First published on Investment Week, November 2023

Voluntary carbon markets have matured substantially since they first emerged around 20 years ago. Yet as these markets have grown, so have the questions around how they are evolving. 

It is important to first distinguish between the two main types of carbon markets. Mandatory carbon markets – such as the UK Emission Trading Scheme (ETS) – are created and regulated by public authorities, with a view to guiding emission-intensive sectors in their decarbonisation pathways. The number of credits available is strictly controlled, incentivising companies that can reduce emissions below a certain threshold to sell their spare credits to other entities at a profit. In contrast, voluntary markets are designed to formalize the effect of emission removal or avoidance via solutions such as forestry. They are not regulated, there is no ceiling to the number of credits that can be generated, and prices are determined based on supply and demand in the open market. 

Given the much more fluid nature of voluntary carbon markets, it is perhaps unsurprising that some problems have emerged. In absolute terms, carbon credit issuance is surging, with estimates from Boston Consulting Group anticipating that the market will reach between $10 and $40 billion in 2030, up from just $500m in 2020. Yet, unfortunately, the questionable quality of much of the current supply is creating challenges for end purchasers and limiting the flow of capital that can support the development of higher-quality projects. 

The current emphasis on projects that focus on avoiding or reducing future GHG emissions is another challenge. While these efforts are important, PwC analysis has highlighted that just 20% of the total carbon credits purchased by FTSE 350 companies in 2022 were allocated to projects that directly remove emissions from the atmosphere, such as carbon sequestration or technology-based carbon capture from industrial processes. As technology evolves, the removal of emissions will need to hold a larger weight if net zero targets are to remain within reach.  

More broadly, the large variation in the quality of available information required to assess a credit’s integrity has dented the trust of many market participants. This has been evidenced by the withdrawal of several high-profile companies from carbon markets this year, with demand in 2023 now expected to fall on a year over year basis.

Despite these challenges, carbon credits can still serve an important purpose. A successfully functioning voluntary market can incentivise innovation in new decarbonisation technologies and can help to drive capital to scale existing solutions, while also creating flexibility for when and where emissions are reduced or removed. In addition, carbon credits will play an important role in helping many organisations achieve their own net zero targets, by offsetting the remaining emissions that cannot be abated. 

So how can these markets be navigated? 

As a starting point, any carbon credit should demonstrate its permanence. Think of a carbon credit as a balloon – it’s no good offsetting an emission by storing emissions in a balloon elsewhere, if that balloon is popped just a few years later. 

The second key principle is additionality. A high-quality carbon credit will be able to prove that the emissions reduction or removal would not have occurred in the absence of the offset credit. If reforestation of an area is already planned and funded, then buying a carbon credit attached to this project “after the fact” is not going to move the needle. 

Admittedly, being able to verify these qualities is not a simple matter. Third party verifiers do exist, but they can only be as accurate as the information that is available to them highlighting the important role that engagement may play. 

Innovation should help to make this process easier over time. We expect to see greater collaboration across countries in an effort to improve the quality and consistency of these markets, as principles such as those laid out by the Integrity Council for the Voluntary Carbon Market (ICVCM) gain traction. New blockchain technology targeted at tracking credits more accurately to ensure individual use is showing signs of promise. In some emerging economies, “debt-for-climate” swaps are growing in popularity to help free up fiscal resources for governments to improve infrastructure resilience without sacrificing spending on other priorities. 

Carbon markets are not a silver bullet, but that does not mean they should be overlooked. While there are a number of hurdles today, expertise and engagement can help to ensure carbon credits deliver on two key principles: permanence and additionality. Over time, innovations lie ahead that should help investors to see the wood from the trees. 

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