A Primer on Carbon Markets

During the final week of COP26, over 200 countries came together and established an agreement on the rules for international trading of carbon credits. These agreements resulted in a set of negotiations, also known as Article 6, that lay out the rules for creating, accounting and verifying carbon credits in an international regulated exchange.  

While these exciting updates have created much buzzworthy news, there is still plenty to sort out – and an education curve for all involved. So let’s break down some of the confusing terms floating around and try to answer several basic questions: What are carbon markets? Who participates? And what are the open questions that remain to be seen? 

Types of Carbon Markets

To start, there are two different types of carbon markets: regulatory markets and voluntary markets.  

Regulatory carbon markets arise when companies or governments are required by law to account for and limit their GHG emissions. Many regulatory carbon markets are often organized through “cap and trade” systems, where governments quite literally cap the emissions for specific sectors and distribute allowances. According to the CDP, as of 2021 there are 64 carbon pricing initiatives in place or scheduled by governments and regulators, up from 61 in 2019. (For more information and case studies on these programs, please click here

Voluntary carbon markets have emerged with a force in recent years, and differ from regulatory markets in that participation is not compulsory. The rise of investor-led ESG frameworks and disclosures has created great demand and pressure for companies to track and report emissions, set emission reduction goals, and ultimately reduce carbon. To date, companies have primarily traded carbon through voluntary markets to offset their own emissions by purchasing carbon credits generated by projects that reduce or remove CO2 from the atmosphere. The results: an increased pool of capital, and pressure to reduce emissions at faster rates.

Who Participates and How?

In regulated markets, only covered industries, sectors or regions can participate. The largest international markets were developed to meet the requirements of international climate negotiations. Examples of regulatory markets in action include the United Nations-run Clean Development Mechanism (CDM) and the Joint Implementation (JI) – both project-based mechanisms for enabling countries with carbon emissions caps to invest in emissions-reducing projects to generate credits – and the EU Emissions Trading System (EU-ETS), all of which fall under the Kyoto Protocol, and in which only member-countries may participate. 

In the United States, the Regional Greenhouse Gas Initiative (RGGI) program covers the power sectors across 13 states, while ​​California’s cap-and-trade program covers virtually the entire state economy and is the first multi-sector cap-and-trade program in North America.

So how do they all work? For both regulatory and voluntary markets, the concept is similar: companies and So, how does it work? For both regulatory and voluntary markets, the concept is similar: organizations can either fund carbon removal projects (purchase carbon credits) or purchase allowances that allow them to emit above certain thresholds. The primary difference between regulatory and voluntary markets is that regulatory markets generally rely on carbon allowances, whereas voluntary markets rely on carbon credits. For example, in regulatory markets, governments give an X amount of allowances that Y organization can emit and if Y organization exceeds its allocated amount of carbon credits, Y organization can buy additional allowances through an auction. In a voluntary market, X company can essentially fund a carbon removal project (plant X number of trees) to offset their emissions and meet their carbon reduction goals. Another difference is that regulatory markets generally have more rules and guidelines to ensure fairness and avoid issues, such as double counting carbon emissions across multiple parties, whereas most voluntary markets do not (yet).

Challenges and Questions Ahead

While Article 6 is a big win for the international carbon market, there is still much work to be done to get carbon trading off the ground and create the momentum to reduce atmospheric emissions at the pace required to meet global reduction goals and limit global warming to 1.5 degrees. 

While Article 6 might inform some of the future guidelines for voluntary markets, there are few guidelines to date. Furthermore, because voluntary markets encourage participation via offsets, many worry that the focus on offsets could distract from the trickier business of taking significant actions to reduce carbon associated with business operations. 

A recent report from South Pole found that for companies setting new net zero targets, over 60% have either set targets far into the future, or no clear target dates at all. 76% of companies stated that renewable energy will be a top strategy for reaching net zero, and only 48% are exploring ways to decarbonize their supply chains by addressing Scope 3 emissions. 

As voluntary markets evolve, we will likely see more rules and guidelines to help govern market behaviors and provide more detailed frameworks for sectors like real estate. With the increase in state and local regulations, like New York’s Local Law 97, there may be new opportunities for commercial real estate to participate; some regulations may even incentivize building owners to focus on operational efficiency and discourage offsetting.  For example, New York is conducting a study on the feasibility of rolling out a carbon market to help building owners comply with its new local law through a regulated carbon exchange/trading system. In all, we expect carbon markets – both voluntary and regulatory – to expand in scope and participation as momentum around ESG continues to grow.

Stay tuned for more to come on this topic in the coming weeks!