Basis Risk (in Climate & Carbon Credit Markets)

Basis risk refers to the potential mismatch between the performance of a hedging instrument, such as carbon credits or carbon credit derivatives, and the actual underlying climate-related exposure being hedged. In carbon markets, this arises because credits vary by project type, geography, methodology, permanence, and verification standards. If the characteristics or market behavior of the credits used for hedging do not perfectly track the emissions or compliance exposure being hedged, the hedge may not fully offset the risk.