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Carbon Markets

What Are Carbon Markets and How Do They Work?

To meet reduction targets, regulators set maximum allowed emissions. Firms and other emitting entities receive permission (credits) to emit such that the total emissions do not exceed the maximum. Some firms may emit just the allocated amount, while others may emit less or wish to emit more. A carbon market is a way to allocate emission credits to those that value them most. Formally, carbon credits represent a right to emit one ton of carbon dioxide, or equivalent (CO2eq) greenhouse gas. These credits, or “allowances,” can be allocated without cost or auctioned by the government. Firms are generally allowed to emit CO2eq only if they have a credit. Firms that wish to emit more can purchase additional carbon credits in the market. Sellers have a surplus of credits because they emitted less than their “limit.” More generally, a whole industry that operates within a carbon market system will have a “cap” equal to the total maximum emissions. The cap and the resulting market for emissions trading are why they are referred to as cap-and-trade schemes. To be effective, this cap must be set below current emissions and consistent with attaining a long-term goal (Paris Agreement). The cap usually decreases annually.

ISF Primer Video Series

How carbon markets can work to reduce GHG emissions, with Dominique Barker

“If we can put a price on carbon, we can do a lot of special things.” ISF Research Director Ryan Riordan interviews Dominique Barker, Managing Director and Head, Sustainability Advisory, CIBC Capital Markets, about how carbon markets function, the different kinds of markets and carbon credits, how to ensure they are reducing greenhouse gas emissions, and a “massive opportunity for Canada” for a carbon management industry.

What About Carbon Offsets?

In addition to government-allocated emissions permission (credits), carbon markets can be designed to allow credits in the form of a “carbon offset credit.” These offsets are different than allocated carbon credits because anyone can generate one. Offsets represent an audited reduction of one metric ton of CO2eq. These offsets can be generated through carbon capture efforts, such as reforestation or direct air carbon capture. Offsets can also be created by not doing something. For example, firms may pay to delay the harvesting of trees in exchange for carbon offsets (1). The purchase of offset credits indirectly reduces a firm’s emissions, and, in practice, verification of offsets is challenging.1 Some offsetting activities can be contentious, explaining why some carbon markets prohibit offset credits. Offsets create the incentive to develop carbon capture technology and other technologies that can reduce emissions. The Taskforce on Scaling Voluntary Carbon Markets note that voluntary carbon markets should not undermine incentives for emissions mitigation by emitting firms (3).

1 A 2016 report prepared for the Directorate-General for Climate Action, a department of the European Commission, “...estimate[d] that 85% of the covered projects and 73% of the potential 2013-2020 [Certified Emission Reduction] CER supply have a low likelihood of ensuring environmental integrity (i.e. ensuring that emission reductions are additional and not over-estimated). Only 2% of the projects and 7% of potential CER supply have a high likelihood of ensuring environmental integrity.” (2)

How Widespread Are Carbon Markets and Where Are They Located?

According to the World Bank’s Carbon Pricing Dashboard, there are 38 national jurisdictions covered by an implemented emissions trading system (ETS).2 These ETSs cover 16.4% of global GHG emissions and have a total value of $67 billion (USD). China’s recently implemented national ETS covers 7.4% of global GHG emissions, the largest such market. These ETSs are most common in North America, Europe, and Asia.

2 “ETS does not only refer to cap-and-trade systems, but also baseline-and-credit systems such as in British Columbia and baseline-and-offset systems such as in Australia.” (4)

Growing Pains and Lessons Learned

Before China’s recently introduced ETS, the largest carbon trading market was in the EU and was established in 2005. At first, most emission permits in the EU were allocated without cost. Due to an oversupply of permits, the combined carbon emitting permits exceeded all emissions, defeating the purpose of the ETS (5). In 2015, policy makers created a market stability reserve (MSR), which addressed the oversupply of emission credits. The growing pains experienced by the EU’s ETS should serve as a lesson to policymakers attempting to implement an effective ETS, highlighting the importance of capping credits below business-as-usual emission levels. Recently, the carbon price in the EU market has hit record highs, putting it on a path to trigger investments in clean technologies and make prices for green alternatives competitive with their fossil fuel counterparts (6).3

3 For example hydrogen fuel produced from renewable energy vs. hydrogen produced from fossil fuels.

What Are Voluntary Carbon Markets?

Voluntary carbon markets are similar to carbon markets, but participation is voluntary. Firms join voluntary carbon markets to help verify that they are reducing emissions. Voluntary carbon trading is not new: it first occurred in 1989 and primarily involved deforestation avoidance (3). Voluntary markets generally accept carbon offsets. The demand for carbon offsets has grown as companies pledge increasingly ambitious emission reduction goals. Influential figures, such as Mark Carney, the former Governor of the Banks of Canada and England, advocate for larger voluntary carbon markets, and are pushing to establish transparency in the voluntary carbon market.

Voluntary Carbon Market Issues

Some sustainability leaders in the UK have voiced concerns about renewed plans for voluntary carbon markets. John Sauven, executive director of Greenpeace UK, and Craig Bennett, chief executive of the Wildlife Trusts, have both written to Carney cautioning that this program has the potential to serve as a large greenwashing exercise, granting a “get-out-of-jail-free” card to polluting firms. They also worry that voluntary carbon markets will undermine tighter control in international agreements, pointing out that these schemes assume that the natural world has unlimited potential to absorb climate-wrecking emissions (7).

What Is Happening in Canada?

In 2016, the federal government announced that all Canadian jurisdictions would need to have carbon pricing in place by 2018 (8). Generally speaking, carbon pricing means either a carbon tax or a cap-and-trade system. Some provinces had carbon pricing policies in place before this, but for most, this announcement and the federal backstop that followed sparked their first engagement with carbon markets. This federal backstop served as a default mechanism; if a province did not come up with a system that meets federal requirements, then the backstop would either be applied partially or in full. This backstop is composed of two elements:

  • a carbon levy applied to fossil fuels
  • an output-based pricing system (OBPS) for high-emitting industrial facilities (9)

The second element in this backstop creates a carbon market. Facilities that emit less than their associated emissions-intensity standard receive “surplus credits” (or carbon credits), whereas facilities above their limit must submit compliance units or pay the carbon price to make up the difference (9). In March 2021, the Government of Canada announced draft regulations to establish the Federal Greenhouse Gas Offset System which will support the carbon trading market under the OBPS (10).

After the federal carbon pricing policy was implemented, six provinces and territories use their own carbon pricing system, three use a mix between their own and the federal backstop, and four employ the federal backstop in full (11). This variation in systems highlight the equal importance of both, and how one system by no means trumps the other.

CIBC, a Canadian private financial institution has been working to advance voluntary carbon markets. In July of 2021, CIBC, along with banks from Brazil, Australia, and the U.K., announced their partnered launch of Project Carbon, a voluntary carbon marketplace (12). Project Carbon aims to apply blockchain technology to address concerns with offset markets, such as double counting and verification.4

4 Blockchain is a valuable and appropriate technology to use for offsets because, blockchain is known for its ability to increase security, transparency, and traceability for transactions (13).

This series explores the foundations of sustainable finance, one of the most important emerging fields of our time. Sustainable finance aligns financial systems and services to promote long-term environmental sustainability and economic prosperity.