Carbon Offsets: Decarbonization or Transition-Washing?

As the world is racing to transition to carbon neutrality, voluntary carbon markets (VCMs) have emerged as a potential tool to support decarbonization efforts. By tapping VCMs, corporations can offset their emissions by purchasing and retiring carbon offset credits issued by third-party project developers.

However, there is widespread skepticism regarding the authenticity of climate claims made by some offset projects and their end users. On May 28, 2024, the U.S. Treasury, Energy, and Agriculture Departments jointly announced a policy statement featuring a template of rules to govern VCMs, underscoring the importance of understanding the implications of the lack of transparency and authenticity in VCMs for the incentives of corporations that participate in these markets. There is a big gap in our understanding of these issues.

Our paper, Carbon Offsets: Decarbonization or Transition-Washing?, aims to fill this gap by providing the first systematic evidence on the landscape of carbon offset projects and the determinants of offset usage by publicly listed firms around the world. We use a rich hand-collected dataset that includes information about which entities retire how many carbon credits to offset their greenhouse gas emissions in a given year, and which offset projects those credits originate from. 

Our analysis covers a variety of offset projects, such as those developing renewable energy, installing energy-efficient housing and appliances, and preserving forests and grassland. These projects are geographically dispersed, with the majority of them based in Asia, Africa, and the Americas. About half of all projects issue carbon credits that are purchased and retired by listed firms around the world. Consistent with offsets being a transition tool, larger firms with higher institutional ownership and net-zero commitments are more likely to use offsets to reduce their carbon footprints.

We formulate the incentives of firms to use carbon offsets with two non-mutually exclusive economic hypotheses. The first is an “outsourcing hypothesis:” Firms with smaller carbon footprints use offsets more intensively to reduce their carbon emissions indirectly due to lower marginal costs associated with offsetting compared to reducing emissions directly through abatement investments and innovations, while heavy-emission firms are more likely to reduce their emissions in-house. The second is a “certification hypothesis,” where firms care about their credentials with outside stakeholders and use offsets strategically to signal their commitment to reducing their carbon footprints.

Supporting the outsourcing hypothesis, we find that low-emission industries, such as services and financials, are highly intensive in their use of offsets relative to their modest emissions, almost offsetting their direct emissions one-for-one. In contrast, the aggregate share of direct emissions that are offset using carbon credits is close to zero in high-emission industries such as oil and gas, utilities, or transportation. Also consistent with the certification hypothesis, we find that relatively few offset projects are externally verified as having high quality and that most offset credits used by firms are quite cheap (more than 70% of retired offsets are priced below $4 per tonne).

To make causal inferences, we exploit an exogenous change in companies’ ESG ratings – and their incentives to boost these ratings – triggered by a major rating methodology change at a leading ESG rating agency, Sustainalytics. At the end of 2018, Sustainalytics implemented a new methodology for their ESG scores that created an average within-industry ESG rank reshuffle of 20 percentiles. Consistent with the strategic role of carbon offsets, firms offset more of their emissions using carbon credits after experiencing an exogenous ESG rating downgrade. In particular, light emitters in industries with narrow cross-peer emission gaps become more likely to behave this way, whereas heavy-emission firms in large-gap industries do not. Moreover, firms that strategically increase the use of offsets do so by retiring credits from low-quality offset projects, which command lower prices and therefore provide a cost-effective way of “transition-washing.”

These findings do not support proponents who argue that carbon offsets can be effective at facilitating net-zero transitions by heavy-emission firms. Although we find some evidence that heavy-emission firms can be incentivized to choose high-quality offsets over low-quality ones, we find no evidence that these firms would use such “good” offsets in large enough quantities to meaningfully reduce their net emissions.

Our study has important implications for understanding the current state of VCMs and designing future policies and regulations. Our findings suggest that VCMs are currently flooded with cheap, low-quality offsets due to the lack of integrity guidelines and regulations, which likely discourages the use of high-quality offsets by firms motivated to take serious steps to reduce their emissions. This highlights the importance of commonly adoptable rules and regulations to ensure the transparency and authenticity of offset projects. Much future research is needed to help design and regulate the carbon offset market so that it facilitates a healthy transition to a carbon-neutral economy.

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By Sehoon Kim, Tao Li, and Yanbin Wu (University of Florida)

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