Our Take: Carbon Market Insights – Trials, Targets, & Trajectory

Written by Sean Penrith, CEO

Carbon offsetting involves individuals, companies, or organizations investing in projects aimed at reducing or capturing an equivalent amount of greenhouse gas (GHG) emissions to offset their residual and hard-to-abate emissions. This practice is undertaken to compensate for their carbon footprint, ultimately contributing to the mitigation of the overall environmental impact. Carbon credits, each representing 1 tonne of CO2 equivalent GHG emissions, symbolize these offsets and are traded within both voluntary and compliance markets.

Antonio Guterres, UN Secretary General pointed to the vital role of carbon markets at the launch of the IPCC Sixth Assessment report in March of 2023. He referred to carbon markets as the ‘net in net zero,’ adding, “Our world needs climate action on all fronts: everything, everywhere, all at once.”

Under the Paris Climate Agreement, Article 6 allows countries to engage cooperatively to achieve their Nationally Determined Contributions (NDCs) either directly or through the use of carbon markets. Article 6 aims to empower parties to achieve more than they could individually through the implementation of their NDCs, fostering greater ambition and efficiency in resource allocation among cooperating parties. Article 6 created two primary pathways for cooperation embodied in Articles 6.2 and 6.4.

Article 6.2 allows Paris Agreement signatories to set up bilateral agreements for trading of emissions reductions or removals, referred to as Internationally Transferred Mitigation Outcomes (ITMOs).

Article 6.4 creates a generic carbon market, similar to the Clean Development Mechanism (CDM) under the Kyoto Protocol, in which projects can be registered to create ITMOs under the supervision of the United Nations Framework Convention on Climate Change (UNFCCC).

COP28 held in December 2023 saw minimal progress regarding Article 6.4, with no consensus reached on essential measures for its implementation. Challenges related to integrity and the role of removals significantly impeded advancements. Ongoing development and negotiations are anticipated throughout 2024 in preparation for COP29 in November.

As for Article 6.2, most engagement rules are established, and countries are actively forming bilateral agreements. During COP28, the European Union advocated for heightened oversight of credits within these agreements, yet agreement was not achieved. Notably, the first-ever transaction of ITMOs was authorized between Thailand and Switzerland following COP28.

Research from the International Emissions Trading Association (IETA) and the University of Maryland found that international cooperation through carbon market mechanisms has the potential to reduce the costs of meeting signatories of the Paris Agreement’s NDCs by $250 billion per year in 2030. These savings can be reallocated towards other higher-ambition climate initiatives. Countries have noted this benefit, which is why “83% of NDCs state the intent to use international market mechanisms to reduce greenhouse gas emissions.” In short, carbon markets effectively reduce mitigation costs and increase climate ambition.

In 1730, Richard Cantillon, an Irish-French economist, expounded his treatise on economics that included his cause-and-effect methodology. These NDC cost savings follow this classic economic principle; whenever the marginal cost of producing an outcome differs across signatory countries, opportunities exist for cooperation to achieve the same outcome with net gains for all parties. Countries for which emissions reduction opportunities are greater than those required to meet their NDCs offer the opportunity to transform them into internationally transferred mitigation outcomes (ITMOs). These can be sold to countries for which emissions reduction opportunities are more difficult or expensive for meeting their NDC.

While carbon markets play their part in our response to global warming, it is important to note that carbon credits from the voluntary carbon market (VCM) constitute a minority of corporate GHG emissions. In 2021, the average purchaser in the carbon market acquired credits equivalent to less than 2% of their overall emissions for offsetting. 

The Role of Carbon Credits

Carbon credits are one of the tools for use in the shift toward a zero-carbon economy. A study by Sylvera reflected that companies utilizing carbon credits are more inclined to have initiated internal decarbonization efforts compared to their counterparts that have not engaged in the carbon credit market. Trove Research emphasized the cost-effectiveness of carbon credits to achieve some degree of cost containment in the transition to net-zero emissions in contrast to certain internal abatement options. Trove concluded that by enabling firms to cover 50 percent of their emissions shortfall with carbon credits it could serve as a compelling incentive. It could potentially prompt an additional 1,000 companies to engage Science Based Targets – an almost 20 percent increase from the current number of organizations with such commitments.

The Ecosystem Marketplace (EM) 2023 report backed up the conclusions reached by Sylvera. EM found that those engaged in the VCM are almost twice as likely to be on the path to net zero, dispelling the myth that companies are simply using credits as an avenue to ‘buy their way out.’ EM’s research discovered that 59% of buyers in the VCM disclosed a decrease in gross emissions on an annual basis due to reduced emissions and/or increased utilization of renewable energy. In contrast, this reduction was reported by only 33% of businesses that were not engaged in carbon markets. EM research also showed that carbon credit buyers were ~3 times more likely to have an approved Science Based Target in place and ~4 times more likely to have implemented a shadow price or an internal carbon price.

Carbon removal credits do contribute to a corporation’s net-zero commitments. The Science Based Targets Initiative (SBTi) currently allows the offsetting of 10 percent of hard-to-abate emissions. However, ongoing discussions revolve around whether SBTi signatories should be permitted to offset a higher proportion of their Scope 3 emissions and still claim net-zero emissions. Notably, the Voluntary Carbon Markets Integrity Initiative (VCMI) has recently issued new guidance for corporate carbon credit claims, permitting companies to offset up to 50 percent of their Scope 3 emissions. While the specifics may evolve, carbon credits will certainly remain integral to our net-zero strategy.

High-quality carbon credits come from projects characterized by transparency, providing open access to non-confidential information, ensuring public availability of detailed project data, and maintaining clear transparency in project requirements and decision-making processes. Such projects not only contribute to the reduction of greenhouse gas (GHG) emissions but also generate substantial social and economic co-benefits, including job creation, community income, and infrastructure development. Aligned with UN Sustainable Development Goals, these projects serve to go beyond environmental impact, incorporating safeguards to prevent negative social and development impacts.

Nature-Based Carbon Credits

In the evaluation of nature-based carbon credits, well-executed projects offer a host of social and environmental benefits while concurrently addressing climate-related issues. These encompass the protection of ecosystems, the enhancement of biodiversity, the provision of clean air and water, the restoration of degraded lands, the promotion of long-term food security, and the sustenance of community livelihoods. These collective efforts work in tandem to nurture climate resilience and adaptation.

The spate of negative sentiment on the VCM has prompted some corporate entities to reevaluate the carbon market’s role within their broader initiatives aimed at facilitating the transition to a net-zero emissions-based economy. The urgency of the situation is underscored by the stark reality that we have limited time to combat escalating global warming. Projections indicate a probable rise in average global temperatures exceeding 1.5 degrees Celsius in the forthcoming years.

Acknowledging the need for transformative action, key stakeholders worldwide are exhibiting a collective understanding that change is needed and indeed, achievable. This is evident in the global shift towards clean and renewable energy, buoyed by substantial investments and policy support. The current focus centers on exploring how nature-based climate solutions can make analogous contributions to this ongoing transformation.

It is imperative to recognize that even if the energy and industrial sectors successfully cut their emissions to align with climate targets, mitigating the worst-case scenario demands that we address the destruction and degradation of natural ecosystems. These ecosystems, encompassing forests, peatlands, grasslands, and other carbon-absorbing environments, play a crucial role in removing GHGs from the atmosphere.

On that note, the 2022 Exponential Roadmap for Natural Climate Solutions spelled out the imperative for maximizing nature’s role in tackling global warming. Specifically, it found that to avoid catastrophic climate change, the land sector — including agriculture and forestry — must reach net zero emissions by 2030.

The world is failing to stop tropical deforestation and to protect, sustainably manage, and restore forests, grasslands, and wetlands. Corporate carbon finance creates one of the most significant opportunities to value these ecosystems and the critical services they provide for biodiversity, traditional livelihoods, and regulating the climate.

The Way Forward

Despite the concerted negative media campaign against the VCM, it remains resilient. AlliedOffsets published a report in 2023 titled, “Navigating the Future of Carbon Markets through Supply, Demand, and Price Forecasting.” It records the continual entry of new buyers accessing the VCM. Last year saw 1,200 new buyers enter the VCM arena, which marks the second year in a row that more than 1,000 new corporate buyers have engaged with the market. This movement underscores the sustained interest in channeling climate finance into emissions avoidance and carbon removal activities. This momentum is projected to drive demand from buyers up to 1.5 billion tonnes of carbon credits by 2030, offering projects an opportunity to command higher credit prices.

AlliedOffsets also reported that one-third of those buyers analyzed had already set Science Based Targets confirming that buyers in the VCM saw the role of carbon credits as part of their holistic and integrated corporate climate strategy.

Conclusion

The United Nations has given its endorsement to carbon markets as an important component in reaching global climate targets, recognizing them as an effective toolset for achieving sustainable outcomes. The performance of the credit market in 2023, despite facing numerous challenges, serves as a testament to its indispensable role in climate action. This market resilience sends a clear message of global determination to harness carbon markets effectively in the pursuit of climate goals.

Projections indicate that VCMs are set to scale by at least 100x over the next decade. As carbon credit integrity and use case of credits are addressed by ICVCM (Integrity Council for the Voluntary Carbon Market and its Core Carbon Principles – CCPs) and VCMI respectively, carbon prices will rise dramatically as ambitious emissions reduction commitments are met, and disparate markets converge. VCMI and ICVCM are collaborating closely to map a cohesive, high-integrity pathway for the VCM based on transparency and accountability.

We will continue to see the entry of some of the world’s largest asset managers, corporations, family offices, and High Net Worth Individuals. Early adoption for those on net-zero journeys is the key to success. Entities that adopt a ‘wait and see’ approach will face significantly increased future carbon prices, higher risk, and lower returns.

This is the time to steadfastly adhere to the opportunities presented by high-integrity carbon credits, particularly within the realm of nature-based solutions. Carbon markets underscore the business imperative of climate action.