Decoding the Carbon Markets (Report Summary)

July 10, 2023
Tom Herbstein
9 Mins Read

Carbon markets play a crucial role in addressing the global challenge of climate change. However, their effectiveness in reducing carbon emissions and driving decarbonization has been limited. In this summary, WeESG co-founder Dr Tom Herbstein summarises a recent paper he co-authored with Paul Fisher and Martina Garcia exploring why carbon markets were created, how they work, the challenges they face, and what market practitioners and policymakers can do to make them more effective.

Why Carbon Markets Were Created

Carbon markets were established to address the negative externality of greenhouse gas emissions. When emitters release carbon dioxide and other greenhouse gases, they benefit from free waste disposal, but society bears the cost through pollution and climate change. The concept of the “polluter pays” principle emerged as a solution, charging emitters for the full societal and environmental cost of their emissions. Carbon markets provide a mechanism for pricing carbon emissions and creating incentives for emission reductions.

Carbon markets have been in existence for over three decades. The first large-scale “cap and trade” program was introduced in the US in 1990 to reduce emissions of sulphur dioxide, the cause of acid rain. Since then, international agreements such as the Kyoto Protocol and the Paris Agreement have aimed to apply cap and trade to reduce global greenhouse gas emissions. However, these efforts have had limited impact, and carbon markets currently cover less than a quarter of the world’s emissions.

How Carbon Pricing and Carbon Markets Work

Carbon pricing can be implemented through three main market mechanisms: direct taxation, cap and trade emissions quota systems, and carbon offsets.

  • Direct taxation involves levying taxes on fossil fuels based on their carbon content. This can be done through a sales tax or a fixed duty per unit. However, setting the tax rates accurately to reflect the carbon emissions of all goods and services is challenging.
  • Cap and trade emissions quota systems involve creating a limited number of emission allowances and allowing companies to trade unused allowances. Over time, the total number of permits decreases, creating a future emissions price curve. This system allows for differential speeds of adjustment across sectors.
  • Carbon offsets allow polluters to offset their emissions by investing in carbon-reducing projects or activities. These offsets can be traded, providing an additional way to reduce emissions.

It is important to note that carbon pricing mechanisms require regular calibration, strict enforcement, and accurate measurement and verification of emission reductions.

Why Carbon Pricing is Not Working Globally

Despite the existence of carbon pricing initiatives, global emissions continue to rise. This can be attributed to several factors:

  • Insufficient carbon prices: The current carbon prices are often lower than the levels required to drive significant emission reductions. Experts suggest that carbon prices should range between $50-100 per tonne by 2030 to meet the goals of the Paris Agreement.
  • Lack of global coordination: Carbon pricing initiatives vary across countries, leading to regulatory inconsistencies and limited interoperability between markets. This lack of alignment hinders the effectiveness of carbon markets.
  • Inelastic demand: The price elasticity of demand for carbon-intensive goods and services is often low. Even when prices increase, consumers tend to revert to previous consumption patterns, diminishing the impact of carbon pricing.
  • Political challenges: Implementing high carbon prices can be politically challenging, as it may lead to increased costs for consumers and potential backlash from industries and the public.
  • Carbon leakage: In some cases, carbon pricing measures can lead to production shifting to countries with lax regulations, resulting in increased emissions overall.

To address these challenges, policymakers and market practitioners need to focus on improving the effectiveness and coherence of carbon pricing mechanisms.

Alternatives to Carbon Markets

While carbon markets are necessary, they are not without limitations. Alternative approaches, such as direct legislative action, can complement carbon markets. However, these alternatives also have their drawbacks. Direct legislation can lead to unintended consequences and may be difficult to implement in a democratic society. Additionally, prohibitions on certain activities can result in demand and supply shifting to alternative, equally harmful options.

Given the magnitude of the climate change challenge, a combination of tools and approaches is needed. Some direct legislation will be necessary, as well as softer forms of government intervention. Carbon markets should remain a central tool in financially rewarding decarbonization efforts and enabling the participation of the general population.

What Market Practitioners Must Focus On

Market practitioners play a crucial role in the success of carbon markets. To navigate the challenges and maximize the effectiveness of carbon markets, practitioners should focus on the following:

  • Price volatility: Carbon prices can fluctuate significantly due to various factors such as supply and demand dynamics, regulatory changes, and geopolitical events. Practitioners need to consider this volatility when pricing carbon credits and planning decarbonization strategies.
  • Oversupply of credits: Weak demand, over-allocation, and poor-quality offset projects can lead to an oversupply of carbon credits. Technological advancements and changes in industrial efficiency can further disrupt the demand for certain types of credits. Practitioners should carefully consider the quality and reliability of carbon credits.
  • Measurement and verification: Accurate measurement and verification of emission reductions are essential for maintaining market confidence and transparency. Practitioners should ensure robust measurement and verification processes to uphold the integrity of carbon markets.
  • Carbon leakage: Carbon markets need to address the risk of carbon leakage, where emissions increase in countries offering offsets or hosting “dirty” production processes. Proper regulation, verification, and transparent reporting are necessary to mitigate this risk.
  • Regulatory inconsistencies: Carbon markets face complex and inconsistent regulations. Practitioners need to stay informed about regulatory changes, comply with rules, and be prepared for potential reputational damage or legal penalties for non-compliance.
  • Social and environmental impacts: Carbon projects should deliver against social and environmental impacts, in addition to offsetting carbon emissions. Market practitioners should ensure that credits genuinely address climate challenges and provide broader benefits, such as access to clean water, improved health outcomes, and job opportunities.
  • Market integrity: Market practitioners should prioritize market integrity, addressing issues such as double counting, additionality, and permanence. Clear standards, verification, and accreditation systems are crucial for maintaining the trust and effectiveness of carbon markets.
  • Global price coordination: The lack of a unified global price for carbon creates challenges and disparities in carbon markets. Practitioners should support efforts to align carbon prices internationally to promote consistency and reduce arbitrage opportunities.

What Policy Makers Must Focus On

Policy makers have a critical role in improving the effectiveness of carbon markets. To enhance the performance of carbon markets, policy makers should prioritize the following:

  • Enlarge the scope of emissions covered: Consistent carbon pricing should be implemented across all goods and services to avoid distortions and perverse incentives. Equity considerations should be taken into account to ensure fairness in the transition to a low-carbon economy.
  • Address global equity issues: International cooperation and climate finance are essential to address global equity issues. Compensation for developing countries and addressing the imbalances in voluntary offset markets can help promote fairness and reduce inequality.
  • Coherence and integrity: Policy makers should work towards improving market integrity by addressing regulatory inconsistencies and clarifying concepts such as double counting, additionality, and permanence. Standardization and alignment of carbon market standards can enhance the transparency and effectiveness of carbon markets.

In conclusion, carbon markets are a vital tool in addressing climate change, but their effectiveness can be improved. Market practitioners and policy makers must work together to address the challenges facing carbon markets and enhance their impact in driving decarbonization. By focusing on price volatility, oversupply of credits, measurement and verification, carbon leakage, market integrity, and global coordination, carbon markets can play a more significant role in achieving global climate goals.

Access the full paper here.

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