In recent years, there has been an increased number of discussions about carbon finance as climate action. However, a sense of mystery regarding the concept remains. Many people struggle to understand what the carbon markets really are. This in turn hinders its growth.
In this post, we aim to demystify what the carbon markets are by giving an overview of the following:
- Carbon markets
- What are compliance carbon markets?
- What is the voluntary carbon market?
- How does the voluntary carbon market work?
The carbon market is comparable to the stock market. You purchase stocks, or in this case, carbon credits. The prices fluctuate according to supply and demand. This means you can sell these credits when the market is surging for a profit.
But why does it exist? Put simply, the 1997 Kyoto Protocol created the blueprint for the carbon market. The idea was straightforward: companies that pollute must contribute to projects that help compensate for their emissions.
There are two types of carbon markets that have emerged, and these are targeted at different audiences.
What are compliance carbon markets?
Compliance carbon markets are heavily regulated by various geopolitical jurisdictions. The European Union’s Emissions Trading System, or EU ETS is the most widely known. Under this scheme, you can purchase and sell EU Allowances (EUAs). This mandatory system exists for entities that emit substantial amounts of greenhouse gases (25,000tCO2e and above), such as national power companies.
Beyond market fundamentals, prices are also affected by external factors, such as political tension. Significant price downturns were seen at the onset of the Russian invasion of Ukraine, although we are now seeing a return to pre-conflict rates. This is explained in greater detail in July’s edition of the Voluntary Carbon Market Outlook. Please email us at email@example.com to request a copy.
Brexit has led to the creation of an emission trading system exclusive to the UK, where UK Allowances (UKAs) are traded under the UK ETS. Drivers of UKAs prices are largely a reflection of the European system.
Under both trading schemes, there are two markets for allowances: the primary and secondary markets. The primary market is the auction system, which is mostly used by utilities companies with sizeable and regular demand for allowance. Meanwhile the secondary market is an over-the-counter system in which any individual or company, can trade their allowances.
The other type of carbon market is the voluntary carbon market.
What is the voluntary carbon market?
In contrast to mandated participation in compliance carbon markets, the voluntary carbon market (VCM) is for anyone who wants to offset their carbon footprint through the purchase of credits produced by a variety of environmental projects. One credit is equivalent to 1 tonne of carbon dioxide which has avoided being emitted or has been sequestered and stored. Careful selection of credits is important, as this market is not regulated. As a result, there is more variation in the price and quality of credits in contrast to the allowances in ETS.
It is possible – and not uncommon – for entities to be active in compliance markets as well as offsetting additional emissions of their own will, in order to achieve operational carbon neutrality for certain periods of activity. As the public sense of urgency toward climate action intensifies, there are major reputational benefits to going “above and beyond” in this way.
How does the VCM work?
Smaller emitters can purchase credits from brokers, retailer and directly from project developers to compensate for their emissions. These need to be verified by organisations such as the United Nations Clean Development Mechanism (UNCDM), Gold Standard and Verra, which produce methodological frameworks guiding acceptable offsetting practices. The prices of these credits are different for each type of projects, and prices are regulated by the developers, often in line with supply and demand.
In a following post, we will do a deeper dive into the diverse types of credits, accreditors, and project types that exist within the VCM, as well showing you how Plannet Zero can help you to confidently engage in the carbon markets.