What are carbon markets?

Carbon markets have received a lot more

media, investor, and policymaker attention in recent years. You've probably seen headlines or news segments about carbon offsetting projects that came under fire, companies touting new 'net zero' initiatives, or new companies working in carbon markets.

So… what are carbon markets?

Carbon markets are systems or structures designed to limit greenhouse gas emissions by establishing a price for carbon. They are markets in which entities transact in products or certificates (we'll call them 'credits') that represent greenhouse gas emissions.

Specifically, credits traded in carbon markets usually represent the removal, reduction, or avoidance of greenhouse gas emissions. Carbon removal credits only represent ~5% of the current supply in voluntary carbon markets; reduction and avoidance credits command the lion's share of the market.

Interestingly, reduction and avoidance credits represent hypothetical, future emissions that haven't happened and that we can't see (let alone empirically quantify or measure). This poses challenges, especially in terms of transparency, oversight, and emissions accounting in carbon markets.

While they're called 'carbon' markets, credits traded in them don't exclusively deal in carbon. Other products representing the avoidance or prevention of other greenhouse gases also trade. Still, these are often standardized in terms of their carbon (CO2)-equivalent global warming potential.

Why do carbon markets exist?

Carbon markets' main goal is to reduce greenhouse gas emissions. While investments in clean energy and other technologies designed to mitigate climate change have increased in recent years, global emissions are still increasing in parallel.

Further, even if the world stopped emitting carbon, methane, and other greenhouse gases today, there are already significantly more planet-warming greenhouse gases in the atmosphere than there were historically. Removing CO2 from the atmosphere will be essential even after emissions reductions and avoidances aren’t necessary any longer (and we’re a long way from that point, mind you).

To drive emissions reductions and to promote carbon removal efforts, carbon markets create financial incentives that penalize emissions and incentivize emissions reductions or removals. They attempt to do so by creating products to which markets assign value. Carbon market participants can monetize emissions reduction efforts by selling credits, while entities that don't reduce their emissions may have to pay for excess emissions under specific carbon market structures.

What types of carbon markets are there?

There are two main types of carbon markets, voluntary and compliance markets.

In voluntary carbon markets, entities participate of their own volition, not because there's a rule they must comply with. They may participate for philanthropic reasons or to meet targets they've set for themselves. In recent years many firms have set 'net zero' targets, which often include target dates by which they aim to reduce their emissions. However, full decarbonization (elimination of all emissions) is only realistic for these companies in some cases; others for whom full decarbonization isn't feasible can 'net' out their emissions by paying for carbon credits.

Carbon markets offer products that represent emissions reductions, avoidances, and removals that can help achieve net zero targets by 'netting' out a company's residual emissions in its operation or supply chain.

In compliance markets, entities have a set emissions limit. If they emit less than their limit, they can sell their unused emissions allowances to other market participants who emit more than their limit. This creates a financial incentive for entities to reduce their emissions. Ideally, over time, financial incentives will help decarbonize the economy. This structure is called a cap-and-trade market.

There are also other types of carbon markets, like industry-specific markets. CORSIA, the Carbon Offsetting and Reduction Scheme for International Aviation, is one example. International states and countries voluntarily opt into CORSIA, making it more like a voluntary market with a governing body that provides guidance and oversight.

Of the two main types of markets, compliance markets have a long history and are much larger in terms of the volume of money traded than the voluntary carbon market.

A brief history of carbon markets

In 1989, Applied Energy Services began the first carbon offsetting project. The company sought to 'offset' the future emissions of a new coal-fired power plant it built by financing the development of an agriforest in Guatemala. While that first project wasn't ultimately successful, today, carbon markets are a $250B+ industry. The vast majority of that market is in compliance markets,

Compliance markets were the first carbon markets and exist because of international protocols and treaties. In 1997, the Kyoto Protocol first set annual limits on allowable greenhouse gases for countries and other major emitters (e.g., large corporations). When entities exceed their allowed annual limits, they buy carbon credits that are issued based on rules set by the governing bodies of the market. These credits are issued to market participants who are below their cap and thus have cap space to sell or to other projects that reduce, avoid, or remove emissions.

The European Union's Emissions Trading System (EU ETS) is the largest compliance market globally.

While smaller than the compliance market, the voluntary market has grown significantly in recent years and is a hotspot for investment and innovation. In 2021, the voluntary carbon market crossed the $1B threshold for the first time, a fivefold increase from 2016. Estimates for the future size of the voluntary carbon market range from $50B to $100B.

Does the carbon market work well?

Despite high growth in the past decade, there are many questions surrounding whether carbon markets 'work' well or not. Concerns range from how to verify and monitor whether projects faithfully perform (and maintain) the work their carbon products represent to what rules should govern trading, accounting, and transacting in different carbon markets in general.

In the past, while significant amounts of capital have cycled through carbon markets (especially compliance ones), meaningful emissions reductions have still been hard to come by globally. Correlating emissions reductions to carbon market activity has also been difficult.

At the same time, a new generation of startups is working hard to strengthen carbon markets with sound accounting, new tech solutions, better carbon management, and new market infrastructure to make carbon markets more transparent.

All this progress also presents challenges for regulatory bodies and institutions that have participated in carbon markets for a long time, as well as for outsiders looking in or plotting their first foray into carbon markets. There's a lot of change to keep up with; it's a rapidly evolving landscape, though concerns like double-counting that have been around for decades persist.

Nori is one of the next-generation carbon market companies working to ensure markets fulfill their original purpose, namely reducing greenhouse gases. Learn more about how we approach it here.