What are Carbon Markets?
A carbon market is a specialized type of financial market, through which carbon credits can be bought and sold. Carbon credits are essentially permits that allow the purchaser to emit a certain amount of carbon dioxide or other greenhouse gases. Some carbon markets are run and regulated by governments or international bodies, with certain industries required to participate, while others are entirely voluntary.
KEY TAKEAWAYS
- Many nations and groups of nations now have carbon markets that attempt to reduce greenhouse gas emissions through the issuance of carbon credits that may be bought and sold.
- Those are known as compliance, or mandatory, markets.
- There are also voluntary markets, where businesses and individuals can purchase carbon credits or offsets if they wish to.
- Carbon trading has been criticized as less effective than promised, but both the compliance and voluntary markets continue to grow rapidly.
How Carbon Markets Work
Carbon markets are a key element of cap and trade programs intended to reduce greenhouse gas emissions. In a cap and trade program, also known as an emissions trading system (ETS), governments or groups of governments cap emissions at a certain overall level and assign limits to entities, such as countries or companies, covered under the rules. An entity that doesn’t need to use all of the carbon credits it has been issued can sell them to one that expects to exceed its limits.
In addition, entities can create carbon credits, or offsets, either by reducing or removing carbon dioxide, that they can then sell. Reduction refers to initiatives that serve to lower emissions, such as adding solar panels or building a wind farm, while removal refers to projects that remove and then store carbon dioxide, such as through reforestation or sophisticated carbon capture technology.
Each carbon credit is equal to one metric ton of carbon dioxide.
Not only do entities like countries and large industrial plants buy and sell carbon credits, but other businesses, organizations, and individuals can, as well. Their motivation might be to offset their carbon footprint, to live up to a corporate pledge to support the environment, or to speculate in carbon credits as they might in cotton or wheat futures. As the United Nations (U.N.) puts it, “Carbon is now tracked and traded like any other commodity.”
Types of Carbon Markets
There are two basic types of carbon markets: compliance and voluntary.
- Compliance markets are established by governments or multi-government bodies that control the supply of credits and regulate their trading.4
- Voluntary markets are those in which carbon credits may be traded voluntarily. “The current supply of voluntary carbon credits comes mostly from private entities that develop carbon projects, or governments that develop programs certified by carbon standards that generate emission reductions and/or removals,” the U.N. notes.
Note
The terms “carbon credit” and “carbon offset” have become virtually interchangeable, especially in reference to the carbon markets. However, some draw a distinction between the two, associating “credits” with mandatory cap and trade systems and “offsets” with the voluntary market.
Examples of Carbon Markets
There are some 30 compliance carbon markets around the world today and an untold number of voluntary ones. The compliance markets are far larger, accounting for $850 billion in value in 2021, compared with $1 billion to $2 billion for the voluntary markets, according to BloombergNEF.
The European Union’s EU Emissions Trading System (EU ETS), launched in 2005, is credited as the first carbon market and claims to be the world’s biggest. It covers all of the EU nations plus Iceland, Liechtenstein, and Norway and regulates emissions involving some 10,000 facilities in the energy and manufacturing sectors, as well as aircraft operators in the region. In 2024 it will be adding the maritime transportation industry to its purview.
The People’s Republic of China introduced its own ETS in 2021, which is said to the world’s largest in terms of covered emissions. As of recently, it only applied to some 2,000 companies in the power sector but was expected to expand to other sectors in the future.
The United States does not have a national cap and trade policy or a carbon market of its own, although California, the state of Washington, and a dozen Eastern states have implemented programs. California’s program, for example, gradually ratchets down the number of credits (which it calls “allowances”) that it is issuing, in order to incentivize companies to reduce their emissions.
The examples above are all compliance markets. The voluntary carbon market, while smaller, is much more fragmented. A couple of the major players are the exchanges Xpansiv CBL in the U.S. and ACX (formerly Air Carbon Exchange), based in Singapore.
The U.N. has also launched a voluntary United Nations Carbon Offset Platform, where organizations and individuals can “purchase units (carbon credits) to compensate greenhouse gas emissions or to simply support action on climate.”
Why Are Carbon Markets Important?
Greenhouse gas emissions are widely recognized as a major contributor to global warming and its harmful effects around the world.14 Carbon markets put a price on those emissions, rewarding nations and businesses that reduce their emissions over time and creating financial disincentives for those that emit more than their share. As the World Bank explains, “Carbon markets help mobilize resources and reduce costs to give companies and countries the space to smooth the low-carbon transition.”
Benefits and Challenges of Carbon Markets
While carbon markets and cap and trade programs have important potential benefits, they are also controversial. Critics on the right charge that mandatory programs interfere with business and cost jobs. Those on the left maintain that they aren’t going far enough or fast enough to address the urgent problem of global warming and climate change.
Voluntary credits, in particular, have drawn criticism. The progressive Center for American Progress, for example, noted in 2022 that “for a variety of reasons, many offsets simply do not achieve the results they claim.” It also highlighted their potential role in greenwashing: “These instruments may serve as a convenient way for businesses to claim that they are climate friendly while avoiding taking steps toward tangibly reducing their own carbon footprints.”
A 2023 report from the World Economic Forum faulted the current voluntary carbon market for a lack of transparency for investors. It also cited news reports suggesting that, “in some cases significant shares of end-user costs do not reach the projects and communities that so acutely need financial support.”17 A 2022 Wall Street Journal headline put the problem more bluntly: “Middlemen Snag Carbon-Credit Cash Aimed at Peruvian Amazon.”
The challenge facing the markets, the World Economic Forum said, is to “ensure that carbon credits are a trustworthy representation of real mitigation action. The action must also be additional—that is, it would not have happened without the income from carbon credits—and permanent, and it must not result in adverse effects within or outside of its boundary.”
Similarly, the consulting firm Deloitte notes that the markets face a serious challenge in the form of investor skepticism. “Carbon offsets offered by world leading carbon standard providers have been widely criticized for overrepresenting the amount of carbon reduction they are causing,” it wrote in a 2023 report. “This impacts consumer confidence and makes it increasingly difficult to distinguish between high and low quality VCCs [voluntary carbon credits].”
Responding to the criticisms, the U.S. Commodities Futures Trading Commission (CFTC) announced in 2023 that it was creating an Environmental Fraud Task Force to “focus on addressing fraud and manipulation in carbon credit markets and other forms of greenwashing, including material misrepresentations about ESG investment strategies.”
The Future of Carbon Markets
Despite the well-publicized problems, the investment firm Morgan Stanley says in a 2023 report that, “the voluntary carbon-offsets market is expected to grow from around $2 billion in 2022 to about $100 billion in 2030 and around $250 billion by 2050.”
The Boston Consulting Group is a little more cautious in its estimates, foreseeing a $10 billion to $40 billion market in 2030, but it also expects demand to grow at a rapid clip, based on a survey of business executives. One reason is that more companies are setting net-zero emissions targets and buying more offsets to attain them. Another is that promised improvements in monitoring, reporting, and verification practices will give buyers greater confidence their money is going where it is supposed to go.
Meanwhile, the compliance market, already much larger than the voluntary one, also continues to grow as more countries adopt cap and trade programs or expand the types of industries that the rules apply to.
Do Carbon Markets Really Work?
To some extent yes, but not as well as they might. A 2017 analysis of various cap and trade programs by professors at MIT and Harvard concluded that, “Overall, we have found that cap-and-trade systems, if well designed and appropriately implemented, can achieve their core objective of meeting targeted emissions reductions cost-effectively. But the devil is in the details, and design as well as the economic environment in which systems are implemented are very important.” By themselves, the authors added, these programs are “surely not sufficient” to address the problem of climate change.
Are Carbon Markets a Good Investment?
Individuals cannot buy many types of carbon credits directly, but there are a number of ways to invest in them. Some voluntary carbon credits are sold to investors through brokers that specialize in this market. There are also exchange traded funds (ETFs) that offer exposure to the carbon market, chiefly in the form of carbon credit futures contracts.25 These funds are small and relatively new, so it’s too early to tell how good an investment they’ll be.
Can You Make Money From Carbon Trading?
Maybe, but there are number of caveats to keep in mind. One is that voluntary carbon credits are largely unregulated and notoriously lacking in transparency. Another is that, like other commodities, they can be risky, and the average investor is likely to find themselves competing against more experienced professionals.
What Is a Carbon Tax vs. a Carbon Credit?
A carbon tax is another way that governments can attempt to control greenhouse gas emissions. Polluters must pay a tax based on the volume of their emissions, and, unlike carbon trading, there is no market on which they can buy credits to offset them.
The Bottom Line
Carbon markets are an attempt to reduce the worldwide emissions of greenhouse gases, using a financial market mechanism. While carbon credits have been widely criticized as less effective than originally hoped, they do appear to be doing some good, and efforts are underway to fix the problems associated with them.
