A brief explainer on carbon markets

What are they, and how do they work?

In 2018, more than USD 44 billion was raised from carbon pricing, including carbon taxes, according to the World Bank. Trending Topics 2019, Flickr
26 November 2019

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Talk of carbon markets and carbon taxes, emission trading, and cap-and-trade schemes as ways to lower emissions is on the rise, but what do these terms mean? The following explainer might help.

Very basically, carbon markets were devised by economists as a means for “trading the right to pollute, (thus) creating a financial incentive to curb emissions,” says the World Economic Forum.

Put another way: “carbon taxes, carbon trading and so on, these are just shorthand descriptions of methods to put a price on emissions, which economists say is one of the most important steps society could take to limit them,” says The New York Times.

Of course, carbon dioxide (CO2) is not the only greenhouse gas (GHG) emitted into the atmosphere, but the U.N. has said CO2 is the principle GHG, hence its reference in “carbon markets.”

In fact, the current story of carbon markets, emissions trading and the like goes back to the U.N. Framework Convention on Climate Change (UNFCCC) and the 1997 Kyoto Protocol, which came into force in 2005, announcing binding emissions reduction targets for the countries that signed the Kyoto accord. It also included a mechanism through which countries were encouraged to meet their targets – that mechanism being emissions trading.

In carbon markets, there are a few different approaches that corporations or similar entities can use to trade emissions. Cap-and-trade schemes are one popular approach, in which the governing body of the particular market sets a cap on total allowable emissions from entities therein, with the expectation that the cap – their emissions – will be gradually reduced.  

Business or other entities in that market that don’t have a sufficient allowance to cover the emissions they are creating must either cut their emissions or buy spare carbon credits (sometimes called carbon certificates) from another entity in the market. Market players with extra allowances can sell or save them for future use. This possibility to essentially borrow or buy allowable emissions constitutes the ‘trade’.

But what is a carbon credit? Basically, it’s a permit or certificate allowing the holder – say, a business – to emit CO2 or other GHGs. Generally, the credit limits the emission to a mass that is equal to one ton of CO2 carbon equivalent.

Emissions trading schemes (ETS) create market-based incentives for entities to reduce their emissions, according to the Berlin-based International Carbon Action Partnership (ICAP). ETS exist at regional, national and sub­national levels all over the globe, with one of the largest and best-known established in the European Union (EU), which encompasses all EU countries plus Iceland, Liechtenstein and Norway.  The EU ETS covers more than 11,000 power stations and industrial plants, and about 45 percent of all EU GHG emissions. Participants are allocated a certain amount of emissions “allowances” which they can buy or sell on the open market. The incentive to remain below their allowances is the threat of heavy fines for those who exceed the limits set by the market regulators.

The ICAP – an international forum for governments and public authorities that have implemented or are planning to implement ETS – recently reported that it now boasts 31 full members*. That includes four Canadian provinces, almost a dozen U.S. states and most European countries.

In addition to the EU, four countries have enacted national-­level ETS: New Zealand (2008), Switzerland (2008), Kazakhstan (2014) and South Korea (2015). A number of other countries have announced similar plans: China recently launched a trial plan covering some 1,700 companies accounting for more than 3 billion tons of CO2 equivalents per year. Thailand, Turkey and Ukraine are exploring design options for an ETS; and 13 other countries are exploring carbon pricing mechanisms, says UNDP.

The value of global markets for CO2 allowances is soaring, according to a report by analysts at Refinitiv, a financial market data agency. Quoted by Reuters in January, Refinitiv said that CO2 allowances jumped by 250 percent in 2018 to a record high of 144 billion euros (USD 164 billion). The report suggested the jump was due to the soaring cost of carbon permits in Europe’s ETS, which reportedly more than tripled in 2018 to around EUR 25 per ton, up from EUR 8. Some 9 billion carbon permits were traded globally last year, up 45 percent compared to 2017, the report said.

Voluntary carbon markets, which involve carbon offsets purchased outside the regulated system, operate alongside the much larger “mandatory markets” – those associated with such international treaties as the Kyoto Protocol as well as official national, regional or international carbon reduction regimes. Such official markets are always certificated backed up by accounting standards and audits, and their market size can be defined through regulations set by the regulators. The price of carbon in the official market is much higher than the price in the voluntary market, because demand (and therefore, trading volumes) is fairly low in voluntary markets. Those markets can also be certified but might not have the same level of standards.

Authorities have a handful of other options to reduce GHG emissions, including introduction of a carbon tax where businesses must pay for the amount of CO2 they produce. That provides a strong incentive for businesses to invest in cleaner technology and low-carbon approaches in order to reduce their emissions and avoid the tax.

Meanwhile, industrialized countries that have committed to cutting GHG emissions are also permitted to invest in emissions-reducing projects in developing countries as an alternative to emission reductions in their own countries which could be more expensive.

*Members: Arizona, Australia, British Columbia, California, Denmark, European Commission, France, Germany, Greece, Ireland, Italy, Maine, Manitoba, Maryland, Massachusetts, Netherlands, New Jersey, New Mexico, New York, New Zealand, Norway, Ontario, Oregon, Portugal, Québec, Spain, Switzerland, Tokyo Metropolitan Government, United Kingdom, Vermont, Washington State. Observers (as of January 2017): Japan, Kazakhstan, South Korea, Ukraine.


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