Carbon Emission Trading Schemes have been around for some time now. Since the concept was first introduced in 1997 after the signing of the Kyoto Protocol, many schemes have entered the scene. While there are many different features characterising each scheme, what they all have in common is the purpose to, through trade and market mechanisms, accommodate the progress towards the goal to limit global warming to well below 2℃, as set out in the Paris Agreement. All schemes fall into two main market categories: the compliance carbon market and the voluntary carbon market (VCM). This article will focus on the VCM, which has emerged since Article 6 of the Paris Agreement was enacted.
So what is the Voluntary Carbon Market? In its essence, it is a market in which any actor is free to opt in and out, in contrast to the compliance market, where the participation of actors is enforced by e.g, a governmental body. Nonetheless, the VCM is still governed by third-party regulators, normally NGOs. The most renowned ones are Verra and The Gold Standard. The role of these third-party regulators is to develop frameworks, commonly referred to as standards, to safeguard credibility and quality standards throughout the entire market in order to prevent market failure.
The core function of the VCM is twofold. Firstly, to serve as a medium for companies which seek to outsource their GHG-emission reductions. Secondly, to encourage private actors to innovate and invest in projects that have climate mitigating effects and to accelerate the decoupling of economies. The former constitutes the demand of the VCM, and the latter represents the supply.
Demand in the Voluntary Carbon Market:
Figure 1 illustrates the drivers of the demand in the VCM. The drivers of demand have been broken down into blocks stacked on top of each other to form a pyramid. The bottom of the pyramid represents the initial driver of demand, where a chain reaction is initiated which drives demand through the different blocks till the top.
The initial driver of demand is climate change. To be more precise, it is climate change caused by human activities producing GHG-emissions, which has been thoroughly confirmed by scientists. Climate change imposes great challenges to both our society and our economy. Recent research published in the Environmental Research Letters estimated that by 2100 climate change alone could lower the world's GDP by 37%. Whilst increasing temperatures would be causing most harm in countries where the climate is already hot, the indirect implications for the rest of the world would still be significant due to the interconnectedness of economies. Unforeseen shocks due to climate change or escalating geopolitical tensions, similar to the conflict in Ukraine, will likely disrupt global supply chains.
Looming disasters caused by climate change are numerous: rising sea levels, collapsing ecosystems and higher frequency of natural disasters. The social and economic existential threats of climate change have motivated international cooperation in the form of treaties and agreements. One of the main drivers of VCM Demand is the 2015 Paris Agreement.
The Paris Agreement sets the platform for collaboration and unity towards tackling climate change on an international level, and this is linked to the following driver, which occurs on a national level. Every 5th year, all signatories submit their plans on how to reduce their GHG-emissions, a cycle that is designed to get more ambitious after each round. Each party is responsible to enact policies and monitoring systems to incentivise and steer the process of reducing GHG-emissions domestically, and this is the subsequent driver of the demand.
When it comes to climate change, everyone is a stakeholder. The activities of companies are constantly scrutinised by the public. Their carbon footprint is highly relevant for many important performance metrics, such as brand value and finances. As seen in chart 1 (below), higher ESG ratings have a positive correlation with corporate financial performance for the majority of companies across markets. Pressure from the general public and NGOs are the 4th driver of demand in the VCM.
Finally, at the end of the chain, we find private sector actors. These actors all have one common interest, which is to reduce their carbon footprint. These incentives come from further down the pyramid. Changes in all the preceding blocks may alter the final demand coming from the private sector. Consequently, demand in the VCM is influenced from many different angles and trends in each of the blocks needs to be studied to make predictions on future demand.
Supply in the Voluntary Carbon Market:
The suppliers in the VCM are projects that reduce GHG-emission. As illustrated in chart 2 (below), most of these projects are either related to forestry and land use, or renewable energy.
Furthermore, all projects can be grouped into 2 main categories - carbon removal projects and carbon avoidance projects. Carbon removal projects can be either nature based solutions, such as reforestation, or technical carbon removal, such as direct air capture. Carbon avoidance projects are projects that prevent the emission of GHG-gas emissions that would have been emitted in the absence of the project. For example it could be preventing deforestation in the Amazon rainforest or establishing a solar park.
A key component of the supply side are standards developed by 3rd party regulators. A standard governs the entire upstream leading to the issuance of carbon credits in the VCM, and the regulator maintains a registry to avoid double counting in the downstream. A standard is industry specific and includes guidelines and rules that are bundled together forming a variety of methodologies and modules each relating to a specific GHG-emission reducing project. Methodologies and modules outline concrete steps to take for e.g risk management or MRV (measurement, reporting and verification). A standard’s purpose is to ensure that quantification of GHG-emissions are accurate and to deter opportunistic actors looking to mislead.
A well-functioning market must be backed by a standard that ensures credibility and accuracy of the following four main features related to a GHG-emission reducing project:
Baseline - is the business as usual scenario
Additionality - is the GHG-emission reductions achieved compared to the baseline
Permanence - relates to a project’s ability to avoid reversal of GHG-emission reductions achieved
Leakage - refers to increases of GHG-emissions as a direct consequence of the project.
Entry barriers imposed by standards may vary, but the ones governed by reputable developers may be higher, and access restricted to suppliers willing to pay the cost of lengthy registration processes and strict requirements for robustness and accuracy. However, going through stricter requirements normally pays off as credits issued may be sold at a price premium due to higher quality derived from elevated transparency and trust.
Lastly, efforts to address the lack of coordination in the VCM is undergoing. One example is the Integrity Council, who are currently developing a set of core principles and an assessment framework. The goal is to bring all standard developers under a common framework in order to increase transparency and ensure high quality of credits in the market. The public consultation period has been open since July 2022 and the principles and the assessment framework are expected to be issued in Q4.
Writer: August Borgstrand
References
Ecosystem Marketplace (2021), ''State of the Voluntary Carbon Market'', Installment 1.
Friede et al., ESG and financial performance: aggregated evidence from more than 2000 empirical studies (2015). Journal of Sustainable Finance & Investment
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