Carbon Markets

What this article covers

This article discusses the role of carbon markets in addressing some of the problems posed by climate change and explores the challenges, proposed solutions and means for the private sector to contribute to the solutions.  

Introduction

For decades scientists, policymakers and even the highest emitters understood and (briefly) acknowledged the impact of excess greenhouse gas emissions on the earth’s atmosphere, Exxon’s scientists even published a report in the 1970s accurately predicting climate change. Despite this, emissions, along with global average temperatures, have continued to rise - just as the modelling published in Exxon’s report in 1977 predicted. 

More worryingly, even knowing the negative economic impact of climate change was not enough to overcome the market forces and cost-benefit analyses that continued to drive decision making.

The economics of climate change

Past cost-benefit analysis considered greenhouse gas emissions to be an external cost of high-emitting activities that had very real benefits in terms of increased global economic output that brought billions of people out of poverty. But excess greenhouse gases were also predicted to contribute to increasingly extreme weather, higher temperatures and ocean levels, ocean acidification, resource deficiency, habitat loss and global migration. It’s now increasingly clear that the consequences of excess greenhouse gases may have been grossly underestimated. Many economists consider climate change to be a market failure. If the purpose of a healthy market is to ensure the prosperity and wellbeing of the people it serves, then the cascading impacts of global warming clearly demonstrate failure. One of the most often proposed solutions is to put a price on carbon – that is, to charge for emitting it; the idea being that, if high-emitting activities are more expensive, then it will create an incentive for high polluters to transition to lower emitting technologies and spur innovation. 

What are carbon markets?

In 1997 in Kyoto, Japan, the delegates at COP3, the third meeting of the signatories to the 1992 international climate change treaty, agreed to the adoption of ‘carbon markets’ to put this idea to the test. The carbon market is a market-based method to put a limit on the number of tonnes of CO2 that heavy polluters can emit. It also allows countries (or companies) that emit below their quota to sell their ‘excess’ rights to emit to the heavy polluters who have exceeded their own quotas – a system called ‘cap and trade’. In theory, this should implement the ‘polluter pays’ principle whereby those responsible for the emissions are financially on the hook.

This market, known as the compliance carbon market, because it requires compliance with a contractual agreement, depends on offer and demand. Prices on carbon in the regulated market are set by government registry – for example, the European Union Emission Trading System (EU ETS) – and carbon credits sold must have a certain level of transparency to avoid cheating. Although it is conceivable that a well designed and implemented cap and trade system could achieve the objective of reducing emissions and raise public funds to support compensation and adaptation, to date they have mostly failed in their objectives. One reason is that the cost of emitting a tonne of CO2 has been far too low to cover the cascading negative consequences.

Layout of the carbon market today – offsets and insets

The compliance carbon market, or Emission Trading System (ETS), is aimed at high polluters and is only active in three major ETSs around the world (the EU, California and China). 

By contrast, the notion of ‘carbon offsetting’ is much more widely recognised, with private companies from all sectors having long been engaged in purchasing carbon credits from another carbon market, called the ‘voluntary’ market. Credits purchased on the voluntary market are referred to as offsets and are used to compensate for greenhouse gas emissions released. However, this practice is not without challenges.

To date, the voluntary carbon market has been a largely unregulated space where companies buy and sell carbon credits – often of dubious quality. The credits sold each represent one metric tonne of CO2 and there is no standardisation on the cost of carbon. The credits can come from all kinds of activities but typically come in three forms: 

• reduced emissions (eg through investment in energy efficiency measures or renewable energy infrastructure, investment in clean cookstoves),

• removed emissions (eg nature-based sequestration projects like peatland restoration or rewilding depleted areas or technology-based direct carbon capture), or 

• avoided emissions (eg protecting rainforests, rural electrification projects).

Problems with voluntary carbon markets

Claims of carbon offsets may rest on companies paying ‘protection money’ to prevent carbon emitting projects from going forward. (“That’s a nice forest you’ve got there – it would be a real shame if someone were to cut it down.”) There are examples of forests held ‘hostage’ to make claims of avoided deforestation.

Claims of carbon offsets that are credibly verified – even by ‘trusted’ offset verifiers can fail to reduce global carbon emissions and even cause outright damage.

Companies looking to avoid the ‘Wild West’ of the carbon offsetting market are now moving towards ‘insetting’ – or using investments to reduce emissions within their own value chains. For example, a company that purchases a lot of raw materials may choose to work only with suppliers who use zero-carbon energy or embed circularity in their products – and can demonstrate the impact. Insetting is often a more transparent approach but may be less useful for companies with a more service-based value chain.

What is the ‘true’ cost of carbon? Article 6 and the attempt to bring order to a disordered market

The first challenge in creating the market is affixing a cost to the release (or capture) of a tonne of CO2. But capturing the ‘true’ cost of carbon goes well beyond traditional quantifiable profit and loss of physical assets.

There have been attempts to estimate the full economic cost of a tonne of CO2 through models like the Social Cost of Carbon (SCC), which consider not just physical damage but also health outcomes, agricultural production and property values. However, capturing every potential ‘if-then’ impact is impossible.

Despite the challenges, there is a role for carbon markets, however imperfect, to play in addressing the climate change problem. Done correctly, they can provide a means for both the private and public sector to drive real change by mitigating emissions, incentivising innovation and financing positive social outcomes.

At COP29 in Baku in 2024, one of the main topics of discussion was Article 6 of the Paris Agreement, signed at COP21 in 2016, which covers climate finance and is an attempt to address shortcomings in the carbon market. There are three components, which are:

1. Establishes Internationally Transferable Mitigation Outcomes (ITMOs), which allow countries to trade carbon credits – but where only one country can count the emission reduction towards its nationally determined contribution (NDC), which is the mechanism through which countries lay out their plans to meet emission reduction targets.

2. Enables countries to collaborate on emission reduction projects and initiatives to promote the transfer of clean technologies and foster sustainable development.

3. The article also establishes the Sustainable Development Mechanism (SDM), which aims to incentivise emission reduction projects in developing countries to promote the co-benefit of addressing the UN’s sustainable development goals as well as climate action. 

Conclusion

Despite the many challenges, a properly implemented carbon market is an integral part of addressing the climate change problem. A transparent and high-integrity carbon market which uses a carrot and stick approach – where the price of emissions is appropriately high (stick) while offering incentives like sustainability-linked lending (carrot) – can have real sway on moving money to those who need it most while meeting decarbonisation aims.