Carbon trading is booming globally – what is it and how does it work?

Carbon trading arose in the late 1990s with the signing of the Kyoto Protocol, which saw landmark commitments to cut GHGs.

An important element of the Kyoto Protocol was the establishment of the Clean Development Mechanism (CDM), a flexible market mechanism for carbon trading.[2] Under the CDM industrialised economies can implement emission-reduction projects in developing nations. These projects can generate saleable certified emission reduction (CER) credits. Industrialised nations can then use these CERs to meet part of their emission reduction targets under the Kyoto Protocol. As of June 2022, across the world, a total of 7845 project activities are registered under the CDM.[3]

Several international treaties and conventions have refined and adjusted carbon trading since, including the Paris Agreement in 2015. Significantly, the Paris Agreement included a carbon trading ‘rulebook’ in Article 6, but the details and mechanics were in negotiation.

A critical breakthrough came in 2021 at the 26^th UN Climate Change Conference in Glasgow (COP26). After years of stalemates, COP26 delivered crucial progress on the Article 6 ‘rulebook’ including:

• setting new rules for regulating carbon accounting
• creating a mechanism for countries to transfer carbon reductions
• the establishment of a global carbon market overseen by a United Nations entity.

The new UNFCCC Mechanism adopted by states enables international emissions trading by both public and private actors.

The developments formed part of the Glasgow Climate Pact, which strengthened global warming commitments and included the adoption by 153 countries of 2030 emission targets under Nationally Determined Contributions (NDCs).

In November 2022, Egypt hosted the 27^th UN Climate Change Conference (COP27), focussed on moving from planning to implementation. This included the launch of the African Carbon Markets Initiative to help drive green development in the region.

Limiting global warming to 1.5 to 2 degrees Celsius will require emissions to be cut by 25 – 50% by 2030.

Experts predict this is unlikely to happen without a global carbon price of around US$75 per tonne by the end of the decade.[7] Stringent caps imposed in regulated carbon markets, together with tight environment regulations, will be key in raising carbon prices and promoting green alternatives to fossil fuels.

How do regulated / compliance markets work?

‘Regulated’ or ‘Compliance’ Markets are created and regulated by mandatory national, regional, or international carbon reduction regimes, and are currently the main method used to obtain carbon reductions across corporate entities and industry emitters. Regulated markets can be split into two categories:

1. cap and trade schemes - are the most common and work by setting a fixed limit on emissions through a set of permits released into the market via auction or distribution according to certain criteria.
2. baseline and credit mechanisms - do not have a fixed limit on emissions, and companies trade offsets which are granted to companies that reduce their emissions more than they are otherwise obliged to. In this system, the items being traded are for past reduction in emissions as opposed to future pollution as seen in a cap and trade system.

At a high level, a compliance market is used by companies and governments that are required by law to account for their GHG emissions. Regulatory carbon markets are supervised by state and international authorities.

Features of cap and trade schemes include…

• Market participants are usually identified by governments based on sector, carbon emission intensity or size.
• Governments set an emissions limit (cap) on market participants and issue either by free allocation or auction a quantity of emission allowances consistent with that cap.
• An auctioning system is the preferred approach because it requires companies to purchase allowances and therefore further incentivises companies to reduce their emissions.
• Overtime this cap is reduced so that GHG emissions decline. To avoid heavy penalties at the end of each compliance period companies must surrender an allowance for every ton of GHG emitted.
• Companies that have reduced their emissions can either retain the spare allowances to cover future emissions or can sell their spare allowances to companies that will exceed their cap. By purchasing the spare allowances, the emitter is allowed to exceed their cap because they are effectively paying someone else to reduce their emissions on behalf of them.

Examples of regulated markets include…

• The world’s first ETS, the European Union’s (EU) introduced in early 2005. The EU ETS is a ‘cap and trade’ scheme.
• National ETSs including in the United Kingdom and sub-national ETSs such as that in California.
• The world’s largest ETS, China’s national ETS, introduced in 2021.

How do voluntary markets work?

‘Voluntary’ Markets function outside of regulated markets and enable companies, government entities and individuals to purchase carbon offsets on a voluntary basis with no intended or possible use for compliance purposes. Permits or credits are often purchased under voluntary schemes to achieve internal CSR or public relations purposes or corporate initiatives.

An increasing number of companies are making commitments to reduce their own emissions, emissions associated with supply chains, and emissions produced using their products.

Carbon credits, purchased voluntarily, enable companies to compensate for the emissions they have not been able to eliminate themselves and thus meaningfully contribute in the transition to global net zero.

More recently, the certification of carbon credits has come under a great deal of scrutiny. The success of these voluntary markets is contingent upon the accuracy and integrity of carbon credit certification.

Features include…

• They cover a wider variety of sectors than compliance markets which typically deal with high emitting industries such as energy production.
• An overarching aim of incentivising private actors to finance projects that remove GHG emissions from the atmosphere.
• Regulation is often outsourced to non-governmental organisations (NGOs). These NGOs have created their own methodologies to certify emission reduction projects.
• Voluntary carbon markets are independent of regulatory markets and therefore companies under an emissions cap cannot purchase voluntary carbon credits to meet their legal obligations.

Projects that generate voluntary carbon credits are generally categorised as…

• Avoidance and reduction projects: These reduce emissions from current sources. Examples include implementation of lower-carbon technologies such as renewable energy; avoidance of practices that cause emissions such as deforestation; upgrading industrial processes to capture methane as well as other GHGs instead of releasing these into the atmosphere.
• Removal and sequestration projects: These take carbon from the atmosphere and either use or store it. Removal and sequestration projects can be either nature or technology based. Nature based projects take advantage of the ability of biosphere to sequester carbon dioxide from the atmosphere and include reforestation and ecosystem restoration initiatives. Technology based projects remove carbon dioxide from the atmosphere with the help of modern technology that either uses the captured carbon dioxide or stores it in the geosphere.

Examples of voluntary markets include…

• The aviation industry-wide reduction scheme: under the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) established by the International Civil Aviation Organisation (ICAO), ICAO Member States can voluntarily offset their aviation-based carbon emissions.
• Australia’s carbon credit unit (ACCU) voluntary scheme.

Carbon trading contracts and the growing trend towards standardisation

Increasing attention on carbon trading has resulted in a focus on trading contracts and their standard form agreements.

In regulated cap and trade markets, auctioning is the default trade platform used for issuing allowances. Companies then trade these allowances.

Governments also enter carbon contracts for differences to guarantee a fixed price and minimise price fluctuations.[8] This is a useful method to minimise risk whereby a government or institution will agree with an agent on a fixed carbon price over a given period.

• During the life of the contract, agents can sell carbon emissions reductions at that given price.
  • If sold at lower the given price the agent will receive the difference.
  • If higher the agent will return the additional revenue to the government.[9]

These kinds of carbon contracts provide more certain revenue streams and assist agents in mitigating the effects of carbon price fluctuation.

As a result, various industry bodies have started drafting market standard or template documentation for carbon credits transactions. For example:

• the Australian Financial Markets Association (AFMA) has published a template contract for businesses to use for the sale and purchase of carbon credits from third parties.
• the International Swaps and Derivatives Association (ISDA) published the 2022 ISDA Verified Carbon Credit Transaction Definitions on 13 December 2022. This is part of a broad effort to support the transition to a green economy by developing robust legal and risk management standards for markets related to environmental, social and governance activities. The ISDA Standard Definitions create additional template language to be included in the Schedule to an ISDA Master Agreement to facilitate derivative transactions for voluntary carbon credits.[10]

Our carbon markets experts are closely watching developments. To follow their insights in the rapidly evolving space, subscribe here.

For more information on carbon markets, visit our insights and publications:

• Trading Carbon in China: A Game Changer
• China’s National Carbon market: A Guide for Investors
• ESG – Understanding Carbon Markets in China
• Flying Carbon-Free? Aviation’s Green Transformation
• Safeguard Mechanism Reforms – Consultation Opens on Draft Legislation
• Reforming Australia’s carbon crediting scheme and consultation on Safeguard mechanism reforms

Thank you to Eliza Saville for drafting assistance.