Our Take: The Imperative of Expanding Regulated Carbon Markets

Introduction

Well-intentioned groups and individuals around the world are grasping at straws in the search for effective solutions to mitigate and adapt to the ever-intensifying impacts of climate change. For those on the front lines, the urgency is palpable. It grows more acute with every new daunting scientific report and each piece of breaking news about the latest climate disaster felt by communities around the world. No one-size-fits-all climate change solution exists, but we do have established solutions that can help.

The thesis of this essay is straightforward – we must continue to put a price on carbon.

One of the most effective and proven methods to achieve this is through regulated carbon markets. We must not only push for the expansion of existing regulated carbon markets but also advocate for the establishment of new ones in countries around the world, while leveraging the gains from the voluntary carbon market.

Just last week, we wrote about a significant milestone in Egypt – the launch of the first voluntary carbon market in Africa. While voluntary, this market’s creation was far from an isolated initiative; it was heavily supported by various arms of the Egyptian government and the Egyptian stock market. This intertwining of regulation with voluntary efforts is a promising first step for Egypt and the entire continent. As admirable as this new market is, it is not the final step. On the contrary, it’s just the beginning. We need to go further.

Current State of Compliance Mechanisms in Carbon Pricing

Regulated carbon markets are widely distributed across the globe, implemented at national, sub-national, and regional levels, and cover approximately 23% of global greenhouse gas (GHG) emissions. This significant coverage emphasizes their role in global climate strategies because it influences a substantial portion of worldwide emissions.

As of 2024, the landscape of carbon pricing has expanded significantly, with 73 carbon pricing initiatives either implemented or scheduled for implementation worldwide. This growing number reflects a recognition of the importance of carbon pricing as a tool to mitigate climate change by incentivizing reductions in GHG emissions. As climate disasters escalate, so must our efforts to price carbon effectively.

Carbon pricing initiatives are typically divided into two main types: Emissions Trading Systems (ETS) and carbon taxes. There are currently 34 ETS initiatives in place across the globe, alongside 39 carbon tax initiatives. ETS mechanisms cap the total level of GHG emissions in certain economic sectors and allow industries with low emissions to sell their extra allowances. This creates a market that directly incentivizes companies to cut down their emissions. On the other hand, carbon taxes set a direct price on carbon which makes it more costly to pollute and encourages a shift toward cleaner alternatives.

Several key nations stand out in the global carbon pricing landscape. The European Union operates the largest multi-national ETS, setting a benchmark for other regions. China has implemented the world’s largest national ETS, covering more than 2,000 power plants and serving as a pivotal tool given China’s status as the world’s largest emitter of GHGs. Meanwhile, countries like Mexico and Japan use a hybrid approach by implementing both ETS and carbon tax systems which offers comprehensive coverage and flexibility in addressing emissions across different sectors.

The price of carbon varies significantly across these different systems. This reflects the diverse economic contexts and policy objectives of the implementing regions. This wide range also highlights the challenges in creating a uniform global carbon price and the need for ongoing efforts to harmonize pricing mechanisms to avoid market distortions. The sectoral coverage of carbon pricing initiatives is broad, with the energy and industrial sectors being the most commonly regulated. These sectors are major sources of GHG emissions, and they must be included in carbon pricing mechanisms in order to achieve significant emission reductions.

Regulated carbon markets are not just theoretical constructs; they represent genuine efforts to reduce GHGs, and more importantly, they are working. By creating financial incentives to reduce emissions, they are integral to driving the transition to a low-carbon economy.

The Success of Established Regulated Carbon Markets

The European Union Emissions Trading System (EU ETS) is a pillar of success in the world of carbon markets. Developed in 2005, the EU ETS is the largest and most established carbon market globally, covering around 40% of the EU’s total carbon dioxide and other GHG emissions. The system has proven remarkably effective. As of 2023, it has achieved a 47% reduction in emissions from covered sectors between 2005 and 2020, compared to 2005 levels.

However, the impact of the EU ETS extends beyond just emissions reductions. The system has also generated substantial revenue through the auctioning of emissions allowances. Since 2013, the EU ETS has brought in €175 billion, which has been strategically reinvested in climate and energy projects across the EU. In 2022 alone, the ETS system amounted to €38.8 billion, of which €29.7 billion went directly to EU Member States. These funds have fueled a wide range of initiatives, from enhancing energy efficiency in buildings to promoting the adoption of electric vehicles, amplifying the market’s overall impact.

On the other side of the Atlantic, California’s Cap-and-Trade Program has also made significant strides in reducing emissions. Launched in 2012, the program covers about 85% of the state’s GHG emissions, making it one of the most comprehensive carbon markets in the world. California’s market has been instrumental in helping the state meet its ambitious climate goals, enabling it to reduce emissions to 1990 levels four years ahead of schedule.

In addition to driving down emissions, California’s Cap-and-Trade (C&T) Program has also been a vital source of funding for clean energy and climate resilience projects. Revenues generated by California’s program are deposited into the state’s Greenhouse Gas Reduction Fund and allocated to state agencies for the implementation of programs aimed at further reducing GHG emissions and helping communities adapt to the changing climate. By law, 35% of these revenues must be directed to environmentally disadvantaged and low-income communities. This dual focus on mitigation and adaptation is an example of the broader value of regulated carbon markets in fostering a better future. Since its inception, the program has generated a total of over $5 billion in revenue.

Climate Finance Generated by Regulated Carbon Markets

The effectiveness of regulated carbon markets in reducing emissions within covered sectors cannot be overstated. These markets create a clear economic incentive for companies to reduce their carbon footprint, driving innovation and the adoption of cleaner technologies. The EU ETS and California Cap-and-Trade Program are prime examples of how well-designed carbon markets can lead to significant emissions reductions while also supporting economic growth.

The success of regulated carbon markets is reflected in tangible projects that have made a real difference on the ground. Examples of EU ETS-funded projects include:

PREPAC Programme (Italy): this program aims to renovate at least 3% of the heated and/or cooled total floor area of Italy’s central public administration buildings to make them more energy efficient. This initiative not only reduces emissions but also lowers energy costs for the government.
CO2 Building Retrofitting Programme (Germany): this program focuses on improving energy efficiency in buildings, a major source of GHG emissions. The program has led to significant reductions in energy consumption and carbon emissions.
The ANRAV-CCUS Project (Bulgaria): this is a large-scale carbon capture utilization and storage (CCUS) project in Bulgaria and the first of its kind in Eastern Europe.

California is effectively redistributing funds as well. The proceeds have been strategically invested in clean energy projects and climate resilience efforts. These initiatives have helped to reduce emissions while also preparing California’s communities for the impacts of climate change.

The cumulative outcomes from the program’s revenues are impressive, with over 57% of the funding, amounting to more than $3 billion, benefiting priority populations. These funds have supported the implementation of more than 428,000 individual projects, including the construction of over 4,700 affordable housing units and the planting of 108,000 urban trees. The program has also funded over 600 transit agency projects, leading to the addition or expansion of transit services, and has contributed to the preservation or restoration of more than 690,000 acres of land. More than 150,000 projects have installed energy efficiency measures in homes, and 287,000 rebates have been issued for zero-emission and plug-in hybrid vehicles.

These projects illustrate the broader benefits of regulated carbon markets and show how they can drive innovation and broaden eco-equality.

Global Expansion of Regulated Carbon Markets

Currently, 24% of global GHG emissions are covered by compliance mechanisms, with 19% coming from ETS and 6% from carbon taxes. Expanding regulated carbon markets globally has the potential to cover even more GHG emissions, with the ultimate goal being 100% of total emissions. This expansion would drive significant emission reductions and help us meet the goals of the Paris Agreement to limit global warming to well below 2°C.

Emissions aside, the expansion of carbon markets also has positive economic implications. It could create countless jobs in the clean energy and climate mitigation sectors thus driving economic growth while reducing emissions. The potential for carbon border adjustments, such as the EU’s Carbon Border Adjustment Mechanism, could protect industries from carbon leakage and ensure fair competition in international trade.

The increased revenue generated by expanded carbon markets would provide governments with additional resources to invest in climate adaptation and mitigation projects. This is particularly important for developing countries, which often lack the financial resources needed to implement effective climate policies. By expanding carbon markets, we can ensure that more funds are available to support global climate action.

In addition to the current markets, a growing number of countries are in various stages of developing or considering carbon pricing initiatives. Emerging markets such as Indonesia, Vietnam, Thailand, Turkey, Colombia, and Chile are exploring ETS or carbon taxes as part of their national climate strategies, which is crucial for expanding the global coverage of carbon pricing and ensuring broader participation in global climate efforts. These emerging markets represent a step toward broader global coverage and the realization of a more consistent and impactful carbon pricing system.

Developing efficient carbon markets is not a light-handed effort. Collaboration and information sharing are essential to expanding markets to new countries and helping interested nations more effectively navigate the myriad of challenges. International organizations play a critical role in supporting the development of these new carbon markets.

The World Bank’s Carbon Pricing Dashboard provides valuable data and insights which can be a foundational step in assisting countries design and implement effective carbon pricing mechanisms.

The Global Green Growth Institute (GGGI) and the Partnership for Market Readiness (PMR) offer technical assistance and capacity-building support to countries looking to establish carbon markets.

The International Carbon Action Partnership (ICAP) and the International Emissions Trading Association (IETA) also facilitate knowledge sharing and collaboration among countries with existing or developing carbon markets.

These organizations are instrumental in ensuring that new carbon markets are well-designed, effectively regulated, and integrated into the broader global system.

Voluntary Carbon Markets

Voluntary carbon markets (VCMs) have gained traction as a parallel mechanism to regulated markets, allowing companies to offset their emissions by purchasing carbon credits. However, VCMs have continually faced limitations, including a lack of standardization and quality control. This has led to concerns about the environmental integrity of the credits being traded, with some projects failing to deliver the promised emissions reductions. Significant efforts are currently underway to elevate VCMs, address these challenges, and restore market confidence.

Despite these challenges, there is increasing integration between voluntary and regulated carbon markets. For example, under the current version of California’s Cap-and-Trade Program, regulated entities are allowed to fulfill up to 4 percent of their compliance obligations through offsets from emissions-reduction projects. These projects are restricted to the United States and are limited to five specific areas: forestry, urban forestry, dairy digesters, destruction of ozone-depleting substances, and mine methane capture. To ensure their credibility, offsets must be independently verified. This intermingling demonstrates the potential for VCMs to complement regulated systems, particularly in regions or sectors not yet covered by compliance markets.

To maximize the effectiveness of carbon markets, there needs to be a clear roadmap for transitioning from voluntary to regulated systems. A phased approach to regulation, with the gradual inclusion of VCM credits in compliance markets, could facilitate this transition. Harmonizing standards and methodologies between voluntary and regulated markets will also be key to ensuring a smooth and effective integration.

The Paris Agreement and Article 6

The Paris Agreement, adopted in 2015, aims to limit global temperature rise to well below 2°C. Articles 6.2 and 6.4 of the agreement provide key frameworks for international cooperation through carbon markets, essential for achieving these climate goals.

Article 6.2 allows countries to cooperate bilaterally or multilaterally to meet their Nationally Determined Contributions (NDCs) by exchanging emission reduction credits known as Internationally Transferred Mitigation Outcomes (ITMOs). This provision offers a flexible approach, enabling countries to set up their own agreements and systems for trading emissions reductions. While not a regulated market itself, Article 6.2 creates a framework that could link and enhance existing regulated market mechanisms.

Article 6.4 establishes a more structured international carbon market under the supervision of a designated body appointed by the United Nations (UN). It facilitates the trading of emission credits (A6.4ERs) generated from validated public or private projects. This mechanism is akin to regulated carbon markets, providing standardized oversight and ensuring transparency in global emissions trading.

Both Article 6.2 and Article 6.4 frameworks could potentially integrate with and enhance regulated carbon markets. Article 6.2 allows for the linking of national or regional markets through bilateral agreements, while Article 6.4 offers a centralized mechanism with standardized procedures. These frameworks support international cooperation in emissions reduction, expanding the reach and impact of existing carbon markets. As implementation rules are finalized, these mechanisms will have a hand in shaping the future of global carbon trading.

Challenges and Opportunities in Expanding Regulated Markets

Carbon markets, while powerful tools for reducing GHG emissions are not born perfect and require continual improvements and modifications to remain effective. As these markets evolve, they often face challenges such as carbon leakage, price volatility, and ensuring the environmental integrity of credits. These issues necessitate ongoing adjustments in market design, regulatory oversight, and the introduction of new mechanisms to address emerging gaps and inefficiencies.

The success of carbon markets depends on their ability to adapt to changing economic conditions, technological advancements, and the increasing urgency of climate action. This makes it essential for policymakers, businesses, and stakeholders to remain engaged in refining these systems.

One of the primary challenges in expanding regulated carbon markets is the risk of carbon leakage, where companies relocate production to regions with less stringent emissions regulations. This not only undermines the effectiveness of carbon markets but also creates competitiveness concerns for industries in regions with stricter regulations. Addressing these issues requires coordinated international efforts and the development of mechanisms to prevent carbon leakage.

Despite the challenges, opportunities simultaneously exist. Expanding regulated carbon markets presents an opportunity to link existing markets across borders, such as the linkage between California’s Cap-and-Trade Program and the Canadian province of Québec. This linkage in 2014 created the largest carbon trading market in North America, allowing for the exchange of greenhouse gas (GHG) emission allowances between the two jurisdictions.

Article 6 of the Paris Agreement provides a framework for such market cooperation, allowing countries to trade emissions reductions internationally. Linking markets could enhance their efficiency, reduce the risk of carbon leakage, and create a more cohesive global carbon pricing system.

Another critical opportunity lies in expanding carbon markets to cover hard-to-abate sectors such as aviation and shipping. These sectors are among the largest sources of GHG emissions, yet they have been challenging to decarbonize. Expanding carbon markets to include these sectors would provide the necessary financial incentives for innovation and emission reductions.

Conclusion

The necessity of expanding regulated carbon markets globally is a given. Despite their imperfections, these markets have proven their effectiveness in reducing emissions, driving innovation, generating capital, balancing equality, and supporting sustainable development. As we look to the future, we must continue to push for the expansion of existing markets, the establishment of new ones, and the integration of voluntary markets into regulated systems. Policymakers, businesses, and international organizations must work together to create a global carbon pricing system that covers all regions and sectors. Only then will we have armed ourselves with a powerful tool to drive the world toward a sustainable, low-carbon future.