Carbon Markets: Part 2
Two steps forward or one step back?
“The most important, single, central fact about a free market is that no exchange takes place unless both Parties benefit” – Milton Friedman, Economist.
Carbon Markets. The term evokes either optimism or skepticism in most people familiar with it. My colleague, Aadil, in his blog, highlighted his (warranted) skepticism on the problems with carbon markets. There is no denying that carbon markets are an information-bare landscape with severe heterogeneity and a lack of standardization in the quality of credits traded. However, we must accept that carbon markets are essential in driving sustainable development while making investing in these circular economies attractive to investors.
Carbon markets started decades ago when corporates with high emissions in developed countries were mandated to reduce emissions through “caps” on annual emissions. They invested in modernizing technology-debt-ridden industries in developing countries to reduce emissions. These reductions were then “bought” by companies in developed countries to meet their emission “caps.”
The Beginning - “ChIndia” Development Mechanism
This process was formalized in 1997 under the United Nations Kyoto protocol as the Clean Development Mechanism (CDM). Since the CDM, compliance markets have come up regionally all over the world. The European Emission Trading Scheme (EU ETS) is the most popular, with similar trading schemes launched in other countries such as Korea, China, and the United States.
The emergence of global compliance markets led developing countries such as China and India to flood the CDM market with cheap CDM credits. India received 13% of the issuances of total Certified Emission Reductions (CERs) issued by the United Nations Framework Convention on Climate Change (UNFCCC) CDM Executive Board. At a conservative estimate of $10 per CER, the CDM projects corresponded to potential inflows of $2.51 billion into India in ~5 years.
The CDM failed because the demand for CDM Credits, known as Certified Emission Reductions (CERs), vaporized when the European Union prohibited their use for corporates based in the EU. One possible reason for the EUs ban is that due to low viability gaps for generating emission reductions in India and China, the CERs generated weren’t in line with EUs environmental integrity standards. Additionally, a major buyer, Japan, retreated from the CDM mechanism due to domestic issues.
However, the CDM helped companies globally realize the massive potential of carbon markets. In turn, this led to the proliferation of voluntary carbon markets (VCM), which we see today.
The Duality of Voluntary Carbon Markets
VCMs haven’t always been as demonized and criticized as they have been in 2021 and 2022.
After the UN climate conference in 2021, also known as COP 26, VCMs saw a massive boost in participation, helping jump-start global voluntary markets.
Before going deeper, what is a voluntary market?
Voluntary carbon markets allow carbon emitters to offset their unavoidable emissions by purchasing carbon credits generated by projects that remove or reduce GHG from the atmosphere. The quality of credits is verified by international third-party organizations, such as Verra or Gold Standard.
At COP 26, ambitious climate commitments were made not only by governments but also by corporations. Over a third of the 2,000 largest publicly traded companies announced Net Zero targets for 2050 or before. Over 4,000 companies globally also committed to science-based targets (realistic medium-term targets that do not allow offsetting for achieving emission reduction goals). As a result of these ambitious climate targets made by both governments and corporates, the carbon credits traded volume increased almost four-fold.
VCMs can be a force for good and help companies reduce their emissions, which in turn would help countries meet their Paris Agreement targets.
However, there continue to remain issues within the VCM. Some concerns are that verifiers are incentivized to approve projects because of commissions per project, leading to low-quality generating projects or projects with questionable sustainable impact getting approvals (the Verra exposé being one such incident). Whatever the situation’s reality, it is non-debatable that the structure of the VCM - with 170 types of carbon credits across eight areas with varied pricing based on social impact - is an unnecessarily complex structure that requires some level of standardization.
Nonetheless, we are seeing considerable activity and excitement in the private sector about the utility of carbon markets.
Everybody gets the credit.
According to Reuters, VCMs and regional trading markets such as the EU ETS contributed to a record $909 billion in CO2 emission allowances traded in 2022. Even though the state of capital markets globally led to a reduction in the quantum of credits traded, the value of the credits increased, driving the market value by close to 14%.
The price of one EU ETS carbon credit averaged over 80 euros a tonne, almost 50% higher than in 2021, as energy prices surged following the Ukraine war. Markets in North America and China also saw significant changes.
Carboncredits.com further underscored how increasing investment activity in renewable sectors increased the volume of voluntary carbon market transactions. Forestry and Land Use credits increased 4-fold in volumes, with the value of credits traded increasing from $315.4 million to $1327.5 million; transportation saw a 5-fold increase, with chemical process and industrial manufacturing credits increasing 9 -fold. Interestingly, energy efficiency and fuel switching decreased 66% in the volume of credits, probably due to the decreasing viability gaps in solar and the technology advancements in batteries and energy storage solutions. The 2022 numbers may trend downwards because of the global economic landscape; however, the price of the credits definitely increased, according to the Economic Times.
Companies and project proponents are buoyed by global policy-level coherence on sustainability and climate goals. The level of international adoption of climate goals and the adoption of Article 6 at COP 26 has generated much global optimism.
’A’ can trade credits. ‘B’ can’t trade credits.
Article 6 of the Paris Agreement aims to set up a robust compliance carbon market learning from the mistakes of the CDM. Carbon credits traded through Article 6 must be additional, permanent, authentic, and tracked transparently. They are, theoretically, solving all the issues people have with carbon markets.
Under the old compliance market of the CDM, developing countries had no climate targets. Under the Paris Agreement, though, everyone has climate goals. Otherwise known as Nationally Determined Contributions (NDCs).
India has ambitious targets for 2030, along with the Net Zero target by 2070. If all emission reductions in the country are traded outside, India will probably not be able to achieve its declared targets. If no credits can be sold internationally, innovative climate technology projects may move to other countries, reducing India’s capacity to generate emission reductions.
To tackle the issue of international credit trading, the government has to define criteria for credits to be authorized for international trade or authorized for use toward NDC. The newly launched Nationally Designated Authority for the Implementation of Article 6 of the Paris Agreement (NDAIAPA) will define this “green and red list” of sectors based on India’s progress and several factors such as viability gaps in projects, socio-economic impacts of projects, potential technological innovation, and more. The projects have to align with sustainable development criteria, and countries must report to the UN on projects authorized for international trade, highlighting alignment with sustainable development criteria and socio-economic impacts.
This “listing” of projects may sound unfair towards project proponents investing in low viability gap projects. However, policymakers will be wary of the low viability gap, cheaper credits being sold to countries, and high viability gap, expensive credits not finding any buyers. The argument is that developed countries should not be able to meet their NDC targets by buying cheap credits from developing countries. High viability gap technologies and projects should be incentivized through Article 6 mechanisms. We are yet to understand whether these projects with low viability gaps will move to VCMs or participate in the soon-to-be-launched National Carbon Market in India. We can be assured that policymakers and businesses are wary of the losses that project proponents faced after the fall of the CDM. The new market must build on those mistakes and create a robust ecosystem of domestic and international markets that enable a thriving ecosystem of high-quality carbon credits, prioritizing additionality and transparency.
The future of carbon credits looks promising. The negotiations on implementing Article 6 are still underway, and we can expect concrete rules, modalities, and structures to be in place by early 2024. The market governed by Article 6 promises to be focused on environmental integrity and absolute emission reductions. A UN Supervisory Body is set up working on standardizing methodologies to reduce the heterogeneity of carbon credits.
As investors, we are excited about the opportunities that follow carbon credits. Revenue from carbon trading is helping attract investments into technologies with significant viability gaps, getting innovation off the ground. Regenerative Agriculture exemplifies the power of carbon credits to drive meaningful change and positively impact the environment. The potential additional revenue from carbon trading influenced behavioral change in farmers to move towards regenerative agriculture in areas ranging from eastern India and the United States. A carbon trading-based sustainable food system model drives benefits toward water security, biodiversity, and farmer incomes. It is only the beginning, hopefully.