Introduction
How the voluntary and mandatory carbon markets work
17 October 2023
To the uninitiated, the world of carbon credits and offsetting can be confusing. But science – and leading global institutions – tell us that we will not come close to limiting global heating to the required 1.5 °C level without them.
For many industries, particularly hard‑to‑abate sectors like oil & gas, aviation and heavy manufacturing, reducing carbon emissions is incredibly challenging. Eliminating them entirely is almost impossible. By supporting projects that reduce, avoid or remove carbon dioxide from the atmosphere, companies (and also individuals or states) can lower their overall impact, down to net zero or even beyond. The currency of these projects is often called carbon credits or offsets. The supply and demand of carbon credits has formed carbon markets of which there are two principal types: mandatory markets (sometimes referred to as compulsory or compliance markets) and voluntary markets (often referred to as VCMs).
Mandatory carbon markets
Mandatory markets are a regulated marketplace for the exchange of carbon credits. These markets often operate under a cap‑and‑trade system in which only a limited number of permits (to emit greenhouse gases) are issued. Businesses that are included generally receive an ever decreasing annual emission allowances. Those who exceed the allowances must pay for additional credits from others in the market or by way of penalties to the regulator. Whilst businesses cannot create or eliminate permits, they can trade existing ones.
The biggest mandatory market is the EU Emission Trading Scheme (ETS): a cap‑and‑trade scheme where certain high‑emitting installations such as power plants, industrial factories and aviation buy and trade allowances on the regulated EU carbon market. The cap imposed on emissions is reduced annually in line with the EU’s climate target, to ensure that emissions decrease over time. Carbon prices in the EU ETS are relatively stable and have been priced between 60 EUR and 100 EUR over the past two years (note: the penalty price for exceeding allocations is 100 EUR per credit/tonne).
The UK operates a similar scheme (the UK ETS – introduced after it left the EU equivalent in 2021) which is overseen by a designated UK ETS regulator. While the mechanism is the same, the market has seen a wild downswing in carbon pricing due to a perceived over‑issuance of credits to UK businesses following the exit from the EU.
Compliance markets exist in various countries across the world although most are still lacking in some jurisdictions. The US notably does not have a national carbon market and only a single state‑level market exists in California.
The price of carbon credits tends to be relatively stable in mandatory markets, given that the number of credits in the market is fixed and so too is the penalty price for exceeding carbon allocations.
Voluntary carbon markets (VCMs)
VCMs function outside of any regulatory environment. In these markets, carbon credits are purchased voluntarily, often by organisations reducing emissions in line with net‑zero ambitions, rather than to comply with any legally binding reduction obligations.
VCMs have been gaining traction in recent years as companies have come under increasing pressure to lower their emissions and have chosen to invest in carbon‑related projects. The value of the global VCM is projected to grow from $ 2 billion in 2022 to between $ 50 and 100 billion dollars by 2030. But the market has experienced a backlash recently from some media outlets and NGOs who suggest that many credits being supplied in the VCM lack integrity, transparency and effectiveness. In essence, the offsets derived do not reduce atmospheric carbon at the levels they claim to.
A key factor in the scepticism of VCM credits lies in the perceived lack of regulation. The voluntary nature of the market, in particular the trading of credits on exchanges and the transparency around who purchases and retires what, leads many to question the effectiveness of the VCM. This has led to corporations taking the decision to abandon offsetting and replace them with a commitment to further decarbonise their own operations and value chain – a process known as insetting.
As a result, prices of carbon credits have become extremely volatile and polarised with high quality credits trading at the levels of the mandatory market or beyond, while most markets are trading low quality credits for as little as a dollar per credit.
The lack of any centralized, or even localized, regulation makes weeding out the market’s bad actors difficult. Organizations like the ICVCM and VCMI have recently put forward standards and frameworks for regulation of the VCM, aiming to instill greater integrity and transparency in the marketplace. Furthermore, Article 6 of the Paris Agreement sets out a process by which countries and private sector companies can co‑operate together to lower carbon levels as part of each country’s nationally determined contribution (NDC). These are important steps towards regulation in the VCM and welcomed assuming they do not negatively impact the financing and innovation that free markets attract.
What can VCMs learn from the mandatory markets?
In general, the EU ETS has been a successful model for reducing emissions through a financial market model. By learning from schemes like the EU ETS, VCMs can develop into more mature and effective markets, playing a greater role in achieving global climate goals.
Regulation
Mandatory carbon markets are typically regulated by governments, which set out the rules for how the market operates, including the types of projects companies must finance, the emissions that are covered and the penalties for non‑compliance. This regulation helps to ensure that the market is fair and transparent, and that it delivers on its environmental objectives.
Regulatory frameworks ensure clear rules on the eligibility of projects are established, the types of credits that can be traded and the disclosure requirements for buyers and sellers. Regulation could also help to address some of the challenges facing the VCM, such as the risk of fraud and the lack of liquidity in some markets.
Mandatory participation
One of the key features of mandatory carbon markets is that they require certain companies or facilities to participate. This helps to ensure that the market has a sufficient number of participants to function effectively, covering a significant share of emissions, and that there’s a level playing field for competing businesses.
Regulated VCMs would more likely encourage companies to participate in the market with fewer concerns over media, investor or consumer backlash.
Ratcheting down of allowable levels
Another key feature of mandatory carbon markets is that the cap on emissions is typically reduced over time. This helps to ensure that emissions continue to decline in the long term by creating a strong financial incentive for this to happen.
VCMs could consider mechanisms through which credits are priced relative the performance of the companies purchasing them, e.g. lower costs for those that are reducing their own emissions faster or are more transparent in their reporting. An increase in credit prices would have the knock‑on effect of incentivising companies to further reduce their emissions and more quickly.
A centralized approach
Mandatory carbon markets typically have a centralized body that is responsible for setting standards for projects and credits, reviewing projects for eligibility and arbitrating disputes. This helps to ensure that the market is credible and that the quality of credits is high.
VCMs could learn from this by developing their own centralized bodies – or perhaps a single body – to set standards, review projects and arbitrate disputes. This would help to improve the quality and credibility of the VCM and further incentivize participation by corporates while demonstrating greater integrity to concerned stakeholders such as NGOs or the media.
Public disclosure
Companies that are required to participate in mandatory carbon markets are typically required to publicly disclose their emissions and their purchases of carbon credits. This helps to ensure that the market is transparent and that companies are accountable for their emissions.
VCMs could learn from this by encouraging companies to publicly disclose their purchases of carbon credits. This would help to increase the transparency of the market and build trust among participants. A robust market infrastructure, including a central registry of allowances and credits, and a system for monitoring and enforcing compliance would also improve integrity in VCMs.
Getting the balance right
A lack of regulation in any market leaves it open to abuse, volatility and uncertainty. We’ve seen this for decades in just about every other form of market including global financial markets. But too much regulation can stifle innovation and capital investment. VCMs require a level of regulation that provides market participants with the confidence they need to take part without driving innovation and finance away through bureaucracy and complexity.
It can be easy to forget that at the heart of the voluntary carbon markets sits the challenge of averting a climate disaster that’s already well underway with alarming tipping points having already been passed. Financially incentivizing those who wish to tackle the problem is perhaps the only chance we have in solving it. And providing an appropriately regulated platform through which to do it seems like an imperative next step.
