Making Sense of Carbon Markets: An Introduction and Assessment
As the threat of climate change looms, it is vital to comprehend the environmental impact of organizations’ daily operations, which release greenhouse gases via activities such as electricity consumption, manufacturing, and transportation. Comprehensive analysis of a company’s carbon footprint is necessary to measure its emissions. With mounting regulatory and stakeholder pressures to reduce carbon emissions, businesses worldwide are searching for ways to mitigate their impact. This article provides an in-depth analysis of the mechanisms underpinning carbon markets, examining how market forces, regulations, and stakeholder expectations interact and influence one another.
Purpose of Carbon Markets
At a high level, companies can turn to carbon markets to support their efforts in reducing emissions and meeting climate commitments. Carbon markets offer certificates known as offsets or offset credits, which represent a standard amount of carbon dioxide that has been removed or will be removed in the future. This mechanism allows businesses to achieve their emission goals without necessarily reducing their own emissions, although reducing emissions directly should be prioritized.
Carbon markets are designed to facilitate actions that address climate change through a transactional marketplace. They provide businesses with the option to offset unavoidable emissions or comply with local emission regulations.
The foundation of carbon markets is based on the concept that a unit of carbon dioxide released through a company’s operations can be offset by removing or sequestering an equal amount of carbon dioxide from the atmosphere. Alternatively, companies can purchase carbon offsets from other parties who have taken on the project that generated the offsets. These offsets represent activities that either remove carbon dioxide from the atmosphere or prevent emissions that would have otherwise occurred.
The principle behind carbon markets works because greenhouse gases mix in the atmosphere, so the location of emissions is less important than reducing global greenhouse gas levels. However, it is crucial to consider the quality of the offsets and the execution of a company’s net zero emissions strategy in assessing the effectiveness of the activities.
Understanding Key Terminology in Carbon Markets
To navigate carbon markets effectively, one must become familiar with the unique terminology used in this field.
The most commonly used term is “carbon offset,” which is also known as an offset credit or an offset certificate. This represents a quantifiable unit that tracks the reduction or removal of greenhouse gas emissions in another location. It’s important to note that the term “offset” implies compensation, but it’s crucial to distinguish between carbon credits and offset credits. A carbon credit denotes an amount of pollution that a business is legally allowed to emit and is also referred to as a carbon allowance. Carbon credits are not equivalent to offset credits, but since they both refer to one ton of carbon dioxide equivalent emissions, they are often used interchangeably. Carbon credits are only found in jurisdictions that have cap and trade systems.
Carbon markets are marketplaces where businesses can buy and sell carbon credits and offsets. These markets are divided into two categories: voluntary and compliance. Offsets available in these marketplaces relate to carbon dioxide reduction or removal activities, such as implementing carbon capture technologies or leveraging the earth’s natural sequestration capabilities through wetland rehabilitation initiatives or other natural projects. These offsets may be certified by a specific program or registry, which serves as a standard-setting, trusted body that verifies the credibility of the offsets for the offset certificates. Verra and Gold Standard are examples of such programs and registries.
The activities that generate offsets in carbon markets are referred to as projects. A broad range of projects generates offsets, including reforestation, cleaner cooking stove upgrades, and renewable energy infrastructure.
History & Policy
Carbon markets, which include both voluntary and regulated compliance markets, are presently of utmost importance due to the rising demand from corporate stakeholders for companies to reduce emissions and mitigate their impact on climate change. Additionally, the implementation of new disclosure regulations regarding emissions has contributed to the increased significance of these markets. Other pivotal events and drivers have also converged to shape the carbon markets as they exist today.
Several significant events on the regulatory front have been instrumental in highlighting the necessity for carbon markets, with the most noteworthy ones being the 1997 Kyoto Protocol, the 2005 introduction of the European Union’s emissions trading scheme, and the 2015 Paris Agreement.
In 1997, the Kyoto Protocol was established as an international treaty with the aim of obligating industrialized nations to restrict their greenhouse gas emissions. Under the treaty, countries that agreed to its terms were allotted a set maximum for their carbon emissions and were subjected to penalties if they surpassed those levels. This initiative resulted in the creation of the first international carbon market system. Despite being viewed as somewhat unsuccessful due to the lack of participation by major polluters such as China and the United States, the Kyoto Protocol formed the basis for later advancements, ultimately being replaced by the Paris Agreement.
In 2015, all participants in the United Nations Framework Convention on Climate Change signed the Paris Agreement, which mandated countries to restrict their emissions and submit nationally determined contributions outlining their climate action plans. The agreement acknowledged the utilization of carbon markets, with robust provisions for preventing their misuse. Since then, regulatory coverage has been progressively expanding each year, with a notable increase in 2021 as countries aimed to display leadership in tackling climate change.
Although voluntary markets have existed for a significant period, there has been a recent upswing in interest in these markets. This can be attributed to the constantly evolving legislation surrounding climate change, as well as the mounting pressure on management teams to reduce their organizations’ carbon footprints. You may have come across companies that claim net zero emissions. These claims typically hinge on the purchase of offset credits from voluntary markets, which enables companies to offset their direct emissions, especially those that are challenging to reduce solely through power source and operational alterations.
In the following sections of this article, we will explore the nuances of both voluntary and compliance markets. However, the main takeaway for now is that both of these markets have experienced significant increases in participation and are predicted to continue expanding rapidly.
Carbon Markets vs. Carbon Taxes
It is important to distinguish between carbon markets and carbon taxes, as the two are often discussed in tandem, but are fundamentally different. When lawmakers seek to reduce or limit emissions, there are typically two approaches: cap emissions or tax emissions.
In a cap and trade system, which is the basis of compliance carbon markets, organizations are granted a set emissions allowance and are able to buy or sell allowances based on their needs. If they exceed their permitted emissions, they can purchase credits from the compliance market to cover the excess. The earliest cap and trade system was established in the Northeast and Middle Atlantic states in the US in 2008, while California launched the first economy-wide cap and trade system in 2013.
On the other hand, carbon taxes place a financial penalty on emissions, usually linked to fuel or energy use, and are designed to incentivize companies to reduce emissions in order to avoid the added cost of the tax. Carbon taxes do not limit emissions but create cost parameters for organizations to consider. Canada has implemented a federal carbon tax law that includes a levy charge on the sale of petroleum products in addition to a regulatory charge on fuel. Provinces can either adopt the federal approach or develop their own carbon taxation scheme.
Both carbon markets and carbon taxes are being implemented by governments worldwide to achieve regional emission targets and meet sustainability commitments.
Compliance & Voluntary Markets
It’s essential to understand the differences between compliance markets and voluntary markets when it comes to carbon trading. Compliance markets operate under government-regulated cap and trade systems, like California’s. Organizations trade carbon allowances or credits, and participation is mandatory for companies within the regulated market. Compliance markets are closely monitored by local regulatory bodies to ensure they follow policy and monitoring requirements.
Voluntary markets, on the other hand, are not regulated by the government and are guided by carbon offset standard providers. Individuals and companies choose to engage with these markets to buy and sell carbon offsets to meet their objectives. There is a broad range of projects in these markets, and they are not subject to the same level of transparency and verification as compliance markets. Although voluntary market projects work with standard providers for validation, it is not legally required, and not all projects undergo the same level of validation and assurance.
It’s essential to know that carbon credits or allowances only trade on their corresponding compliance markets, and the credits themselves are only valuable to other participants within the same cap and trade network.
1. Compliance Markets
Compliance markets are regulatory systems established in various regions or countries to meet specific environmental policies. They aim to help organizations comply with their emissions obligations as mandated by law within their respective jurisdictions. For instance, the European Union ETS focuses on managing emissions in the EU, while the Mexican ETS addresses emissions in Mexico.
As noted previously, these markets operate within a cap and trade system where there is a set limit on the total permitted emissions for the entire region or system. The local regulator responsible for overseeing the system distributes credits or allowances either through direct allocation to regulated companies or by selling them at auctions. The allocation of allowances is based on specific industry allocations determined by the impact of the industry on local emissions levels.
Each compliance market has its own policies and methods for allocating credits. Factors such as size, emissions footprint, revenue, industry-specific environmental impacts, and more are considered in the allocation process. The number of credits issued annually is determined by the system’s emission reduction goals and committed timelines. Over time, the cap or number of credits available gradually decreases, compelling participants to improve their operational efficiency or purchase more credits. Hence, compliance markets provide a trading mechanism for participants to manage their emissions obligations.
Important Compliance Markets & Market Dynamics
Many management teams aim to reduce their greenhouse gas emissions through direct reduction work within their operations. However, compliance markets provide another tool for meeting legal obligations around emission limits. Compliance markets are trading schemes that allow companies to trade credits when they need to meet their emission obligations. The European Union established the very first emission trading scheme (ETS) in 2005. Today, there are three major compliance markets in the world: the European Union Emission Trading System, the California Global Warming Solutions Act, and the Chinese National Emission Trading System. Among these systems, China’s covers the largest amount of greenhouse gas emissions. Additionally, several smaller emissions trading schemes exist, including the Korean ETS, the Kazakhstan ETS, the New Zealand ETS, the Japan ETS, the Canada ETS, and the Mexico ETS.
Understanding regional policies and trading schemes is critical for companies to ensure that their activities align with regulations, and that leadership is effectively managing regulatory risk exposure.
Between 2019 and 2022, the price of credits on the EU market increased by over 27%, making these credits a high performing asset class worldwide over that period. As carbon credits have become increasingly popular as a tradable asset, it’s crucial to understand how they are priced and valued. Carbon credits in each market are priced based on specific regional dynamics and market participants. The price is determined by the supply and demand of carbon allowances in offsets, as well as the expectations of market participants regarding the future price direction.
However, there is a lack of consistency, and the price per ton can vary significantly between jurisdictions. For example, at certain periods in 2022, the price per ton in California’s cap and trade system was about four times that of China’s system, and the price in Europe was almost triple that of California’s. As the regulatory environment and stakeholder expectations for corporate emission reductions continue to intensify, prices for carbon credits are expected to continue to rise.
Net Zero vs. Carbon Neutral
The terms “net zero” and “carbon neutral” are often used interchangeably, but they have some important distinctions. Both terms aim to remove polluting emissions from the atmosphere, but they differ in the types of emissions being removed and the scale of that removal. Net zero refers to the removal of all greenhouse gases, including carbon dioxide, methane, nitrous oxide, sulfur dioxide, and hydrofluorocarbons, whereas carbon neutral specifically refers to the removal of the same amount of carbon dioxide emitted by company activities within a given timeframe, typically one year.
Carbon credits and offsets can be applied to residual emissions, the emissions that remain after all other operational and technological reduction strategies have been exhausted. Offsets can also be applied to reduce Scope 3 emissions, which are the most challenging to influence as they are impacted by upstream stakeholders like suppliers and downstream stakeholders like customers. Offsets can be used to support either a net zero or carbon neutral commitment.
When it comes to net zero, the specific greenhouse gases being removed can vary depending on the entity making the commitment. For example, New Zealand’s net zero commitments exclude methane emissions from agriculture, organic waste, and livestock farming. Corporations also make net zero claims with varying degrees of technical accuracy. For example, Walmart’s net zero commitment does not account for emissions from its global value chain, which comprises approximately 95% of the company’s total emissions footprint.
Therefore, it’s essential to understand the underlying science behind these commitments and evaluate the credibility of such claims and their associated risks. Carbon neutral commitments are more straightforward, as carbon offsets are applied until there is an equilibrium between emissions produced and any emissions removed.
Voluntary Markets
Many companies, especially those in resource-intensive industries like manufacturing, energy, and finance, are committing to reach net-zero or carbon neutrality by certain dates. They are implementing various methods to achieve this goal, such as procuring renewable energy, improving energy efficiency, and making operational changes to reduce direct emissions. However, for residual emissions that can’t be reduced, companies can offset them by buying carbon credits.
Voluntary markets provide a flexible pathway to offsetting residual emissions, as they are not specific to any region or industry. Voluntary markets have seen significant activity and growth in recent years and are expected to continue to grow and evolve in sophistication. These markets have third-party standard programs that verify offsets, each with its own standards for validating project quality. These programs cover different types of projects, ranging from forest conservation to technology-based projects using carbon removal technologies. The most reputable verifiers include Verra, Gold Standard, and American Carbon Registry.
However, it is important to understand the inherent risks associated with unregulated voluntary markets. The price of one carbon offset could vary from a few cents to $300, depending on the type of project and the issuing program. Given this price range and the anticipated growth of the carbon market, McKinsey estimates that voluntary carbon markets will be worth more than $50 billion by 2030. Therefore, companies must consider the value of a credit and associated costs or revenue for a given project or exchange of credit.
Projects in Carbon Markets
Carbon offsets can be created through different types of projects, which fall under two main categories: nature-based and mechanical. Nature-based projects reduce carbon dioxide through carbon sequestration, meaning that CO2 is absorbed by trees, plants, grasslands, soil, and other natural ecosystems. Examples of nature-based solutions include wetland restoration, tree planting, forest management, regenerative agriculture, and more. As climate science advances, more nature-based solutions are being developed to maximize carbon sequestration potential. Historically, forestry-related projects have been the most common in voluntary markets.
Mechanical solutions involve technologies that increase the efficiency of carbon dioxide reduction or sequester carbon through advanced technology applications, such as direct carbon capture and storage. Examples of mechanical projects include renewable energy development, direct air capture technologies, ozone-depleting substance removal, and waste-to-energy conversion projects.
There is a wide range of potential carbon reduction solutions, each requiring specific considerations to evaluate the credibility of offset claims. The credibility of offset claims affects the credibility of a company’s emission reduction efforts overall. Projects of questionable efficacy or legitimacy can result in offsets that are perceived as less credible, making their use case in the best scenario, green washing, or in the worst case, potential outright fraud.
Offset Characteristics & Credibility
When it comes to carbon offsets and project that underpin them, there are two important characteristics to understand: the number of offsets created and their value or price.
The number of offsets generated by a project depends on the amount of carbon that will be captured or eliminated. For example, if a project is expected to eliminate 100 tons of CO2, then it will create 100 offsets. However, it’s important to note that the project should ideally be validated by one of the verifier programs, such as the Gold Standard, Verra, or American Carbon Registry, but it’s not always a requirement for engagement with the voluntary markets. Once the offsets are created, they can be sold on approved offset exchanges, and the transaction is registered on a registry such as the American Carbon Registry.
The value of carbon offsets is determined by several factors, including the legitimacy and credibility of the offset, which is influenced by the underlying project and its outcomes. Verified offsets, which are certified and verified by a third-party rating agency like Gold Standard, Verified Carbon Standard, or Climate Action Reserve, are typically considered to have higher credibility and are thus more valuable than unverified ones.
Other factors that can influence the value of offsets include the timeline to completion, execution risks, and other unique nuances of each project. Ultimately, the value of carbon offsets is a complex and imprecise science that depends on various factors, and it’s important to carefully consider these factors when investing in carbon offsets.
Project Ratings
Carbon offset projects can be evaluated using different frameworks. One such framework is presented by GivingGreen.earth, a team of experts who specialize in assessing offset projects. GivingGreen.earth identifies seven key metrics or dimensions that projects can be assessed on to determine their credibility and value. These metrics are mechanism, causality, project-level additionality, marginal additionality, permanence, costs, and co-benefits.
The project mechanism metric asks whether the project removes or reduces carbon emissions. Projects that sequester or remove carbon tend to be perceived as more impactful and, therefore, more credible and expensive. Ideally, companies and project developers should engage in both removal and reduction initiatives.
Causality refers to whether the project directly caused less carbon in the atmosphere. For example, if a project developer claims to have protected a wetland area, did that action in and of itself create or cause any real impact? If the wetland area would have remained undeveloped for many decades due to being a bad site for real estate, the causality hurdle may not be cleared.
Additionality refers to whether the project would have taken place if there wasn’t a carbon market to sell offsets on. Project-level additionality specifically considers whether the project would have happened without the potential revenue stream from selling offsets. For example, if a large manufacturing company in the US Southwest installs solar panels at all their facilities, it may not meet the additionality hurdle if it is economically cheaper for the organization to run on solar without the revenue from selling offsets. Additionally, if there is a state or country-level mandate requiring businesses to decarbonize, the project may not meet the additionality hurdle as the developer had other motivations behind the project.
Marginal additionality is a concept that measures the scalability of a project’s impact. If a company wants to generate carbon offsets, it needs to pass the project level additionality hurdle. This means that the project needs to be able to generate more units of its product than it would have without generating carbon offsets. For example, if a solar company historically sells 100 units a year at $100,000 each, and demand dries up at that level, generating carbon offsets wouldn’t make sense unless it could help subsidize their core operations and sell the units more cheaply. In that case, by generating and selling offsets, the company might be able to sell 125 or 150 units at a lower price point, which would meet the marginal additionality criteria.
Permanence refers to the ability of a project to maintain its carbon offset impact over time. For example, in the case of nature-based solutions, a wetland restoration project can be reversed in a variety of ways, from someone purchasing the land for private use to local policy changes or natural disasters that damage the area. Because permanence is difficult to estimate, some certification bodies require that a project developer retain a certain percentage of the offsets generated from the project in a “buffer pool” to compensate for some of this risk.
The cost of an offset project reflects the monitoring, measurement, and management of the project. Higher costs tend to be correlated with better quality projects that have more accountability and oversight. Therefore, less expensive credits may be associated with lower quality projects and less accountability.
Co-benefits refer to any additional positive impacts that a project may have on other environmental and social issues, which are outside the core scope of the project. For example, the American Forest Foundation’s Family Forest Carbon Program provides rural landowners with financial incentives to implement more sustainable forest management practices that enhance the carbon sequestration potential of their land. This initiative also brings with it the co-benefit of rural economic development, which is positive for those communities and ticks a lot of ESG (environmental, social, and governance) boxes. This co-benefit may be perceived as extremely valuable to some purchasers of offsets who want to achieve their sustainability goals and show progress in their ESG framework.
Offset Certification Process
Third-party auditors have created certification programs to help validate offset projects due to the range of variables to consider when assessing project credibility. These certification programs vary based on geographic region, project type, and whether the offset enters voluntary or compliance markets. Each program has its own standards and methodologies for validating emission reduction, so it’s crucial for buyers to research the underlying projects and program credibility.
Although there are nuances between each verification program’s methodologies, the following core steps are always included:
- Applicants provide project verifiers with documentation outlining their assumptions, emission reduction potential estimates, and any additional evidence that justifies their project’s plans and projected impacts.
- These inputs are then run through the project verifier’s model to validate the number of offsets the project will generate over the estimated lifetime of the project.
- Applicants must also provide evidence and associated documentation regarding the project’s additionality, proving that the project would not have happened without a carbon market to sell these offsets in.
When a project is certified, third-party auditors validate project claims, and the certification programs issue the quantity of certified offset credits. However, if a project isn’t certified, the project developers estimate the carbon savings themselves. It’s crucial to be wary of uncertified projects and associated offsets, as issues and controversy regarding monitoring, transparency, and double counting typically occur, creating additional risks for both the project developers and offset purchasers.
Getting Involved in Carbon Markets
To make an informed purchase of an offset, buyers should understand the offset lifecycle. This is because each stage of the lifecycle has implications for price, delivery timeline, and risks. As an offset progresses through its lifecycle, it generally increases in price and decreases in risk and delivery timeline. At the initial stage of designing an emissions reduction or removal project, there are often security concerns that the project will not go forward as planned. Unexpected changes can prevent offset projects from moving forward, which is why understanding where the credit is in its lifecycle is critical to assessing its associated risks.
The basic lifecycle of an offset is as follows: first, a methodology is designed for the offsets to adhere to a specific project type or program methodology. Next, an offset project is designed, financed, and potentially certified by a specific program. At this stage, the project is implemented and monitored to determine the quantity of emissions that will be reduced or eliminated. Offsets are then issued where they can be traded or used and then retired. Each verification program has its own qualifications for when offsets are issued, and they tie back to their monitoring and documentation requirements for certification.
Offsets selling on voluntary markets come with significant risks and are not required to be verified. It is highly recommended to get a third-party verification if you want to be a credible player in selling offsets and creating projects. Buyers can enter the offset lifecycle at different stages, ranging from direct engagement in offset projects to purchasing offsets on an exchange. The more hands-on engagement by a buyer, the greater insights they would have into the real risks and opportunities involved in the project. The risk that a project may not materialize as designed is higher earlier in the lifecycle but much lower later, and the inverse is true of credit price.
To ensure credibility, it is highly recommended to stick with third-party validated projects from recognized verifiers. Designing and implementing a well thought-out due diligence process with clear criteria aligned with business objectives is also advised.
Ensuring Due Diligence for Climate Commitments and Project Quality
When it comes to voluntary markets, sellers may find it easier than buyers, who face risks when investing in low-quality credits. This can result in financial and reputational risks, as well as negative environmental and social consequences from poorly managed projects. Financial risks include losing funds to fraudulent entities and receiving little or no return on investment. Reputationally, funding a poorly monitored project without third-party verification or credibility in the field can result in accusations of greenwashing.
To assess a company’s efforts towards net zero and its engagement with voluntary carbon markets, there are key steps and considerations to take. The first step is to understand the mitigation hierarchy, which is a series of steps or levels that a management team can implement to minimize environmental impacts. These levels are avoidance, reduction, restoration, and offsetting. While offsets are better than nothing, there are many levels above offsetting that management teams should be working towards.
The next step is to understand quality and credibility. As mentioned previously, key elements of credibility include additionality, permanence, and co-benefits. Additionally, it’s important to review project reports and disclosures to ensure that the number of offsets generated actually results in equal emission reductions. Third-party validation can also provide additional assurance.
The next element is the actual project details. First, it is important to determine whether the project is nature-based or mechanical, as well as who is managing the project and whether there is a third-party validator involved. Additionally, understanding what stage the project is in and how many offsets it is projected to generate is crucial.
Project types that have a proven track record of successful rollout and project managers with experience in the space tend to execute better and achieve emission impacts closer to expectations.
Verification methods are also critical, especially when considering the implications for a publicly traded company facing increasing climate and ESG disclosure regulations as well as increasing greenwashing risks. If a project is verified by a recognized third-party standard, one can assume that the methodology is legitimate, the project has been audited, and the offsets have been correctly registered.
Regulatory implications are important to consider in the context of carbon markets, project investments, and offset purchases. In the US, the Securities and Exchange Commission’s 2022 ruling on climate risk disclosures requires greater transparency in detail regarding climate risk management approaches and outcomes. This makes the information quality and data integrity on offsets increasingly important given the heightened scrutiny on these claims. Similarly, carbon market-specific initiatives such as the Integrity Council for Voluntary Carbon Markets are issuing recommendations on offset claims, quality, and reporting, that could create a new de facto standard for how these offsets are communicated in the context of financial reporting.
Cost and supply are other important elements to consider, especially with the growing demand for offsets worldwide. Given the amount of time and the specific expertise required to get a project off the ground, typically three to five years, supply is not keeping up with demand. In fact, figures from the 2022 Carbon Credit Crunch Report revealed a 50% decline in available offsets in 2021. Although cheaper credits don’t always mean worse credits, a good rule of thumb is that more expensive offsets may be more expensive because of validation oversights and quality control costs.
Overall, the risk profile of the offset and/or project type will depend on the assessment of these topics and the company’s objectives, and how important sustainability really is to their strategy and brand.
Offset due diligence is becoming increasingly important in enterprise risk management as disclosure regulations, investor requirements, and stakeholder expectations shift towards greater transparency and accountability on all things ESG and climate. Negligence at the project level can create a reputational crisis for organizations, just like poor behavior from suppliers.
Conducting offset and project due diligence should be incorporated into enterprise risk management efforts to align with broader ESG objectives. A company is only managing its risk properly when offsets are applied to addressing residual or unavoidable emissions. If a company appears to be buying their way out of emissions instead of adapting their business practices and model to reduce their operational carbon footprint, they are taking on significant risks, including operational, reputational, and strategic risks.
Where to Buy Offsets?
Purchasing carbon offsets involves several stakeholders and markets, depending on the buyer’s needs. Once the buyer determines the type and quantity of offsets they want, they can purchase them from project developers, brokers, exchange, or retailers.
When purchasing earlier in the offset lifecycle, buyers can obtain offsets directly from project developers, which can minimize transaction costs. However, this approach also entails higher risk exposure due to the range of potential outcomes. Hence, buyers need to understand and assess the trade-offs when considering what, when, and from whom to purchase.
Brokers often work with project developers to fund specific projects and ensure the delivery of credits as soon as they are issued. This process involves an Emission Reduction Purchase Agreement (ERPA) that provides upfront financial assurance for developers. Buyers can use brokers to purchase offset credits from different project types and get details and analysis on the associated projects, but this approach comes at a higher cost than buying via an exchange.
Buyers can also purchase offsets directly from carbon markets through an exchange or secondary market, which is a lower-cost approach than using a broker. However, this method may not provide incredible third-party verification and may not protect against poor quality offsets.
For buyers looking to acquire only a small number of credits or requiring offsets derived from a specific type of project, retailers may be the best option. Retailers provide access to offset credits from a range of different projects and maintain accounts with various offset project registry systems. Although this is the most expensive approach, retailers offer white-glove service and support, making them ideal for small purchase volumes.
The Current State of Carbon Markets
Trends in Carbon Markets
Carbon markets are undergoing rapid expansion globally, driven by growing programs, emerging project types, and the formalization of offset standards in several key regions. The London Stock Exchange’s announcement of a voluntary carbon market in November 2021 is one example of this expansion, allowing public funds focused on offset projects to be traded using the exchange’s infrastructure. Similarly, China rolled out its nationwide cap and trade system in 2021, making it the world’s largest compliance market.
Regulatory efforts have also been significant, with 46 national jurisdictions implementing compliance markets of carbon taxes and a total of 68 programs worldwide as reported by the World Bank. These initiatives have eliminated 11.83 gigatons of carbon dioxide in 2022 alone, representing 23.11% of global greenhouse gas emissions. However, the current patchwork of regulations has led to significant volatility in pricing, difficulty in standardizing offsets, and discrepancies around which industries should participate in compliance markets.
Commitments made at COP26 in 2022 suggest that governments will continue expanding the reach and stringency of their legislative programs and requirements. Voluntary markets are also expected to continue surging in engagement. Overall, the expansion of carbon markets presents significant opportunities for buyers and sellers to participate in efforts to mitigate climate change, while also posing challenges related to regulation, standardization, and market volatility.
Current Issues in Carbon Markets
Carbon markets have been viewed positively as a means of reducing greenhouse gas emissions. However, there are various challenges that undermine their credibility and perceived value. One key issue is the lack of credibility in offsets, which need to represent true permanent emission reductions or removal. The current offset system is trust-based, lacking adequate checks and balances, which often leads to over-crediting or double-crediting. This creates a consistent skepticism, distrust, and volatility in the carbon market.
Another challenge is the patchwork of inconsistent regulations, where heavily polluting regions may not have a national policy capping emissions, causing leakage. This occurs when polluters relocate emission hotspot facilities to other regions with less regulation in place.
The cost of carbon is also a challenge, with carbon pricing historically being too low to make a meaningful impact on climate change. Carbon pricing can mean different things, depending on the context. In a compliance market, the regulator sets the price, while in a voluntary market, prices are impacted by supply and demand, perceptions of offset quality, and any co-benefits that can be assigned to value.
Finally, there is a larger question of whether offsets should be treated as emissions compensation or charitable environmental contributions more aligned with corporate philanthropy. With an abundance of unverified offsets and limited land available for future nature-based solutions, there is a serious question as to the long-term viability of the offset system in carbon markets. The Science Based Targets Initiative, a non-profit organization that helps companies set evidence-based climate goals, does not allow offsets to be applied within their own operations or supply chain operations.
To ensure a functioning market that can evolve and exist into the future, further standardization, transparency, and regulatory alignment across regions will be critical in addressing the range of issues surrounding carbon offset and carbon market legitimacy.
Sources:
Solomon, A. (2022, April 21). A guide to compliance carbon credit markets. Carbon Credits.
World Bank. (2022, May 24). State and Trends of Carbon Pricing 2022. Open Knowledge Repository.
