If you’ve got an interest in carbon offsets, you’ve probably also come across the concept of carbon markets. In this article, we’re going to go through a brief bit of background on the markets, before looking at what the situation is today and what that means for you as an individual or business.
Some Background on Carbon Markets
Offsets have become an essential form of emissions reductions, helping to prevent the worst effects of climate change. Primarily, the emissions come from the burning of fossil fuels across various industries, which produce greenhouse gases.
Carbon dioxide (which is primarily what is referred to when we say ‘carbon emissions’) is the most common of these harmful greenhouse gases in our atmosphere, thanks to its prevalence in industry and transport.
Carbon offset projects exist to reduce the carbon footprints of individuals, organisations, and nations either by preventing carbon from reaching the atmosphere (e.g., through a renewable energy project) or by taking existing carbon out of the atmosphere (e.g., through a reforestation project).
The carbon market is a marketplace where carbon credits can be bought and sold so that we can reach carbon neutrality or net-zero carbon emissions. It extends to net-zero emissions more generally, including other harmful greenhouse gases (GHGs), such as methane and nitrous oxide.
Offsets are purchased in the form of carbon credits where one credit equals the removal of one tonne of carbon or CO2 equivalent (CO2e). (One tonne of CO is not equivalent to one tonne of, say, methane because, for example, methane has a warming effect 30-90 times greater than carbon. This, therefore, has to be adjusted for when calculating GHG offsets.)
Since the Kyoto Protocol in 1997 — the landmark United Nations climate accord — there has been a market for buying and selling carbon. A UN initiative known as the Clean Development Mechanism (CDM) was set up in order to create standards and targets around offsetting. The practical mechanisms for trading carbon internationally was further refined in the Paris Agreement as outlined at the 22nd climate summit (COP22) in 2015 and most recently at COP26 in Glasgow.
The CDM also specified that the offsets market should contribute to sustainable development and constitute a meaningful source of investment from economically developed to developing countries. This is in order to support them in adapting to the worst effects of global warming, as well as in their economic development, through investment in offsetting projects. It also goes a small way to addressing the inequalities inherent in climate change, although this is far from simple.
How Big Is the Carbon Market?
In 2020, it was estimated around 95 million metric tons of CO2 or equivalents were offset, more than two times as many as in 2017. While such growth is positive, this figure is a mere 0.25% of the 36.7 billion metric tons emitted in 2019, meaning further growth in the sector is needed to meet emissions targets.
As a whole, the carbon market is worth about $851 billion per year internationally.
This is comprised of two subcategories of the market:
- The larger, compliance market
- The smaller, voluntary market
The principal difference between these markets revolves around regulation (as well as their size). First, let’s look at the compliance market.
The Compliance Carbon Offsetting Market
Participation in the compliance or regulatory market is obligatory for certain high-emitting organisations, such as heavy industry and aviation. It involves trading carbon credits in order to remain within an officially mandated government allowance. A credit is essentially a permission slip to emit carbon within this allowance. (If this seems complicated, don’t worry. There will be an example at the end of the section.)
This allowance is set by national institutions in line with a country’s NDCs (nationally determined contributions), where carbon emission targets are set out. Credits are bought and sold through state-level, national, or international trading schemes, such as the EU Emissions Trading System (EU ETS), which is the largest in the world.
The market operates under a cap-and-trade system. Here, a ‘cap’ is set on how many emissions an organisation can release, and participating organisations are free to trade with one another based on how much they exceed or fall below their targets. Organisations must stay within these limits or else they receive hefty fines from the regulatory bodies.
Let’s look at an example of how this works.
Let’s say the EU ETS has set an emissions limit of 200 tonnes of carbon for two companies. Company A operates in an especially high-emissions industry and is on track to release 250 tonnes of carbon this year, whereas Company B is on track for 150 tonnes.
Company B can sell its 50 remaining credits to Company A through the ETS, meaning both companies remain within their allowance and avoid a fine. This also generates a profit for Company B.
The idea is that the market incentivises decarbonisation (i.e., the reduction of emissions across a business’s activities) because of the potential profit available to low-emitting organisations and the cost for high emitters. (It doesn’t always work like this though. Sometimes, it’s cheaper for an organisation to continue to emit and then to pay for offsets after. This is one of the challenges the market faces.)
How Big Is the Compliance Carbon Offsetting Market?
Because incentives are high in the compliance market — i.e., to avoid hefty fines — the market is large and growing quickly.
From 2017 to 2020, the total market size grew from US$47 billion to US$261 billion. The EU ETS, made up of 11,000 companies across the member states, accounts for 90% of the global value at 683 billion euros.
This growth is partially driven up because emissions ‘caps’ are being gradually decreased each year. When an organisation is struggling to bring down emissions, they are forced to invest in credits, sending the price of these credits up, as well as increasing supply to meet the increased demand.
Additionally, more organisations are being included in compliance schemes, such as aviation in recent years, also increasing the size of the market.
The process for introducing new sectors in the compliance market takes place gradually to give organisations time to adapt their business practices. For example, currently, many emissions trading schemes grant airlines most of their carbon credits for free, with the understanding that this will be phased out over time. The idea is that organisations are incentivised to use this grace period to invest in strategies that will reduce their emissions before it is too late.
The Voluntary Carbon Offsetting Market
Participation in the voluntary market is, well, voluntary. It extends to all organisations and individuals who want to reduce their carbon footprint.
As stated, participation in the voluntary market is not subject to regulation. Here, rather than carbon credits being set by organisations, participants buy ‘carbon offsets’ (also known as ‘carbon offset credits’). They use them to meet internally set carbon emissions targets.
This lack of regulation doesn’t mean offsets purchased on this market don’t uphold certain standards, however. In order to attract customers by proving their green credentials and avoid accusations of greenwashing — making misleading claims around environmentalism to boost brand image — organisations are incentivised to invest in accredited schemes.
Industry standards are set by schemes such as the Verified Carbon Standard or the Gold Standard, which establish benchmarks that offsets should meet in order to gain certification. The organisations behind these schemes then review and accredit projects in line with their criteria.
They can ensure that offsetting projects, such as tree planting schemes, not only achieve carbon reductions but also achieve wider environmental benefits, such as ecosystem degradation and biodiversity loss. This ensures long-term considerations, such as carbon storage, are factored in.
Such schemes help drive up standards within the industry and play an important role in sustainability in its various forms.
Examples may include:
- Supporting livelihoods for local communities in the form of forestry projects that build on indigenous knowledge and practices
- Supporting clean energy infrastructure in the form of solar projects or wind farms
- Combatting deforestation
- Investing in energy-efficient cookstoves
- Funding entrepreneurial schemes, such as encouraging the circular use of products that would usually go straight to landfill for use in biomass generators
Again, even with these safeguards in place, there remain offsetting projects that fall far short of what they claim as well as organisations guilty of greenwashing. There needs to be a continual movement toward greater consistency of standards across the sector to support high-quality offsets.
How Big Is the Voluntary Carbon Offsetting Market?
Because transactions occur outside of regulated emissions trading schemes, it is difficult to measure the exact size of the voluntary market. A report by Ecosystem marketplace put it at around $1 billion at the end of 2021, and it could reach $200 billion by 2050.
Further growth will be dependent on a range of factors, such as whether the industry can leave behind accusations of greenwashing and begin to demonstrate consistent and widespread reductions in emissions.
How Does the Carbon Offsetting Market Work in the U.K.?
Following its exit from the EU and Britain’s drive to become a global leader in the offsetting market, Britain established its own U.K. Emissions Trading Scheme (U.K. ETS) in 2021.
The scheme is similar to the EU one, covering energy-intensive industries, the power generation sector, and U.K. aviation. However, the scheme claims to be more ambitious, with a cap 5% lower than that set by the EU ETS.
Trading works via auction. Every two weeks, organisations can purchase credits or UKA (U.K. Allowances) at a minimum price of £22. One UKA permits an organisation to emit one tonne of CO2e. Organisations may also sell credits if they are within their allowance or if they believe they will be able to buy back credits at a better price at a later date.
How Much Does It Cost to Offset Carbon in the U.K.?
The cost of offsetting differs depending on whether the carbon is being purchased on the compliance or voluntary market. And even then, there are other factors to consider.
Price on the Compliance Market
As stated, on the compliance market, the U.K. ETS sets a reserve price for carbon of £22, below which bids will not be accepted.
This is slightly lower than the price on the EU ETS and is designed to support companies in reaching the more ambitious emissions caps set by the U.K. ETS while providing continuity in pricing as the U.K. transitions to its own system.
The average price will fluctuate depending on how much supply and demand there is in any given auction. If it gets too high for example, which would disincentivise organisations from participating in the market, the U.K. regulator may decide to intervene through the Cost Containment Mechanism (CCM).
The mechanism sets a maximum price threshold for carbon. If the price rises above that point, a review process is triggered. This happened in December 2021 and January 2022 after high prices in October, November and December, triggering the CCM to review prices. It decided not to intervene in those cases, despite concern that if prices rise too much it will create too large of a gap between U.K. industries and foreign ones, hampering trade between the U.K. and EU ETS, for example.
Prices must remain low enough to encourage organisations to buy them on a given market but also high enough to incentivise companies to reduce their emissions, rather than simply emitting first and paying for offsets later.
Price on the Voluntary Market
On the voluntary market, the price is not predetermined. Instead, price is based on supply and demand as well as the cost incurred by the offsetting project in the first place.
This has been a problem in the voluntary market. Prices should be approaching $40 to $100 per tonne to ensure the quality of the offset and incentivise organisations to decarbonise. However, in 2020, they remained around $5 to $6 mark.
Lower price does not mean an offsetting scheme is ineffective — for example, if it takes place in a country where land and labour is relatively cheap. But paying less may result in a false economy if the scheme is not properly accredited, with transparent and clear carbon mitigation claims.
So, Can I Buy and Sell Carbon Credits in the U.K.?
In the sections above on the compliance market, it should be clear how participants in the compliance market buy and sell credits to remain within their allowance.
However, there are certain other ways credits can be bought and sold by individuals and organisations who are not participating members of the compliance market.
This is through something known as the secondary carbon market. Here organisations outside the ETS can trade carbon ‘derivatives’ or ’futures.’
Basically, a derivative is a contract relating to an asset — such as a carbon credit — which locks in the price of that offset for a sale at a given time in the future. By locking the price in, this guarantees the organisation who owns this contract can buy/sell that asset for this price when the time comes.
For example, an organisation may be concerned about the price of a commodity they sell going down in the future, meaning they will sell at a loss. They therefore purchase a derivative, which will guarantee that they can sell for a profit later on.
These derivatives therefore take on a value of their own because of their value in protecting organisations against risk. This means that derivatives themselves are bought and sold many times over before the underlying asset — such as a carbon credit — is actually sold.
Let’s say carbon is priced at £25 per tonne now, and you come across a derivative locking in the price at £30 per tonne a year from now. Because you believe the market price of carbon credits will grow enough to exceed this price, you may purchase that derivative. It turns out the price does rise, so you can then sell it back to another organisation and turn a profit. No carbon has actually been offset because of this trading. You have simply made a profit betting on the cost of offsetting going up.
Individuals and organisations outside the ETS can participate in the market in this way. However, it is not recommended for individuals without experience and knowledge of the carbon market. Moreover, this kind of participation may quickly become more about profit than offsetting emissions and may therefore distract us from the real goal.
The Best Way to Buy a Carbon Offset
As can be seen, the offsetting market is complex. For high-emitting companies, the best way forward is to reduce emissions as quickly as possible. This is because caps are becoming smaller and smaller, while carbon prices are rising all the time, meaning higher fines for organisations who do not decarbonise.
Because of the complications relating to derivatives, it is much easier for individuals and other businesses to buy offsets on the voluntary market.
While it is not currently possible to sell these offsets, buying them is straightforward and should help you make meaningful reductions to your carbon emissions as long as due attention is paid to accreditation.
Check out the carbon offsets that Terrapass has available to help you lower your footprint.
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