Interest in carbon markets has recently spiked worldwide. Approximately 83 percent of nationally-determined contributions (NDCs) include intent to use international carbon market mechanisms to achieve climate agreement targets. Through limiting emissions, countries aim to prevent global warming from crossing the threshold of 1.5 degrees Celsius.
Carbon trading is also known as emissions trading and involves the purchase and sale of units in the market to other parties or companies, which enable them to emit a certain amount of CO2. Other key terms in this field include carbon tax, which refers to the fixed amount that emission-producing entities must pay in the carbon market for carbon emissions. Carbon credits are tradeable instruments that enable companies or other entities to offset their carbon emissions through funding projects that aim to reduce or remove CO2 from the atmosphere. Once credits are used to reduce, avoid, or remove emissions they are considered offsets that can no longer be transferred.
Meanwhile, governments can permit any entity to emit set amounts of carbon using emissions allowances or carbon credits. These credits can be traded among regulated companies and give the holder the right to emit 1 ton of CO2.
The idea of implementing carbon trading was proposed for the first time as part of the Kyoto Protocol. This 2005 treaty extended the UN Framework Convention on Climate Change. It focused on encouraging all countries to reduce greenhouse gas emissions, while the wealthiest countries would support the efforts of poorer nations through buying their "credits," i.e., the right to emit carbon.
There are various points that shed light on the benefits of carbon trading and how it works, including:
1. Systems for buying and selling carbon credits: Carbon markets are essentially trading systems for buying and selling carbon credits. Companies or individuals can use carbon markets to offset greenhouse gas emissions through buying carbon credits from entities that will remove or reduce their emissions. It is important to note that there is no fixed international price for carbon. Instead, prices fluctuate depending on the nations engaged in trading and supply and demand conditions in the market.
2. Diverse carbon markets: There are two types of carbon markets: mandatory and voluntary offset markets. Mandatory markets are established in response to policies or organizational requirements, whether at the national, regional, or international level. National and international voluntary carbon markets involve creating, buying, and selling carbon credits on a voluntary basis. These carbon credits are usually supplied by private entities that are working to develop carbon projects, or by governments that are developing verified carbon standard programs to reduce or remove emissions.
Demand for carbon credits usually comes from individuals who want to offset their carbon footprint, companies that are trying to achieve sustainability goals, or other actors who aim to buy and then sell carbon credits at higher prices to make a profit. The right to emit carbon can be sold in various markets at the international, national, or local level.
3. Cap-and-trade system: Carbon trading relies upon emissions cap-and-trade systems, which previously succeeded in reducing sulphur dioxide pollution in the 1990s. These systems create market-based incentives to curb pollution. Instead of imposing specific measures, the policy rewards companies for reducing their emissions and sets additional costs for companies that are not able to do so.
4. Encourages adoption of innovative technologies: Supporters of carbon trading say that it is a cost-effective partial solution to the problem of climate change. It encourages adoption of innovative technologies and has quickly made the most of technological developments. As a result, carbon trading has become a key component of many proposals to mitigate or prevent climate change and global warming.
5. Creates financial incentives for countries and participants: Supporters of carbon trading also point out that the market creates financial incentives that help encourage countries and companies to establish technologies and initiatives to reduce emissions. These include mechanical carbon sequestration systems as well as planting forests, which helps reduce carbon dioxide levels in the atmosphere.
In recent years, global trends have helped develop carbon trading, including through the following avenues:
1. Global diversification and development of carbon markets: There are signs that carbon markets are diversifying and developing via various services, platforms, advanced technology markets, and enhanced products. New investors have entered the sector, which means that carbon pricing will be more standardized with regard to the weighted moving average (WMA). There will also be greater regulation of the market. According to a 2023 World Bank report on carbon pricing, there are now around 73 different carbon pricing instruments, which cover 23 percent of global greenhouse gas emissions.
2. Financial revenue for governments that cooperate on carbon trading: Industry forecasts indicate that demand for carbon credits used as offsets will grow significantly in the coming years. According to the 2023 World Bank report on carbon pricing, revenue from carbon taxes and emissions trading grew 10 percent during 2022, rising to about 95 billion USD worldwide.
According to a study conducted by the International Emissions Trading Association (IETA) and the University of Maryland, the cooperative implementation of nationally-determined contributions through international carbon trading (instead of on an individual basis) could result in financial transfers increasing from 300 billion USD per year in 2030 to much higher amounts in the following years. Some estimates suggest that relying on carbon markets will make it possible to reduce the total cost of implementing NDCs by more than half, or by 250 billion USD annually, by 2030. It could also facilitate curbing emissions by 50 percent by 2030 without any additional costs.
3. China launches a national emissions trading program: In July 2021, China launched a national emissions trading program that was designed to help the country achieve its objective of becoming carbon neutral by 2060. This resulted in establishing one of the largest carbon emissions trading markets in the world. The market covers around 2225 companies in the energy sector, which account for 40 percent of China’s carbon emissions, and enables these companies to trade emissions units. In China, this market reached a cumulative trade volume of more than 200 million tons by the end of 2022, which is a positive indication of the growth of carbon trading in China.
4. EU launches first international emissions trading system: The EU launched the world’s first international emissions trading system in 2005. In recent years, this system has enabled the EU to become one of the largest carbon trading markets in the world. The market now serves as the reference standard for carbon trading. On 14 July 2021, the European Commission approved a series of legislative proposals aimed at achieving EU climate neutrality by 2050. This includes a medium-term goal of reducing net greenhouse gas emissions by at least 55 percent by 2030, and reevaluating the international system for European emissions trading. However, it seems that after major growth since 2020, the rise of carbon credit prices in the EU Emissions Trading System (ETS) began to slow in 2022. Nevertheless, the system has demonstrated flexibility in dealing with various challenges that have occurred at the macroeconomic level in the EU. Despite rising carbon prices during the European energy crisis of 2022, half of carbon instruments’ prices rose, while around a third remained at consistent levels.
5. Carbon trading agreement signed during COP26: After extensive discussion, rules for the global carbon market were established during COP26, the climate change conference held in Glasgow in 2021. This conference resulting in the signing of the Glasgow Statement. Regulations include establishing a central system for the private and public sectors and a bilateral system designed for countries to trade carbon offset credits and achieve their emissions targets. The new agreement stipulated that entities setting up carbon credits would deposit 5 percent of the revenue generated in a fund to help developing countries in addressing climate change challenges.
6. Regional Voluntary Carbon Market Company in Saudi Arabia: In October 2022, the Saudi Public Investment Fund and Saudi Tadawul Group jointly established (with 80-20 percent ownership, respectively) the Regional Voluntary Carbon Market Company. This company was established to play a key role in expanding the scope of the voluntary carbon market and to encourage sustainable and climate-conscious business practices. It also hopes to spur action at the regional and international level in supporting various companies in the region across different sectors, and to enable them to reach net-zero emissions. It ensures the purchase of carbon credits to curb carbon emissions in value chains.
The Regional Voluntary Carbon Market Company hosted its first auction during the sixth annual Future Investment Initiative, which was held in Riyadh in October 2022. The event succeeded in selling more than 1.4 million tons of carbon credits. The Olayan Financing Company, Aramco, and Ma‘aden (the Saudi Arabian Mining Co.) all purchased significant quantities of these credit units. In June 2023, the company held a second voluntary auction for carbon credits. During this second auction, more than 2 million tons of carbon credits were sold to 15 buyers, most of whom were Saudi or international entities.
7. UAE Carbon Alliance buys African carbon credits: In April 2023, the UAE Carbon Alliance, which includes companies that were formed specifically to develop carbon markets in the UAE, pledged to buy 450 million USD of African carbon credits by 2030. It sees this agreement as a positive step towards unleashing the potential for carbon credit generation in Africa, as well as supporting climate action on the African continent. This will also help the UAE adhere to its climate pledges.
In February 2023, Dubai-based company Blue Carbon set up partnerships with Zambia and Tanzania to preserve 8 million hectares of forest in each of these African countries. These agreements aim to generate carbon credits that the company can sell on the global carbon market. It also recently signed an agreement in early October 2023 with Zimbabwe to create carbon credits through offsetting projects worth 1.5 billion USD. This means that the UAE will fund projects to protect and restore forests in Zimbabwe. Though these agreements, Blue Carbon has received the right to develop carbon offset projects that cover 24.5 million hectares in Africa.
8. Forest-rich nations show increased interest in carbon trading: The Southeast Asian nation of Cambodia has extensive experience with voluntary carbon markets in the forestry sector. This constitutes part of its updated nationally-determined contributions (NDCs) and ambitious long-term strategy for carbon neutrality. Forest-rich nations such as Costa Rica are considering how to strategically engage with carbon markets as part of their NDCs. Meanwhile, countries such as Ghana have been pioneers in implementing carbon market instruments developed through voluntary cooperation among countries under Article 6.2 of the Paris Agreement.
Despite the advantages of and broad interest in carbon trading at the moment, there are many challenges facing this emerging sector, including the following:
1. Unreliability of carbon credits: Voluntary carbon markets have dealt with considerable challenges with regard to reliability, given the prevalence of low-quality carbon credits. This has raised doubts about the extent to which the credits actually reduce emissions, and whether they will do much to further mitigate climate change in the region. Furthermore, there is a significant lack of transparency in carbon markets, which is a result of various factors including inconsistency and scarcity of relevant information about the quality of credits and transaction history throughout the supply chain. Given the market’s limited transparency, it is difficult for companies to know if they are truly reducing emissions or not.
2. Fragmentation of markets: Markets also face fragmentation and an inability to deal with upcoming challenges in carbon trading. For example, some countries consider carbon credits to be an expense, while others see them as an asset, and still others view them as a commodity. Depending on the legal framework for these units, there are indirect effects on how they are dealt with from a tax and accounting perspective.
3. Lack of carbon credit supply: The entire concept of carbon markets ultimately involves putting capital into projects that aim to reduce carbon emissions, whether through planting forests, developing solar energy, or direct carbon sequestration through market instruments. As a result, investments in these projects are predominantly what produces carbon credits. One of the most significant issues that the carbon trading market faces is a lack of liquidity due to a lack of credits available. This supply deficit needs to be addressed, while price transparency could also be improved.
4. Lack of brokers for the market: Another gap in the carbon market in the lack of brokers. Potential clients at banks often want to buy carbon credits but prefer to deal with bank partners and brokers to identify sources of carbon credits and make purchases on their behalf. Having more carbon trading brokers would generate more activity in secondary carbon markets and also help institutionalize these markets.
In conclusion, the continued rise of global temperatures means there is a pressing need to strengthen climate policies. This has brought carbon pricing to the center of climate discussions. As current trends develop, voluntary demand for carbon trading has increased, amidst calls for adoption on a wider scale. As a result, it has become increasingly clear that carbon trading is key in bolstering global efforts for a sustainable and carbon-free future. Through adhering to high standards of integrity and transparency in carbon trading, carbon markets can help expedite necessary shifts and reach global targets for net-zero emissions. This will require setting effective carbon prices and creating economic incentives to curb emissions. It will also help generate the huge sums necessary to develop resilience in the face of the far-reaching consequences of climate change.