Carbon market mechanisms

Carbon market mechanisms have become increasingly popular as a tool to support climate change mitigation efforts, with their origins traceable to the 1997 Kyoto Protocol. The goal of carbon markets is to reduce greenhouse gas (GHG) emissions by establishing a price on these emissions using two types of market-based instruments: emission allowances and carbon credits.

Emission allowances are tradeable permits that allow the holder to emit one metric ton of carbon dioxide equivalent GHG per allowance. Carbon credits, on the other hand, represent one metric ton of GHGs reduced or removed from the atmosphere. This distinction is essential because it affects the type of carbon market in which a company may decide to trade.

There are different types of markets, such as compliance markets, voluntary markets, and compliance offset markets. Compliance markets are also called cap-and-trade or Emission Trading Schemes (ETS) markets. These markets are set by cap-and-trade regulations at regional, national, and state levels, with carbon allowances issued by governmental organizations and then traded in a secondary market. Compliance markets exist as mandatory schemes, with companies within scope obliged to redeem emissions allowances to cover their GHG emissions and participate in the scheme to pay for their allowed quota of emissions.

In contrast, voluntary markets allow companies, governments, and others to purchase carbon credits on a voluntary basis. These markets are largely unregulated and enable entities to offset some or all of their carbon emissions. Carbon credits are issued concerning climate change mitigation projects, either through carbon removals and through emissions reductions, for example, by investing in renewable energy or planting trees. Voluntary markets are a possible means to offset emissions-producing activities that cannot yet be eliminated or significantly curtailed.

The Taskforce on Scaling Voluntary Carbon Markets (TSVCM) estimated that demand for carbon credits could increase by a factor of 15 or more by 2030 and up to 100 by 2050. According to TSVCM, the market for carbon credits could be worth upward of $50 billion in 2030, driven in large part by firms’ public commitments to net zero emissions. The voluntary carbon market has fluctuated in size, in part due to international-level negotiations. However, the value of the Voluntary Carbon Markets (VCMs) has more recently been on an upward trend, reaching the $US 1 billion mark in 2021, with market size, in terms of trading volumes, increasing five-fold since 2017 as long-term net zero commitments increase on the demand side.

As the demand for carbon credits continues to increase, it is important to consider what sound and efficient voluntary carbon markets should look like and what role financial regulators could play in promoting integrity in those markets. Additionally, it is essential to identify key regulatory considerations stemming from other financial markets, particularly commodities markets, to generate a discussion about appropriate market infrastructure and existing good practices in relation to the functioning of primary and secondary markets, both spot and derivatives, as well as the activities of market participants within these markets.

In conclusion, carbon markets have become a crucial tool in supporting climate change mitigation efforts, with different types of markets catering to different needs. The demand for carbon credits is expected to increase significantly in the coming years, making it crucial to ensure the soundness and efficiency of voluntary carbon markets.Reg