Carbon Markets

Carbon markets refer to the market mechanisms or economic approaches to solve climate change. The biggest percentage of greenhouse gases is from energy, from which industry and power generation plays a big part. And the greenhouse gas with most consequence is carbon dioxide, which is mainly from the extraction and burning of fossil fuels.

Fossil fuels provide about 80% of the energy that supports global economy, making them the biggest culprit in climate change.

Therefore carbon markets work by putting a “price” on carbon itself, and so create a market for the trading of carbon. Basically, they put a price on carbon pollution and the cost it has on society. The polluter pays principle charges the polluting entity for emitting carbon dioxide thus encouraging lower emissions.

Carbon markets provide green climate finance

There are different carbon markets but the main ones are cap and trade and carbon taxes.

Cap and trade is a system where there is a cap or limit put on the amount of greenhouse gas emissions that can be emitted by an entity likely a country, region or industry. The emissions limit or ‘cap’ would be the maximum number of tons of carbon dioxide equivalent that an industry or country is allowed to release into the environment in a given time frame, likely a year.

This cap is determined by the government, and is based on the calculated amount of emissions an industry produces in a year. The cap is then further subdivided into an equal amount of allowances. These allowances are also known as carbon permits and essentially assign you the amount of emissions you as a company can emit in a year. These allowances can be freely distributed by government or auctioned for individual companies to buy.

One carbon permit gives you a set quantity of carbon you can emit and so a company buys permits according to the quantities of carbon it knows it will emit. How this works is that when permits are distributed by the government in an already set manner, a company that pollutes more will require more permits and so buys more, either from the government(in an auction) or from other companies. This is where the trade part comes in.

The cap and trade system encourages lesser carbon pollution because one, the set cap on emissions by the government is reduced by a percentage each year, making the permits fewer as well. This means collectively and individually an industrial sector will have to cut emissions in order to abide by the cap.

So, it encourages companies to invest in clean technology and find ways to be less carbon intensive because buying permits becomes more expensive and adds to the financial cost of running a business. In this way, the company or industry in question is likely to find cleaner, more efficient and cheaper technology instead. That is, a company will try to reduce or remove the carbon aspect from its operations altogether.

As companies within a sector trade with one another for the ‘right to emit’ they create a source of revenue. Let me explain. A company buys a certain number of permits but cuts its own emissions and so doesn’t use up the entire allocated permits. This company might then sell the remainder to another company that needs more permits i.e. releases more emissions, but does not have enough of the required permits to fill that gap.

The price used in this internal trade of carbon permits is determined by the forces of demand and supply and so creates a different avenue for revenue which is apart from a company’s primary business. This bolsters economic growth, encourages green innovation and protects climate health.

Cap and trade systems are also known as emission trading schemes (ETS). ETS also work for climate by allowing the sale of emission reductions (carbon credits) between different parties. One carbon credit equals a ton of carbon dioxide equivalent removed from the air. They are quantifiable units that show how an entity has either absorbed or reduced carbon pollution by their activities. These units are then sold in a free market to willing buyers who need to meet their carbon reduction goals and lower their carbon footprint but cannot so this on their own.

Under the Kyoto protocol, these carbon credits were under the clean development mechanism (CDM) and joint implementation mechanism (JI).

The European Union Emissions Trading System is the biggest cap and trade in the world and has been in operation since 2005. The EU says that industrial emissions under the EU-ETS had been cut back by 21% in 2019.

The second type of carbon market is a carbon tax. It is the price put on one ton of greenhouse gases and is calculated as the financial cost that fossil fuel use has on society. It is the cost incurred by climate change impacts such as droughts and failed harvests, damage occasioned by heavy flash floods, heat waves and stronger hurricanes and is quantified in monetary form.

So in essence, the extraction and use of fossil fuels is taxed as the price of each ton of carbon dioxide released.

This type of tax makes the use of fossil fuels more expensive and so gives an economic incentive to companies and the economy in general to pivot from fossil fuels and turn to a low carbon pathway.

Both cap and trade and carbon tax provide a revenue stream for the government which is the collecting agency. This money is in turn used to cushion against the effects of climate change on society or even as welfare for social projects e.g. health. It can be put into research into green technology and renewable energy. Alternatively, the government can use it to plug gaps in tax revenue generation and so significantly lower taxes collected from the general population of a country.

In Canada for example, this money amassed from carbon taxes or cap and trade is given back to the citizens as tax rebates.

Under UN Climate Change, there are several carbon trading schemes such Clean Development Mechanism, which encouraged carbon negative projects and sustainable development in developing countries. The certified emissions reductions from these projects were then sold to countries and companies in the developed world. In this way, there is climate finance flow to the developing world and lowered emissions credited to the buyers in the West.

Carbon markets have been a part of climate change deliberations and are a part of the Paris Agreement as Article 6. The rules governing these markets were finally agreed upon in 2021 in Glasgow during COP 26.

Emission trading schemes are a market driven way of fighting climate change and there are over 52 such initiatives in the world today. Canada and California have successful emission trading schemes and have agreed to work together in an effort to cut emissions. China intends to introduce a national trading scheme which would help the country to reach its climate mitigation goals. This is particularly important because China is the world’s leading national emitter of greenhouse gases.

ETSs help countries to mitigate climate change in a way that is significantly cost efficient and less harmful to both the economy and climate.

Some of the drawbacks of both systems is that sometimes it can be difficult to accurately calculate emissions from a given sector and so estimates are instead used. These maybe inaccurate.

Also, some companies find it easier to just buy permits instead of cutting emissions. This actually does nothing for climate because emissions continue, even though they have been paid for.

It is the ‘right to climate pollute’.

Carbon taxes also increase the cost of fossil fuel use and because this is passed onto consumers, it makes things more expensive and can injure the economy.

Another important point is the carbon price used in various countries differs. It is not uniform. Each ETS/region sets its own carbon price and so there is need of global harmonization whereby the world will use one agreed upon carbon price.

Another aspect is that companies paying a carbon price might face unfair competition from other companies producing similar products but lie outside the domain of the carbon markets.

Additionally others argue that these schemes will not be necessary especially in the future- if the entire world does cut emissions, which is the eventual goal of the Paris Agreement. The logic here is that there is no need to buy carbon credits which give you the right to emit if ideally you are already focused on reducing emissions and investing in low carbon technology.

However, carbon markets are some of the measures used by hard to decarbonize sectors such as cement and steel, and the chemicals industries. Such industries are heavily reliant on fossil fuels to operate, and so partially rely on carbon credits bought elsewhere to bring down their carbon footprint.

Tight and clear rules and regulations are needed for these markets because of abuse in the past, where sometimes they’ve been used to just generate money without any climate impact. It is also necessary to avoid cheating where both buyers and sellers count the emission reductions as part of their individual efforts in climate mitigation.