An Alternative Approach to Carbon Markets: Impact Reduction Options

Several weeks ago at the International Impact Investing Challenge, Benoit Passot and his teammates from the Stanford Graduate Business School presented a fascinating approach for carbon reduction wherein companies issue “impact shares” alongside regular equity shares. Benoit and I later discussed variations on the concept that his team presented, including an approach where companies write options with environmental performance improvement targets as triggers (instead of traditional strike prices) that facilitate real cash payouts to the company if they achieve the improvements. In this post, I’d like to elaborate on this concept and argue that it has the potential to materially affect the overall market for carbon reductions.

The overall goal of the option, from the purchaser’s perspective, is to achieve a reduction in a negative impact such as the release of carbon into the atmosphere. The purchaser is willing to put up collateral to cover the option in the case that that environmental target is reached (and option triggered), and the purchaser loses nothing monetarily if the targets are not met – the option simply expires. For the sake of this illustration, assume that the “purchaser” is some sort of environmental advocacy group that is taking a market-based approach to facilitating carbon reduction.

From the firm’s perspective, they will routinely be presented with the ability to write these options. As in any good “option”, there is significant upside for the firm in that they can generate revenue by achieving targets and exercising the options and collecting the payout from the advocacy group. These options change the financing structure of carbon reduction activities and will lead to a more favorable outlook for these activities across the firm’s capital budgeting. From the perspective of the advocacy group, the cost associated with the options (the payouts to firms that achieve reductions and meet targets) takes the place of other costly activities such as lobbying firms and governments. It is not meant to fully transplant these activities, rather the option can be thought of as a powerful tool for advancing a specific advocacy agenda such as “cleaning up” a certain industry or region.

As with the Stanford team’s impact shares concept, the impact reduction options that I am advocating have almost endless variations. Benoit argues persuasively that there are in fact many permutations of the idea, and generally that the concept of these environmental target-based financial tools is best thought of as a suite of financial derivatives. In the case of the impact reduction options, one could imagine a firm buying them for “zero” dollars from the advocacy groups, buying them for a small price to ensure alignment of incentives, or even selling them off at some point in time to entities that seek to provide performance guarantees for carbon-reducing products.

The fundamental question is as follows: will firms adopt the use of environmental improvement objectives and incentives as a means to manage their internal cost of capital? That remains to be seen and is most likely the main objection to my argument that these options can be viable tools for carbon reduction. My counter to such skepticism takes me full circle, back to the setting for my initial conversations with the Stanford team: the Impact Investing community. The Monitor Institute estimates that in the near term, Impact Investing can grow to 1% of overall global assets under management. That’s about $500 billion, of which even a fraction dedicated to these financial instruments (impact shares, impact reduction options, etc.) can make a sizable market. At this point, the real potential for demonstration that reductions to a firm’s cost of capital for carbon reduction measures will substantially alter their decision making process.

We’ve all seen the cost curves for eco-efficiency upgrades and have scratched our heads and debated why firms time and time again make “no-go” decisions. Impact shares and impact reduction options might unlock this easily captured value.