Carbon markets: who sets the price for carbon offsetting?

As the deadline for the Sustainable Development Goals looms large, policymakers have been devising new mechanisms to accelerate emission reductions on an international scale. At last year's COP26 gathering in Glasgow, nations continued to thrash out plans for global carbon markets that could revolutionize the way businesses and entire nations offset their emissions.

So what are carbon trading markets, and how do they support efforts to combat climate change? How do carbon markets differ from traditional carbon offsetting programs? Who determines how carbon credits are priced and what are the advantages and disadvantages of this approach?

In this guide, we aim to answer all the questions above. So let's begin with exploring the broader backdrop.

How does carbon offsetting fit into the wider context of climate change?

Greenhouse gases, or GHGs, help regulate the planet's temperature. They are responsible for absorbing heat and reflecting it back down to Earth. But due to rising GHG emissions, we now have too much of this natural greenhouse effect.

While GHGs are found naturally, the sharp spike in CO2e emissions since the industrial revolution has contributed to global temperatures rising by 1 degree since 1880. While a single degree might seem small, we are already witnessing the effects of global warming.

In 2015, the United Nations gathered leaders to discuss a new climate agreement to act as a successor to the Kyoto Protocol. Known as the Paris Agreement, among its pages, policymakers set out to establish bold solutions to global warming by tackling the emission of the most prolific greenhouse gas, carbon dioxide.

Carbon dioxide has some of the most detrimental effects on the environment, and it is the greenhouse gas that humans emit the most. In its efforts to tackle climate change, Article 6 of the Paris Agreement outlined 3 strategies where countries could sign up to cooperate towards reducing carbon emissions and the effects of global warming.

Two approaches were based on establishing carbon markets and the third, while less defined, allowed for a framework of cooperation away from trading more akin to traditional international development programs.

What are carbon markets?

Up to date, engagement with carbon offsetting programs has come in two forms. The first is a compliance market, where companies purchase carbon credits to avoid breaking GHG emissions caps instigated by the governments such as Australia or political unions such as the EU. The second is a voluntary carbon market where businesses that do not fall under any legislation can still demonstrate their commitment to sustainability by signing up to support voluntary carbon offsetting programs.

The Paris Agreement sought to expand on these models and establish new systems to encourage larger carbon-busting initiatives. By creating a mechanism where a ton of CO2e can be commodified, countries in the developing world can establish programs that can monetize reducing carbon emissions while supporting other key development goals. Developed countries can invest in these programs and offset or mitigate their emissions.

The first of the plans outlined in Article 6 would enable nations that surpassed their emission goals to trade carbon credits with countries struggling to meet their reduction targets. The second made provisions for a carbon market where programs to reduce emissions could turn their efforts into credits that private, and public entities could purchase to offset their carbon footprint. Eco-friendly initiatives like wind farms, methane capture, or solar power plants could sell these carbon offsets to businesses or governments to help them reduce their emissions and hit targets.

The carbon market concept rests on the notion that without them, public and private sector entities wouldn't engage with these eco-friendly efforts on the same scale. Because purchasing carbon credits is significantly cheaper than revolutionizing operations in a business or tackling national emissions, the hope is that marketplaces can increase the number of green initiatives across the globe.

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Trial runs of similar schemes that fall under the compliance side of the carbon offsetting market have already been implemented in specific regions or for particular industries. For example, in the United States, California has instigated a cap and trade program to help meet state targets for greenhouse gas emissions. In July last year, China launched its scheme to reduce the carbon footprint of over 2000 power plants responsible for 40% of the national carbon dioxide emissions.

However, the most established carbon trading network is the European Union emissions trading system. The EU-ETS scheme was established in 2005 to mandate that factories, power plants, and airlines flying within Europe purchase carbon credits for their operations. Designed to incentivize organizations to reduce their emissions, the European Union plans to expand the ETS coverage by 2026 and install carbon taxes at borders.

But how are the prices of carbon credits determined?

How does carbon pricing work?

Carbon pricing in the voluntary carbon market

In the voluntary carbon market, each offset credit is equivalent to reducing one tonne of carbon dioxide. After developing an initiative, projects are certified to ensure certain standards are met and that external agents can verify monitoring and reporting.

Some renowned certifications that regulate the voluntary carbon market are the Gold Standard, the Verified Carbon Standard, and Climate Action Reserve. Other certifying boards incorporate other sustainable development goals into the accreditation for their offsets. VERRA acts as administrator for a variety of standards that integrate development goals, including;

The Climate, Community, and Biodiversity Standard (CCB)

The Sustainable Development Verified Impact Standard (SD VISTA)

The Gold Standard for the Global Goals (GS4GG)

SD VISTA and GS4GG both enable credits that have made valuable contributions towards the SDGs to be traded.

The lack of a centralized marketplace is where the voluntary carbon offsetting sector differs. Credits are sold by the projects themselves or, in the case of REDD+ programs, by governments typically in developing countries. Credits are marketed directly to buyers or through a middle man. Purchasing credits through a recognized certification scheme allows projects to be bundled by type so buyers can choose which type of activities they want to support.

When presenting options to purchasers, carbon credits are typically categorized by project type (e.g., carbon capture, forest protection, or renewable energy), certification board, or credit quality. We will get into the factors that affect this in more detail shortly, but elements that can influence value include the year it was created or the number of tokens available.

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Carbon pricing in the compliance carbon market

In the compliance context, carbon pricing essentially establishes the costs incurred by the effects of GHGs. These are costs paid by the public when faced with droughts, property damage from increased storms and flooding, and other phenomena caused by climate change. Unlike the voluntary market, carbon credits generated in the compliance market are 100% exchange-traded. Their prices are not influenced by the project's methodology or other factors we will explore.

Governments hope that carbon pricing in the compliance market can create some much-needed revenue for their sustainability programs. Budgets for environmental initiatives are notoriously tight so linking the reduction of carbon emissions to commercial enterprise has many advantages.

On the other hand, organizations can use the cost of carbon to evaluate their operations. Carbon pricing enables businesses to see how the increasing risks posed by climate change will affect their bottom line and can adjust their practices to lower their carbon footprint. Investors will also be able to see the effect of carbon emissions on their portfolio and switch to more eco-friendly and sustainable options.

In theory, this approach will move the financial burden of the effects of climate change away from the general public to the corporations responsible for large-scale carbon emissions. Policymakers hope that by instigating laws and taxes that compel companies to enter the carbon market, businesses will have extra incentive to analyze their practices and reduce emissions wherever possible.

What forms of carbon pricing are there?

By 2017 42 countries and 25 states or cities had instigated carbon trading schemes. As the need for global climate action increases, more are joining, and a wider range of carbon pricing initiatives are being drawn up to support existing laws and regulations.

Carbon taxes

Carbon taxes are seen most frequently in mandatory carbon-reducing efforts. These taxes set out the price companies need to pay per tonne for their total emissions.

Emissions trading scheme

As the name suggests, ETS allows participants to trade carbon credits to meet their emission allowances. These can either take the form of cap-and-trade systems where carbon limits are set like those used in California. There are also baseline-and-credit emissions trading systems where emitters are audited, and credits are distributed once their reduction targets are surpassed.

RBCF

RBCF allows for payments to be withheld until key aims for the carbon mitigation program are achieved. On top of reducing emissions, these targets are often linked to international development goals such as lessening inequality, delivering greater access to clean energy, and improving health care in developing countries.

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What factors influence the price of a carbon credit?

Several elements cause the cost of carbon credits to fluctuate. These include:

Methodology

Methodology refers to the type of project that delivers the carbon credit. From forestry to renewable energy, different initiatives hold different values due to the impacts they achieve.

In the past, concerns have been raised that reforestation projects have plunged local communities into crisis. Increasingly programs like eco-friendly cooking stoves or carbon capture that tackle more than one Sustainable Development Goal are considered more effective and less controversial.

Vintage

Like wine, the year that the carbon offset was issued can affect its price. However, unlike the finest vintages, the newer credits are more expensive with carbon trading. This trend will likely continue as schemes gain more clarity and stringent frameworks.

Project issuance volume

Like any product, the more limited the edition, the more it will be in demand. The fewer credits a scheme has to offer, the higher the value.

Verification Standard

Many different systems exist to accredit carbon offsetting schemes. Most renowned are VERRA, REDD, and the Gold Standard. The price of your carbon offsets will also depend on which of these your credits fall under. The stricter the scheme's criteria, the more expensive purchasing offsets will be.

Does carbon trading work?

As we alluded to earlier, the instigation of carbon markets was a hot topic at last year's COP26 discussions. Hypothetically establishing these systems could incentivize sustainable technologies and fast-track the arrival of a low-carbon economy.

However, not everyone is convinced. Accusations of inaccuracy have plagued the voluntary offsetting market, and there is controversy around whether new efforts should include established programs. Another point of contention is around additionality. If the carbon credits created are not driving down emissions, do they have real value? For example, if a forest is not under any real threat of deforestation, does supporting it have any merit in terms of reducing carbon footprint?

There are still many details to thrash out before the ideas outlined in Article 6 can become a widespread reality. For example, policymakers are yet to decide whether credits earned under an early pilot scheme should carry over into new initiatives or whether regulations were too weak for them to be valid going forward.

Participants also need to tackle the potential pitfall of double counting. If both the seller and receiver of carbon credits register these against their emissions targets, it could undermine the entire market. Many of these sticking points will take time to iron out due to their technical nature and the political nuances involved.

Customers are becoming increasingly savvy to businesses who are not walking the walk to establish a more eco-friendly future for their enterprise. If carbon markets are not backed by comprehensive reporting and transparency, they will do little to assuage fears that they enable countries and companies to greenwash problematic practices and avoid making real changes to reduce their carbon footprint.

Some organizations are leading the fore and shaping a more sustainable path. Thanks to their environmentally friendly focus, these companies are winning lifelong customers by re-evaluating production chains and ditching fossil fuels for green energy sources. After doing this tough work, carbon offsetting can help remediate those last unavoidable emissions, and clients can feel assured that businesses are putting the planet before profits.

Despite the possible problems, the Organization for Economic Cooperation and Development has backed carbon pricing as an effective tool for reducing global emissions. According to the OECD, for every $12 increase in the cost of a ton of carbon dioxide, emissions fall by 7%.

The main issue is that most carbon pricing is currently too low, and companies and governments are not incentivized to buy the higher-priced carbon credits. While prices are increasing, there is still a way to go till we can hit key climate goals and avoid the worst outcomes of global warming.