Carbon markets’ contribution to net-zero ambitions
At a time when organizations are starting to take concrete actions to realize their net zero commitments, there has never been a greater need to clarify how carbon markets fit into a global net zero strategy. If properly implemented, carbon pricing incentivizes decarbonization on a huge scale. However, carbon markets are currently fragmented and, without intervention, this fragmentation will only increase. A swathe of competing objectives and vested interests has created unwanted friction. Today, it is generally not possible to trade carbon credits between markets, increasing costs and reducing much-needed liquidity. Of the many ways to address these challenges, adopting global standards and integrating markets will improve market liquidity and accelerate emissions abatement investment. Article 6 of the Paris Agreement is one of the more important tools to facilitate carbon market convergence. However, implementing Article 6 will not be easy. We must determine how to implement markets efficiently, how to achieve consensus and who will lead.
Net zero relies on multiple measures
Historically, organizations took little responsibility for their carbon emissions. This is now changing and debating net zero commitments has shifted to action. Significant investment is needed to encourage carbon abatement. Putting a price on carbon creates the right incentives. Several carbon pricing mechanisms exist, including emission trading schemes (ETSs), and carbon taxes, and incentives like grants or low-cost loans. Worldwide, there are over 34 ETSs, 36 carbon taxes and innumerable incentives.
After initial teething problems, the EU ETS now enables decarbonization at sufficient scale to meet climate targets. Other countries are rapidly developing their own ETS, the latest is Australia’s ETS scheduled for 2023.
Other countries prefer other mechanisms. For example, the US favors incentives. Biden’s Inflation Reduction Act will make USD 386 billion available to halve 2005 US carbon emissions by 2030.
Emissions trading has many advantages …
A carbon market enables the sale and purchase of carbon credits/allowances. An organization with low emissions can sell their excess allowances to another with higher emissions. If the carbon price is sufficiently high, organizations can profit from investments into emissions reduction. Likewise, organizations that emit above targets are financially incentivized to invest in internal carbon abatement, accelerating decarbonization.
A carbon market is a self-perpetuating emissions reduction tool, which manages supply allocation through a price set by market trade. In contrast, carbon taxes and incentives require on-going political support, which can be vulnerable to changing government priorities and policies.
A well-designed carbon market must factor in complex supply and demand dynamics, clearly define market processes, and establish a space to trade credits. Stakeholder participation and education is vital to market success.
... but is held back by low carbon prices and competing requirements
Carbon markets have weaknesses. First, it is important to remember their primary function is to cut carbon emissions. While obvious, it is not uncommon to lose sight of this goal. For example, if reduction targets are set too low, prices are too low to incentivize emission abatement; too high and it becomes too costly and unpopular. Therefore, reduction targets must recognize wider economic and social impacts to ensure participation.
The profusion of schemes has created inconsistencies between individual markets, partly caused by a raft of competing requirements. There are different types of carbon markets: sovereign, regulatory and voluntary. Each use different structures with different decarbonization targets. Sovereign and regulatory are compliance markets, which oblige regulated/committed parties to meet reduction targets; voluntary markets do not and are based on voluntary net zero commitments.
Sovereign markets focus on the fulfillment of countries’ nationally determined contributions (NDCs) through internal reduction initiatives that can be aided by the trade of international carbon credits, which Article 6 creates a framework for doing credibly. Regulatory markets focus on achieving local reduction targets by obliging large emitters to manage and pay for their carbon emissions. Examples include China's national market, RGGI, and EU ETS. Voluntary markets serve corporate net zero commitments through the use of carbon credits to offset their emissions.
These competing requirements have led to widespread inconsistency in carbon credit definitions, methods to quantify and value emissions, and approaches to the use of carbon offsets. This lack of standardization affects cross-market trading (known as fungibility). Participants are forced to understand each market’s complexities, increasing costs and inefficiency. Poor fungibility impacts market liquidity, particularly in smaller jurisdictions with few participants.
While market fragmentation is being addressed, there is still insufficient cooperation. Without widespread adoption of international standards, market heterogeneity will only increase, and the full benefits of carbon trading will not be realized.
The challenge of creating a functioning global carbon market
Carbon markets are more effective if everyone plays by the same rules – where carbon credits are consistently defined, quality standards are universal, and transaction tracking is consistent. Global standards will improve fungibility and liquidity, which, in turn, improves market effectiveness to incent carbon abatement investment.
Common standards are difficult to achieve. Different schemes’ conflicting goals must be overcome, and equity between high- and low-income countries must be considered. Carbon market standards must also align with other abatement approaches, such as taxes and incentives to ensure fair trade by equalizing international carbon costs. Finally, standards must mitigate adverse impact on citizens and businesses to ensure a fair transition to a low-carbon economy.
Creating a bridge between voluntary and compliance markets could be even more challenging. While additional trading may increase liquidity, aligning a voluntary system’s goals with legally binding government obligations will prove challenging.
Growing regional markets integration of Article 6 can lead the way
Consensus remains the major roadblock to an efficient, global carbon marketplace. While enthusiasm at the corporate and national level helps, the most promising approach is through the growing trend for regional carbon markets. Regional markets avoid the need for global consensus and can aim for future global convergence. These market’s participants can leverage global commitments to Article 6 to align NDCs amongst their regional carbon market participants. Regional markets may be the most efficient path to the global carbon market.
What next?
As this significant topic continues to evolve, do look out for future updates and insights on these pages that will provide ongoing perspectives on carbon markets and carbon pricing.
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