Introduction
Mitigating and adapting to climate change is going to require a fundamental redesign of traditional economic models. As countries, companies, consumers and investors strive to make the net-zero economy a reality, science-based targets make it evident that:
- It’s going to take time to decarbonize supply chains because of the technological and business model limitations faced by different industries; and
- There will likely be hard-to-abate residual emissions in many supply chains; localizing production, improving energy efficiency or using alternative energy sources, new technology or industrial processes may only get you so far.
Carbon markets can solve for both, serving as an interim solution provided offsetting is used alongside supply chain mitigation, consistent with the guidelines established by the Voluntary Carbon Markets Integrity Initiative (VCMI), which seeks to support credible net-zero-aligned participation in voluntary carbon markets, and a long term solution for residual emissions which cannot be mitigated by alternative means. Consequently, if utilized appropriately, we believe carbon markets can play a vital role and form part of a comprehensive response in limiting climate change, and at the same time offer institutions a compelling investment opportunity.
Carbon markets, as the name implies, offer an arena to trade in the reduction, avoidance or removal of CO2 and other greenhouse gases (GHGs), collectively measured in tons of CO2 equivalent (tCO2e). In compliance carbon markets participants that emit less than their allowance can sell their surplus to counterparties that weren’t able to meet their emission reduction obligations. Alternatively, parties can establish carbon projects that generate credits commensurate with the resulting GHG reduction, avoidance or removal from the atmosphere, which can be purchased by emitters to satisfy their emission reduction obligations in compliance markets or targets in voluntary markets, a process known as “offsetting.”
The practice of purchasing credits to “offset” one’s emissions has attracted positive and negative attention from the media, academia and the investment community owing to the perceived financial opportunity and criticisms regarding environmental efficacy and integrity.
While we agree with some of the criticisms, the desire to construct a perfect offset market should not be an obstacle to the development of a good one. While there are shortcomings that need to be, and are being, addressed by the industry, overall, offsetting can be a net positive for Earth’s climate, the environment more generally, and local communities. This is sometimes lost in what can be an ideologically charged debate when it comes to climate change.
This primer seeks to provide an objective assessment of carbon markets, their merits and shortcomings, and the factors that investors should consider when contemplating whether to participate in this fast-growing, but complex market.
A brief history of carbon markets
Kyoto protocol
The concept of carbon markets was originally established in 1997 under the Kyoto Protocol (or Kyoto), an agreement among industrialized (or developed) countries to reduce emissions relative to 1990 levels.1
To help signatories (otherwise known as Annex B countries) meet their emission reduction targets, Kyoto created several market-based mechanisms:
- The Clean Development Mechanism (CDM) allowed signatories to establish emission-reduction projects in developing countries that generated Carbon Emission-Reduction (CER) credits that could be utilized in meeting
their emission targets. The Joint Implementation (JI) Mechanism was similar but allowed Annex B parties to earn credits from projects in other developed countries. - The Emissions Trading (ET) Mechanism introduced the concept of carbon trading and granted Annex B parties a set number of units that they could trade with one another. Countries that exceeded their allowance could buy units from countries that remained below their allowances.
While these inaugural carbon market mechanisms were well-intentioned, critics were quick to point out that there were too many allowances under the ET Mechanism such that no one was incentivized to decarbonize. Other detractors focused on the environmental integrity of the credits, questioning whether the emission reductions would have been achieved without a carbon market incentive—a concept known as additionality.2
Paris agreement
Ratified in 2015, the Paris Agreement (Paris) followed the Kyoto Protocol. Though there are some major differences between the two, the basic idea remained the same: Countries that exceeded their carbon reduction targets would be able to sell credits to countries that failed to meet their targets, which were based on strengthening the global response to the threat of climate change by keeping a global temperature rise this century to well below 2°C above pre-industrial levels and pursue efforts to limit the temperature increase even further to 1.5°C.3 Paris also introduced to the world the concept of carbon neutrality, which stipulates that every ton of GHG emitted must be offset.
Since the Kyoto Protocol, distinct carbon markets have evolved. Broadly speaking, there are two types: compliance markets and voluntary markets.
1 The Kyoto Protocol established two commitment periods. The first sought to reduce emissions by 5% by 2012; the second, by at least 18% by 2020.
2 Öko-Institut. 2016. “How additional is the Clean Development Mechanism?”
3 In addition to dropping the Annex B concept, thus setting standards for developing countries and allowing them to participate in carbon markets, Paris broadened its scope to include all GHGs, not just the best-known ones (e.g., CO2, methane, sulfur, fluorocarbons and nitrous oxides).
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