The core idea of the mandatory carbon trading market is to set a financial incentive for companies to reduce carbon emissions. They do this by capping the amount of carbon that can be emitted and allowing the trading of emissions allowances between the market players. It is a system controlled by the EU that only applies to the largest emitters of greenhouse gas emissions. Contrary, the voluntary carbon market is not regulated. Firms ESG-Strategies drive the demand in the voluntary market. Companies rely on NGOs and project developers to offer high quality offsets. However, there are still greenwashing allegations, which is why greater transparency in the market is very important.
In our last blog post, we talked about why we need carbon offsetting to reach net zero. In this article we will take a look at the two different markets that exist to buy carbon offsets.
Mandatory carbon market — EU emissions trading system
The EU ETS [Emissions Trading System] is the cornerstone of the EU’s policy to combat climate change” - Source
What is the ETS and how does it work? The EU has pledged to reduce greenhouse gas emissions by at least 55% by the year 2030 and to be completely climate-neutral by 2050. The Emissions Trading System is used for the EU, Iceland, Liechtenstein and Norway. It was set up in 2005. The four phase program creates financial incentives for the biggest emitters of greenhouse gasses to reduce their emissions. The ETS sets a fixed cap on these industries:
electricity and heat generation
energy-intensive industry sectors including oil refineries, steel works, and production of iron, aluminum, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals
commercial aviation within the European Economic Area
The ETS was designed in four phases. While the first phase was a learning phase, the second one slowly introduced the auctioning of allowances. The goal of phase three was the European harmonization and implementation of an annual linear reduction of the cap, this cap was slightly increased in phase four. Phase three also added the aviation sector to the system.
Development of Allowances
In the first phase the cap stayed the same compared to the baseline year. Between phase one and phase two the cap was reduced by 6.5%. Since phase three, there has been a yearly linear decrease of either 1.74% or 2.2% in phase four.
1 - Over allocation
The first two phases had no annual cap decrease. Because of this, there was an over allocation of allowances over time. This led to 970 million more allowances than were needed. Those allowances were moved to the next phases. Additionally, greenhouse gas emissions can decrease due to external influences. For example in 2020 many allowances were accumulated due to COVID slowing the economy. As with all markets, a high supply will lead to falling prices. And low allowance prices make it easy for larger emitters to just "buy their way out", instead of actually working on reducing emissions.
2 - Many Allowances are free
In Phase 1 almost all allowances were given to businesses for free. In Phase 2 90% of the allowances were free. Furthermore, some industries get exemptions. For instance, the aviation industry currently (during phase 4) gets 82% of the allowances for free. This breaks down into 3% reserve and only 15% are auctioned (3% are set aside for the special reserve of new entrants into the market). In other words: The system only incentivizes the reduction of emissions that exceed the cap.
3 - Trading slows innovation
Each tonne of CO2 brings the participating countries closer to reaching their climate goals. However, this is not perfect, because the emissions can be sold to other companies. After the purchase, those companies have no incentive to actually reduce their emissions. Sectors that use processes that are cheaper to decarbonize reduce their emissions faster than predetermined by the EU and sell the surpluses to companies/sectors that require more expensive decarbonization strategies. But is this really bad? Isn’t just compliance with the quota the only metric for environmental goals?
Sectors that are easy and cheap to decarbonize are more likely to reduce emissions without external financial incentives. Take energy production for example. In the long term, renewable energy is way cheaper than energy from fossil fuels, energy companies are intrinsically motivated to reduce their emissions for simple economic reasons.
Sectors that are expensive to decarbonize rely on significant technical advances to reduce emissions and still remain economically competitive. Giving them an “easy way out” leads to less money invested in necessary technology, therefore technological advances are slowed.
The above explained logic works well as long as there is low-cost savings potential in some sectors. However, as soon as these have been exploited, the more expensive savings potentials must also be used. The artificially slowed innovation in the sector, will make the transition all the more difficult.
Instead of allowing the sale of excess CO2 to other companies, companies with unused emission allowances could sell them to the EU. Proponents believe that this would incentivise more CO2 reduction. It has the potential to exceed climate goals.
The EU saw a similar problem when the emissions went down more than expected due to the COVID crisis. The carbon price went down and companies had a weaker incentive to reduce emissions.
Voluntary carbon market
The voluntary carbon market is, as the name suggests, not legally mandatory. It is used by companies that don't fall under the EU's definition of "energy-intensive industries".
Voluntary carbon markets allow carbon emitters to offset their unavoidable emissions by purchasing carbon credits emitted by projects targeted at removing or reducing GHG from the atmosphere. Source
Since there is no legal obligation for those companies to offset emissions, there is also no one central marketplace or trading system. Instead, there is a fragmented market of projects producing CO2 certificates, verification companies, as well as various intermediaries such as brokers.
Project developers are the companies or individuals implement various carbon removal or avoidance projects to reduce the level of CO2 in the atmosphere. Project Types include reforestation, agriculture, sustainable energy, direct air capture, and many more. The price per tonne of CO2 varies largely between different project types and regions. However, the same project type in the same region can have different prices. The main reason is that some projects focus more on secondary impacts besides just CO2 removal. A common secondary benefit is economic support of local communities. The following describes what that could look like: if a piece of forest has been cut down to produce arable land for a farmer, then it is not enough to replant the forest. Instead, an alternative source of income needs to be created for the farmer so that they no longer have to rely on cultivation on this piece of land in the future.
Unlike the mandatory carbon market, there is no central entity "creating" allowances. Theoretically project developers can just issue their own CO2 credits and standards.This opens this market to some major problem: Overestimation and double accounting.
This is the point where verification firms, sometime also called standards, become important. They are often NGOs (like Verra or The Gold Standard), that check the projects for the following points:
Additionality: The project should not be legally required, common practice, or financially attractive in the absence of credit revenues.
No overestimation: CO2 emissions reduction should match the number of offset credits issued for the project and should take account for any unintended GHG emissions caused by the project.
Permanence: The impact of the GHG emission reduction should not be at risk of reversal and should result in a permanent drop in emissions.
Exclusive claim: Each metric ton of CO2 can only be claimed once and must include proof of the credit retirement upon project maturation. A credit becomes an offset at retirement.
Provide additional social and environmental benefits: Projects must comply with all legal requirements of its jurisdiction and should provide additional co-benefits in line with the UN's SDGs.
The standards often maintain a registry of the projects they have approved, this prevents double accounting.
Brokers and resellers
Some project developers sell their carbon credits directly to the end customer. However, this is very time consuming and often results in tediously small deal sizes. Many developers use brokers and resellers as intermediaries, these entities buy credits in large volumes and resell them to the end customers in smaller packages.
It is the trust in verifiers that many end customers of carbon certificates rely on, since there is no other monitoring entity. The biggest issue is, however, that the verification of a project through a standard can be very expensive. It is so expensive that it is not economical for smaller projects to get those verification. However, since many buyers of carbon credits require verification for fear of greenwashing accusations, many small projects are thus denied access to the market. So we need to drive down the cost of verifications to use the full potential of carbon removal projects we have.
One aspect of driving the cost down while also increasing transparency is a mostly digital verification process and a secure, public database tracking the credits. Blockchain can be a great tool for this as we discussed in a previous post.
For a detailed overview of the players in the Voluntary Carbon market, check out our Carbon Market Map.