The market for carbon credits, which represent greenhouse gas (GHG) emission reductions or deposits equal to one metric tonne of carbon dioxide equivalent (mtCO2e), is growing rapidly. In this article, the third in a series on why carbon markets exist, we will look at the present state of carbon market objectives, functions, classifications, and governance. Here are links to previous articles on the history of compliance markets and voluntary markets.
The present state of carbon markets, viewed as an evolutionary response to the global challenge of anthropogenic climate change, is a collection of nascent and disjointed efforts. Both public and private market participants are trying to solve collective problems independently. Nations and regions communicate when it is convenient yet cannot agree on consistent enforcement. Corporations make pledges to appease public perceptions without any defined plans to execute. New registries are forming while incumbent players are trying to resuscitate their reputations and project developers seek funding to pursue their GHG reduction goals. They say hope springs eternal, but news thrives on negativity.
General Reasons for Carbon Markets
Carbon markets exist as an economic incentive mechanism to address negative externalities of GHG emissions in a cost-effective manner. The inception of these markets can be traced back to the global acknowledgement that a collective and scalable approach was needed to mitigate the environmental impact of industrialization and ongoing human development activities.
Compliance carbon markets emerged from government regulations requiring certain entities to reduce their emissions to meet specific targets, thus creating a formalized system for trading carbon credits to incentivize reductions where they are most egregious. On the other hand, voluntary carbon markets arose as entities, often driven by public relations and the demand for corporate social responsibility, that sought to offset their emissions beyond regulatory requirements, demonstrating accountability and commitment to environmental sustainability.
The formation of these markets is underpinned by the broader goal of stabilizing atmospheric concentrations of GHGs to prevent dangerous interference with the climate system, using CO2e as the unit of measure. However, the question remains: Are these markets effective enough to make a significant difference in the fight against climate change? This critical query points to the necessity of evaluating the overall objectives of carbon markets, which include reducing global emissions, driving investment in clean technology, and promoting sustainable development. Quantifying success involves measuring actual emission reductions, the degree of participation by entities, and the impact on promoting broader environmental and societal benefits.
Function and Common Processes
The current function of the carbon credit market, particularly within the voluntary sector, operates through a refined process that aims to ensure the integrity, transparency, and effectiveness of carbon offset projects. Here’s how the system typically works: project developers make a defined proposal including a methodology, external validation of concepts, implementation of project activities, verification of outcomes, public registration with auditing for transparency, and finally, the issuance and trading of credits.
Proposal of Projects: The process begins when a project developer identifies an opportunity for a GHG reduction or sequestration project. The developer defines the project’s scope, objectives, and expected outcomes based on a specific methodology that aligns with the standards of the carbon market. Methodologies define how the project will verifiably reduce or sequester qualifying GHGs and how they translate to mtCO2e.
Validation: Once the project is submitted, it must be validated by an independent party. This external validator assesses the project’s design, including the feasibility of its calculations and the reliability of its methodological approach. Validation confirms that the project is capable of achieving the stated carbon reduction or sequestration in accordance with recognized standards and can therefore contribute to the overall goals of the carbon market.
Implementation: This is the phase where planned activities are executed, whether that involves planting trees, installing solar panels, capturing methane, or any other carbon-reducing actions. Throughout this phase, the project must adhere to the agreed-upon plan to ensure its environmental integrity and the veracity of its carbon reduction claims.
Verification: After a project is implemented, it undergoes a verification process. An independent party verifies the actual outcomes of the project, ensuring that the reported data is accurate and that the project activities have been completed as per the methodology and the validation. This step is crucial for building trust by confirming that the project has indeed resulted in the carbon savings or sequestration promised.
Registry and Auditing: From the beginning, a single registry system tracks all project activities, from inception and validation through implementation and verification. The chosen registry is essential for maintaining transparency and accountability. Registries should also facilitate an audit process to ensure compliance with the standard and safeguard the integrity of the assets.
Issuance and Trading of Credits: Once a project is verified, credits are issued to represent the amount of CO2 that has been reduced or sequestered at one mtCO2e per credit. These credits can then be bought and sold on the open market to be retired as offsets for carbon emissions.
Classification, Types and Sectors
Due to the vast and varied nature of climate science and opinions on avenues to take, a wide variety of projects have been developed. Even with using CO2e as the common unit of measure, curbing emissions can take many forms. To differentiate between market activities, project developers and buyers can use a multi-layered categorization approach including classification by sector, credit types, and sustainable development goals (SDG).
Capturiant, a Registry and Standard, has done data integration from registries, standards, and accreditation bodies for sector classifications to include every major category of project. The below table includes the sector number and name with non-exhaustive example(s) listed.
To classify the resulting credits from these projects, it is sometimes desirable for buyers to know the type of project they are dealing with. The main project types are reduction, avoidance, and sequestration. These types are descriptions of the way that CO2e calculations are measured relative to their baseline values. In the article on voluntary markets linked above, the difference between engineered solutions and nature-based solutions was highlighted, each of those categories can have projects applied to any of these labels.
SDGs are a set of 17 interlinked global goals designed to be a “blueprint to achieve a better and more sustainable future for all” by 2030. These goals were set in 2015 by the United Nations General Assembly and are intended to address global challenges such as poverty, inequality, climate change, environmental degradation, peace, and justice. The SDGs cover a broad range of social and economic development issues, with each goal having specific targets to be achieved. Carbon credits are closely related to SDG 13 (Climate Action), which aims to take urgent action to combat climate change and its impacts. For projects that impact multiple SDGs, those benefits can be used as a selling point by asset controllers attempting to differentiate in the marketplace.
Governance of Carbon Markets
Carbon market governance can be a shifting landscape. Many regulatory bodies either lack clear jurisdiction or have yet to decide on how to act within their domains. At the same time, a few institutions have taken it upon themselves to become informal gatekeepers to the market. Each of these actions or inactions has unintended consequences.
Formal market governance refers to the systems, rules, and institutions that regulate and oversee market operations and economic activities. It encompasses the formal mechanisms and structures established by governments, regulatory bodies, and financial institutions to ensure that markets function efficiently, transparently, and fairly. The United States, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC), which govern securities and commodities respectively, have yet to take an official stance on how to regulate carbon markets and the entities involved. In the EU, compliance markets cover some industries but leave others to voluntary mechanisms. Countries in the United Nations have agreed to aim for certain climate goals, but the ability to enforce compliance does not exist. The incentive to shirk responsibility remains high so long as the problems can be viewed as someone else’s responsibility.
Due to formal structures in carbon markets being weak, underdeveloped, or absent altogether, some informal institutions have developed attempting to accredit economic activity and provide a system of values. However, inherent limitations and biases have also led to inefficiencies, lack of transparency, and difficulties in scaling businesses. Some of these accreditation programs even conflict with established laws, even if they have not been formally challenged yet. In contrast, groups like the Integrity Council for the Voluntary Carbon Market (ICVCM) have released guidelines trying to establish credibility and trust in the marketplace.
Understanding the interplay between informal and formal governance structures is essential for effectively managing and regulating markets. Groups like ICVCM can provide educational value to market participants in the early stages before formal institutions like the SEC and CFTC decide how to regulate.
The next article will provide a forward-looking perspective on possible market developments that could take place and potential paths for carbon market objectives to be realized.
This article was written by Nathan Murphy, Registry Manager.
Disclaimer: This blog post is for informational purposes only and should not be considered as financial or investment advice.
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