The American Power Act of 2010 is out of the shadows, and some provisions make it possible to earn carbon credits for reducing greenhouse gasses by capturing carbon in trees. But that often involves paying for something today that won’t be delivered for decades. How can the insurance industry engage the forest carbon offset asset market so as to deliver an offset asset that is real, measurable and verifiable as well as secured, insured and preferred?
14 May 2010 | No participants in the forest carbon offset asset market are insured, as of today. Yet better management of forest carbon offset assets requires market participants to be properly insured, as they would be in any other renewable energy project finance deal or other project finance deal, with both property and liability insurance.
The US Forest Service defines real, measurable, verifiable, and additional, as terms commonly used to confirm the validity and legitimacy of forest-based carbon dioxide offsets.
- Real indicates that a reduction in GHG emission has taken place.
- Measurable indicates that a GHG emission offset can be quantified repeatedly using the same methodology.
- Verifiable indicates that the GHG emission offset can be registered and tracked.
- Additional indicates that GHG emission offset represents a scenario or action that is above and beyond what would have typically happened in a business as usual scenario.
Adding the words insured, secured and preferred designates the means to which the forest carbon credit project developer has taken to ensure meeting corporate due diligence expectations. Corporate due diligence methods expect market participants to be properly insured. Many participants in the industrial gas carbon markets are insured, while no participants in the forest carbon offset asset market are insured. This may disclose partly why in 2009, market transactions in the global industrial gas carbon market were US$ 136 billion in 2009, compared to transactions in the forest carbon offset asset market which were roughly US$30 million. By engaging in the insurance market, the forest carbon market can move towards financial risk management best practices.
- Insured indicates adequate commercial insurance policies such as errors and omissions, directors and officers, environmental impairment, general liability, property/forest and non-delivery of carbon credits or equivalent risk transfer methods have been instituted to warranty permanence of issued forest carbon credit.
- Secured indicates all reasonable methods used in proactively protecting the integrity of the certified forest carbon credit. Methods to include definitive actions required to alleviate potential frivolous or legitimate legal exposures throughout the project design, registry listing, verification, certification and potential reversal stages.
- Preferred indicates that all steps have been implemented to meet the “real, measurable, verifiable, additional, insurable and secured standards as defined above. The basis of preferred is design and implement standards that would be recognized and accepted as meeting specific financial guidelines designated by an internationally recognized rating bureau such as Standard & Poor’s and others.
The forest carbon offset standards in the voluntary carbon markets, as they exist today, will require necessary safeguards currently used in traditional business methods. The safeguards include the engagement of proper due diligence including contract reviews, risk management, insurance, and forensic accounting, such as those used in renewable energy project financing. The adoption of a structure integrating stringent policies and procedures will drastically reduce the exposure to potential errors or omissions.
For example, an error or omission, which is a mistake in either the financing, the calculation of the carbon credits, or the integration of the co-benefits of maintaining or enhancing biodiversity and providing sustainable economic opportunities for local communities, which causes financial harm to another individual or organization, can occur on almost any public sector or private sector transaction in the forest carbon offset asset market. Therefore, errors and omissions insurance helps to protect a professional, an individual or a company, from bearing the full cost of defense for lawsuits relating to an error or omission in providing covered professional services while providing opportunities to remedy the impact of these risks within the local communities. This is a separate coverage from a standard general liability or property insurance policy. This structure will need to address issues related to insured, secured, and preferred.
The emergence of the forest carbon offset market, which derives carbon credits from forest related activities, has been touted as a major component in global warming mitigation. Yet, market participants in the forest carbon offset asset market do not engage in financial risk management. It is like giving the keys to your car to your 16 year-old son, while not requiring him to be insured. Is this wise? Some might suggest not.
For example, some of the questions you need to ask yourselves, when purchasing forest carbon offsets are:
- How secure is the viability of the credits purchased?
- Is there a lien on the title of the land that secures the permanence of the forest carbon offset asset in the case of property transfer?
- How can insurance premiums be expensed?
- Has there been extensive due-diligence performed, prior to selection, of these forest carbon offsets?
- Would these steps taken to ensure credible offsets meet the fiduciary responsibility of your shareholders, customers, community, public sector, civil society, or vendor partnerships and relationships?
- There are solutions to the above concerns, which would provide the financial and structural integrity of the forest generated carbon credit. The use of specifically designed insurance techniques and products offer the ability to withstand legal and financial scrutiny.
Potential Exposures and Recommended solutions
While the forest carbon market has gone through a number of metamorphoses throughout its growth, it is important to analyze the fundamental structuring of the registries and buffer pool solutions. The analysis must recognize and label all areas where systems need to be put in place to eliminate any potential areas, which could be construed as misinterpretation or misrepresentation in a U.S. Court of Law.
The carbon registries are dependent upon web-based programs to facilitate the mechanics of the registry administration. Because these registries are typically non-profit organizations, they do not reserve a specific fund for unforeseen expenses including, but not limited to, project dispute issues, frivolous lawsuit defense costs, and/or potential bad faith issues pertaining to administration of self insured carbon credit program (buffer pool).
In order to eliminate potential exposures, the registry should require proof of errors and omissions insurance from all participating contractors and service providers. The inclusion of this requirement will allow any project issues pertaining to an error or omission be directed to the responsible parties, thus minimizing the registries involvement.
Non-profit directors and officers liability insurance protects the board and its members against lawsuits. The board has a fiduciary responsibility to their funding, grant providers, and non-profit mission. By procuring this type of insurance, the board is protecting the organization against potential lawsuits and defense costs, which would otherwise erode their operating funds.
The inclusion of a buffer pool into the internal structure of the registry will require professionals proficient in administering all reversal (claims) processing. .Currently, the registries are relying on verifiers to provide any loss adjusting duties. The fact that registries are acting as insurance faciliator for their designated buffer pools, opens them up to exposures typically experienced by insurance companies. In order to properly protect themselves, the registries will need to procure specific insurance coverages designed for program facilitators. They will need their own errors and omissions policy, directors and officers’ liability, and some form of buffer pool reinsurance.
It is strongly recommended that the registries transfer the administration of the buffer pool to a third party financially solvent in perpetuity. This would remove potential liability issues pertaining to the duties of determining cause of loss, claim settlement, claim disputes, recourse pertaining to intentional reversals, and other related liabilities.
The buffer pool is an area where insurance plays an instrumental role in valuing the forest generated carbon credit. The initial buffer pool structures were designed to provide a mechanism to replace forest carbon credits if there was a reduction in the certified metric cubic tons caused by an unintentional act. The models are based on a shared risk approach, where all participating forest projects are required to contribute a designated percentage of certified credits at time of issuance. At the time of these designs, there were no insurance programs available that would entertain insuring the forest for the time frame required by the registries. Now, insurance mechanisms are available that allow project owners to be rewarded for their management expertise regarding their project’s risk and return profiles.
Projects currently are not required to undergo an appropriate financial audit industry on a periodic basis. Therefore, it is challenging to understand whether projects which are forward looking have the capacity to meet their forward financial cash flows.
Concerns Pertaining to Registry Administered Buffer Pools
Carbon credit project rating structure of contributions is not based on specific actuarial and historical risk data. Each specific geographic area is subject to different natural exposures. The credit rating make up of each project has a variety of complexities, which need to analyze on a location-by-location basis.
Social and environmental issues would be protected by use of specific legal documents, which would not affect the rate of contribution.
The structured policy wording of the registries leaves tremendous room for interpretation. They would not stand up in a U.S. court as a legal and binding contract. Furthermore, given that many projects engage funding and transfer of carbon tons across sovereigns, interpretation of structured policy wording across these barriers would also be challenged.
In each buffer design, the wording leaves room for moral hazards which are the ability for intentional acts to be performed for the projects owner’s personal gain without reasonable recourse.
The integrity of the carbon measurement is diminished by the registries own power of determining the project owner’s reasonable expectations in case of a reversal.
The registry administered buffer pools need to be audited by an appropriate financial audit industry representative on a periodic basis.
There are strategies which combine traditional insurance with self-insured structures to meet the required sequestration time frames. The design and implementation is based on combining insurance knowledge and experience with analysis of the current registries looking at U.S. forest projects.
How Would a Revised Permanence Strategy Differ from Current Buffer Pool Designs?
The basis of these new insurance programs could use A.M. Best Financial Strength Ratings which allows for insurance companies to be rated so as to enhance stakeholders confidence in the stability of the insurer. These programs would allow alternatives to the current buffer pool design to be integrated into the registries and standards methodologies and data systems, providing the ability for full transparency for all stakeholders.
The current web based submission and listing process could be refined to take full advantage of data supplied by each listing project. For example, mechanically, all required information will be entered into definitive fields. This data will allow the registry the ability to run various reports such as concentration of demographics, physical data per region, historical loss history and allometric measurements. Initial risk rating capabilities would be integrated in process to “pre-underwrite” each project. This structured process leaves less room for misinterpretation and misrepresentation and confusion.
This required information would require legal attestation and signature by all project owners and by all project managers. This would add in important issues such as representation, legal dispute resolutions. All information collated would provide a foundation for a historical database to be used by and for the benefit of registries, insurance facilitators, project owners, investors, civil society, and impacted communities and other stakeholders.
To move forward, risks would need to be rated, as they are in a project finance scenario. In this case, the process for determining premium or credit contribution is based on a number of factors, including but not limited to:
- Geographic location;
- Species – types, ages, diameter-at-breast-height (DBH), basal area, stumpage values, thousand board feet (MBF), mean annual increment, or biomass;
- Natural hazard exposures such as ice, wind, fire exposure, disease, or infestation;
- Human potential hazards such as community risk, arson, debris collection, debris burning, and trespass;
- Previous losses due to hazards listed;
- FSC / PEFC / or other certification – if warranted; and
- Protective measures such as fire district information, county preventive standards, project’s land management and fire management procedures, steps to minimize human caused exposures, conservation easements, and other measures.
Separate Administration Structures
The importance of separating the administration of a permanence solution from the certifying registry is essential to providing a truly viable process. This alleviates the registry from potential conflict of interest issues. It meets Board of Director’s fiduciary responsibility regarding safeguarding integrity of registry by removing all potential liabilities connected with the administration of an insurance type structure. This includes claims handling, disputes resolution and policing project owners and managers. Finally, it provides increased confidence to both project owners and carbon credit purchasers because administration would be required to provide proof of errors and omissions coverage, for example.
Respecting particular insurance designs strategies, some of the benefits are that by providing a secure program, registries’ exposure to facilitating an insurance type program is eliminated. Furthermore, it structures the entire process of the forest carbon offset registry to minimize any potential gains for omissions or errors. Transparency in design contributes to a registry’s methodology and potential revisions. Because now there would exist a historical database, this would provide accuracy for forest carbon offset asset buyers’ and stakeholders’ due diligence requirements. A financially backed insurance program would increase investor confidence in credits decrease business risk of the registry. By providing a professional claims handling program, reversal processing and conflict resolution would be available for all stakeholders.
Finally, the focus provided by a structured forest carbon offset asset insurance program enables compliance and regulatory adoption while meeting corporate and SEC standards for governance, allowing for financially secured credits to receive financial rating by Standards and Poor’s, Moody’s, Fitch and others, resulting in increased institutional investment due to minimal risk and increased timberlands, community forests, and forest smallholder participation.
In conclusion, the forest carbon credit process has made tremendous advances in the last two years. In order to protect the integrity of the programs, there needs to be an infusion of business and insurance principles in how one conducts the business process of developing a forest carbon offset asset business, marketing program, standard setting, registry, and sales. We have identified the potential exposures and design solutions to eliminate those issues. The implementation of a proactive structure will attract the larger investment community.
Last year the global credit market was US$ 83 trillion while the global forest carbon market was roughly US$ 30 million. The global credit market engages various insurance mechanisms while the global forest carbon market, as of today, does not.
Gabriel Thoumi is a consultant at Forest Carbon Offsets, LLC and a Lecturer at the Ross School of Business at the University of Michigan teaching Strategy 739: Impact Investing.
Augustus (Gus) Kent is president of CO2RS, LLC., which was formed to provide insurance solutions for the carbon offset market. Gus has 22 years of commercial insurance experience, focusing in the environmental, professional, alternative and high-risk disciplines. He has been working with insurance carriers, who will offer coverages specific to those participating in carbon credit and offset areas. He can be reached at email@example.com or (503) 794-1000.