Everyone's focused on carbon credit offtakes and Voluntary Carbon Market purchases, but the compliance markets represent the vast majority of carbon assets in circulation. How do these markets work, and how might carbon removal interact with them in the future?
Mike Azlen is the CEO and CIO of Carbon Cap Management LLP, a firm which trades within various compliance markets.
We discuss why private traders like his company can help price discovery in compliance markets, and address some common criticisms of market-based approaches to climate change (both VCM and compliance markets.)
Carbon removal is going to figure into various compliance markets in the future, but how exactly will that work? Might that be the demand boost that carbon removal needs to scale?
There is also bonus content from this episode about some of Mike's observations about VCM failures. It will be released on Saturday, May 24th. Become a paid subscriber to access it when it is published!
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Full Transcript
Ross Kenyon: Hey everyone, thank you for listening. This is Ross Kenyon, and I’m your host. I have two sponsors that I’d like to tell you about today. They’re both organizations doing valuable work within carbon removal. One of them is a new sponsor of the show and the other one has been with us from the start, so I’m going to start with the new one. I’m going to give them a chance to go first. It’s ClimeFi. Personally, I think they produce some of the best content within carbon removal. Their reports are top tier. I always look forward to reading them. I’ve learned a lot from them.
There’s one in particular that I like that I referenced in a blog post I wrote a while back called “Bridging the CDR Financing Gap: The Comprehensive Guide.” Just really powerful, great work. If you’re looking for good intel on carbon removal, check out the ClimeFi reports. They’re really good. There are lots of intermediaries within carbon removal. If someone wants to buy carbon removals, many people will heed the call and try to sell them some. ClimeFi is a group that I see almost more as a white glove service. They’re quite selective in what they choose to do.
The way that they put it is that they empower companies to develop and manage robust, high quality, durable CDR portfolios that’s built upon market intelligence. They have a proprietary rating system. You may have heard that they just gave Deep Sky in Canada a very high rating. They’re involved in the procurement themselves of facilitating, sourcing and managing RFPs for companies. So if you’re looking to run a carbon removal RFP, a request for proposal, so you could have carbon removal companies coming to you with proposals for what they might be able to do, ClimeFi is a group that can very much help you with that.
Perform the due diligence, structure the portfolios, negotiating, executing transactions — that’s all something that they can help you with. And then also just managing the portfolio, making sure that the projects are monitored, warehoused appropriately, and then when the time comes, retired. ClimeFi’s project database covers about 95% of all the durable CDR projects globally, but out of the 500-plus projects reviewed by ClimeFi, only 15% meet their standards for delivery and integrity that they look for. And eventually only 5% of those projects are included in client portfolios. If you’re looking to buy some carbon removals, if you want to run an RFP, follow the link in the show notes to learn more about ClimeFi.
And of course, I’m also very happy that Arbonics is sponsoring the show again. Arbonics connects European landowners to corporate credit buyers in order to remove CO2 and protect biodiversity. They’re very data-driven. They’re trying to turn degraded and abandoned land in Europe, in the Baltic States, back into biodiverse forest. That’s a really impactful, good thing to be doing for its own sake. Outside of carbon removal, it’s a good thing to do, but is also very much focused on how much carbon can be sequestered while also pointing us towards the importance of co-benefits and ecosystem services, I think, that sometimes carbon removal people forget about.
We’re pretty focused on the PPM, but the other stuff is really important too. They’re doing fascinating work on the data layer side. I’m not sure if you’ve seen the digital twinning of forestry, but they’re making it. It’s exactly what it sounds like. Arbonics is on the cutting edge, trying to make forestry work for carbon removals and turn Europe back into that beautifully forested continent that it once was. So if that interests you, the link is in the show notes to go check out Arbonics. Also, Lisett Luik, one of the founders and COO of Arbonics, was on the podcast earlier this year.
Go check that out, because we dig into a lot of the role of temporary removals within carbon removal. It’s a fascinating big topic and Lisett brings her A game to it, so I hope you enjoy. Links to both sponsors are in the show notes. If you’d like to be a sponsor of the show too and hear more about what that might look like, you can email me. The email is in the show notes. And then also, if you’re podcasting and you want to use Riverside for recording or Descript for editing and transcription services, I have affiliate links in the notes too. And that also helps drive the show’s financial solvency. So thanks so much for listening. Here is the intro to your show.
Hello and welcome to the Reversing Climate Change podcast. I’m Ross Kenyon, I’m an entrepreneur working in carbon removal and climate tech and I’ve been here for about eight years now. Thanks for listening. I’m, I’m really glad you’re here. I have so much fun with this show. It’s a lot of work to make, but I love it and I really don’t want it to end. I’ve been trying to get more subscribers to the show. It’s $5 a month. It’s in Spotify. You can also subscribe elsewhere, but Spotify is the easiest. It comes with ad-free listening from the programmatic ads, bonus content.
In fact, a good chunk of today’s episode is going to go into bonus content because it’s good stuff. It deserves to be published, but just doesn’t fit into the rest of the show, doesn’t get a chance to be fully expressed. And I know people like to have shows that are consumable, that are not these epic shows. So for shows that just don’t fit the theme as nicely, I’m trying to move a lot of that content into bonus content. So if you want it, it’s there. If not, you get your learnings, you get your intellectual stimulation for the day, and it can move on. So anyways, link is in the show notes, $5 a month. Thanks so much. A great rating and review in Apple Podcasts, Spotify, also appreciated.
And now I’m going to tell you about the return of Mike Azlen. Mike has been on the show once, maybe twice. And Mike is the CEO and CIO of Carbon Cap Management LLP. Mike is a trader of carbon assets within the compliance markets, and my understanding is he trades within five of them. And we spend most of the day talking about what he’s learned from years working in these markets, how he’s thinking about how compliance markets will work to drive parts per million of greenhouse gases in the atmosphere down, why he thinks that’s the correct way to go, why he’s been disappointed in the voluntary carbon market space.
I actually share a fair amount about my experience. The first company I founded within climate tech is called Nori. Nori was a carbon removal marketplace, and I used to be a much stronger believer in voluntary climate action. I thought that there would be sufficient motivation outside of compliance, the need to do something just because it’s required, in order to make a dent in climate change and at least start to get us towards a future where the technology was sufficiently developed. Or maybe we did such a good job that government was not necessary for managing climate policy.
I’m realizing, as I say these words out loud, that it, it sounds — it’s a dream. It may even be ideology and not necessarily merely a dream, the idea that we would be able to manage the climate from a purely market-driven perspective. We would not be where we are now without some very generous and far-seeing employees and founders at companies that made big bets on carbon removal, that wanted to be there to support this industry when it was really just a twinkle in a bunch of founders’ eyes. It was not what it is now. I think that’s a beautiful thing and I’m really grateful for all of that.
But it’s hard to imagine that we’re going to get to the scale of carbon removal without having some sort of compliance regime in place. The numbers are just too big. We need government to de-risk a lot of this tech, and it’s probably just inappropriate to expect unilateral or mostly unilateral action from private citizens and corporations to do the amount of work necessary to drive the carbon removal industry. If you’re listening and this sounds obvious, sorry. Yeah, I suppose that is pretty obvious, but for a long time I was resistant to the idea.
I’ve mostly experienced policy — and I’ve spoken about this elsewhere, especially with Grant Faber — as being a sort of difficult, clunky process. Policy can often feel boring. It requires reading, and the reading that it requires you to read is oftentimes legalistic, hard to understand. A lot of the mechanics of dealmaking within politics don’t happen in the open. You’re reliant upon journalists. Those journalists have different perspectives and political orientations and they may not have all of the facts. And I found that to be a field that I avoided because I thought that was an inefficient way of making decisions and allocating resources and just determining policy in general.
And then going through this process of trying to, I don’t know, make into a commercial activity a line of work that should properly be a government function — I think one just runs up into barriers all the time. I don’t think I’ve told this story, but I had a meeting, though, that cracked me up with one of the companies that is involved in tax credit trading. And what’s interesting about tax credit trading, especially for something like clean energy development, is that there’s a customer who wants what the seller is selling and they have a need for it that is not abstract in any way.
The clean energy producer is producing more tax credits than they can consume against the profits that they’re generating. So they have a surplus of tax credits. They are selling them on the market to someone that would like tax credits and could consume more of them, and the generator of those credits sells those credits at a discounted rate relative to what is on the tax credit. So if it’s a dollar’s worth of tax credit, they might sell it for $0.90, for example, and the person buying it receives a discount on their tax bill. That’s pretty efficient. That drives more money to clean energy development. And that sounds so nice to me.
You know, there’s no sort of, “Well, this is going to help you with talent retention and going to give you access to a future where the supply of carbon removals is extremely limited and you already have a relationship here. You’ll know how to do it. The marketing value that this purchase represents is great. It’ll drive more customer acquisition,” blah, blah, blah — stuff that you’ve all heard a million times about the benefits of carbon removal and voluntary purchasing of carbon removal. And over time, they no longer felt as true in my mouth.
I have seen some data recently about the types of carbon credits that are being purchased in the voluntary market and how that’s changing and how we’re shifting to higher quality. And within that type of very high quality credits, there is more of a supply crunch. And I’m glad to see it. Though I just no longer really believe a lot of that rationale that I’m hearing. I would be very welcome to being proven wrong on that. I want to believe people will do so many of these activities for their own sake and because they care about why we’re here — for climate action and to make sure we restore a livable climate.
I share that vision. I would want that independently, if my salary depended upon it or not. But that’s not true of all companies and maybe we shouldn’t just assume for that. I’ve even been in job interviews on the demand side recently where I know I shouldn’t have said this, but also just been like, I don’t really understand why anyone would be buying this right now. They don’t need to. That’s bad. If they are prominent enough, being a very vocal financial supporter of carbon removal and climate action could conceivably make them a political target in the US. It’s just not obvious to me that this represents good value for companies to be involved with right now.
And that was not the right answer for why you should hire me to generate demand for your carbon removal company. Which is one of the reasons why I like doing this show, because right now I feel like I can maintain a lot of independence. And even previously, when this was a Nori podcast, I never felt muzzled in any way. I always spoke my mind. But it is nice to just be able to zoom out a little bit and say something like, why are people buying carbon removal? It’s a sort of a wild way to spend money in a time of erratic policy, trade war, geopolitics.
I like being able to just, you know, wonder those things aloud. And that’s why it’s important to me that, hey, become a subscriber, become a sponsor. I’m going to tell you what I really think about this, about the world that we live in and carbon removal and climate change. And I’m a learner. I’m trying not to be too ideological or hold my position so strongly that I can’t learn anything or change my mind. In fact, this podcast I really like because Mike’s helped me change my mind. Mike’s been very persistent in showing how effective compliance markets have been.
That being said, I’ve also read criticisms of market policy just in general, for both compliance markets and for VCM. One book that made me think — and I’m still thinking about it years after I initially read it — is Danny Cullenward and David G. Victor’s Making Climate Policy Work, which is quite critical of the political economy of carbon markets, for many of the reasons that we even talked about in this show: that the caps are often set, you know, pretty high. They are subject to political influence. The regulated entities that fall under compliance regimes are oftentimes powerful industrial combinations that can make their will known. There are also just alternatives outside of markets for thinking through what climate policy means.
And look, I’m someone that — I remember being in high school economics class and seeing a demand curve. And I remember asking about Say’s Law, about how prices clear markets, and feel like I don’t understand how anyone could see a demand curve and just not want the intersection of supply and demand and to have prices clear the market. That seems to me so intuitively obvious that you would want that for so much within society. And I remember my professor just sort of chuckled at that. He’s just like, well, that’s a very, you know, sort of orthodox free market position, isn’t it.
And I’ve never forgot the moment. And I also remember someone in the class was looking at me and staring with mouth agape, like, how could you — how could you think that? I remember exactly where I was sitting and how it was, but it was such a light switch kind of moment for me. It just always made really intuitive sense. And there’s a number of interesting psychological reasons why that way of seeing things is important. I think there are good reasons for caring about markets, and markets can do a lot of really important work both in climate and outside of climate.
One thing for sure, though, is that I’m no longer a purely VCM booster. That’s had me concerned for a while now and you probably caught glimpses of it previously, but here I am declaring it. So I hope you enjoy today’s show. Bonus content, by the way, for paid subscribers from this show. So if you want to listen to Mike and I talk about some of the problems he’s noticed in VCM, you can subscribe and check that out. Thanks so much for listening. And here is your show with Mike Azlen.
Mike, welcome back to the show. Thanks for being back on Reversing Climate Change.
Mike Azlen: Hey, Ross, great to be back.
Ross Kenyon: I’m glad you want to do this again, because every so often I loop back around to thinking very seriously about compliance markets. I come from a very strong VCM, voluntary carbon market background. I used to think that voluntary carbon markets were going to do the bulk of the heavy lifting, and I’m feeling a bit delusional about some of my past ideological stances on this. And you’ve been a nice little thorn in my side for a long time talking about compliance markets. So I thought it was time to come back on the show, reintroduce the topics to listeners. Why should they be caring about compliance markets? And tell them a little bit about your work. So why don’t you reintroduce the topic for everyone?
Mike Azlen: Sure. Just a little bit of background, Ross, for those who haven’t heard about me before. I’m a Canadian who’s been living in London for 30 years now. I did my graduate degree at London Business School and worked in the financial services industry, and mainly in the fund management industry. And I was fortunate to build and sell a business to a public company. And that’s when I took some time out to think about the next chapter in my career. And climate change was always something on my list. And this was about one year before Greta Thunberg really broke onto the scene.
And because I’m an empirical person, I started reading the peer-reviewed academic research on the science of climate change. And I was in a fortunate place. I didn’t have to work at that time, so I could spend full time. And I’m a bit geeky that way. After about three or four months of wading through, learning the terminology, climate forcing, etcetera, I spoke to a lot of climate scientists around the world, in particular scientific skeptics. I wanted to understand scientists who were skeptics, their point of view. But I really came to the conclusion that we’re in a terrible place, that climate change was much worse than even many people who work in the industry, and that it definitely had a human fingerprint.
I was aware that, you know, the paleoclimate records about the changes, but there’s no question it is a human fingerprint. So I then enrolled at the LSE in their Economics of Climate Change program, and that is where I was first exposed to these carbon markets. And you know, once I learned how the mechanism worked, which took a little while and a focus, but I found it to be a fabulously interesting and elegant mechanism to deal with carbon emissions, the externality. And the carbon markets were trading back then in around 2018 about 10 billion a month liquidity.
So I hired a PhD student at that time, brought him in. We then collected data on all these carbon markets, wrote a full academic paper. It has now become the seminal academic paper on carbon as a liquid and investable asset class. It took three years in the peer review process, but it was published in 2022. And the basis of that paper allowed me to form my second business, which is an environmental asset management company. And our objectives are obviously generating returns for our investors, but also direct impact on climate change, which is something I’m very passionate about.
And so we launched the company five years ago. We’re now the biggest in the world at what we do in environmental asset management. And we’re a small team, but a very successful five years are behind us. We manage over half a billion in assets under management. And the way we have achieved the impact on climate change is we charge a performance-related fee, and 20% of that fee each year, if indeed we perform, we use that to buy compliance carbon — not voluntary. We purchase compliance carbon permits, much higher price of course, as we’ll find out in a moment, and we cancel those.
And I’m very pleased to say that because we’ve had positive contributions there, that $1.7 million US thus far has been used to buy and cancel compliance carbon, about 33,000 metric tons. So there’s a nice alignment and creating, we believe, real impact by doing that in the compliance markets. And yeah, that’s a quick background. So, you know, hopefully on this, you know, I’m sure you’re going to take me through questions on, you know, how do these compliance markets work, and the history and success of them. And I think it’s a really interesting topic.
Ross Kenyon: I have questions for you. I have loads of questions. Let’s just pick one. I imagine the European ETS is the place to start to have a conversation about this, but maybe speak in general terms about what the goals of compliance markets are, and then how does the European ETS work in layman’s terms?
Mike Azlen: Yeah. So there are two key objectives to an emission trading system. The first is to cap and lower emissions, and the second is to achieve that reduction at the lowest cost to society. Very important, the second objective. We want to address climate change, but we want to do it at the lowest possible cost, and those are the two overarching elements of how an emission trading system works. The background was, originally the Republican Party in the United States in the ’80s under the Bush administration launched the Sulfur Dioxide Emission Trading System to cover acid rain issues with sulfur dioxide. It was fabulously successful.
There are multiple papers on our website if people are interested in that, in tracking that success independently. It was really successful, and the Europeans, Ross, saw that, and in 2005 they decided to adopt an emission trading system, a cap and trade, for Europe. They launched the emission trading system in Europe in 2005, and since then emissions in Europe have declined by 1.1 billion tons per year. That’s an annual run rate decline of 1.1 billion; 900 million tons of that has come directly from the entities that are covered under the ETS. So it has been fabulously successful, both in sulfur dioxide — as a Canadian, I remember the acid rain issues we had in Canada. And so it has been a very successful mechanism. And I think because of that, we’re now seeing it spreading around the world.
Ross Kenyon: When people conceptualize compliance markets, they imagine — I’m going to put myself in their shoes — I think that they imagine legislators and the regulated entities, the companies that have to comply with the compliance regime. But they aren’t thinking about you, Mike. Everyone should be thinking more about Mike Azlen here. Where do private traders fit into this? Why do we need your involvement here to make this successful?
Mike Azlen: Yeah. So it’s really interesting. So let’s just go through the key steps of how these markets work. The first thing is it’s called a compliance market because you must comply. So any entity in, let’s say, the state of California, or in Europe, or the UK — the UK now has its own emission trading system — any entity above 25,000 tons per year, you are mandated. You’re in the market. You don’t have a choice. You’re in. That means annually, Ross, you’re audited by the government. So if you have a factory that emits 1.2 million tons, by April of the year following that year you must give the government 1.2 million permits.
Where do you get them? The government issues these permits, so they set a cap on the total amount of permits. And normally these are sold in auctions. So in the case of Europe, they have an auction every single day. In the UK it’s twice per month, and in California it’s four times per year. They auction 50 million tons of permits four times a year in California. So that’s how the supply comes in. But it’s interesting — that means that the total supply is capped among those underlying entities.
So let’s go through a compliance cycle. The supply, 200 million, let’s say, is issued. The underlying companies, let’s say their total emissions — there’s thousands of companies — their total emissions are also 200 million tons in the state of California. And they’re pretty smart. These are big public companies. Who are the sectors? That’s the power sector, steel, cement, chemicals, glass, oil refineries. It’s these big, big companies, right? So they forecast their emissions. They know they have to comply. If they don’t hand in the permits, the penalties are extremely severe. They’re far higher than the price of a permit. So we get 99.9% compliance. That’s very, very important.
Now when the government — so these companies hand in the 200 million permits that were issued by the government; they bought them at the auctions or they bought them in the secondary market. Now the companies have the permits, they give them to the government. Government says OK, you complied, no penalty. Second company, you complied. The government has received all the permits back. What do they do? They destroy those permits, they tear them up. And that compliance period has now completed. We go to the next year and instead of 200 million, the government only sells 190. Oh, the next year 180, then 170. So the total supply of these permits becomes scarce.
That means that each CEO is looking at not one carbon price, the permit price — they look at two prices. This is the beauty of the carbon compliance markets. It forces the emitter to look at the compliance price. Let’s say in California it’s $30 US per ton. Or he calls in the head of engineering and he says, Jim, we’re emitting 4 million tons a year. It’s costing the company $120 million a year I’m giving to the state. I don’t want to do that, right? We’re running a business here to make a profit. Can you, on the factory floor, get some new machines in and get my emissions down?
And the key question is the cost. What’s the cost of reducing my emissions? So every CEO, you can bet your bottom dollar, knows two carbon prices. They know the permit price and they know their internal abatement cost. And when the permit price is above their internal cost — what would you do, Ross? If, if, if you could cut your emissions for $20 and the permits are 30, would you pay 30 or would you cut for 20?
Ross Kenyon: Yeah, obviously 20.
Mike Azlen: Why? Why would you do that?
Ross Kenyon: Because the cost of just complying is better than having to go out on the market and buy the credit.
Mike Azlen: Yeah, because you’re after profit. You’ve got your eyeball, as a CEO, on profit. And here is the key power of this mechanism. It takes the most powerful motivating force in business today: profit. We might not like it, but that is what it is — short-termism, quarterly earnings — and it focuses that profit motive to achieve what? To achieve the three magic words: least cost abatement. These are the magic words we want to achieve. Never forget those three words. Not abatement at any cost — least cost abatement.
Among those thousands of CEOs, when the California price is 30, some of those engineers come back to the CEO and they say, John, our cost is 90. And the CEO says, OK, well, I’m not going to invest and pay 90, I’ll just buy the permit. But there are some companies where the cost is 20 or 25, and indeed those companies abate, they cut. Now the next year there’s even less permits. So if you picture a merit order — and this is called the marginal abatement cost curve — and this really unlocks, Ross, a visual image of how a carbon market achieves the least cost abatement.
Every year when the supply gets lower and lower of these permits, it stimulates some companies to abate. And the only way we can get the next rung on the ladder — if we lined up all the mitigation or abatement methods from lowest price of abatement to high, you have to climb that marginal abatement cost curve over time. And so the expectation in carbon markets is supply is reduced, and you let the invisible hand of the market with the profit motive seeking the least cost abatement. So every year when there is abatement, because there must be — we’re playing musical chairs and we pull out a chair, there must be abatement — we can be pretty confident that it is the company with the lowest internal abatement costs. They’re the ones who choose, because they’re profit motivated.
Now here’s where the role we come in, Ross. You can only make that assumption that the least cost company will abate if there’s two things that hold, very important: liquidity and price discovery. Now this goes back to fundamental economics, lots of empirical evidence and academic literature, particularly in commodity markets. In order for them to function, you need liquidity and price discovery. If no one knows what the price is in California, no one will know what the gap is and who should cut. So you want wide dissemination of that price signal. The price signal is all, and therefore this is well studied.
Now, how do you achieve liquidity and price discovery? Very simple. You bring in a full ecosystem of participants. So you have the compliance entities, and they’re very active in most carbon markets. The compliance entities have sophisticated hedging, but you also need financial investors like ourselves, short-term speculators, arbitragers who will arbitrage between the futures price and the physical permit price. And this all brings liquidity and price discovery, which in the end results in the magic words of least cost abatement. And as I said, the proof is in the pudding. Both in California and Europe now there’s been quite dramatic decreases in emissions while at the same time seeing very solid economic growth.
Ross Kenyon: Do the regulated entities see you as a beneficial force? I could also see them seeing you as someone who’s pulling profit out for yourself but also raising prices for their compliance costs. Is that a thing, or maybe not?
Mike Azlen: So I think what’s very, very important with the primary objective of these markets is abatement, and to achieve the environmental objectives, right. So it’s very important that financial actors, like in all things, have limits. So there are position limits, there’s maximum holding limits for the physical permits. Most of the liquidity in carbon is futures — like most commodities, gold or oil, it’s the futures market. There are also limits on the size of futures positions that financial traders can take in these carbon markets. So, you know, I think the regulator’s been quite good about sort of finding a nice mix between allowing financial participants to bring liquidity and price discovery, not allowing to, like, game the market.
Perhaps you’ll remember when the Hunt brothers tried to corner, you know, the silver market and prices spiked. We definitely don’t want that. At the other end of the spectrum, very interesting: in South Korea, they launched the carbon market over five years ago and they took a different tack. They said no financials, only the compliance entities can trade the carbon. It was a disaster. What happened is the day before the compliance deadline, they went into the market and the price spiked. And then the day after the compliance deadline, they had the price collapse. And this happened every single year.
So finally these huge companies, Korean chaebol companies, went to the government and said, look, can you please bring some liquidity in? So they brought in two rounds of allowing financial actors, domestic Korean actors, into the Korean market. Liquidity has picked up and things are stabilizing. And next year, we believe they will open to international investors like ourselves.
Ross Kenyon: That is so fascinating, thanks for sharing that. I’ve seen various pitches before and I’ve never fully understood how this would work for political reasons. The case is that someone could raise enough money to buy up all of the available compliance assets, retire them — the musical chairs, more chairs be pulled out — then companies really need to actually do business and not fail to meet their obligations and be fined in some horrible way. It sounds like that cannot happen, and it sounds like you probably wouldn’t even want that to happen either, because these companies need a glide path down to net zero. That’s like the best case of this, too.
I’ve also seen cynical interpretations of compliance markets as well, which is that the regulators are subject to political influence and that the rate never comes down nearly as fast as we needed to, and that there’s lobbying happening that we don’t know as much about as the truth. Somewhere in between these perspectives — what do you think?
Mike Azlen: So one nice thing: we invest in five different compliance carbon markets around the world. They all have very similar structural design. What do I mean? The two key components: they have a cap and it declines each year. Typically it’s between 3 and 5% per annum. So this is a graduated lowering of emissions. And the second thing that most markets have in common is that a significant or all of the supply of the permits comes to the market through the government auctions. And here’s where the politics is very interesting with the mechanism.
If you look at California, California auctions about 200 million tons a year at $30. So there’s $6 billion a year of revenue into the California coffers. Now in most carbon markets, 100% of this polluter-pays revenue, 100% is segregated and it’s used to reinvest in energy efficiency and low carbon initiatives. But what do politicians love? They love pork. They love that revenue stream, they get hooked on that revenue stream. So it makes this policy, unlike other regulatory policies, hard to cancel once it’s in place, right? Because they love being able to go to the local community and say, we’re building this — this is the new energy efficiency on the shopping mall, look at the solar panels we put on the roof, $50 million, right?
So there’s some nice political elements. And when you study, as I did at LSE, all of the climate policy mechanisms that have been tried to be pulled by governments, this not only has been, you know, by far the most successful in raw emissions reductions, but it’s been the most sustainable. You know, the EU ETS now has been around for 25 years, California since 2012. So there’s some good reasons, there’s some good political design into the mechanism, I think, that make it good.
The other final point, which no one talks about, but I think it’s very relevant: if you’re in California and you are a university professor, you’re a tinkerer, and you come up with a new way to extract carbon dioxide at flue gas, at point of emissions, point sourced — you go to a VC in California and you say, I look at this great technology, I can extract flue gas emissions and very cheaply, it’s completely new technology. That VC is going to back you. You will raise capital. Why? Because in the state of California, you know, you have a pathway to monetize.
So a carbon market, a liquid market that trades — in the case of, you know, these markets are now trading $70 billion per month — means there’s an ability to monetize. And it promotes intellectual property development, specifically targeting reduction in emissions. And that’s what we need, right? We need breakthroughs. So there’s a primary benefit: cap and lower emissions. Secondary, we do it at the lowest cost. Tertiary, we reinvest the proceeds into reduction. And fourth, we stimulate intellectual property development. It’s just a smart, smart mechanism.
Ross Kenyon: When you’re at whatever industry gatherings, cocktail parties that happen with people who are regulated under schemes like this, are they contented? Do they like being a part of this regime? Do they wish it were some other way? Or are they glad for the transparency, the regularity, the predictability of it? How do they feel?
Mike Azlen: So you get the entire gamut of, you know, profit-motivated companies and boards of directors, you know, who have put climate change and any social commitment to one side. They don’t like it because they see it as an additional cost of doing business. So they don’t like it. But then on the completely other side, you have major CEOs of companies — perhaps more so in Europe today, it’s fair to say — who are very aware of what we’re looking down the pipe at in terms of our children’s future and climate change. And they recognize that there has to be a mitigation mechanism.
And so they may not 100% like it, but they recognize we need to have some means of stepping down. In the EU, it’s 4.3% per year that that cap comes down. And as I mentioned, it’s been over 25 years. All of a sudden you’re down 1.1 billion tons a year. Not bad in a world of 40 gigatons.
Ross Kenyon: One phrase that is continuously repeated within carbon removal is pre-compliance, and that carbon removal is generally in a pre-compliance period. I think there’s been a lot of concern about monopsonistic effects within carbon removal. The demand is quite concentrated with a small number of buyers, people that you could name off of your hand. And everyone in carbon removal is looking forward to being able to rely upon that steady demand signal that you’re talking about with regard to California. And we just do not have that yet.
There are various changes to law, coming primarily in Europe but not exclusively, that may allow carbon removal to fit into various types of compliance markets or other types of compliance regimes. How do you see that impacting your work, either as a trader or as someone who’s just observing compliance from afar?
Mike Azlen: Yeah. So the first thing, just coming to that, is, you know, when we started our research on compliance markets, they were trading at 10 billion a month. Now they’re trading 70 billion a month. China, of course, in the interim has launched a compliance carbon market. South Korea’s launched. Mexico’s in the second year of their pilot. Japan, the fifth biggest emitter, a Western, a liberal democracy, good financial infrastructure — they are launching a compliance market next year. They’re morphing their GX League, which is in between a compliance and a voluntary, into full compliance next year. We’re really optimistic about that.
And then the big ones, Brazil and India, are both moving legislation through. So all the Asian tigers — Indonesia, Philippines, Malaysia, Thailand, Vietnam — are all at some stage of launching a compliance carbon market. So today we have about 18% of global emissions that are in compliance markets, but that is likely to rise significantly in the coming five years. And this is good news for climate change, right? The Chinese carbon market, to put some numbers on this: they’ve just added steel, aluminum and cement to the market. It’s now 7 billion tons — 7 gigatons is the cap. Europe’s 1.3 billion and California’s 300 million.
So just put that in perspective, right? That is enormous. Now if you bring a 7 billion cap down by 5%, that’s 350 million tons in one year. That’s the entire emissions of the UK taken out. So when people say to me, what’s the quickest way we could address and have a hope of bending the curve anywhere near what we need, at the scale we need, in the very limited carbon budget time we have remaining — ETS is one of the only mechanisms because it’s so scalable. If Brazil caps and starts bringing that cap down, these are big numbers.
So I just wanted to reiterate, you know, hopefully the growth of these markets. And in my view, if one would say, OK, let’s look at all the resources that are being spent around the promotion and education of compliance carbon markets to mid-level bureaucrats in emerging market countries — here’s the number: tiny. How much money is being spent on LiDAR for forestry, REDD+, and other, excuse my language, weird carbon abatement avoidance schemes and cryptocurrencies linked to VCM? This is a huge, in my view, misallocation of resources. And one of our missions is simply to educate more people. I’m sure most people on your show probably don’t know anything about these carbon markets, yet they’re the most successful policy mechanism. I mean, it’s crazy.
So anyway, I’m sorry, went off on a bit of a tangent there, Ross. But the beauty — coming back to your question — in any economy, we talked about the marginal abatement cost curve. If you’ve got an industrial process, you can probably get 70, 80% of the emissions out at some reasonable cost, right? Maybe it goes up to 100, $150 a ton, right. But that last 10 or 20% of emissions — and I think this is what’s dawning on European policymakers — that last 10 or 20% of emissions, maybe $1,000 a ton. Now, if I can prove to you, as your listeners know, that we could provide high quality, durable carbon dioxide removal for 200 or $300 a ton, why would we force a company to abate and pay 1,000 and potentially bankrupt that business, when you could actually remove the carbon, inject it deep underground for long term storage, for let’s say 300?
So there’s a deadweight loss to society. And I think this is the main — again, we come back to economics, don’t we, as the driver for these decisions. This is why Europe and the UK — the UK is even the front runner here — are looking at integrating only high quality CDR, very important, the quality metric here, into the emission trading system. And that would happen in stages. So, you know, instead of having to submit 100% of permits to match your emissions, they would allow you perhaps 5% could come from CDR sources, but only government approved sources, and then the next year might be 7% and then 10%.
And we see this — we call this convergence, whereby compliance carbon markets, instead of the permit being a permit that allows one ton to be emitted, they will morph into markets where actually what gets traded represents the removal and permanent storage of one ton. And this probably extends the life of these markets by perhaps 25 to 50 years, because as you know, we’re going into massive overshoot and we’re going to have to be removing carbon for, for decades. So I think that this is the — what we call convergence between compliance and CDR. It’s very exciting. I think the issue is time horizon, and happy to tell you what the UK is doing and what Europe is doing.
Ross Kenyon: Oh yeah, I’d love to hear more about some of the specifics, although I do feel honor bound to defend carbon removal people a tiny bit. I think the way that you came into carbon was a very interesting mix of first principles thinking and empiricism, where you reviewed the literature, you saw that this was the lever that you wanted to spend time pulling that had the greatest potential impact, and you found your way there. I think a lot of people come into carbon removal knowing that carbon removal will be necessary, if for nothing else for residual emissions. We just need to have this technology ready to go. And they come at it that way and go from there. You guys are looking at different ends of the telescope, I think, is what happened.
Mike Azlen: Yeah. You know, as you know, Ross, I’ve done a very, very deep dive on the voluntary market, and we came to a very strong conclusion that you just simply should not be placing capital there. We’ve got — I can — anyway, that’s a different podcast, but many, many—
Ross Kenyon: No, no. No, it’s — I think it’s this podcast too, but—
Mike Azlen: But there’s many, many clients of ours — many have invested in very large VCM projects, had lost very large amounts of money. We estimate last year between 3 and 600 million US dollars was lost in voluntary investments. But within the voluntary, of course, carbon dioxide removal is a very tiny subset, we know. And I love CDR. Why do I love CDR? Very simple. I’m an empiricist. If I can feel it, touch it, weigh it, liquefy it, transport it, inject it and cap that well, I know that is long term durable storage.
And that is simple. Yes, it’s 300, it’s 400, it’s 500. But that makes sense to me. It has to be more expensive because you’re getting what it says on the tin, right? I mean, when you understand, as I do — I mean, let’s not even go into it. You should get Elias Ayrey on your podcast to talk about the multiple methods that, you know, a lot of VCM, both methodologies and then projects, are games, unfortunately. But high quality CDR, absolutely love it. And there’s no question.
I mean, just to give you what’s happening in the space: so the EU has now issued their carbon removal and carbon farming regulation, and they’ve broken down CDR into really three categories. Carbon farming, which covers farms and forests. Permanent removal — that’s of course DAC, BECCS and bio-CCS, right. And then a third source, just like sort of everything else that sort of falls outside of those categories. So they are looking very seriously — this is going to move through legislation in the next probably 24 months, with probably an earliest implementation date when CDR permits — and these would be EU approved permits — would become fungible for a portion of those compliance companies, for a portion of their annual obligation. And let’s put a number on it: 3% in year one or something small.
Now the history of this is very interesting. Back in the days of the CDM, the Clean Development Mechanism, in 2005 to 2008, the EU allowed international CDM credits from global projects to become fungible for a large portion of obligations. And Ross, I can tell you, having studied that and knowing people who worked very closely in it, it really was a disaster, because you had very low quality credits being used. It collapsed the price. And remember what stimulates abatement. Does a low price stimulate abatement? No, a low price doesn’t stimulate. When the price of carbon removal is high, then people abate. So there was a very bad experience with that in the EU and it left a lot of scars.
And I think that’s a good thing, because I think when they bring CDR in now, it will only — my hope certainly — be very high quality methodologies that will be allowed, durable long term storage. The EU even mentions a 1,000 year time horizon [unclear] for storage. So you know, biochar and DAC are definitely in the frame. But, you know, wonderful too — I wish they would accelerate this a little bit, a little bit further, because we know, as you just mentioned, CDR needs a kickstart. And today we had the news of Climeworks going to be doing major layoffs. Unfortunately, I don’t know all the details, but CDR is a tough game, and we need — but we need CDR desperately. So I think this is great news, that the integration of CDR in will bring liquidity and demand to the CDR market.
Ross Kenyon: Do you think the price of allowances in the EU will become high enough that carbon removal can compete with it or even be lower cost than allowances?
Mike Azlen: So I think it’s possible to be lower cost. So, you know, again, you get into methodologies here. Now there are some methodologies I like that are pretty low cost. Biomass burial, for instance, is something that, you know, I like the simplicity of it. Again, the devil’s always in the detail with these methodologies, but certainly it ticks a lot of boxes depending on — and it’s always about your feedstock when you have a, a biomass. So it’s very important to track that feedstock. But that could certainly be a lot lower cost than where the ETS price is going. Our forecasts are that EU ETS and UK ETS prices are going to be well over $100 a ton, probably in 24 months, based on the supply-demand relationship that is occurring now. So, you know, I think it’s very possible that you could have very competitive CDR methodologies, high quality methodologies, that could be around that level.
Ross Kenyon: It seems that we’re entering a period of increased protectionism. I hope not. It might just be that the world trade system is going to reorient and maybe move around the US, which has become increasingly erratic in terms of what trade goals it even has. It’s hard to even know. I’m wondering if that’s going to stick, if it will jolt back. I’m an American, I hope predictability returns and trade continues to improve. But even before the second Trump administration, there have been various indicators that protectionism would play a role in carbon markets.
I know that there have been carbon removal companies, project developers, who have received strategic investment from Japan, so they would be eligible to participate in the Japanese compliance market. I know the EU is exploring whether or not Global South credits will be eligible for the ETS and/or even just carbon compliance. They have various policies that all interact with regard to carbon there, but it’s unclear. Yeah, those are all up for debate. Is the world going to a new commitment to free trade? Is it going in a more mercantilist or protectionist direction? What do you think is going to happen?
Mike Azlen: I think, you know, I think the signs are very clear that we’re moving towards a more, more insular, national, national interests, which is a shame, right? That’s not good. It’s also, you know — someone was saying this last night. As someone who grew up, you know, in a small town very close to the US border, of course, you know, almost everything I consumed in TV and stuff was, you know, from the USA. And don’t feel—
Ross Kenyon: Too bad, it’s because all your comedians come down and it’s all Canadian anyway.
Mike Azlen: But, you know, when I hear the US national anthem, that’s a moving experience for me as a Canadian. Now, of course, I love my country, Canada, and the Canadian anthem is the anthem for me. But there’s no question that what the US anthem evokes and what the US stands for and stood for — you know, to see it crumble now internationally somewhat is, you know, it isn’t great. So, you know, and then it’s being repeated by other countries. You see, they’re turning more inwards. They’re saying, well, if the US is, you know, turning inwards, then, you know, why should we engage? So let’s hope, Ross — but you know, let’s hope that this is a temporary, a temporary thing and not a permanent thing.
With regard to CDR specifically, the EU certainly has made it very clear right now in the CRCF framework that it will only be European based projects, and the credits that come from that, the CDR that comes from that, that will initially be considered for fungibility into the EU ETS. And again, you know, I think because of what happened in the past, I think a cautious, slowly, slowly approach really makes sense. The UK is slightly ahead of the EU in this regard. And of course, being the UK, they can’t use the term CDR. That would be too, too — they use the term GGR. So it’s called greenhouse gas removals, but it’s the same thing.
But they’re on a quicker timeline and could see integration of GGRs into the UK emission trading system as soon as two years from now. Again, it’ll be a small, probably a small integration. They’ve also made it — in their consultation document, they’ve made it clear that the addition will not affect the overall cap. So they won’t increase the cap on emissions. These credits will have to be part of the existing cap. And I think, again, that that’s the right way of going about it.
Ross Kenyon: Interesting. I’m actually really curious about the privileging, especially of BECCS within the EU. And it should come as no surprise that Europe is quite good at BECCS. I think that should make you wonder which of those came first. That’s a very cynical way of framing the question. Is there anything to that, or is that a conspiratorial mindset?
Mike Azlen: I think, I think, you know, to summarize that — you know, you get cynical when you get old like me and you’ve been in business for so many years. And it’s just very apparent to me now that if you don’t have a policy that interacts with supply, demand, price or profit, you are not on a winner. You are going nowhere. You are not scaling unless you’re interacting with these four capitalistic levers. And it’s sad to say that, right? But that is the ultimate realization. It’s all about the money.
So you know, the financial incentives and the long term financial sustainability of CDR — and this is, I think, what Climeworks has to get to grips with, right? Can they find the funding to sustain the drop down that technology learning curve to get DAC down to that hundred kind of $150 a ton? And I certainly hope they can sustain that. But it really does come back to the financial economics. So when we talk about Europe, it’s a combination of regulatory stimulus or lack thereof, and then the financial incentives. And there’s been some real successes on the bio-CCS, as you know, that Microsoft, I think, did a big deal with the, the Norwegian — or not Norwegian. Are they Finnish? I can’t, I can’t remember. But when you take this—
Ross Kenyon: They’re all over the [unclear].
Mike Azlen: Yeah, when you take that project apart, they received debt funding, European Development Bank funding — it was a multifaceted funding source to put that whole thing together. And again, it’s early days, but it certainly looks like they’re going to have a very big, successful CCS facility, capturing hopefully a lot of carbon.
Ross Kenyon: You’re in the UK. I hear more bad things about Drax and BECCS in the UK than pretty much anything else about BECCS. I mean, some of the big Nordic deals look nicer, but I know it caused a lot of controversy where you are too.
Mike Azlen: Yeah, I have to say I’m not a, I’m not a fan of the Drax conversion to BECCS. You know, I don’t know how close you’ve been following it, but there’s been multiple investigative journalistic reports now that have sourced the fact that the pellets, the wood pellets that come from Canada, some of them have come from Canadian old growth forest. And you know, that’s just wrong, right? And then to claim that you burn that and the emissions go in the atmosphere and it doesn’t count under the emission trading system — so since those reports have come out, there’s even been a television documentary here in the UK on that. You know, Drax has been hit pretty hard. There’s an investigation ongoing, I think, with the government.
And separate from that, they’re in a consultation in the UK about whether should bioenergy with carbon capture and storage — or sorry, should burning of biomass and releasing the emissions really be exempt from the emission trading system? Because the argument is the trees grow back, they sequester the carbon, and then it’s like a closed loop cycle, right? It’s neutral. But, you know, I think they’re on weak ground there. And I certainly hope the government does the right thing and tightens that up.
Ross Kenyon: Mike, that was fascinating. I always appreciate you being here and teaching me so much about this. I feel like I slept on this for a long time, and I’m now starting to nerd out on it much more heavily. So I basically just need to go through all of the resources that you’ve gathered on your website. I’ll put the link in the show notes to that too. If people are inspired listening to this conversation, that’s a great place to start. Thanks for being here, Mike.
Mike Azlen: Yeah, no, great. Great, Ross. And I know I, I blab on and on, but you know, I’m just, I’m very passionate about it. But I’d love, I would love to get into these more. Like, I know these other topics when it’s less empirical — perhaps not saying you’re not an empirical person, but what I like about the way your brain works, that’s different than a lot of others: it’s like you have this great way of bringing in, you know, emotion and empathy into conversations rather than just like this one we had, was pretty empirical, right? And so, you know, when we talk about the social cost of carbon and, you know, some of these other things, I know you’ll bring in, you know, a lot of these other aspects and it’ll be a much more, like, I don’t know, emotional conversation. I would love to do something like that too.
Ross Kenyon: No, we could definitely do that. I tried to bring it there a little bit too, being like, what happened in my own mind that made me so skeptical towards compliance markets and so supportive of VCM for so long? I think part of it is also just a base level American-ness, where the scariest words in the English language are “I’m from the government and I’m here to help,” as Ronald Reagan once said. That’s part of our national psyche, whether you like Ronald Reagan or not, within our culture.
And I think that can drive Americans in a very specific kind of way that may lead them to be more supportive and more skeptical in ways that are contrary to the truth. And understanding yourself and knowing when am I making decisions for poor reasons, or motivated in some non-ideal way, I think it’s really important. I’m always trying to check that in myself, because you can know that is true and still fail to spot it in yourself. But I appreciate you giving me a chance to explore those ideas, and we should just do more there. We clearly didn’t exhaust your subject matter expertise of this topic, and it’s really fascinating.
So more to come, listeners. If you want to hear more about compliance markets and difficulties with VCM — you dropped that money lost on supporting VCM projects, God, that needs to be unpacked. Let’s do another episode, Mike.
Mike Azlen: OK, great. Excellent, Ross. Well, listen, have a great weekend, and thanks. Thanks very much for having me on.
