Why carbon markets?

When companies or individuals go about their daily lives and conduct business they use energy. When this energy is derived from fossil fuels such as oil, coal and gas, it releases carbon and other greenhouse gases (GHGs) into the atmosphere. This is one of the key contributors to climate change.

Carbon markets provide the infrastructure for carbon trading or ‘offsetting’ -- the process by which businesses and individuals can be accountable for their unavoidable emissions by funding certified GHG emission reduction projects elsewhere in the world. The World Bank State and Trends of Carbon Pricing 2016 report estimates that carbon markets have the potential to reduce global mitigation costs by more than 50 percent by mid-century. 

Compliance carbon markets under the Kyoto Protocol 

In 1992 the United Nations Framework Convention on Climate Change (UNFCCC) was created to raise awareness and build knowledge to help mitigate climate change. In 1997, more than 170 countries adopted the Kyoto Protocol to the Convention. This set legally binding targets for 37 industrialised countries to limit or reduce overall GHG emissions by at least 5% below 1990 levels during the period 2008-2012.

To achieve the targets set within this protocol, three flexible financial mechanisms were created:

  1. Emissions Trading – the international transfer of emission allocations between industrialised (Annex 1) countries. E.g. a country that stays within its target can sell the surplus allowances to another country that has exceeded its limit.
  2. The Clean Development Mechanism (CDM) – creates carbon credits called Certified Emission Reductions (CERs) through emission reduction projects in developing countries, regulated by the United Nations. Emitters who have exceeded their emission allocations can purchase these CERs to make up the difference.
  3. Joint Implementation – any Annex I country can invest in emission reduction projects in any other Annex I country as an alternative to reducing emissions domestically.

The rationale behind such schemes is that climate change is a global problem and that the location of GHG emission reductions is irrelevant in scientific terms. This means that a tonne of carbon dioxide reduced in a cook stove project in Kenya has the same environmental value as a tonne of carbon dioxide reduced through a wind project in China or a clean energy project in the United States. The difference in these projects is the cost of implementation.

The emission reductions generated by these flexible mechanisms are collectively referred to as ‘carbon credits’. A carbon credit is a financial instrument that represents a reduction or the avoidance of one tonne of carbon dioxide equivalent (tCO2e) from the atmosphere.

These three mechanisms, along with the European Union Emissions Trading Scheme (EU ETS) put in place by the EU in order to meet its Kyoto target, make up the largest environmental market in the world for the trading of carbon credits.

The voluntary carbon markets

In a voluntary carbon market, an entity (company, individual, or other “emitter”) chooses to take accountability for its carbon footprint by purchasing carbon credits that reduce the amount of carbon in the atmosphere. It is driven by a company’s desire to demonstrate climate leadership and/or ‘do the right thing’ and has been around in different forms for many years.

The Paris Agreement 

The Paris Agreement is an agreement within the UNFCCC aimed at achieving greenhouse gas emissions mitigations, adapting to the effects of climate change, and driving climate finance beginning in the year 2020. The agreement entered into force in November 2016 after 114 countries ratified it.

Article 2 of the Paris Agreement outlines the aims of the convention as:

  1. Holding the increase in the global average temperature to well below 2 °C above pre-industrial levels and to pursue efforts to limit the temperature increase to 1.5 °C above pre-industrial levels, recognizing that this would significantly reduce the risks and impacts of climate change;
  2. Increasing the ability to adapt to the adverse impacts of climate change and foster climate resilience and low greenhouse gas emissions development, in a manner that does not threaten food production;
  3. Making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.

In addition to these goals, the agreement outlines the National Determined Contributions (NDCs), which are the contributions each member country should make in order to stay ‘well below’ the 2°C degree target.

Article 6 of the agreement provides the framework for international cooperation to drive down emissions through market and non-market mechanisms. It is expected to feature a Sustainable Development Mechanism – the successor to the Clean Development Mechanism established by Kyoto Protocol. This and other mechanisms position countries to achieve the mitigation and sustainable development goals, and therefore meet their NDCs.