Markets and Pricing
This introduction to the fundamentals of Carbon markets provides a condensed overview of essential information discussed in Lesson 1. As we recall, climate change is considered a “market failure” where the costs of greenhouse gas emissions are not borne by those causing them.
These mechanisms aim to reveal the social and environmental costs associated with greenhouse gas emissions while offering financial incentives to reduce emissions.
Did you know 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. This means that carbon trading could enable the elimination of 50% more emissions (approximately 5 gigatons of carbon dioxide annually by 2030).
But before we continue further, we need to understand what Carbon Pricing means.
“A key aspect of carbon pricing is the “polluter pays” principle”.
Carbon Pricing Leadership Coalition
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”
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. Carbon Markets and the Mechanisms that Operate under them.
Issues and transacts credits and allowances based on international and domestic regulatory requirements. To date, it is composed of 36 initiatives including 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.
It refers to the voluntary purchase of carbon credits to meet sustainability goals such as offsetting. This can be achieved through independent crediting mechanisms (such as the American Carbon Registry, Climate Action Reserve, Gold Standard or the Verified Carbon Standard) or by voluntarily canceling compliance units (for e.g. CERs).
Credits issued by independent crediting mechanisms are either traded “over the counter” or through exchanges. Noting though, as explained in Lesson 1, that these credits can also be used in some compliance markets such as CORSIA.
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.
Figure 2.3. Logos of a few Standard bodies
SHARE OF CARBON EMISSION COVERAGE BY PRICING MECHANISM
In 2021, it is estimated that 53,018 MTCO2e (or 53 GTCO2e) were emitted (EDGAR Community GHG emissions database, https://edgar.jrc.ec.europa.eu/dataset_ghg70).
At the same time, the VCM issued close to 396 MTCO2e, equivalent to 0.75% of global emissions (Ecosystem Marketplace 2021).
The same year, ETS and carbon taxes covered about ~24% of global emissions as shown in Figure 2.4. This leaves close to 75% of global 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 2.5. 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 comes from net-zero targets. There is a large scientific consensus on the need to limit global warming to 1.5 degrees Celsius. To do so, we must reduce current GHG emissions by 50% by 2030, and achieve net zero emissions by 2050. Net Zero targets are critical to avoid the worst impacts of climate change.
Figure 2.6. Modelled Pathways of GHG Emission Reductions (Source: UN SDG:Learn)
In recent years, net zero commitments increased across all sectors worldwide. It is estimated that net zero targets currently cover 88% of global emissions, 89% of the global population, and 75.8% of countries. According to Net Zero Tracker (2023), these commitments are increasing at regional/urban and company levels.
These targets are expected to drive demand for future climate mitigation projects.
Figure 2.7. State & Trends of Net Zero Commitments (Source: Net Zero Tracker, 2023)