2022 will likely be remembered as the year when carbon finance was an important issue for an array of industries.
In the 2022 class of new participants in carbon markets that are voluntary oil and gas majors hedge funds, banks and hedge funds were identified as the most active players with a firm commitment to enter the market. As the year progressed, many other industries joined the market following their commitments to reduce carbon footprints.
Many of the political institutions like the EU or in the UK as well as the US state of California have carbon markets that target specific industrial areas and gas. These are a crucial part of the process to reach the Paris Agreement target of limiting global heating at 2° Celsius above preindustrial levels (with an ambitious target of staying within the limit of 1.5 C increase), even though some of these market structures predate those of the Paris commitments.
Some sectors have also adopted the same principles as compliance schemes and promised to offset their greenhouse gas emissions (GHG) by taking part in carbon markets voluntarily.
Voluntary carbon markets enable producers of carbon to reduce their inevitable emissions by purchasing carbon credits emitted by projects targeted at removing or cutting down GHG out of the atmosphere.
Each credit, which is equivalent to one metric tons of lessened, avoided or removed CO2 or similar GHG , can be used by a company or an individual to pay for the emission of one ton of CO2 or similar gases. If a credit is utilized to offset the emission of gases it will be converted into an offset. It is then transferred to a register that is used for retired credits, also known as retirements, and then it ceases to be tradeable.
Companies can join the voluntary carbon market either in a single transaction or as part of an industry-wide program, like The Carbon Offsetting and Reduction Scheme for International Aviation, which was created by the aviation industry to reduce carbon dioxide emissions. International airline companies participating in CORSIA have committed to offset all the CO2 emissions that they create over a base level of 2019.
Although compliance markets are restricted to specific regions, carbon credits offered by voluntary carbon markets are more fluid, unrestrained by borders established by nation states or political unions. They also have the potential to be used by any industry instead of just a handful of industries.
The Taskforce on Scaling Voluntary Carbon Markets that is run by the Institute of International Finance with support from McKinsey estimates that the carbon market credits could be worth upwards of $50 billion as early as 2030.
The participants
Five main players are the engines of carbon markets.
PROJECT DEVELOPERS
Project developers form an upstream section of the market. They create the projects that issue carbon credit which range from industrial-scale projects that are large in scale like hydro plants with high volumes and smaller community-based ones like cooking stoves that are clean.
There are several projects that aim to take away or manage direct emissions that result from industrial processes like emission management fugitive, ozone capture or the destruction of substances that deplete ozone and treatment of wastewater. Nature-based projects are REDD+ (avoided deforestation) soil sequestration and forest afforestation. Other kinds include tech carbon capture such as direct air capture, and new categories are added regularly.
Each credit comes with a particular vintage, which is the year when it was first issued, as well as the specific date of delivery and the time at which the credit will be available for sale. Alongside their primary objective of preventing or eliminating GHGs from the air credits can produce additional ‘co-benefits’ and help meet certain of the United Nations’ Sustainable Development Goals (SDGs). They could, for instance, contribute to improved welfare for the population in the area, improved drinking water, and reduction of inequality in the economy.
END Buyers
The downstream market is made up of end buyers: companies as well as individual consumers – that have committed to offset a portion or all in their GHG emissions.
The first buyers of carbon credits were tech firms like Apple and Google airlines, as well as oil and gas companies, however, more industries such as finance are entering the market as they set their own net-zero targets or search for ways to hedge against the financial risks posed by changing energy sources.
Implementation of Article 6 of the Paris Agreement on the 13th of November at the UN Climate Conference, or COP26, in Glasgow set the rules for a crediting mechanism that could be used by the 193 parties to Paris accord to achieve their emission reduction targets or contributions that are determined by the national government. The Article’s implementation made it possible for nations to purchase voluntary carbon credits, so provided that Article 6 rules are respected.
RETAIL TRADERS
To link supply and demand, there are brokers and retail traders, similar to in other markets for commodities. Retail traders purchase large amounts of credit directly from the supplier they then combine those credits into portfolios, ranging in size from thousands to hundreds of tons of CO2 and sell those bundles to the end buyers usually with a small commission.
The majority of the transactions are currently happening through private conversations or over-the-counter trades, some exchanges are also emerging. The two largest carbon credit exchanges currently currently are NYC-based Xpansiv CBL and Singapore based AirCarbon Exchange (ACX).
Exchanges have been working hard to make simpler and speedier the process of trading carbon credits – that have a high level of complexity due to the multitude of factors that impact their value by developing standards-based products, that guarantee certain basic requirements are met.
For instance, both CBL and the CBL along with ACX have created standard products for nature-based trading carbon credits CBL’s Natural-based Global Emission Offset (N-GEO), and The ACX Global Nature Token.
Credit trading that is conducted under these labels are certain to be regulated by specific characteristics including the type of base project, its recent time frame, and certification that is a part of a select group of standards.
Exchanges’ standardized products – especially those designed for forward delivery – are most popular among traders and financial players looking to buy and hold ahead of increasing demand for carbon credits.
End buyers who need to purchase credits to offset their carbon emissions tend to favor non-standardized products, as they are able to investigate the specific features of each project, ensure the quality of the credit they purchase and thus protect themselves from potential allegations of greenwashing.
In many cases, exchanges are used to settle huge bilateral contracts that have been done offscreen. In a market note shared the month of May CBL declared that an greater number of bilateral deals negotiated offscreen were brought in by traders to be settled on the CBL platform.
These deals comprised large portions of transactions transacted on CBL.
BROKERS
Brokers buy carbon credits from a retailer trader, then market them to an end buyer, usually with some commission.
STANDARDS
There is a fifth participant that is unique to carbon markets. Standards are usually organizations, typically NGOs, which certify that a particular project meets its stated objectives as well as its stated volume of emissions.
Standards include a variety of guidelines, or methods, for each type of carbon-related project. For example Reforestation projects must follow specific rules when calculating the CO2 absorption capacity from the forest being planned and therefore the number of carbon credits it generates over the course of time.
Renewable energy projects will have a different set of guidelines to adhere to when calculating the value by reducing CO2 emissions as well as carbon credits earned over the course of.
Certifications by standards also assure that certain essential principles or the requirements of carbon finance are adhered to:
Additionality: The project should not require a legal requirement, standard procedure, or financially appealing without credit revenues.
The CO2 emissions reduction should correspond to the number of offset credits that are issued for the project and should take into account any unintentional GHG emissions that are a result of the project.
Permanence: The impact of the GHG emission reductions should not be at risk of reverse and will result in a long-lasting drop in emissions.
Unique claim: Every metric tons of CO2 can be claimed once and requires proof of credit retirement after the project’s maturation. Credits are offsets at the time of retirement.
Offer additional environmental and social benefits: Projects must comply with the lawful requirements of the jurisdiction of the project and must provide additional benefits in accordance with the UN’s SDGs.
In-between roles, bilateral trade
There is an overlapping of roles that are specific with carbon markets.
Many brokers operate as traders, and a lot of financiers have both brokering arms and projects development arm.
End buyers are also able to finance their own carbon projects and then decide to retain all or part of the credits issued for their own offset requirements.
Each of these organizations could eventually market credits to a buyer or developer. A developer might organize to sell them directly. These juxtapositions could have an impact on prices, and eventually affect market transparency.
Pricing a wide range of products
When a company turns to free carbon market as a potential option to offset its carbon emissions One of the primary pieces of information it looks for is the price of carbon credits. With this information an organization can make a decision on what level of ambition to set when setting the goal of reducing its emissions and whether markets that are voluntary can assist in achieving it.
In the same way it is important to have a clear price signal for carbon enables those already trading on the marketplace to make sure they are trading their carbon at a value that is in line with the market value.
But putting a price on carbon credits is far from an easy task, mostly because of the wide range of credits in the market and the variety of factors that affect the price.
Carbon credits issued by projects are of a variety of kinds and sub-types. The nature of the project is one of most important factors that influence the cost of the credit.
Carbon credits can be divided into two broad groups, or baskets such as avoidance projects (which avoid emitting GHGs completely therefore reducing the volume of GHGs emitted in the atmosphere) in addition to removal (which remove GHGs straight from the environment).
The avoidance basket is comprised of renewable energy projects but also the forestry and farming emissions reduction projects. These projects, often referred to as REDD+, stop destruction of wetland habitats or deforestation, or utilize soil management practices in agriculture that reduce GHG emissions, such as initiatives aimed at reducing the emission of dairy cattle as well as beef cattle by varying their diets.
Cookstove projects and fuel efficiency, or the building of energy efficient structures also are included in the avoidance basket as do projects for capturing and eliminating industrial pollutants.
The removal category covers projects for capturing carbon out of the atmosphere and storing it. They can be nature-based and rely on trees or soil for example , to remove carbon dioxide and capture it. Examples are afforestation and reforestation projects, and wetland management (forestry and farming). They can also be tech-based and incorporate technologies such as direct air capture, or carbon storage and capture.
Credits for removal tend to be traded with a higher value than avoidance credits, and not only due to the larger amount of investment required by the underlying project but because of the high demand for this kind of credits. They are also considered to be a stronger instrument in fighting climate change.
Beyond the nature of the project’s base, the price of carbon credits is also dependent on the quantity of credits being traded at one time (the higher the volume the cheaper the price generally) or the geographic location that the company is located in, its date of birth (typically the older it is, the less costly the cost) as well as the delivery time.
When the underlying carbon project helps achieve some of the UN’s SDGs in this case, the value of a credit from that project to potential buyers could be greater, and the credit may be sold at a higher price than other types of projects.
For instance, community-based initiatives tend to be localized, and often designed and managed locally by NGOs, local organizations or groups – tend to have smaller amounts that are carbon-based credits. It is also often more costly to get them certified. However, they often provide higher co-benefits and are able to meet the UN’s SDGs which contribute for example, greater welfare for the local population, better water quality or decrease in economic inequality.
In this way, credits generated by community-based initiatives could be traded at a premium against projects that don’t fulfill SDGs, such as industrial initiatives, that are usually larger in scale and often generate large volumes of credits with greater, more easily verified GHG offset potential.
In the present carbon market prices for one carbon credit can range in price from just a few dollars per metric ton of CO2 emissions up to $15/mtCO2e in afforestation or reforestation initiatives to $100 or even $300/mtCO2e in removal projects based on technology, such as CCS.
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