsibility and industry leadership the primary drivers for offset purchases [[1]Results-based finance[[2]] (RBF), also referred to as “payment for outcomes” or “performance-based payment”, is viewed as a much-needed alternative finance instrument to drive investment in voluntary carbon markets. Investors are demanding more rigor and clarity around the benefits delivered by their investments, and are no longer prepared to pay up before evidence has been established that these benefits did indeed occur. Results-based finance has been a prominent feature of the “aid effectiveness” agenda in development finance for number of years and is rapidly spreading to environmental and climate finance [[3]]. This includes REDD+, payments for ecosystem services (PES) and other advanced market commitments. The fundamental idea of results-based finance is that payment is contingent on the delivery of specific results, the results being independently monitored and verified.

In the voluntary carbon market, a sizeable portion of the market value (approximately 64 percent), is paid to offset sellers at the point of transaction, primarily via spot contracts and prepayment for future delivery of carbon credits, rather than at the time of offset delivery. If payment is only made after delivery of the results, the project developer (agent) will need to have access to sufficient funds (pre finance) to cover any upfront costs. This is a challenge not only for longer-term projects, such as forestry, but also other capital-intensive projects including wind and hydropower. This will require a shift change in how the voluntary market operates, where buyers are included at the onset of a project, rather than just at the transaction stage.

If the agreed outcomes cover the additional co-benefits linked to carbon projects, it becomes critical to clearly define the results or outcomes to be achieved and how these will be measured. In many cases, this may be more difficult to measure than carbon credits themselves. For instance, health outcomes linked to improvements in indoor and outdoor air quality is a complex science. Apart from monitoring hazardous air pollutions (at baseline and after the mitigation measure), linking this to specific measureable and verifiable health outcomes in a local community is difficult.

Acute health risks can be more readily identified with specific targeted indicators, however chronic and carcinogenic health risks may only materalise well after these projects are completed. Therefore, under a results-based finance scheme, it may be necessary for the indicators to be explicitly endorsed by principal, agent and scheme administrator prior to the commencement of the project, as well as relevant triggers for payments. While different approaches have been applied to monitor and control results in aid and development programs, including self-reporting followed by random audits, third party verification, computerized collection of data and surveys, its crucial that the indicators and outcomes are agreed upon at the start of the program, typically through a consultative process.

The challenge of defining appropriately subtle but not overly complex indicators should not be underestimated. Results-based finance schemes are also likely to impact the associated monitoring and verification costs that may include better understanding of a project baseline (if co-benefits are included), additional stakeholder consultation and the additional work required to determine appropriate targets. In addition, appropriate results-based finance payment conditions align closely with the desired overarching outcome or impact, as to minimise perverse incentives.

In Aid and Development, results-based finance has had undesirable effects when potential perverse effects have not been considered. For example, pressure to achieve certain objectives has resulted in other priorities being neglected or delayed. In other cases, project proponents have chosen to focus on those projects and indicators that can be easily measured and delivered, e.g., energy efficiency over a forestry project resulting in poor outcomes or selective project activities.

Results-based finance presents a significant opportunity for the voluntary carbon markets, in particular where the outcomes are clear, measurable and verifiable. The rigor of a results-based finance scheme can be beneficial to project proponents and beneficiaries, as this is likely to drive projects to be better structured, supporting cost-effective service delivery with robust governance frameworks. These efficiencies, allocation of risks, credible administration and better overall project delivery is likely to drive much needed private sector investment in voluntary carbon markets.

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[1] Maneuvering the Mosaic, State fo the Voluntary Carbon Markets 2013, Ecosystems Marketplace

[2] RBF is a funding approach where payments are only made after specified outcomes can be proven to have taken place.

[3] US Experiences on Results-Based Finance, Forest Carbon, markets and communities (FCMC) program, Oct 13, USAID