Introduction to Carbon Markets
As discussed in Lesson 1, climate change emerged as a consequence of a “market failure” where the costs of greenhouse gas emissions are not borne by those causing them. To address these externalities, stakeholders worldwide are involved in implementing carbon pricing mechanisms. These mechanisms aim to reveal the social and environmental costs associated with greenhouse gas emissions while offering financial incentives to tackle these challenges.
WHAT IS CARBON PRICING?
“A key aspect of carbon pricing is the “polluter pays” principle”.Carbon Pricing Leadership Coalition
Nonetheless, it is important to highlight that the World Bank estimates that carbon markets could reduce the costs of climate change mitigation by as much as USD 250 billion per year by 2030 (IETA. 2019. “The Economic Potential of Article 6 of the Paris Agreement and Implementation Challenges”).
TYPES OF CARBON PRICING
“Carbon pricing by itself cannot address all of the complex drivers of climate change; some combination of regulations, standards, incentives, educational programs, and other measures will also be required” (PMR-ICAP 2021)
There are many types of carbon pricing instruments as defined by the World Bank. For this course, we classified them into:
Figure 2.1. Carbon Pricing Instruments (The World Bank Carbon Pricing Dashboard).
these instruments depend on the trading of priced units of carbon allowances or carbon credits. This is what we call “Carbon Markets”.
- An emissions trading system (ETS) is a system where emitters can trade emission units to meet their emission targets. The two most common ETS are cap-and-trade and baseline-and-credit systems.
- A crediting mechanism designates the GHG emission reductions from project- or program-based activities, and issue carbon credits according to an accounting protocol and have its own registry.
“Other tools and programs”:
we use this as an “umbrella” term for instruments that do not lead to tradeable units. Yet, these tools can have an impact on how stakeholders incorporate the price of carbon into their decision-making process.
- A carbon tax directly sets a price on carbon by defining an explicit tax rate on GHG emissions.
- A Result-Based Climate Finance (RBCF) is a funding approach where payments are made after pre-defined outputs or outcomes related to managing climate change, such as emission reductions, are delivered and verified.
- Internal carbon pricing is a tool an organization uses internally to guide its decision-making process in relation to climate change impacts, risks, and opportunities.
It is still common to classify carbon markets by the goal of the end user: to comply with regulations or agreements, or to meet voluntary emission reduction targets.
Figure 2.2. Types of carbon markets and their mechanisms (IOSCO 2022)
Issues and transacts credits and allowances based on international and domestic regulatory requirements. It relies to date on 36 initiatives Emission Trading Systems (ETS) and international (CDM & JI) & domestic crediting mechanisms.
There are two types of compliance market mechanisms:
- Cap-and-trade: Based on a maximum emissions allowance per industry sector, the allowances are distributed across all market participants. Those who exceed their allocated allowances must purchase additional allowances to cover their emissions.
- Baseline-and-credit: based on a pre-determined maximum amount of CO2e units that a holder is “permitted” to emit. Allowances are issued to those organizations that have reduced their emissions below the set limit. Those allowances can then be traded in secondary markets to other organizations that exceed their limit.
Issues and transacts carbon credits generated by independent project-based crediting mechanisms. Under this space, entities buy carbon credits to offset their own carbon emissions. The issued credits can be traded “over the counter” through brokers/exchanges. And, these credits can be used to meet compliance requirements. Some of these mechanisms include the American Carbon Registry, Climate Action Reserve, Gold Standard, Verified Carbon Standard, etc.
Figure 2.3. Logos of a few Standard bodies.
A recent report by the International Organization of Securities Commissions (2022) points out significant vulnerabilities or challenges in this space:
- Environmental integrity: quality of carbon credits, lack of standardized methodologies to measure additionality of projects, leakage of carbon, and risks surrounding permanence of outcomes.
- Transparency: in methodologies to measure reductions/removals of carbon emissions, potential conflicts of interests, and lack of transparency in the remuneration of both project suppliers and others.
ARTICLE 6.4 MARKET
The Paris Agreement introduced an international market-based mechanism that allows countries to engage in emission trading. This could involve the participation of companies and can take the form of
- Internationally transferred mitigation outcomes (ITMOs), or through
- Joint projects.
The implementation of this mechanism is still being finalized. The implications of the existing voluntary carbon markets are not clear. Yet, this could represent a significant change in how the VCM operates as we will discuss later in Lesson 3.
Nevertheless, as the current share of carbon emission coverage shows next, there are still great opportunities for action in these markets.
SHARE OF CARBON EMISSION COVERAGE BY PRICING MECHANISM
In 2021, it is estimated that 53,018 MTCO2e were emitted including CO2 (fossil only), CH4, N2O, and F-gases and excluding land use, land use change and forestry (EDGAR Community GHG emissions database, https://edgar.jrc.ec.europa.eu/dataset_ghg70).
At the same time, the VCM issued close to 396.07 credits or million tCO2e, equivalent to 0.75% emissions coverage (Ecosystem Marketplace 2021).
Similarly, for 2021, the ETS + carbon taxes were responsible for ~24% emissions coverage as shown in Figure 2.4. This leaves close to 75% of emissions as an opportunity for expansion! (World Bank. 2021. State and Trends of Carbon Pricing).
Finally, we summarize this information in Figure 2.5. showing a breakdown of emission coverage by carbon pricing instruments.
Figure 2.4. Share of global GHG emissions covered by ETS and carbon taxes
(Source: World Bank. 2023. State & Trends of Carbon Pricing)
Figure 2.5. Share of emission coverage by carbon pricing instruments.
(Source: World Bank State and Trends of Carbon Pricing 2021 for Compliance (ETS) & Carbon Tax; Ecosystem Marketplace for VCM 2021 issuance)
NET-ZERO COMMITMENTS: A DRIVER OF DEMAND
An opportunity for carbon market growth lies in net-zero targets. These are important commitment targets in global GHG emissions to stop the disastrous impacts of climate change. According to the large scientific community and the IPCC, we should aim at limiting our global warming to 1.5 degrees Celsius. In order to do so, we must reduce by half (50%) current GHG emissions by 2030, and achieve net zero emissions by 2050.
Figure 2.6. Modelled Pathways of GHG Emission Reductions (Source: UN SDG:Learn)
In the last couple of years, net zero commitments increased across all sectors worldwide. This drive has led to ambitious coverage targets of emissions (88%) and stakeholders (89% of population and 75.8% of countries) worldwide. Also, according to Net Zero Tracker (2023) these commitments are increasing at regional/urban and company-levels.
These targets could translate into a source of demand for future climate mitigation projects. In this landscape, it is important to highlight the divergence in economic capacity to address these challenges. For instance, there is a significant range in how much carbon is emitted in the generation of wealth worldwide from 1.71 to 853.6 ton CO2e per USD. This goes back to the cost-effectiveness of market mechanisms driving climate change mitigation.
Figure 2.7. State & Trends of Net Zero Commitments (Source: Net Zero Tracker, 2023)
According to the UN High‑Level Expert Group on the Net Zero Emissions Commitments of Non‑State Entities (2022), outline 5 key principles to meet these commitments:
- Ambition which delivers significant near and medium term emissions reductions on a path to global net zero carbon dioxide emissions by 2050 and net zero greenhouse gas emissions soon after.
- Demonstrated integrity by aligning commitments with actions and investments.
- Radical transparency in sharing relevant, non-competitive, comparable data on plans and progress.
- Established credibility through plans based in science and third-party accountability.
- Demonstrable commitment to both equity and justice in all actions.
In addition, the Committee made several recommendations on how to put these principles in practice. On the use of Voluntary Credits, it is important to consider the following:
“Non‑state actors must prioritize urgent and deep reduction of emissions across their value chain. High integrity carbon credits in voluntary markets should be used for beyond value chain mitigation but cannot be counted toward a non‑state actor’s interim emissions reductions required by its net zero pathway.”
In the next topic, we will investigate the role of Additionality in upholding environmental integrity. And, later in lesson 3 we will investigate in greater detail the guidelines under development for the supply and demand side and those can have an impact on the work of Project Developers.
- Carbon markets are an instrument that solves for the market failure of climate change.
- Carbon markets allow actors with high abatement costs to buy units from actors with lower abatement costs. As such, carbon markets help reduce the cost of climate action.
- It brings together both the demand and supply of carbon reduction or removal credits that can be use to mitigate for climate impact in a cost effective way.
- Crediting mechanisms are a type of carbon pricing instrument that provides standards and rules, accounting, and the capability to register carbon credits to be traded in a transparent and cost-effective way.
Figure 2.8. Representation of carbon market’s supply and demand sides.