Are Carbon Markets a useful tool for Climate Change?

Estimated Reading Time:  8 minutes, 17 seconds.

Summary

• Articles on the Economics of Carbon Markets

• What Carbon Markets are, their functions and policy behind them

• Criticisms of Carbon Markets

This week we are diving into Carbon Markets. You're probably thinking something like, what do Carbon Markets have to do with Agriculture? Carbon Markets are the incentive structure that helps the world reduce carbon usage. Agriculture can be a tool that helps achieve this end.

Articles about Carbon Markets

• 3 key fronts on which Africa must combat climate change: Africa emits less than 4% of the global greenhouse gas emissions, and absorbs the most Carbon of all continents.

• Carbon Markets Driving Price Discovery: No one really knows how to price Carbon Credits, because of how young the industry is.

• Gabon Carbon Credits Seen Fetching as Much as $35 a Ton: Gabon will release 90 million tons of Carbon Credits onto the market using REDD+. These credits prevent deforestation.

Carbon Markets: A Primer

Carbon markets are misunderstood. Many see them as a scam, others see them as the best tool to combat Climate Change. The boring reality is that they are somewhere in the middle. The most basic definition is a market that helps put a price on emissions.

Net 0 is the frame of reference for which the world looks at Climate Change. It's the Climate goal that has been set by 120 nations across the world. The basic definition is that the number of tons between what an entity produces and absorbs come down to 0. If you want to learn more about the importance of net 0, check out this paper.

What are Carbon Markets?

They are a mechanism that incentivises emitters to reduce Greenhouse Gas emissions. The base currency of this market is Carbon, but it aims to reduce all Greenhouse Gas emissions.

Carbon Markets aim to make emitters bear the economic costs of their actions. While it’s not a perfect system, it does force behavioural change by emitters. 83% of the Emissions reductions commitments made by nations include the use Carbon markets. This proves that Carbon Markets will be a primary tool to combat climate change.

A University of Maryland study found that the market could see $1 trillion of activity by the year 2050, driven by a sharp rise in global carbon prices over time.

Market Types

There are two main types of Carbon Markets; compliance and voluntary. The most important thing to remember is that as the cost of Carbon rises, innovation will become cheaper.

Compliance Markets

Compliance markets have government regulation and address specific industries. They give industrial scale emitters an allowance. If the emitter stays under the allowance they can sell or save the rest. If an emitter exceeds their limit, they can buy others credits or face penalties. This cap and trade system, allows reductions to happen where it is cheapest.

The biggest compliance market is the EU ETS. It covers heavy industry and power generation in Europe, which makes up about 40% of the EUs emissions. The EU ETS must keep markets competitive, while incentivising a switch to sustainable practices.

80% of EU ETS respondents consider Europe's carbon market a very important driver of emissions reductions compared to other policies and economic factors.

Voluntary Markets

Voluntary markets drive finances to activities that reduce Greenhouse Gas emissions. They help buyers offset their emissions.

Many companies have set net 0 goals (check out this list to see the health of some large corporation’s goals). They will do their best to innovate away emissions, but there will be a difference that they must offset. For those, they will buy offsets on the voluntary market.

The voluntary markets enable companies and investors work towards net 0. They finance activities elsewhere, which address their emissions while they work towards zero. Yet, the challenge with voluntary markets is in the name… they’re voluntary. There is no one forcing these companies to hold their promises.

Paris Agreement

The Paris Agreement is a legally binding international treaty on climate change. Its goal is to limit global warming to well below 2 degrees Celsius, compared to pre-industrial levels. The Agreement works by forcing nations to set ambitious goals to reduce their greenhouse gas emissions.

The Paris Agreement sets forth a framework for emissions trading. “Parties shall, where engaging on a voluntary basis in cooperative approaches that involve the use of internationally transferred mitigation outcomes towards nationally determined contributions.” Nations can cooperate with another to transfer their load to another nation. This is important, since most Carbon Credit activity occurs in developing countries.

Why are the Paris Agreements important? Policy determines incentives and incentives dictate action. The Paris Agreements layout the framework that will dictate how governments work to solve Climate Change. From this framework governments will set up incentives to attack those goals.

Offsets

Not all offsets are equal. Some are higher quality than others, and thus demand a higher price. Standards organisations like Verra and Gold Standard asses the quality of the Carbon Credits.

There are two main categories of offset, avoidance and removal. Avoidance credits are generally lower quality. They reduce the amount of Carbon Dioxide emitted from regular activities. These could include cook stove projects in Nepal, or building solar farms in South Africa.

Removal credits are higher quality, and remove Carbon Dioxide from the atmosphere. These credits fall into to nature based solutions (planting trees), and technological solutions (Carbon Engineering).

High quality Carbon Credits maximise climate, socio-economic and ecological benefits for local communities and ecosystems. They also lock carbon away, for long periods of time.

To make an impact, Carbon Credits must be beyond business as usual. This means that the carbon wouldn’t have been sequestered without Carbon Credits. This is additionality. Additionality is important, because Carbon Credits must go beyond business as usual. These projects should be pursued because of Carbon Credits. This is also the biggest “gotcha” for project developers.

If you’re curious about what makes a high quality credit, read this guide.

Standards Bodies

Standards bodies, like Verra and Gold Standard, are responsible for certifying Carbon Offsets. The these organisations look to certify that reductions are real and additional. That means that the climate benefits from the project, and it’s not business as usual.

Projects must go through an intense examination process, or a methodology. Methodologies are a rigorous accounting process; goals for benefits of a project and provide guidance to help project developers determine project boundaries, set baselines, assess additionality and quantify the reduced or removed GHG emissions.

The main job of a Standard body is to give some level of assurance to the quality of the offset, which gives buyers confidence in their purchase. While true, they do not offer any guidance to emissions buyers.

Benefits

Carbon markets allow emissions reductions, globally. This allows a decrease in the cost of reducing greenhouse gas emissions. Developing Nations will face the effects of Climate Change disproportionate to how much they contributed to it. This system helps developing nations to be a part of the solution, and make progress to sustainable development goals at the same time.

By generating economic value for emissions reduction, Carbon Markets incentivise innovation. Because there is now a price for emissions, companies should look at how they can reduce their footprint vs. keeping business as usual. That facilitates step-changes in technology and processes.

Because of Net 0 commitments companies can also put their Carbon Credit purchases in a different bucket on their balance sheet. Instead of a Marketing or PR expense, Credits can become a governance and treasury expense. This may seem like a trivial differentiation, but it makes a difference in how leadership handles the expenses.

Finally, it creates early action. While we may not be able to stop emitting today, but we can reduce near term reductions of Greenhouse Gases. (Figure 2 https://www.nature.com/articles/s41558-021-01245-w). Global temperature change is determined by the total of all emissions over time, and not isolated emissions at a particular point in time. That means the speed of emissions reduction is critical. It preserves optionality, and prevents corporate inertia (https://hbr.org/1999/07/why-good-companies-go-bad) from taking over.

Criticisms

While these systems make a difference, there are valid criticisms that they don't go far enough fast enough given the nature of the problem. Market based solutions have the challenge of managing incentives.

Market based solutions put a price on Carbon Dioxide, yet don't consider the full social cost. But putting a price on carbon is hard. The Social Cost of Carbon (fantastic primer, here) is a number that is often calculated to understand the damage that humans do to the environment. The Biden administration estimates this cost to be around $51 / ton. Many startups in the space build their models around a price of $20-25 / ton (dashboard for pricing). This means emitters could be getting up to a 50% discount on their emissions.

One controversy that illustrates challenges with Carbon Markets came in the early 2010s with HFCs. Hydroflourocarbons or HFCs are gases produced by air-conditioning and refrigeration. They have a 78x warming factor when compared to carbon. Producers of this gas manipulated production to increase their revenue from flaring the gas.

It’s also important to look at the incentives of certifying bodies. While these are the stewards of the industry, they too are subject to human nature. The current incentive structure is set up for them to approve as many projects as possible. This is not to say that’s what they’re doing, but the incentives are set up to do so.

Many, who could generate Carbon Credits don't want to do so on moral grounds. They say that they don't want to offset emissions of multi billion dollar corporations, who should take more initiative upon themselves. One farmer we spoke to even said, "They can't use my work to bail themselves out."

The current Carbon Market solution isn’t ideal… but it’s a tool we have. One solution could be to set up a government regulator, which oversees carbon credit issuance. This way project developers would be held to a standard that isn’t incentivised to push lower quality projects through. This could also standardise the marketplace’s units and allow trust from top to bottom. Corporations would benefit, as they wouldn’t be responsible for “greenwashing” and could rely on quality.