Lynn Strongin Dodds looks at the evolution of the carbon markets and the role they hope to play in meeting the Paris Agreement targets.
Carbon markets are not new, but they have gained momentum as the focus on climate change has moved to the fore. However, as with many elements of the sustainable world, the wheels of progress turn slowly, and it may be a long time before credits and offsets make the dent required to tackle the multi-faceted problems.
A brief history
The challenges were seen at the beginning when the Kyoto Protocol and the Carbon Development Mechanism (CDM) Trade were introduced in 1997. They marked the first time that international participation in carbon markets could become a reality, but the road to implementation was not smooth. It took until 2005 to see the light of day because of the lengthy and complex ratification process. .
The Protocol was part of the United Nations Framework Convention on Climate Change drive to compel industrialised countries and economies in transition to limit and reduce greenhouse gases (GHG) emissions in accordance with agreed individual targets. The Convention itself only asked those countries to adopt policies and measures on mitigation and to report periodically. The CDM targeted emission-reduction projects in developing countries that generated carbon credits used by industrialised countries to meet part of their emission reduction targets.
The Protocol lacked bite mainly because the US did not come on board. The country signed the document in 1998, but Congress failed to ratify the agreement. The general view though was that it kick started the process and laid the groundwork for the Paris Agreement, which many believed was more inclusive and potentially more effective.
This was because the Paris Agreement was a legally binding international treaty on climate change adopted by 196 Parties at the UN Climate Change Conference (COP21) in Paris on 12 December 2015. It entered into force a year later with the ultimate goal of limiting global warming to 1.5°C. This meant that GHGs had to peak before 2025 at the latest and decline 43% by 2030. The aim was to hold countries accountable for their actions or inactions around reducing their carbon footprints.
The nuts and bolts of trading
The Agreement set rules to strengthen the integrity of carbon markets. Emissions fall into one of two categories – carbon credits or offsets although the terms are often used interchangeably. However, they operate on different mechanisms. Carbon credits or allowances are used in compliance carbon markets where government organisations or regulatory authorities provide regulated companies a certain number of carbon allowances every year, allowing them to emit one ton of CO2 per credit. Market participants, which often include both emitters and financial intermediaries, can trade allowances to meet regulatory requirements or for hedging or trading purposes. Learn more here.
The main platforms to trade these credits are emissions trading systems (ETS). They operate on a cap-and-trade principle which puts a lid on the maximum level of emissions and creates permits, or allowances, for each unit of emissions allowed under the lid. More here
The European Union was ahead of the curve with the world’s first international ETS in 2005 and two years ago, the UK introduced its own platform in the wake of Brexit. Reforms are underway to tighten limits on carbon dioxide pollution and expand to include new sectors in 2026.
China also launched its own ETS in 2021, and it has become the world’s largest, estimated to cover around one-seventh of global carbon emissions from the burning of fossil-fuels. . As for the US, there is no federal carbon trading market, but several states have implemented their own, most notably California in 2013 and Washington this year.
Carbon offsets, which are typically traded on voluntary carbon markets, enable companies and individuals to offset their carbon emissions by buying carbon credits created by projects that either reduce or remove emissions. They can also be used in compliance carbon markets to satisfy a portion of cap-and-trade requirements.
The S&P report notes that voluntary markets came into their own in 2021 due to an influx of new entrants such as oil and gas heavyweight firms, hedge funds and banks who were active and took long positions. Many other sectors of the economy joined the market following their pledges to reduce carbon footprints.
The main differences between the two venues are that voluntary markets are considered much more fluid since they are not constrained by boundaries set by nation states or political unions. They also have the potential to be accessed by every sector of the economy instead of a limited number of industries. By contrast, their compliance counterparts are currently restricted to specific regions, according to the S&P report.
Blurring of the lines
Despite these distinctions, there is an increasing level of overlap between the two. (https://www.csis.org/analysis/voluntary-carbon-markets-review-global-initiatives-and-evolving-models). Multiple initiatives have come to the table to create a hybrid model. One of the most notable examples has been the London Stock Exchange’s voluntary carbon market which issued its first designation to the Foresight Sustainable Forestry (FSF) fund late last year.
The objective is to provide issuers with capital for high-quality climate mitigation projects to ensure supply meets demand as well as inject greater transparency across the voluntary carbon market value chain. Under the rules, a fund or company would have to issue a prospectus vetted by the Financial Conduct Authority that gives details of the carbon emission-cutting project it wants to finance.
This makes it the first exchange to apply a public equity market framework to facilitate financing in climate change mitigation projects that generate carbon credits. The market also provides access for investors and corporates seeking exposure to carbon credits which may be issued in the form of a dividend in specie. (same MM link)
Looking ahead, voluntary carbon markets are set to become at least five times bigger by 2030, with volumes comparable to annual emissions by the global aviation industry in 2019, according to a new report from Shell and Boston Consulting Group.
In essence, they estimate that the voluntary carbon offset market, which was worth about $2 billion in 2021, will grow to $10-40 billion in value in seven years’ time, transacting 0.5-1.5 billion tonnes of carbon dioxide equivalent, compared with the current 500 million tonnes.
The big question, of course is whether this will be enough to meet the Paris Agreement targets. So far, the answer is no if the latest Intergovernmental Panel of Climate Change, report is anything to go by. It might still be years before countries can offset their emissions in an international carbon market first called for in Article 6 of the 2015 Paris climate accord.
Summarising five years of research, the climate science acknowledged that adaptation and mitigation measures are helping, with many regulatory and economic instruments already having been deployed successfully. “In many countries, policies have enhanced energy efficiency, reduced rates of deforestation and accelerated technology deployment, leading to avoided and in some cases reduced or removed emissions.”
Among the most cost-effective mitigation options, the report cites solar energy, wind energy, electrification of urban systems, urban green infrastructure, energy efficiency, demand-side management, improved forest- and crop/grassland management, and reduced food waste and loss.
However, the report said that progress is uneven, and funding is still insufficient, while financing for fossil fuels remains greater than for climate adaptation and mitigation. “The overwhelming majority of tracked climate finance is directed towards mitigation, but nevertheless falls short of the levels needed to limit warming to below 2°C or to 1.5°C across all sectors and regions.”
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