Carbon Markets: A big problem


2 May 2023

If climate change is the issue shouldn’t putting a price on carbon be the answer? Mark Dunne looks at what’s gone wrong.



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If climate change is the issue shouldn’t putting a price on carbon be the answer? Mark Dunne looks at what’s gone wrong.

Oil makes the world go round. Since the first commercial oil well opened almost 200 years ago, it has accelerated human evolution to what were once unthinkable levels of wealth and comfort for the masses.

It fuels our cars and airplanes, powers our homes and businesses, makes plastics and medicines while it helps grow food through fertilizing soil. Yet time has shown that there is a cost for such a high standard of living: a changing climate.

The abundance of carbon released into the atmosphere from burning fossil fuels stops heat from escaping into space causing average temperatures to rise and creating extreme weather events. Indeed, fossil fuels are being blamed for heatwaves, floods, droughts and wildfires.

Yet untangling oil from our lives is difficult if we want to maintain the same living standards. If proof was needed of how tough this task is, carbon markets are a case in point.

What’s it worth?

Also known as cap-and-trade schemes, carbon markets were introduced in the mid-90s to provide a financial incentive for companies to reduce their greenhouse gas emissions. The idea is that governments committed to net zero limit the harmful gases heavy polluting industries emit. Those keeping within their quota receive carbon credits, or offsets, that they can sell through a trading system, known as a carbon market, to those who exceed their quota.

This financially rewards those who keep their CO2 emissions low and punishes those who don’t. The concept has been well received as voluntary carbon trading markets have since emerged. Here companies that are not considered to be major polluters but wish to offset their unavoidable emissions can buy carbon credits from those working to reduce or remove harmful gases from the atmosphere.

This is different from the compliance market. Instead of keeping harmful emissions low, the proceeds could fund innovation and development in areas such as reversing deforestation or carbon capture and storage technologies.

Putting a price on carbon is crucial to addressing the climate crisis, believes Nick Stansbury, head of climate solutions at Legal & General Investment Management (LGIM). “More than any other lever, any other regulatory measure, any other policy tool, head and shoulders above all of them would be for policymakers to put an effective price on carbon emissions.”

Fit for purpose?

The voluntary carbon market is believed to have raised more than $1.2bn (£981m) for sustainable projects during 2022, which helped mitigate 161 mega-tonnes of carbon, according to Trove Research. But the success of these proceeds in fighting climate change is coming under increasing scrutiny.

There are reports that voluntary carbon markets are illiquid, have scarce financing, inadequate risk management and offer limited data. “If you are looking at the whole market, then you could make those kinds of accusations of some of the projects,” says Tim Currell, Aon’s head of investment for international wealth.

“But there are also some high-quality projects which are delivering real carbon capture and ancillary benefits too. “The voluntary carbon market is not perfect,” he adds, “but they are the best tool we have for encouraging money to flow into solutions for removing carbon from the atmosphere.” Stansbury adds that the voluntary carbon markets are complicated. “They are opaque, illiquid and you have lots of different types of carbon credit,” he adds.

Another concern is that not all of the proceeds from carbon trading find their way into decarbonisation projects, with those brokering the deal pocketing a share.

Some of these issues could be why less than a quarter of companies committed to net zero intend to use the voluntary carbon markets, according to a survey by the World Economic Forum and Bain & Co, a consultancy.

Indeed, there were fewer transitions in 2022, down by a fifth in 12 months to 12.5 billion tonnes. In particular, demand for forestry-related carbon credits fell to 359 million from 380 million a year earlier, according to Trove Research and Allied Offsets.

Market imperfections as well as question marks over transparency and credit quality were given as reasons why these markets are not being included in decarbonisation plans. More of a concern is that the potential for public criticism was cited by 40% of respondents for not using them.

It appears that they are right to be cautious, if an investigation published in The Guardian earlier this year is accurate. The report claimed that 94% of the forest carbon o sets approved by Verra, a certification body, provide no benefit to the climate.

These credits, which are bought by the likes of Shell, Easyjet, BHP and the rock band Pearl Jam, could even be making the planet warmer. Verra denies this.

Even before this report was published, the World Economic Forum called for the supply side of these markets to be reformed to reduce greenwashing.

Stansbury believes that three things must happen to build confidence in the voluntary market. One, better delineation between carbon removal and carbon avoided credits.

Two, better transparency so that people can understand what they are buying.

Three, investors need to see that carbon removal has an important role to play. “It would help if prices went up,” Stansbury says. “One of the big criticisms of the voluntary carbon market is that it creates incentives for companies to continue to emit and offset their emissions at an unrealistically low price.”

For example, would companies rather pay $8 for emitting a tonne of carbon or change what they are doing? “Once pricing reaches levels where you are not creating false incentives, we will be in a much better position,” Stansbury says.

A world of difference

Putting a price on carbon might be the best way to reduce climate-harming gases, but there are more than 40 carbon trading mechanisms around the world. A high price is important and when it rises, companies change how they allocate their capital, which, Stansbury says, has resulted in harmful emissions falling. “The trouble is that it is difficult to implement pricing equally to all regions,” he adds.

The result of not having a universal price is that it creates the potential for industrial activity to move to other regions, allowing companies to escape financial penalties. “In our minds, it is clear: no effective carbon price, no net zero,” Stansbury says.

Various markets around the world are experiencing different outcomes. China is a huge climate polluter but it only established a carbon market less than two years ago. It is not going well with transactions diving 71% last year.

Early pricing is typically low when a cap-and-trade system is introduced, as it takes a reasonable amount of time for allocations to settle, Stansbury says. “Imagine throwing a bunch of stones in a pond. Ripples and waves emerge, but gradually the water settles.

“In new carbon pricing cap-and-trade models, those waves need to settle until you get some idea of where equilibrium is,” he adds. “Then the market can start to function effectively.”

Providing an incentive

“Companies and governments should not rely on voluntary carbon markets to achieve net zero,” Currell says. “It is important to understand that o sets are not a substitute for getting to grips with emissions. They should only be used for the residual, hard to abate emissions.”

Stansbury is not convinced that voluntary carbon markets are driving decarbonisation. What they need to do is incentivise billions of tonnes of CO2 to be removed from the atmosphere and stored primarily in trees. “That is true of pretty much any decarbonisation scenario you look at.

“Is the voluntary carbon market the most effective way to incentivise that economic activity? Probably not, but it is the market that we have today,” he adds.

It’s not only about funding regenerative power sources. Carbon emissions also emanate from agriculture, which is responsible for 8.5% of such gases globally, while deforestation weakens the world’s natural defence against rising carbon levels and is believed to contribute almost 15% of global carbon emissions.

For Currell, voluntary carbon markets, although far from perfect, are part of the answer to tackling climate change.

He adds that cutting emissions alone will not solve the problem and we need to channel funding towards technological and nature-based solutions to remove carbon from the atmosphere. “You need to scale them up almost as aggressively as you are trying to deal with reducing carbon emissions,” he adds.

“The compliance markets do not withdraw carbon from the atmosphere. They just bear down on existing emissions,” Currell says. “Voluntary carbon markets are the answer, or part of the answer, to that.

“Investors could buy land and let it grow wild, and low and behold, they have sequestered some carbon. Voluntary carbon markets enable investors to do that on a global scale. And they can also include all the other aspects of looking after local com- munities and biodiversity. There is a lot extra in the voluntary carbon market.”

Setting a standard

The credibility and effectiveness of these markets could be improved by setting universal standards. The Paris Climate Agreement has taken a huge step in this direction by adopting REDD+ sovereign credits, which 192 countries have agreed to trade.

Then there is the Integrity Council for the Voluntary Carbon Market, an independent body working to improve governance in the voluntary carbon markets. The Voluntary Carbon Markets Integrity Initiative is another organisation that wants to improve standards by introducing a code of practice.

For Currell, better reporting and verification will bring certainty of delivery to these markets. “Better use of technology to monitor those offsetting assets is needed to make sure they exist and that they are doing what is claimed.

“There is no question that historically there have been projects which have not delivered as they were expected to do,” Currell says. “There is a wide variety of reasons for that, so definitely work is needed.”

Stansbury has a specific idea of what is needed. “An awful lot of work needs to go into the voluntary carbon market to improve its transparency and the quality of the credits traded. We need to have an effective forward market where people can procure streams of credits into the future, like you can with other financial instruments.”

He adds that one day the compulsory and voluntary markets will converge, which could be a good outcome for net zero. This is starting to happen in California, New Zealand and South Africa. “It is not sustainable for voluntary carbon markets to remain voluntary,” Stansbury says, adding that converging with compliance markets will create the scale needed to be effective. “That will be the endgame, which will involve a mass repricing as the two pull together.”

Despite the many issues deterring corporates from voluntarily using these markets, it appears that the premise is strong enough to make a difference in the fight against climate change. “If mankind is going to beat this crisis, then voluntary carbon markets are an important but under-utilised tool. They have a bad press, for reasons I agree with,” Currell says. “I just feel they need to be nurtured rather than rejected.”


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