Introduction to Carbon Markets
The carbon market is a collection of actors and exchanges facilitating the purchase and sale of carbon credits. A carbon credit represents the reduction or removal of one unit (typically a metric tonne) of carbon dioxide or other greenhouse gas CO2 equivalent from the atmosphere.
Today there exists two distinct carbon markets.
- The compliance market developed as a result of the Kyoto Protocol in 1997. These markets are governed by a regulating entity and are legally binding and enforced. Entities are only allowed to emit so much and if they emit more than their allowance they must buy additional credits or face fines and punishments. An example of this market would be the European Union Emission Trading System (ETS).
- The voluntary market developed in the mid-to-late 2000's as organizations began to set emissions reductions targets on their own. This market is not legally binding; there is no punishment or fine for entities that do not hit their target. It is driven solely by organizations' own desire to reduce emissions.
Carbon markets originated as a tool to hold corporations and countries accountable for their emissions. Cap-and-trade schemes were some of the first mechanisms in the market to develop. These schemes worked by allocating a certain amount of emissions to the entities in the market and then allowing the entities to trade the emission allowance between them. Say company A is allocated 1,000 metric tonnes per year, but they only admit 800 metric tonnes. Company A could sell this excess capacity to another company that has emitted more than their allowance.
As the market has evolved and the voluntary side has grown, it has emerged as an effective tool to direct investment into carbon reduction technologies. Without carbon markets, project developers would find it difficult to secure funding. However, with a well-established carbon market, investors feel confident supporting the development of projects because there is sufficient demand for the credits. This attracts more investors and more project developers and creates a flywheel accelerating the removal and reduction of carbon.
The voluntary carbon market (VCM) is growing rapidly, passing the $1 billion mark for the first time in 2021. Issuance of carbon credits nearly doubled to 0.35 billion tCO2e in 2021, while retirements, which are seen as a proxy for demand, were at 0.159 billion tCO2e in 2021, also doubling compared to 2020. Putting that into perspective, with global CO2 emissions at 36.7 billion tCO2e, the VCM covers barely 1% of global CO2 emissions.
This is just the start, and demand is expected to increase by a factor between 15 and 100 by 2050. The VCM is complex. It has a multitude of stakeholders, methodologies, and project types and operates outside of regulated or mandatory carbon markets. These factors lead to issues like lack of transparency and double-counting of credits.