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22 November 20237 minute read

What are carbon markets?

Carbon markets broadly refer to markets on which instruments are traded which facilitate GHG emission reductions (commonly referred to as a credit) or permit GHG emissions (commonly referred to as an allowance). They are multi-faceted. 

Carbon markets allow a benefit associated with these reductions or a right to emit to be transferred between persons.  

In the case of a reduction, the benefit is transferred between a person that created the emission reduction and a person that would like to pay for and make use of the emission reduction in its activities.  

In the case of an allowance, the right is transferred from a governmental authority which created the allowance to a person which requires it to emit GHGs in its commercial activities, often by burning fossil fuels.  

The instruments traded in carbon markets are mostly dematerialised certificates in the form of a unique number or identifier held in an electronic registry. This allows emissions to be unitised (usually expressed in tonnes of CO2e) to enable their trading. 

The certificates are issued into accounts either to certify that an GHG reduction or removal has been achieved or to provide a right to emit an amount of GHGs.  

Certificates can be transferred between accounts in the registry, or in some cases between registries, to reflect the sale and purchase of the certificates. 

Ultimately a certificate can be retired in the registry, which allows the person for which the certificate has been retired to claim the benefit of the emission reduction or to demonstrate the right to emit.  

Corresponding somewhat to the different types of certificates (credits and allowances), carbon market are often split into (i) mandatory or compliance carbon markets, and (ii) voluntary carbon markets. 

Mandatory carbon markets

As the name suggests, mandatory carbon markets exist as a consequence of legislation obliging persons to achieve emission reductions but providing them with the flexibility (i) to trade certificates for their compliance to make it economically efficient and (ii) to create commercial incentives for reducing emissions. 

Mandatory carbon markets exist at national and international level. Inherent to most of them is that a sector wide cap on emissions is set and a penalty must be paid for emissions that are not permitted through an allowance, or, in some cases, offset by a credit. The penalty amount sets the carbon price, in lieu of a tax, for example, as another form of carbon pricing. Other than in the case of a tax, the carbon price is not fixed but will vary because persons are, through the ability to trade certificates, incentivised to optimise abatement costs. 

This concept originated from sulphur and nitrous oxide emission regulation. At an international level, it was introduced for GHG reductions by the UNFCCC’s Kyoto Protocol in form of a cap and floor emissions trading scheme, also enabling use of credits in addition to allowances. The European Emissions Trading Scheme, as the world’s first mandatory carbon market, originated from it. All other 28 regional or national emission trading schemes currently in place are modelled on similar principles. 

These include that emissions allowances are issued by a governmental authority and made available to person covered by the mandatory scheme. Participants in the scheme need to return a number of allowances at the end of a compliance cycle, usually 12 months, corresponding to their actual emissions. If participants do better in their economic activities at reducing emissions, they can sell additional allowances or they are required to purchase fewer allowances, thereby creating the economic incentive for reduction. 

Transitional arrangements have often allowed for an initial free allocation of allowances, which have however caused windfall profit issues and often limited economic pressure and incentives to business expansion activities.  Most schemes eventually do, therefore, move to selling allowances only through competitive auctions. In this instance, the scheme usually allows the government to set a minimum price, or create scarcity in the number of allowances allocated, to ensure the carbon price resulting from an auction creates sufficient economic incentives to invest in emission reduction activities. 

Historically, emission trading schemes permitted a broader use of credits in lieu of allowances (e.g. CERs and ERUs instead of EU Allowances under the Kyoto Protocol). However, for a number of reasons, including depressing allowance prices with credit oversupply, veracity of credits, and required corresponding adjustments under Art. 6 of the UNFCCC Paris Agreement, the use of credits in mandatory schemes is limited or used as a transitional element (e.g. in the case of CORSIA). 

Mandatory carbon markets cover a variety of sectors – Transport (12 schemes), Buildings (13), Industry (24), Power (17), Aviation (8), Waste (2), and Forestry (1). They can cover multiple sectors (e.g. UK ETS) or single sectors (e.g. Austrian NEHG) and can cover a diverse range of countries such as China and Montenegro. They can also be subnational (e.g. Quebec ETS), regional (e.g. US RGGI) or in some cases are internationally linked (e.g. Swiss ETS and EU ETS). 

Mandatory carbon markets are, in some cases, also evolving into multi-product compliance schemes, for example, for fuel quotas. These set reduction targets with an associated penalty and, rather than using allowances, quota obliged persons are entitled to meet a mandatory reduction quota with different products and instruments to meet a quota (e.g. the German THG Quota scheme allows credits in the form of upstream emission reduction certificates to be used alongside biofuel, biogas and renewable source electricity). 

Emerging mandatory schemes, such as maritime “blue” carbon markets, also use a combination of quota and credit and allowance and credit related regimes. 

Voluntary carbon markets

Voluntary carbon markets share many features with mandatory markets, for example, the use of electronic certificates, and their trading, transfer and their retirement.

However, unlike mandatory carbon markets, credits in voluntary carbon markets are not traded to meet a legislative requirement, but they are used by businesses to demonstrate voluntarily to their customers their progress in reducing or offsetting emission for their business activities. With increasing regulation regarding disclosure, the risk of misrepresentation and claims, and because of the universal application of the Greenhouse Gas Protocol Scopes and the underlying principles for emissions reporting, the boundary between mandatory and voluntary carbon markets is becoming increasingly blurred. 

In contrast to mandatory carbon markets and because of the lack of legislative requirements for the recognition of credits in voluntary carbon markets, the activities in such carbon markets are generally more international (e.g. credits from reducing emissions through enhancing cook ovens in Gambia being used to offset emission of an airline operator from the U.S). 

The consequences of the relative lack of legislation consistently defining the requirements and the form of the certificates for everyone in the market, is that the nature of credits in voluntary carbon markets can be very different and are usually only based on contract. It is often necessary to agree on further measures, including assignment of underlying legal rights to emission reductions or warranties against double claiming, to ensure the veracity of the credits.  

Another difference is that there are multiple carbon market standards, for example, Verra’s Verified Carbon Standard, the Gold Standard, the Climate Action Reserve Standard, the American Carbon Registry, the ART/TREES Standard, the Plan Vivo Standard, and the Natural Forest Standard. 

There are individual (i.e. organisation-led) voluntary carbon markets and sovereign (i.e. state-led) voluntary carbon markets. Sovereign voluntary carbon markets exist with respect to the Paris Agreement, including the transfer and use of Internationally Transferred Mitigation Outcomes (ITMOs), which can be used towards achievement of Nationally Determined Contributions (NDCs) or other international mitigation purposes. 

Because of the lack ofregulation governing the nature of credits and associated claims, it is important that appropriate safeguards are implemented to ensure that projects which generate carbon credits don’t prioritise emissions reduction at the expense of other environmental, social and governance considerations, such as the impact on local communities. 

There are 10 core carbon principles as a global benchmark for high-integrity carbon credits. They are: (1) additionality; (2) permanence; (3) robust quantification of reductions/removals; (4) no double counting; (5) effective governance; (6) tracking; (7) transparency; (8) robust independent third-party validation and verification; (9) sustainable development benefits and safeguards; and (10) contribution to net zero transition. 

The responsibility for ensuring respect for the core carbon principles and other environmental, social and governance considerations primarily lies with the project developer and the relevant carbon standard that verifies the carbon credits produced, but many buyers conduct their own due diligence and ongoing monitoring.