The Compliance and Voluntary Carbon Markets
Carbon markets are fundamental to achieving net-zero greenhouse gas emissions. Currently, the compliance carbon market is more mature than the voluntary carbon market due to transparency and regulation. The voluntary carbon market, however, presents a massive growth opportunity as demand for carbon credits rapidly increase while cap-and-trade systems only provide a set supply of carbon credits per year.
Compliance Carbon Market Dynamics
The cap-and-trade carbon allowance system underpins the compliance carbon market. In this system, governing bodies set a cap on emissions for companies by issuing carbon allowances. Companies are incentivized to lower their emissions in order to trade excess carbon credits on the compliance carbon market.
The emissions cap also slowly declines each year which places a growing premium on carbon credits. This creates an artificial supply constraint over time forcing companies to face increasing pressure to reduce their emissions. Companies that are unable to reduce emissions may face escalating costs to get under the mandated emissions cap.
This dynamic also creates a potentially attractive market for investors to speculate on the appreciation in the value of carbon credits. Since the compliance carbon market is regulated and transparent, institutional investors and funds can purchase carbon credits from companies with a degree of confidence and potentially remove them from the market for a prolonged period of time as supply continues to constrict over time. This can drive additional upward pressure on prices if companies are unable to reduce their emissions.
While the cap-and-trade system creates supply constraints over time that investors may place additional pressure on, the voluntary carbon market may help to alleviate this dynamic. The voluntary carbon market provides companies with an alternative market to generate, trade, and sell carbon credits.
Voluntary Carbon Market Dynamics
In the voluntary carbon market, companies can purchase carbon credits to offset their emissions. These carbon credits come from projects through carbon offset programs that reduce or remove greenhouse gases from the atmosphere. The voluntary carbon market is separate from the compliance carbon market and is accessible to all stakeholders.
The voluntary carbon market adds additional supply to the global carbon credit market. As carbon credit prices increase, it incentivizes more companies to develop and investors to fund carbon offset programs. Depending on the amount of carbon offset projects, there may be downward pricing pressure if supply outpaces demand.
This is the key reason analysts are predicting massive growth to between $5 billion and $180 billion by 2030. As the compliance carbon market supply gradually reduces, the voluntary carbon market will absorb much of the demand. The reason the range is so large is that companies and investors have trouble determining the validity of carbon credits generated by these programs.
Since there is minimal market regulation and oversight, the voluntary carbon market lacks the transparency, uniformity, and liquidity of the compliance carbon market. Without improved regulation, the market could end up flooded with carbon credits from questionable projects that lead to an oversupply. This is the key factor that contributes to the large range of predicted market size.
Carbon Credit Pricing Dynamics
The price of carbon credits is heavily influenced by future regulation of carbon offset programs in the voluntary carbon market. The current market lacks regulation of carbon offset programs allowing many projects to cut corners and not effectively remove or reduce carbon emissions. This dynamic leads to an increasing amount of projects generating low-quality carbon credits that place downward pressure on price.
BloombergNEF developed multiple scenarios to reflect the effects of the regulation of carbon credits with regard to carbon credit price. The voluntary market scenario represents the status quo and illustrates the effect of low-quality carbon credits on the future of the overall market. The removal and hybrid scenarios reflect different variations of regulation that lead to higher quality carbon credits but vastly reduced supply causing a large price spike within the next decade.
There will always be demand for carbon credits as long as net-zero emissions goals are in place. Regulation of carbon offset programs manages the supply of carbon credits and influences how investors approach this market. If the market is left to the status quo, the financial upside is limited and may not attract enough investors to create a thriving carbon credit market. If supply is constrained by regulation, it creates a sizeable financial upside for investors to enter the market and fuel a large price upswing in the future.
The Global Carbon Market
The global carbon market consists of compliance and voluntary carbon markets. The compliance carbon market is more mature due to improved transparency and regulation paired with the deflationary supply of carbon credits. As demand for carbon credits increases and supply continues to decrease, companies and investors will flock to the voluntary carbon market.
This is why the voluntary carbon market will drive the future of carbon credits. In its current state, the lack of regulation of carbon offset programs is leading to a future oversupply that reduces the potential financial returns that attract investors. If improved regulation is introduced, this will lead to more supply constraints that may create the financial upside investors seek.
Regulation is not just a financial mechanism for the carbon credit market. It also introduces higher quality carbon credits that remove or reduce greenhouse gases from the atmosphere. As carbon credit prices increase due to regulation, more companies may transition to renewable energy, and more carbon offset projects may gain funding due to favorable economics. The loop generates an accelerated path to net-zero emissions as a planet.
Regulation of carbon offset programs will drive the future of the global carbon market. As the voluntary carbon market matures, companies and investors will monitor regulation to understand the future price dynamics. With proper regulation, the voluntary carbon market may spur an entire industry that generates lucrative returns for investors and catalyzes the adoption of renewable energy and net-zero emission technologies.