Carbon Credit Markets Explainer
Carbon Credit Markets
What are Carbon Credit Markets?
Carbon credit markets create supply and demand for carbon emissions and other greenhouse gases (GHGs), so they can be bought and sold like other commodities. The markets help high-polluting industries internalize the costs of burning fossil fuels, with the goal of reducing emissions and slowing the effects of climate change. As of 2023, there were 36 compliance carbon markets around the world, with many more voluntary markets.
Overview
According to the Paris Agreement, in order to stop the disastrous effects of climate change, societies need to limit global warming to 1.5 degrees Celsius by 2030, which means substantially reducing emissions of greenhouse gases such as carbon dioxide, methane, and nitrous oxide.
Carbon credit markets are an effort to create an economic market for greenhouse gas emissions. Without carbon markets, or government regulations, industries have no incentive to reduce pollution, or burn fewer fossil fuels. Through carbon markets, governments can attempt to regulate how much carbon dioxide, and other GHGs, are being emitted in high-polluting industries and put a price on those emissions.
Carbon markets usually consist of carbon credits, or permits, that allow a business or individual to emit one ton of carbon dioxide. The credits can be bought, sold, or traded from one company to another, and companies that pollute less can sell their permits to higher-polluting peers for a profit. There are two types of carbon markets, voluntary and compulsory. Compulsory markets are implemented by governments and regulators, with mandates on which industries must participate. While the voluntary carbon market is relatively newer, and often over-the-counter, it’s currently valued at $2 billion and expected to grow significantly throughout the next decade. Individual investors have limited access to carbon credits directly, but can invest in exchange-traded funds (ETFs) which may include carbon credit futures, to diversify their portfolios.
When governments try to ‘cap’ the total amount of GHG emissions, the market is called a cap and trade system, or an emissions trading scheme (ETS). With cap and trade, a government will reduce the amount of permits available for purchase each year to lower emissions and drive up prices, and make it more costly for an industry to continue to pollute.
When a company removes one ton of GHG emissions from the atmosphere, it may be eligible for a carbon offset permit, which can be sold to another firm to ‘offset’ its carbon emissions. Selling carbon offsets can be a profitable business. For example, Tesla, which creates electric vehicles, reported $1.77 billion in revenue in 2022 from the sale of regulatory credits to other automotive manufacturers, to help the companies offset their own emissions.
Finally, governments may use carbon taxes as another mechanism for reducing emissions. With carbon taxes, regulators directly tax industries that emit greenhouse gases or burn fossil fuels. As of 2022, 27 countries had implemented carbon taxes, including Canada, Sweden, Mexico, South Africa, Singapore, and Poland.
The History of Carbon Markets
Modern carbon credit markets date back to the 1990’s. The first emissions market was implemented by former U.S. President George Bush Sr., who advocated for a market mechanism to limit sulfur dioxide (SO2) emissions that were the leading cause of acid rain. Due to the success of the tradable permits created in the 1990 Clean Air Act, SO2 emissions in the U.S. have been reduced by 93%, and acid rain is largely a problem of the past.
In 1997, the Kyoto Protocol, an international agreement based on the United Nations’ framework on climate change, mandated that industrialized countries reduce greenhouse gas emissions. The agreement advocated for the establishment of tradable emissions permits, along with additional measures, for each country to meet its target reductions. The Kyoto Protocol was eventually signed by 192 member nations and facilitated the rise of carbon credit markets around the world.
The first voluntary carbon market, the Chicago Climate Exchange, ran from 2003 to 2010, and contributed to the reduction of 700 million tons of GHG emissions. Today, the most active voluntary markets are in London, Japan, and Australia.
China and the European Union have the largest mandatory carbon markets in the world, followed by South Korea and the U.S. State of California. The EU launched the first large-scale cap and trade system in 2005, which has reduced European emissions by 35%. Over 30 countries participate in the EU ETS, and it was the world’s largest in terms of emissions covered, until 2021, when China introduced its own carbon pricing scheme. The China ETS attempts to regulate emissions from 2,000 industries which account for 40% of the county’s total GHG emissions.
In the U.S., the State of California administers its own cap and trade program, which claims to have reduced local GHG emissions by 5.3% since its inception in 2013. The United States does not have a federal carbon market, although several presidents, most recently Barack Obama, have tried to pass federal legislation without success. Thirteen U.S. states, many in the Northeast, have created their own local carbon markets to reduce carbon emissions within state lines.
Carbon Market Controversy
Despite the emergence of new ETS systems, global carbon dioxide emissions continue to rise, leading some to question the systems effectiveness.
Critics argue that carbon caps in markets are set too high and penalties too low, so companies are not properly incentivized to stop emitting GHGs. Also, voluntary markets are subject to less oversight than mandatory markets, and often suffer from a lack of transparency and greenwashing, where companies buy offsets or claim to be net zero without reducing overall pollutants. In 2023, the U.S. government’s Commodity Futures Trading Commission established an Environmental Fraud Task Force specifically to investigate misconduct in voluntary carbon markets and protect investors against fraud and manipulation.
Carbon markets can also negatively affect businesses. Globally, emissions trading schemes lack standardization, and multinational companies may be subject to competing and contradictory rules and prices for creating the same product in multiple locations. Implementing carbon taxes can have the added effect of increasing operational costs, which can lead to job cuts or higher prices for consumers.
Regulators face challenges in accurately measuring emissions, imposing the correct limits, and monitoring and enforcing the caps. Data is often scarce or unreliable, and companies have been known to underreport or cheat emissions tests to avoid buying permits. Industries may also outsource production of high-polluting goods to less regulated areas, creating ‘leakage’ in the markets. Due to these limitations, many investors and consumers are skeptical of the true benefits of carbon markets for investment or GHG reduction.
The Future of Carbon Markets
Regardless of the controversies in carbon pricing mechanisms, new ETS’s are being developed, and demand in voluntary markets is increasing, fueled by the rise in corporate net zero emissions targets. According to Morgan Stanley Research, voluntary carbon offset markets are expected to reach $250 billion by 2050, and from 2021 to 2023, the purchase of voluntary credits increased fivefold. And while the data is still being collected on the effectiveness of carbon markets, an MIT and Harvard study concluded that if designed properly, ETS systems can meet GHG reduction targets at a reasonable cost to regulators.
To improve carbon markets, uniform global standards are needed, including an international carbon price and synchronized financial infrastructure to facilitate trading. Regulators should also adopt and share best practices and promote greater transparency in their systems.
While carbon markets are not sufficient in reversing global warming alone, they are a step in the right direction against the battle against climate change.
Still curious about Carbon Markets?
There are many great sources of information on this topic.
For a quick recap, see Investopedia’s pages on carbon markets and cap and trade systems.
Watch The Economist’s video or TEDx Countdown’s for an overview of the topic.
And listen to the NPR’s podcast Planet Money, for their episode on carbon offsets, called Emission Impossible, or the BBC’s podcast The Climate Question for all climate related updates.
For data on carbon markets, visit Our World in Data, the World Bank Database, Deloitte, or Statista to see the numbers for yourself.
Sources
1. Investopedia: https://www.investopedia.com/carbon-markets-7972128
2. Center for Climate and Energy Solutions: https://www.c2es.org/content/california-cap-and-trade/
3. Deloitte: https://www2.deloitte.com/us/en/insights/industry/financial-services/future-of-carbon-market.html
4. Our World In Data: https://ourworldindata.org/grapher/carbon-tax-instruments?tab=table
5. EPA: https://www.epa.gov/acidrain/acid-rain-program-results
6. Center for Strategic and International Studies: https://www.csis.org/analysis/voluntary-carbon-markets-review-global-initiatives-and-evolving-models