Unpacking the Carbon Credit Market Pt 1

Global carbon markets continue to grow at a rapid pace as companies set aggressive net-zero emissions goals. For the fourth year in a row, the total value of global carbon markets grew by more than 20 percent. In addition, the compliance carbon market value reached over $100 billion with an annual trading turnover of over $250 billion. 

Source: Refinitiv

The global carbon market consists of two markets–compliance carbon markets and voluntary carbon markets. In compliance carbon markets, carbon allowances are traded and regulated; in voluntary carbon markets, carbon credits are traded freely by companies and individuals at will. The overall market is thriving due to the Paris Agreement and shifts in sentiment as investors begin prioritizing environmental consciousness. 

While the compliance carbon market is more mature and transparent, the voluntary carbon market is estimated to grow to between $5 billion to $180 billion by 2030. The market growth is expected to be fueled by growing retail and institutional investment and speculation, improved market transparency and regulation, and increased demand from companies. 

Source: McKinsey & Company

The global carbon market is set to play a significant role in net-zero emissions as governments develop and implement new policies, and companies set aggressive carbon-neutral goals. The compliance carbon market and voluntary carbon market present different dynamics that influence the potential overall growth of each market. These dynamics are important for all investors to understand given the importance of the global carbon market. 

Carbon Credits vs. Carbon Offsets 

The carbon markets are built on the trading of carbon credits (sometimes referred to as carbon allowances) and carbon offsets. While these terms are used interchangeably, there are small distinctions between carbon credits and carbon offsets. 

What are Carbon Credits?

A carbon credit represents one metric tonne of carbon dioxide equivalent that can be traded, sold, or retired. Carbon credit generation typically takes two forms–allowances granted under a cap-and-trade system (like the system the European Union uses) and through carbon offsets. 

In the cap-and-trade system, national or international organizations issue carbon credits for companies to set a carbon emissions cap. This system incentivizes companies to strive to lower their emissions so they can sell excess carbon credits on the compliance carbon market. With a limited, set yearly supply of carbon credits, companies that exceed their allowances must compete to purchase credits from companies that reduce their emissions and have excess credits to sell. This creates a virtuous loop that promotes net-zero emissions from all companies. 

What are carbon offsets? 

Carbon offsets are generated through programs that remove carbon dioxide emissions from the environment. These programs typically occur outside of normal company activities and have a clear project plan, documents, and verification through a third party. The removal of carbon dioxide emissions generates carbon credits that may be traded, retired, or sold on the voluntary carbon market. 

Carbon offsets encourage companies that cannot reduce their emissions to develop programs that offset excess emissions. These programs may take many forms from planting trees or preserving forests, building renewable energy projects like wind and solar farms, and supporting electrification projects. In addition, carbon offsets may provide a significant revenue stream for certain companies that sell the credits generated on the voluntary carbon market. 

Stay tuned for part 2 where we explore market pricing dynamics…

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