When people think about innovation in carbon removal, they're probably thinking about physics or materials science. How do we make CDR faster, cheaper, more durable, or use less energy? What if we told you that a lot of the innovation that is coming is financial and/or contractual?
In this episode of the Reversing Climate Change podcast, Nori Cofounder Ross Kenyon and Nori CEO Matt Trudeau are joined by Racheal Notto, Director of Carbon Markets Engagement at Kita, and James Kench, the Head of Insurance at Kita. Their conversation explores how insurance can play a key role in managing risks within the carbon markets, and why it isn't already more of a player. Insurance companies are the professed masters of risk management. Carbon markets have a fair amount of risk. Shouldn't there be a bigger crossover?!
Kita, a London-based insurance company focusing specifically on insuring carbon projects, explains their goal of derisking high-quality carbon projects, and what that can add to all players in the space.
The discussants weigh the pros and cons of buffer pools vs. insurance and get answers for why some high-quality carbon removal projects may actually be uninsurable.
Insurance is important for any industry to grow. This could be a sign of another step in the carbon removal sector's growing maturity.
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Carbon Removal Newsroom, the news show that ran alongside this one, is over. Its episodes are still up, on the feed Climate Workers Anonymous now uses.
Carbon Removal Memes is still going.
Resources
"Buffers and Insurance in the Voluntary Carbon Market: A Comprehensive Overview" by Kita
"Could VCM buffer pool design risk a "bank run"?" by Matt Trudeau
Full Transcript
Ross Kenyon: You’re listening to the Reversing Climate Change podcast by the team at Nori, the carbon removal marketplace. This is a show about the innovators and entrepreneurs developing solutions to climate change. Hello and welcome to the Reversing Climate Change podcast with Nori. I’m Ross Kenyon and I’m one of the cofounders of Nori and also the Director of Creative and Marketing. Here I am joined by my colleague Matt Trudeau, CEO of Nori. Hey, Matt.
Matt Trudeau: Hey, Ross. Good to be here, as always.
Ross Kenyon: And we are joined by Racheal Notto, Director of Carbon Markets Engagement at Kita, and James Kench, Kita’s Head of Insurance. Welcome, you both.
James Kench: Good to be here.
Ross Kenyon: Happy to have you. Maybe we should start with the simplest question possible. What is Kita?
James Kench: Sure, I — I can kick off. So Kita, we insure carbon, so we build insurance products to de-risk high-quality carbon projects. We think insurance is the key to unlocking the capital that’s needed for the sector to scale, and without insurance it’s difficult to get the financing and therefore difficult to get the projects off the ground. And our goal is to be a one-stop shop to help solve some of the pain points of the carbon markets as they scale, via insurance. Now, a little bit more on the nitty gritty of us. We’re based out of London over in the UK. We’re a small but mighty team of about 10 to 15 people, depending on how you count it, and we are backed by Munich Re, RenaissanceRe and Chaucer. And we’re also a Lloyd’s [unclear] coverholder.
Ross Kenyon: I saw that. And Lloyd’s is famous for, I think, not the original insurer, but for, like, maritime shipping — and hundreds of years ago they basically invented this product class. Is that right?
James Kench: Yeah, so Lloyd’s of London stands for Edward Lloyd’s coffee shop. So it was literally a coffee shop in London. Not sure which century — now you’re testing me — but folks would meet at the coffee shop to discuss ships that were going out on voyages, and they would write their names under the name of the ship, hence the name underwriter. And then they would be on the hook for, you know, for the loss if the ship didn’t — were not to return. So from coffee beginnings to a great kind of international marketplace. Who knew?
Racheal Notto: And the Lloyd’s headquarters in London is also where Kita’s office is, and I’m in the US. So when I got to visit for the first time, I was shown the bell that is still rung to this day when a ship crashes that is insured by Lloyd’s of London.
Ross Kenyon: Is insurance like Fleet Street is famous for — you know, I associate that with Princess Diana and tabloids and just journalism generally in London. Is there a similar insurance district over there?
James Kench: There is, yeah. Lime Street is insurance headquarters. So literally you could throw a football, or, you know, pick your sport of choice, and it will hit an office containing somebody in the insurance sector around that. So it’s a good meeting place of the mind.
Ross Kenyon: I want to make sure that we start someone off here: why should they care about insurance? I hope it’s not insulting to say that I think people’s eyes glaze over a little bit just hearing that three-syllable word, and it spooks them. But insurance seems to be a thing that makes the world go round. Without it, everything becomes much more difficult. You are effectively placing a price on risk, which before insurance just seems hard to quantify, hard to hedge against, very informal. Why should people care about insurance? How should people think about it? Can you make it exciting for them? Maybe I can add this as a hook at the start of the show, just to make sure no one avoids it and gets scared away.
James Kench: Yes, sure. Maybe I can kick off and Racheal can add in, but I think the carbon insurance space is super exciting. I’ve been enjoying the benefit of insurance being a very eyes-glazing-over subject for many years now. At cocktail parties you just say, what do you do? I do insurance. And the eyes glaze over and you can carry on about your business. But now you say carbon insurance and go, well, that’s interesting. What does that do?
But I think we see insurance as having two roles. One is about promoting organizations and individuals to take risks, and then the other is sort of protecting them when things go wrong. I think the protecting part is how everyone sort of sees the kind of classic role of insurance, but the promoting risk I think is quite interesting. So enabling businesses to take risks and replacing the sort of uncertainty of what the losses might be in the future with the certainty of an upfront insurance premium helps them to kind of get stuck in and take those risks, rather than them saying, well, actually we’re just going to avoid it and we’re not going to take action.
Racheal Notto: Yeah. And I think actually my background is not insurance. I’m environmental science and the carbon space and policy for the last 10 years. So when I actually first heard about Kita about a year and a half ago, that was my first introduction to carbon insurance. And as someone that was working at a big-name project developer, credit retailer, I was like, why in the world would you need carbon insurance? And then it took me, like, just reading Kita’s web page and realizing, oh wow, there’s actually a lot of applications. And even myself, being a worker in the voluntary carbon market, I’m just so used to taking on these risks that we really don’t need to take on. And that is why we should bring in the insurance industry, with their centuries-long experience of applying this to varieties of markets. So it was a pretty eye-opening experience for me too, as to why to even get in this space.
Matt Trudeau: So if I could jump in here maybe for a minute. I’m also not from an insurance background, but I’m from a financial markets background. And over the course of the last four years I spent time at a futures exchange and clearinghouse, and one of the projects that I worked on was bringing margin trading into the clearinghouse. And, you know, we might get into this as we talk about some other topics like buffer pools, but clearinghouses do have something called a guarantee fund, which in some ways is a bit like an insurance policy. And in fact some of the exchanges do have insurance as part of the risk stack and the risk waterfall. And so we originally, in working on our guarantee fund, sought to have it just based on an insurance product, and that was originally how we applied to the CFTC.
It turned out that that wasn’t going to be sufficient, but I got a pretty important and interesting education — no eyes glazing over — in insurance, and working through that. And I’ll say that upon joining Nori and looking at the market landscape and understanding some of the impediments and risks involved, one of my very first thoughts was, this is a perfect opportunity for an insurance product. And shortly thereafter I read one of the papers from Kita and said, there it is, this is exactly what I was talking about.
Ross Kenyon: Why is it taking so long? Why haven’t we heard about this previously? It doesn’t seem to be that strange of an idea, or that outlandish. There’s been so much reversal happening in carbon markets. It’s to the point where there’s a common phrase that I hear, which is, we don’t want to end up in a Guardian article, often about quality issues or reversal. So you would think that buffer pooling, while a good thing and certainly necessary, may not be sufficient, and maybe insurance could complement it or do something else with it. Is this less common than I think? Are there other competitors to Kita doing this, or is it just so new that maybe not?
Racheal Notto: There are. Oh, go ahead, James.
James Kench: I was going to say, I think that there are competitors, that there has been insurance around a compliance market for a few years. So looking at the invalidation of compliance offsets. I think what’s new is the VCM approach, and I think the main lacking factor for the industry is just, insurers are conservative. They rely on streams and streams of data and years of loss history. So to underwrite and understand emerging risks, they say, OK, great, see the opportunity, but where’s the data? And there’s no data. So that kind of pushes the onus onto, you know, innovation, and folks that are willing to get their heads in and understand the details of the risk and build new products, and how to determine how to value that risk.
Racheal Notto: Yeah. I think the data part for any company trying to get into carbon insurance is a real impediment, because anyone that works in the voluntary carbon market specifically knows that there is very little transparency, especially on contracting and sale price and everything related to transactions of credits, whether it’s on the primary or a secondary market. I mean, historically, even for myself, kind of the most reliable sources that I think have the most transparency across the voluntary framework — there’s Ecosystem Marketplace, of course, CDR.fyi, and I’m talking about publicly available sources that are free for anyone. And then University of California, Berkeley actually does a really great job scraping all of the registries. But even as someone who’s been in the industry and uses those, I know that those only give a peek into the data that’s available. So that’s definitely a huge issue. And even for Kita, that’s still an issue. As we work on our modeling and risk analysis, we get a lot of private data because of how we’re situated. But obviously that is still an impediment to us promoting additional transparency.
Ross Kenyon: Been working on that at Nori, and merely gathering it — and then once you’ve gathered it, there’s so much heterogeneity involved in it too. Trying to make these things add up in the right columns to be meaningful is a huge amount of work. I want to go back to James. You said this thing that really caught my ear, which is that insurance does play a role in compliance markets. Is it because the premiums are maybe worth paying for an insurance product within those spaces, because if they fail to meet their compliance regime they will face some sort of penalty? Whereas in the VCM it’s basically, maybe you take a marketing ding, or maybe no one even notices, or maybe you just make it up the next year, but there’s not a regulatory reason they must do it. Is that a good explanation for why?
James Kench: I think it evolved in the compliance market. There were some innovators who saw the opportunity a few years ago and who really understood that risk. There was a critical mass, there was no one playing in that space, and they built a product that fit there. I think, like you’re saying, in a more regulated market there’s a lot more de-risking built in, so they’re arguing there’s less need for insurance there. But in the voluntary space, that’s now — last few years we’re picking up pace — that’s completely uninsured. So that’s, you know, a bare market that needed a new solution.
Matt Trudeau: Maybe if we could go back to this topic of where Lloyd’s sits and where Kita sits in the market. One of the things that I learned — and I think you touched on this, James — is that Lloyd’s doesn’t necessarily have expertise in the voluntary carbon market and carbon dioxide removal and soil organic carbon, if you take it down even to, you know, a lower level of detail. And some of the work that I did previously with the clearinghouse, we were working with digital assets, and so that was a relatively new and novel product type. There were years of history, but some of the early years the data was incomplete, was very choppy.
The asset class was extremely volatile in its early years. And so when we were working on trying to develop a policy, we actually had to work with another firm who had expertise. So we developed our own risk model, but we had to work with a firm who had sufficient expertise where they could evaluate our risk model, could determine how conservative they thought it was or wasn’t — and they obviously thought it was conservative.
And then they had to help us to pitch the markets, as they were explained to us, the people that actually have the resources to backstop the policies that are written. So who’s going to ultimately pay out if there’s a loss. So there’s a relationship between us and this firm that was helping to validate our risk approach, and then them helping to translate that to the firms like Lloyd’s that actually have the capital. So is that a similar structure, and is Kita that sort of middle entity there that has that subject matter expertise?
James Kench: Yeah, so Lloyd’s technically is a marketplace. It acts as a marketplace for risks. So insurance producers, agents, brokers that have clients that are looking to place — to find the insurance policies for their clients — they can go to Lloyd’s, and then within Lloyd’s there are several syndicates, what they call their insurance companies, that put capital within the Lloyd’s framework. And then within that, brokers can kind of syndicate the risk and also work on emerging risks. It also functions as a sort of regulator as well within that framework. And then as part of its regulatory function it also has an additional layer of sort of capital support. So as an insurer you have your own sort of financial reserves and oversight from the country-level body. If you’re operating within Lloyd’s, then there’s an additional layer there and an additional backstop, and then from that you can, you know, underwrite and innovate on products.
The good thing about Lloyd’s, though, and how it can be innovative, is that it enables both insurance and non-insurance capital to participate in an insurance space. And it’s because of the kind of concentration of IP, and it’s a fairly collaborative sort of marketplace. It allows a bit more faster, free-flowing of ideas on testing new insurance solutions to emerging risks. So as an example, around 2% of the annual premium that the Lloyd’s market writes is earmarked for innovative risks. So that’s where we come in. So we partnered with Chaucer, which is one of the leading syndicates within Lloyd’s, to say, well, we spot an opportunity in the carbon space, there needs to be insurance products there, let’s partner together to build those insurance products — working with them for their insurance and reinsurance risk capital, and then building insurance products and building the model, and then just distributing those products to the carbon space.
So the USP for us, and the value-add for the Lloyd’s market, is they have capital, they have expertise in underwriting and pricing risk. You know, they have the in-house actuaries, know how to reserve, how to manage claims. What they don’t have is a deep understanding of what those emerging risks are. And the key for understanding risks: you’ve got to be as close to the client, as close to the risk, as possible. There’s a sort of an adage that there’s no bad risks, they’re just bad prices. But to know what that price is, you would need to understand the risk and see whether it’s something that there’s a market for or not.
Matt Trudeau: If I could pick up on that point right there, James, about the bad prices — that I think is a critically important point, and one of the reasons why I think insurance has such an important role to play. So, yeah, we look at — one of the challenges that we hear when we’re out in the market and we’re talking to potential buyers about products is that they’re confused about the multitude of different standards, and what do the standards mean. And there isn’t necessarily in the voluntary market an authoritative standard where there’s some teeth associated with it. There are trade groups and industry groups that are doing admirable work developing the thinking around the standards.
But one of the things that I’ve learned working in the capital markets is that you can have whatever standards you like, but if there’s nobody on the hook, if there’s no skin in the game, what does that really mean? And if you have somebody pricing the risk and saying, I’m willing to collect a premium of X, and understanding that if there’s a loss then I’m going to pay out Y — there is nothing that I think really assesses the risk better than actually putting somebody on the hook for it.
And that’s what felt missing to me when I was first learning about some of the carbon products and some of the hesitation of buyers, VCM standards and assessing quality or reversal risk and these things. So it feels like that’s an extraordinarily important contribution insurance makes to this market, to help the buyers get comfortable that, look, you can look at all the standards you like, but if you’re buying an insurance product and someone has priced the risk, you have a pretty good sense for the underlying quality as a result of that.
James Kench: Yeah, I completely agree. You’re preaching to the choir here. I think we would argue that the insurance is an extra layer of due diligence for investors looking to get into that space. It acts as a sort of pseudo stamp of quality and confidence on the transaction. And then, like you said, you know, there’s very few partners in a business sense where they are sharing in the risk and they also have skin in the game if there is a loss. So there’s a kind of clear alignment of interests, and the insurance industry obviously wants these projects to succeed and wants to help things scale, but they’re also there when things do go wrong, and they’re conscious of that from the get-go. So we want to make sure there’s good risk management baked into the process to minimize that risk upfront.
Racheal Notto: And I think it’s also important to add to the nuance of insurability of a carbon credit or project versus quality of a carbon credit or project. Because everything that James just said is absolutely true, but I think what a lot of people don’t know, or know but don’t think about, is that insurance is a highly regulated industry. So on the side of a bad quality project, we’re not going to insure it. Of course we’re not going to insure an old project under the Clean Development Mechanism. That’s just bad quality, so we’re not insuring it.
But then on the flip side, there are actually some really high quality projects that we can’t insure due to regulatory restrictions based on the country location of where the project is. So, like, an example that everyone knows, like Delta Blue Carbon in Pakistan, which we’ve gotten lots of inquiries about as well, where it is a really good project on the quality side, but because of insurance regulations it is actually really difficult to provide insurance for. So I think it’s also just important to call that nuance, where quality doesn’t necessarily mean insurability, and technically insurable doesn’t mean quality at a generic insurance company. At Kita, we hold ourselves to a pretty high standard.
Ross Kenyon: That’s fascinating. What is it about Pakistan? Or is it just not enough historical data? Is it too risky of a regime or part of the world to do business in? Is it, you know, like barred persons involved that can’t do business with the US, or something like that? What happens with countries like this? I imagine there’s probably several like this too.
James Kench: Yeah. I guess every country has its own regulation around insurance. And then the way you think about risk — the risks, like the financial risk, may sit with an investor or project developer who’s headquartered in the US or EU. But the insurance risk, some of this theoretical risk, may actually sit in Pakistan. So different countries will have different rules around how insurance can be treated in that sense. And Pakistan’s one of those ones which is a little bit tricky. Not saying it can’t be done, but it’s not as easy as saying, right, you want to insure, you know, a South American forestry project or a Southeast Asian forestry.
Ross Kenyon: Is it possibly a Sharia finance law, like against interest? Is there any interaction there?
James Kench: Good, good question there. Yeah, there’s takaful, is sort of the name of insurance around Sharia-compliant insurance products, say, like, you know, key concept in, say, Malaysia and other parts. You’re testing the limits of my knowledge there, but I’ll come back to you on that one with some reading notes.
Ross Kenyon: OK. Sorry to put you on the spot. That is kind of an esoteric one. While we’re still in this early portion of the show where we’re going through how the insurance business works broadly — and we’ll get into carbon removal more specifically as the show progresses — but reinsurance is a topic that gets brought up a lot, I think mostly because Swiss Re has been such a huge part of carbon removal and they’ve showed a large amount of leadership in this space. But I think if insurance is opaque to the average person, reinsurance is just one extra layer of abstraction out. Can you demystify that, and the interaction between more typical insurance and reinsurance?
James Kench: Yeah. And there’s — just to make it even more fun — there’s a reinsurance for reinsurers as well.
Ross Kenyon: Come on. Because it turtles all the way down.
James Kench: Reinsurers all the way down.
Ross Kenyon: This is — is it just like the lender of last resort kind of thing for insurance? Is that a way to see it?
James Kench: No. Well, I think the way I think about it is, insurance is there to manage volatility. So it manages volatility for direct consumers and businesses, and then reinsurance is there to manage the volatility for the insurance. So particularly around aggregation of natural catastrophe risks. You know, so if I’m, you know, Allstate or Progressive, and I’m exposed to, you know, X million dollars of risk in the US for, well, you know, windstorm, hurricanes — there’s a certain amount of risk that I’m willing to take, and then I want to offload the excess to the reinsurance industry. And then the reinsurers have the same challenge of, once they aggregate or accumulate too much risk of a specific category that they’re not comfortable with, then they may reinsure chunks of that off to another market as well. But managing volatility is the main aim of the game, and spreading risk.
Ross Kenyon: I had that question with regard to carbon removal, where given that volumes are so low, there seems to be not that much you can spread against to insure. And there’s also not a lot of historical data about it. Maybe there’s sufficient volume to do this, I don’t know. But it also seems like such a small number of credits to be working with that there’s not a lot of — you know, if you have to buy credits that went bad or reversed, if there’s not a huge pool sitting around, unless, I guess, if you’re OK with future vintages. But how do you do business where it’s not something like housing, where there’s huge amounts of it, or something more conventional?
James Kench: I can kick this one off. I think there is quite a lot of diversification in the market, both in the sense of the type of carbon project themselves. You’ve got the, you know, nature-based versus engineered, avoidance versus removal. The geographic location has a massive impact, and one of the things that we need to keep track of is the accumulation, aggregation of exposure to particular physical risks. So wildfire being a key one — West Coast wildfire is quite a hot topic in the insurance industry recently. Windstorm, you know, drought, pest, disease. So having that geographic diversification process is super key.
Diversification by projects, project developers, methodologies — and Racheal’s maybe better placed to go into the detail of that. But I think there’s massive opportunities for the diversification. And then that’s the great thing about us working under Lloyd’s, is that Lloyd’s has a basically kind of global insurance passport to underwrite risks pretty much in most territories. So we can sort of hunt in that sense and make sure we’re building a portfolio of sustainable, profitable business.
Racheal Notto: Yeah. And then I can continue on that from the carbon removal sections. I think when you’re looking at the supply of credits, it’s really — the pinch to us is going to be the volume for a specific technology in the carbon removal space, and the vintage of the credits, if a buyer is trying to make any sort of claims, because I think the vintage is then going to be really important. And just for clarification too, for the audience, Kita does insurance for carbon removals as well as carbon reduction, but obviously carbon removals is very hot as it’s a growing space. So for us what it really comes down to is actually the concept of fungibility, which of course in the carbon markets, in the voluntary markets, fungibility essentially doesn’t exist. So the way that we look at it is really more of what is like-for-like.
So for Kita specifically, if a company signs up to do an insurance policy with Kita, you have two options in the event that you want to have a claim, you need to have a claim paid out. One, like any other insurance company, you can have it paid out in cash, or whatever the value of the claim was. But alternatively we can also pay out claims in carbon credits. So we have a carbon supplier pool, which is basically just a really sophisticated supplier and network that I managed for Kita, to be able to get credits for a specific claim that we need to pay out.
And because fungibility doesn’t exist in the carbon market space, this is why I said that we look at a like-for-like. So we’ll work with the insured to say, what are the criteria that you need to meet? Maybe it’s methodology, maybe it’s vintage, maybe it’s location. And then we’ll also look at the criteria: what are your nice-to-haves, if we can match it? Maybe it’s standards, SDGs, is it CCP compliant under the ICVCM, anything like that. So we really work on that on a case-by-case basis, to do a like-for-like matching mechanism.
And to kind of take it back to your question on the carbon removals, where that is our approach — because obviously if someone’s buying, like, a typical direct air capture purchase, it might be like 1,000 credits, which is a lot in that space, and that would be pretty tough for us to match straight up if they wanted issued credits at the exact same vintage. But if we use it across our carbon supplier pool, then we would probably source multiple tranches of credits to then make our insured whole.
Ross Kenyon: I was leaving it open for you, Matt, if you want to go to that next question. But there’s also so many good — so much bait in there for you, so many key buzzwords that are very Matt Trudeau. I thought you would just seize it.
Matt Trudeau: I didn’t want to step on your toes, boss, but I do have a litany of questions. So I’ll just — and more come up as James and Racheal talk. So maybe for the benefit of listeners, we’re talking about insurance generally and carbon credit insurance generally. But as we’ve thought about it, and as I’ve thought about the products that we currently offer at Nori and those that we are in the process of offering or intend to offer, there are different types of carbon credits. And Nori got its start with soil organic carbon. We’re moving into, with the launch of the Net-Zero Tonne, soil organic carbon paired up with, let’s say, direct air capture. And when we’ve looked at that, the way that we’ve thought about that product is that as a container with really two buckets. The first bucket is, let’s say hypothetically, a nature-based credit, and those have their own life cycles and shelf life and various risks. And then a more durable, let’s say, direct air capture credit that has different risks. And when we look at the different credits that could go in those buckets, they serve different timelines, they potentially serve different standards depending on where you’re operating, what you’re trying to accomplish, and then they have a variety of different risks.
So when we’re talking about insuring credits, you could break that down even within the context of a credit type to specific risks, if I understand it correctly. And so, for example, just with soil organic carbon, it could be flood, it could be pests, it could be, I guess, fire. There’s probably a number of risks that you would model to determine how you’re going to price the reversal risk of a soil organic carbon credit. Is that fair? Maybe you can expand upon that, if that’s a fair setup.
James Kench: Yes, I think the risk profile of the different — even though the carbon credit should be fungible, the risk profile from an insurance standpoint is very, very different. I think there’s a big difference between particularly the nature-based solutions, because they tend to operate on a very broad land area, versus engineered. You’re thinking, in an insurance perspective, from a kind of point source, you know, by single or in a very small scale latitude, longitude of where the risk exposure is. I’m much more exposed to, say, your traditional fire, flood type of risk exposure. So I think that’s definitely something we will bake in. You know, we’ll adjust our underwriting model accordingly. And then there’s nuance to different types.
So we’ve been doing a deep dive on biochar and enhanced weathering last year. We’re moving into sort of DAC, BECCS, methane, and hopefully pretty soon soil and regen ag. But, you know, going through biochar and enhanced weathering, we’re thinking, well, we understand how we would normally underwrite this, what are the nuances for these risks? So, you know, biochar: it’s the availability of the feedstock, and what is the biochar, the pyrolysis machine, what’s the co-location of that? And then what’s the biochar actually going to be useful for? Enhanced weathering, similar again — you know, availability of feedstock, what are the weathering rates, you know, what’s the distance to the ocean, what’s the, you know, the LCA type impact of this. So the key again is just doing a real deep dive into the weeds of understanding the nuances of that risk, so therefore we can price it accordingly, and hopefully that’s one of the values we can add.
Racheal Notto: And then to go a little bit wider, stepping back from just the risks related to a specific technology: when we’re reviewing a project, we’re also looking at the counterparty risk too. So the project developer and/or the credit seller, if they’re not the same entities, we’re looking at their experience in the voluntary carbon market, but also in the specific technology and methodology and location of the project that they’re doing the credit transaction on. We’re also looking at the failure clauses within the carbon contract for the specific transaction as well — like, that’s something that we also consider.
And then on the carbon standard side, we’re also considering, like, what is the chance that a standard goes insolvent, which is, like, pretty unlikely. But a little bit more likely: what’s the chances that a standard invalidates a project? Again, not super likely. But even a little bit more likely: what’s the chances that a methodology changes, which directly impacts the amount of credits that a project is going to issue at its next or even future issuances as well. So there’s quite a few factors that we’re looking at, both on the technology side, the location risks — oh, I forgot to mention also political risks, especially as it relates to Article 6.4, because that is going to be a huge impact on the voluntary carbon market, slash already is. And of course, the counterparty risks that come with it.
Matt Trudeau: I want to go back to — and maybe this is putting too fine a point on it, but I really think it’s critical — then all of what you just went through, both of you, in terms of the various different risks. And we just talked about risks across multiple different types of credits. One of the other, I think, current impediments to the market right now is that the landscape is pretty diverse. So you have a variety of different credits that have underlying technologies and methodologies and sciences, and that’s a lot to deal with.
And fine, if you’re a very large, well-resourced company that has a whole team of people, including potentially even scientists on staff that are evaluating things — OK, great, maybe you in house can get comfortable with the risks. And fine, if that’s the case you can decide to opt not to get insurance. There may be a case for still getting the insurance, because if there is a loss you’d like to have that covered. But let’s say that you have a sophisticated enough staff where you feel like you have your arms around it. That’s probably, in the world today, a relatively small number of companies. The vast majority of companies, I’m going to go out on a limb and assume, don’t have scientists on staff, aren’t able to properly assess these risks internally. And so, in the absence of an insurance product, they’re taking a bit of a gamble. And that means that they have to get over that initial risk gamble hurdle to even get into the market, because if they don’t know what the risks are, they’re not able to assess them. They just kind of have to take a flyer on it.
And so there’s a cost to the insurance, but it also seems to me like, in addition to just covering your potential risk, for companies that don’t have the sophistication or the resources, they’re able to enter the market with greater confidence. Because so long as they’re comfortable with the cost of the product, the insurance product, they don’t have to have all that expertise. It makes it easier for them to just participate on a fundamental basis.
Racheal Notto: Yeah, I completely agree with that. And when I think about the demand side of the voluntary carbon market, be it a corporate buyer of carbon credits or an investor being an investor into a carbon project looking to get credits out of it — I like to think about it as, like, three tiers of carbon education. So you have your low-educated carbon market players, where they know that they need to be doing something, but they don’t know a lot of information. And sometimes companies want to stay there, and that can be fine, as long as you’re using the right resources. You know, as you’re going out talking to insurance companies like Kita to kind of get that check, talking to ratings agencies like BeZero, Sylvera, Renoster, Calyx Global to also get that check, going to any sort of third-party providers that’ll do your due diligence for you, like Carbon Direct. So as long as they trust the companies that they’re contracting with to do their reviews, you know, you could stay at that level. And arguably those are the people that are best for insurance, because they just want to buy the credits and they don’t care what they don’t know. And that’s where insurance comes in as a great space, to just — that’s your peace of mind, even if you are highly educated in the carbon markets.
And then you go out a tier and you have your moderately educated players. So the ones that maybe have a couple of members on staff that this is their responsibility, but they don’t have enough. So that’s, like, your company that knows what they don’t know, and they’re going out and contracting with very specific companies to get very specific reviews on projects that they’re interested in. And again, insurance still a great place for that, but now insurance is — that’s usually still a pretty targeted ask when we have those type of buyers or investors coming in.
Any of, like, your highly educated market players — so, like, your Salesforces, your Microsofts, where they have a complete in-house team, they know exactly what they’re doing, they don’t need an extra consultant to go over what their purchases are, they have great relationships with everyone, they’ve got their own scientists on staff — and actually in that case, insurance still interesting for them, but it’s usually for very specific risk slices like abandonment and insolvency, or fraud and negligence on behalf of the on-the-ground partner that’s executing the carbon project. And it’s because those players, they understand that there’s a lot of unknowns and to be seen in the carbon market, and they’ve gotten comfortable with that risk. But there’s, like, very small slivers of risk that they still want covered. So that’s kind of how I like to think in those tiers of education.
James Kench: I would add that because insurance is still in a nascent form for the carbon markets, then the awareness is just not there. But if you were to look at a credit as well, like any other asset or investment that the business makes, then you’d get insurance on that, because why wouldn’t you? Why wouldn’t you? You do your best to make sure that it’s, you know, reduced risk as much as possible, but we all know that things can go wrong. Therefore I want to de-risk that with insurance, and it just becomes part of the normal transaction cycle.
Ross Kenyon: I was thinking about the classic debate here, if you’re a purchaser of insurance: should I self-insure or should I pay someone else? And at certain timescales it makes sense to — if the catastrophe is happening tomorrow, you should buy insurance. If it’s not going to happen for 30 years, take those premiums, put them in a high-yield savings account, you’re going to be better off over time anyways.
But for some of these things it sounds like a high-deductible kind of policy here, where, hey, if there’s fraud or negligence — it’s almost like title insurance isn’t the most expensive insurance that you can buy, but you sure want it if someone shows up and throws your home’s title into confusion and may damage your entire claim to your home. I don’t want to self-insure for the home price for that. So it sounds like for at least some of these customers it is sort of a high-deductible catastrophic policy, rather than help me with every little thing that might go wrong with this carbon thing I might buy. Is that correct?
James Kench: Yeah. And we would argue that the role of insurance is not to solve the, you know, high frequency, low severity cases, or the low frequency, low severity — this sort of attritional losses. It’s that high impact, low frequency loss. And a lot of those sort of major corporates, they’ll self-insure, but they’ll have in-house captive insurance companies. So they’ll be insuring it within their own balance sheet, in a sort of internal insurance mechanism. And we can partner with them to help price that risk. So they may take that risk on their balance sheet, but they say, well, how do we price that in terms of an insurance premium that we need to assign and reserve?
Racheal Notto: Yeah. And I’ll add on to that, where I think there are two really classic examples in the carbon market. So there’s an argument for insurance — rather than getting third-party insurance from someone like Kita, rather than doing self-insurance. So on a typical carbon transaction between project developer and/or seller, if they’re not the same entity, and then a buyer or investor, there’s going to be delivery failure clauses in that carbon contract. And I think sometimes unfairly the buyer or the investor puts a lot of the risk on the project developer, the seller. And, like, for example, I mean, there’s a lot of things that are in control by the project developer, there’s a lot of things that also are not. So an easy example for this is, like, what if your next issuance is coming up and it’s delayed because the standard is backlogged? Like, there’s literally nothing the project developer can do, but they’re on the hook for that delivery delay in the carbon contract. That’s something where neither party of that carbon contract are able to do anything. Easy case to bring in Kita for your carbon insurance.
Or another example, on a much wider scale, is obviously the one that’s becoming most popular, with buffer insurance with standards, where — or buffer pools with standards, where a carbon standard could be the insured and they outsource the buffer pool mechanism in part or in whole to an insurance company that can develop a different mechanism to help protect permanence of all the credits that come through that standard, and reversal, if that does happen, through insurance as well. So it’s another great example for it.
Matt Trudeau: Can you talk a little bit about what, if any, relationship you have with the project developers? So in assessing the risks, and some of them, whether it’s fraud risk or operational risks — some of these risks, I imagine you have to talk to the project developer that’s producing the credits.
Racheal Notto: Yeah. So I can start with that. And there are kind of two different types of relationships. One is if the project developer is pursuing insurance for themselves, so they want to be the insured. To date, Kita has very few policies that are specific for project developers, and James can get into this if we need to, but it’s just really tricky — the topic of moral hazard, but also insurance regulations for company, country, locations and operations. Project developers are scattered across the globe. We have to be regulated per country to write insurance there. So that’s one part that can get a little tricky.
But if we’re working directly with the project developer, they’re usually very forthcoming with information for us. I mean, for them it goes back to what James is saying, is a stamp of approval, where they want to be able to show that they’re happy to be transparent and share all the information that they need with an entity like Kita, to then go on to show their counterparty and potentially publicly and say, look, we are up to snuff, we’re insurable for these specific risks, like, we’re very happy with that.
And then the other type of relationship that’s with the project developer is where a project developer has a buyer or investor that is seeking insurance to close a deal, which is very relevant for project developers — their buyer investor wants insurance to get that deal across the line. So typically we have project developers that reach out to us, and that one’s kind of very tricky, with, like, chicken and egg, where Kita needs to talk directly with the insured, which in this example would be the buyer investor. So it’s kind of like project developer comes to us, but then we need to switch and talk to the buyer and investor, but we still actually need to talk to the project developer to review them, review the carbon contract, any details of a project that are not publicly available, to write the insurance for the project developer. So whichever direction that we end up working with the project developer, they are very near and dear to us. They are actually the number one type of carbon company that we talk to, and we work really well with them too.
Matt Trudeau: So one of the topics that we’ve touched on a few different times, Racheal — I think you’ve hit on it probably three or four times — is this notion of counterparty risk. And this is something that’s, you know, one of the most central pieces to financial markets infrastructure, is how you manage counterparty risk. In the case where you’re making a trade, how do you make sure that the person or entity that’s got the money is going to deliver the money, and then the person or entity that’s got the assets is going to deliver the assets, and you don’t end up with one side delivering their component and then not getting what they’re expecting in return.
And obviously there’s an entire framework, multiple different frameworks of regulatory structures in different asset classes in different regions around the world, that deal with that. In the voluntary carbon market, we don’t have such regulations. Obviously you’ve touched also on, the insurance market is heavily regulated. So coming back to the notion of counterparty risk, if I’m buying an insurance policy, I have to be pretty confident that if I have to make a claim, and the claim meets the terms of the policy or the laws, that there’s going to be somebody there to pay what I’m owed. And that’s where regulation obviously does have a part to play. You have somebody presumably that’s got oversight over the resources that are available to backstop those policies, and ensuring that they’re sufficient. Is that a fair assessment?
James Kench: Yeah. So, you know, we work with our reinsurers, they’re doubly rated. And then with Lloyd’s as well, there’s an extra layer of backstop to that. Building on that counterparty risk: when we underwrite carbon projects, one of the main risks is that counterparty risk. In our underwriting model it’s built around, how do you price that. So a lot of the projects are in emerging markets and they’re, you know, brand new companies with little track records. So that counterparty risk is the main driver of how we price it. And then we look at other factors, such as physical exposure, the rights of recourse and the robustness of the carbon purchase contract, et cetera. But it’s kind of baked into our blood at the moment.
Ross Kenyon: If we don’t talk about buffer pools, I’m going to scream.
Matt Trudeau: I’ll go right there, so I’ll help you out.
Ross Kenyon: OK. I read that report multiple times. Dang it, we’re talking about it. Two minutes left.
Matt Trudeau: So I think we have a nice segue, which is coming back to some of my comments about clearinghouses. Clearinghouses have a conceptually similar concept, or structure, which is called the guarantee fund, and that’s a component of default financial resources. So coming back to counterparty risk, the function of a clearinghouse is to make sure that both sides of the trade deliver on their commitments. And you do have examples in history where somebody failed. And one of the most famous examples is Herstatt Bank, where they had a bunch of foreign exchange transactions and everybody sent them their foreign currency, and then they just went out of business and didn’t deliver the currency that they owed all their counterparties, and everybody was just out on that. So there’s a variety of different ways that that counterparty risk, or the Herstatt risk as it was subsequently named, has been managed. Clearinghouses are one structure that seeks to deal with that.
And just as a quick primer, how the clearinghouses typically work is, the members contribute capital, and if one of those members goes out of business, their capital gets wiped out first from this sort of insurance pool. If the loss is bigger than that one member’s capital, then it gets syndicated to all the other member contributions. If all of that gets wiped out, then it goes into the actual resources of the clearinghouse, including up to the equity owners of the clearinghouse. So you don’t really often see — in fact I can’t even think of one — an example where a clearinghouse has been wiped out, because of all those layers of risk management that you would have to go through. And that’s pretty effective.
But the structure of the default financial resources, that’s something that has a lot of oversight by the regulator. So in the US it would be, let’s say, the CFTC, who’s overseeing the futures clearinghouses. And so when you’re proposing the default financial resources guarantee fund structure, you have to go through a lot of rigorous analysis and a whole bunch of different risk scenarios that have to be tested, to ensure that you have sufficient resources in the event of a variety of different types of failures.
And when I think about and have looked at the structure of some of the buffer pools — I mean, mostly to my knowledge, the buffer pools are not regulated. They’re operated in some cases by nonprofits, and I think it’s admirable what they’re trying to do, is to help reduce risk in the market. But I wonder if there are maybe other risks that are being introduced that in some ways are obfuscated, because you think that there’s this pool available to you and that there’s going to be sufficient credits to backfill whatever reversal losses you may have. But there are a lot of assumptions, from what I’ve seen, that go into how those pools are structured. And I know Kita published a paper about buffer pools and the interaction between buffer pools and insurance, and maybe you have some thoughts on that.
Racheal Notto: Yeah. So I can start with that. I think the key part for anyone to think about when they’re talking about buffer pools through the voluntary carbon market is that every standard has their own approach, and some people think that they’re all the same and they’re definitely not. Typical for Gold Standard is they have 20% of credits across the board per project go into that buffer pool. But then, in contrast, you have Verra, where there’s a non-permanence risk assessment, and based on that risk assessment that determines the percent of credits that go into it. And so you need to see each standard as their own process for developing those buffer pools.
And a couple of examples that I think are really pertinent in the space when you talk about the riskiness of buffer pools in the voluntary market as they stand today: we have the Kariba REDD+ project, which has done a lot of good, but also in terms of, like, the on-the-ground community. But also on the flip side, because South Pole pulled out of that project, it’s now in question, like, how many of the credits that were actually issued actually achieved the emission reduction that they said they did. And there is analysis still ongoing, but in terms of the publicly available information, if all those credits that have been issued thus far were actually reversed, then that’s a huge cancellation to Verra’s buffer pool — like, a significant cancellation that puts Verra’s buffer pool into, like, near catastrophic areas of being able to recover, and now that [unclear] taking a long time. So that’s the example for using insurance in place of buffer pools in part or in whole.
And I think another part that’s thought of even less is that the project developers are the ones that have to contribute credits to the buffer pool. So that’s a cost to them, even though the real entities that are being protected are the buyers of the credits and the ones that ultimately retire the credit. So it’s a cost to the project developers, but it’s not a benefit to them, it’s a benefit later on down the line. So that also kind of feels like an uneven distribution of risk allocation, which is something that, as James has said repeatedly, is what insurance is here for.
So that’s another angle that we like to look at it, around buffer insurance, where yes, there is the buffer pools that the standards manage and insurance could take that over, but there are also ways to do both. The ACR and [unclear] — ACR being American Carbon Registry — both are existing carbon standards that have it written in where, to protect against reversal, the project developers can contribute to buffer pools or they can use an insurance mechanism. They’re the only standards I’ve seen that have that written in so far, to my knowledge. I don’t know how that’s been executed, if at all, but that is just another angle to look at it too, where it’s buffer insurance for the standards, but it could also be buffer insurance for the project developers in terms of how they contribute to a pool.
Matt Trudeau: Just wanted to add a little bit of additional comparison to the clearinghouse model for a couple of those concepts. On catastrophic loss, the clearinghouses typically have employed what’s called the Cover 2 model, which is, you assume the loss, the complete loss, of your two largest clearing members, and are the default financial resources sufficient to cover that type of a loss scenario? So that’s a catastrophic loss. And then, because the collateral that is being contributed to the default financial resources is US dollars, there’s, I guess, a weird dynamic, or at least in my view there’s a weird dynamic, where projects are contributing their own credits. So if a project were deemed to be completely worthless in its entirety, then what has it actually lost, if its credits are worth zero anyway? It’s not the same skin in the game as having dollars in a place.
And so, you know, when you look at — because the risks are somewhat mutualized in a clearinghouse model where all the members have assets at risk, the members care about who the other members are. So they don’t want somebody who’s not a good actor in that pool, because they don’t want the pool to become subject to their losses, and so there are standards as to who can even be in the pool. And so I wonder how that gets considered when, you know, if projects that are contributing to these buffer pools, if they have any say in who else can be in there, and how those risks get managed.
Ross Kenyon: I wanted to ask about that same thing too. Sorry, let me just add this and then I’ll pass it over. But I think about adverse selection. People always use this for health insurance markets too. Healthy people don’t want to pay to insure sick people, because it’s just going to raise their premiums and they’re not going to see any benefit out of it. So I can imagine healthy carbon projects don’t want to insure risky ones. But then, of course, then you have all the riskiest projects lumped together with very high premiums. Those projects probably can’t get funding and off the ground, then that’s not good. If sick people can’t get insurance, that’s bad. If sick carbon projects can’t get insurance, that’s also bad. So clearly you need to have some sort of consolidation there, but there’s issues of fairness and how to price this, and I don’t even know. So Matt and I just handed you a giant bundle of impossibly large problems. Please solve them.
Racheal Notto: I think that’s a really good question. So actually starting with Matt’s side of, how are actors even being selected to be put into the standard and put into the buffer pool. I think that this is something that historically the buck has been passed a little bit, and in 2023’s big push for transparency and quality and integrity of the VCM — and hopefully we’ll see that effort continue to go — and passing the buck will stop. Historically it was, oh, the project got developed and it got the stamp of approval from the standard and the verification and validation body, so it’s good. But we obviously know that that’s not true.
So today I don’t have any knowledge of where a standard that’s running a buffer pool gets to say, the contributors to the buffer pool get to say, who does or doesn’t go in there due to bad actors. I think that’s a great point that should be included in all of those integrity and quality work that’s going on in the VCM, and will continue.
And I think also on the part that, Ross, you’re touching on, is it’s also to parse out, like, who are the developers and the projects that are bad actors, and that makes them risky so they shouldn’t be in there, versus who’s doing good work but they’re just in higher risk spaces. So, like, nascent and emerging technologies — obviously that’s high risk, but it doesn’t mean it shouldn’t go in either. So how do you adjust for that? These are things that James, being on the insurance side, can absolutely point to and discuss in a minute, on how the underwriting model and risk assessment works for us. But also on the side of, like, maybe you are in a country that is in the middle of figuring out what it wants to do for Article 6.4, and in Indonesia that’s been stuck with credits for the last few years due to a ban on exportation of credits. Then, like, again, that’s not a risk where someone’s doing something wrong, it’s just a part of the game. And how do you account for that? So I’ll hand it over to James to talk about the more interesting stuff.
James Kench: That was a great summary, Racheal. Yeah, I think adverse selection is a key risk for insurers operating in any product line. I think the good thing about the buffer approach is that it does force all projects to contribute credits to a central pool, so therefore it removes the ex post selection. The key there is, how do you make sure that those buffer contributions are risk adjusted, and what is that mechanism. So I think that’s where we think we’d like to argue we can have value, by bringing an insurance risk management perspective to what that risk-adjusted contribution should look like. It’s not just a blanket 20% across all projects, but it’s adjusted based on all the geographic, physical, counterparty risks that we’ve discussed so far.
So we like the idea of buffers as a sort of self-insurance mechanism. We think insurance can be complementary, supplementary to that, and bringing that expertise across the board. But where we do sort of transaction-by-transaction deals that we see on the buyer side, we’re very conscious of the adverse selection. It does tend to be some of the sort of hottest, hot-to-handle risks that are looking for coverage. And we know that that’s not necessarily where we want to play, but it’s a good kind of screening process, and then that helps us build a broader perspective of what’s out there.
Ross Kenyon: There’s still so much to talk about. Matt and I, I bet we could go a whole other hour here. Maybe we should at some point have you guys come back on. Thanks for sharing all this. I think what you’re doing is very important and very cool.
James Kench: Thank you very much for having us. It’s really enjoyable.
Ross Kenyon: And definitely come back. Great conversation, appreciate it. Thank you so much for listening. If you could please subscribe and give us a great rating and review on Apple Podcasts, or a rating on Spotify, that’d be much appreciated. It helps us get our content out to more people. You can sign up for our newsletter at nori.com, follow us on social media, and we will catch you next time.
