2022 Carbon Series Part 1: Global Carbon Market Primer
In the first of a two part series under our Clockwork Climate banner, we provide a primer on the history and functions of the carbon market mechanisms in practice in the fight against global climate change.
As Summer 2022 has thus far demonstrated, heat waves, record-breaking temperatures, and volatile weather patterns have become commonplace the world over. Society's impacts on the climate are increasingly undeniable.
To help course correct, drastic measures relying in large part on system redesign, research and development and far reaching innovation and invention are required. Markets and private capital have vital roles to play. In broad strokes, it's estimated that $3-5T in annual investment is needed to achieve global decarbonization goals through the coming decades. Globally, investors are actively investing in nextgen climate solutions and low carbon opportunities. According to BCG, that amount is nearly $60B and has doubled since 2020. More capital is needed however, and active fossil fuel divestment initiatives are significant with more than 1500 institutions valued at over $40T committing to the cause.
But to where does the modern climate dialog trace its roots? And what are the building blocks of the carbon markets?
The Kyoto Protocol set precedent for environmental action
The origins of the carbon market trace back to the Kyoto Protocol, a global climate accord crafted in 1997 in response to ozone depletion. In a clause called the Clean Development Mechanism (CDM), the UN outlined a tool to measure carbon emissions – metric tons of CO2 (MTCO2e) released into the atmosphere, and carbon reductions, MTCO2es avoided or removed, additional to natural occurrence. As the call for climate action grew, countries set targets towards net-zero, or carbon-neutral emissions.
Countries that reduced excess carbon relative to their production could generate and sell certified emission reductions (CERs), or carbon offsets, measured in MTCO2e. The aspiration to develop these credits for both economic and environmental purposes stimulated the global development of sustainable energy initiatives and gave rise to the carbon market.
Carbon emissions became restricted and taxable
Governments across the world created economic incentives for carbon reduction through two main programs: carbon taxes and cap-and-trade systems. By enacting carbon taxes, governments reserved the right to regulate carbon production by charging companies an explicitly stated cost per MTCO2e emitted. Presently, there are 44 countries that have enacted carbon taxes. Sweden’s tax tops the list, enacting a tax of $137 USD per MTCO2e emitted. There are no states within the US that have a carbon tax, however a proposal is under consideration in Washington state.
Cap-and-trade systems set a maximum for total emissions that can be released by participants over a year. Each jurisdiction issues a limited number of emissions permits, which give authorization to produce one MTCO2e. Issued permits are either given away freely or auctioned off. During permit auctions, allowances are sold by auctioneers on behalf of participating states. The highest bidder is awarded the permit, and can re-sell it on the market or use it to offset their own emissions. The number of carbon emissions permits issued is intended to decrease over time, therefore gradually escalating prices and putting pressure on emitters. If a company surpasses their cap, they are mandated to pay a tax on their excess carbon emissions. For this reason, companies often prefer cap-and-trade regulations over carbon taxes, as they are less economically impactful.
Within the United States, there are three primary cap-and-trade programs formed by regional jurisdictions: the Midwestern Regional Greenhouse Gas Reduction Accord (MGGRA), the Regional Greenhouse Gas Initiative (RGGI), and the Western Climate Initiative (WCI).
Regulated and Voluntary markets
Carbon credits must be earned through approved projects, the standards of which vary depending on the market. These markets can be broken down into two main categories: regulated and voluntary markets.
Regulated, or compliance, carbon credits are traded to meet regional, domestic, or international legal requirements. Regulated projects must qualify through a rigorous public registration and issuance process to be deemed valid. Voluntary markets, on the other hand, trade credits on an optional basis. Under more flexible guidelines set by committees, each project developer decides how their carbon reductions will be realized, however, both voluntary and regulated markets follow the same structure from end-to-end production:
The standards for each carbon offset project are set through appointed decision makers, who outline project requirements. Projects are then proposed by licensed developers and submitted for review to verify compliance with the set standards. Once the projects qualify through verification, they are enacted, thus creating carbon credits. Once the carbon credits have been produced, project developers sell their credits to brokers, traders, and retailers, or directly to end buyers. The end buyers are then given a certificate, which can be submitted as proof of carbon offsets, reducing their carbon taxes or allowing them to increase their carbon cap.
Whether regulated or voluntary, both of these carbon markets have positive environmental implications globally. They protect biodiversity, prevent pollution, improve public health, and stimulate job creation. Emission trading tackles climate change in an economically beneficial way, stimulating the growth of new technologies and promoting investments in clean energy.
Bloomberg New Energy Finance
Global Fossil Fuel Divestment Database
Boston Consulting Group
S&P Global Platts