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In this publication:

• Regulated emissions trading schemes cover larger amounts of pollution, but fewer entities when compared to voluntary markets.
• Corporations are using carbon credits from projects in developing countries to balance their pollution profile.
• We might need to rethink how long carbon credits last.

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Emissions trading schemes vs. voluntary carbon markets

Emissions trading schemes, also known as emissions allowances, are regulated markets where involved parties (usually businesses) transact certificates that allow the owner of that certificate to pollute (an externality of their business activity).

The issuance of these certificates is controlled by the regulating entity so that scarcity is intact - a key element of the scheme. The ultimate goal is to create an economic incentive for businesses to reduce their carbon footprint by having them buy pollution allowances from the regulating entity or the open market.

Businesses can exchange and transact these allowances with each other whenever facing surpluses or shortages – i.e. whenever a company is polluting less than the number of allowances received or bought, it can sell those allowances to companies in a polluting allowance deficit.

Some examples:

• The EU Emissions Trading Scheme (EU ETS) is the most advanced in the world. The EU sets a limited (and annually decreasing) number of "pollution allowances" to be issued to businesses (some of which are given for free, whilst others are sold), which effectively limits (and gradually enforces a decrease in) the total emissions within the European block.

• In 2020, this trading scheme represented over 90% of the global carbon trading volumes, according to Refinitiv.

• In 2021, China launched its country-wide emissions cap-and-trade system, after being postponed since 2015, and it quickly became the world’s largest. That said, it's still quite nascent, especially when it comes to its secondary trading. California runs a similar cap-and-trade system and it's one of the most developed schemes alongside Europe’s.
• In the US, namely in California and 13 other states, carmakers are required to own a certain number of zero-emissions car credits per year. These credits are received as a reward for each electric vehicle a car maker produces, setting a floor on the annual number of EVs a manufacturer should produce. Large EV producers (i.e. Tesla) tend to be sellers of these certificates, while laggards in adopting these efforts are natural buyers.

Voluntary carbon markets are a completely different system than regulated emissions trading schemes – we're going from foosball (2 to 4 people playing) to American football (close to 100 people playing). (Diego's note: Manuel is still new to the fun analogy game… give the kid some time, we just got him to take off his Patagonia vest a few weeks ago).

Obviously, with voluntary markets, businesses are not obliged to participate, but some do in order to balance their polluting profile.

For context, regulated trading schemes cover a larger amount of carbon emissions with fewer parties involved when compared to the voluntary carbon markets. In 2020, the EU ETS issued over 1,300 allowances of 1mt of CO2 each (for a total of 1.3 billion tonnes). The newly created Chinese ETS is worth 4 billion tonnes. In the same year, the voluntary carbon market issued over 220 million high-quality carbon credits of 1t of CO2 each.

This means that:

• ETSs cover larger polluters and therefore cover a more representative volume of emissions (i.e. 1.3-1.5 billion tonnes in the ETS space vs. 0.22 billion tonnes in the voluntary market), and
• The voluntary markets involve more parties (you and me as a consumer, a small business owner, a large retail company, etc.) and therefore a greater number of emissions certificates.

ETSs are also a larger market given their ties with financial markets (i.e. the EU ETS scheme has a regulated exchange market) which amplifies liquidity. Exchanges facilitate emission allowances transferability, which is then reflected in trading volumes.

• Per Refinitiv, the 2020 global carbon market transaction volume was worth €229 billion, while the voluntary carbon market's primary market is thought to be worth south of €0.5 billion in 2020 and expected to be worth up to €50 billion by 2030.

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Voluntary markets and the types of offsets

Carbon offsets, of all types, are simply highly bespoke efforts to create and bundle ‘negative’ greenhouse gas emissions. Offsets are projects designed to counter polluting activities, either through process improvements, energy efficiency gains, or disruptive technologies. These projects are often run by NGOs that depend on these credits (which they sell in the open market) and other forms of funding as subsidies or are run by for-profit institutions which use these credits as bonuses or subsidies.

For the most part, offsets can be grouped into two categories:

• Avoidance or reduction credits are associated with projects that avoid destruction of existing carbon removal stock (like forest protection initiatives) or are associated with reducing emissions in the future through Greenhouse Gas (GHG) focused process improvements (like the construction of renewable energy projects in places where the alternative would be fossil fuel).
• Removal credits are mostly focused on sequestrating GHG (also known as carbon capture). These come in multiple forms – forest planting, biochar, and other high-tech and deep science solutions to remove carbon from the atmosphere and place it into the geosphere.

Both of these offsets are extremely important to address the climate problem – avoidance credits ensure the existence of more emission-efficient businesses going forward, while removal credits increase the Earth’s sequestration capabilities (beyond our natural wild forests and gardens).

That said, larger problems begin to take place when institutions and individuals use these offsetting mechanisms as their sole solution to climate change. Instead of focusing on implementing carbon reduction efforts within their businesses, there is now a lazier resource at hand – a market offering the “same” carbon accounting outcome at a fraction of the cost of implementing those changes.

Consider the following:

• Diego, Tim, and I start planting trees in Tim's recently purchased land in Ericeira, Portugal.
• We then register our carbon reduction efforts into a credit registry so that (a) it can be validated, and quality controlled, and (b) we can receive credits to trade.
• Some of the most well-known registries are the Verified Carbon Standard(VCS), the Climate Action Reserve(CAR), the European Biochar Certificate (EBC), or the UK’s Woodland/ Peatlandcodes. All of these are focused on certifying projects to their own degree of standards – depending on scientific expertise (e.g. biochar vs. woodland), or to their geography (e.g. CAR being mostly North American, VCS Global).
• Once we’re certified, we will be issued credits by the carbon registry that we'll be able to sell to institutions procuring carbon credits – just like an OTC market – or we can go through a marketplace.
• Most importantly, we will update the carbon registry of who owns each credit when we sell them to someone else. Today’s hottest and highest quality carbon credits rarely end up in a marketplace though as they're often sourced by carbon credit procurement teams from large institutions first (consider Stripe’s carbon credit portfolio management team).
• Once sold, Diego, Tim, and I will have received a monetary subsidy for the trees we planted, which will allow us to maintain the quality of our tree plantation for the foreseeable future.
• The buyers of these credits can use them for their own carbon accounting purposes – which in carbon jargon stands for “retiring the credit” – or they can keep it as a trading asset and simply sell it again later.

Quality assessment within the voluntary carbon markets still suffers from a meaningful subjective effort. Location (i.e. how close to the polluting entity), carbon sequestration permanence (i.e. for how long a credit guarantees carbon sequestration), the expertise of the developer, amongst others, are all important factors when assessing credit quality. This means procurement consultants are still essential to certify the quality of the underlying credits.

Whilst there is a lot of trading of emissions credits, we need not forget the real goal of all this – are we actually reducing emissions?

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Where we're heading

Three things are happening as we speak:

• More and more senior people within financial regulatory bodies are getting anxious about, and scrutinizing, how European businesses are offsetting carbon emission through avoided emissions in places like Burkina Faso instead of lowering emissions in the location of their own activities. Take Mark Carney’s initiative on scaling voluntary markets – the Taskforce on Scaling Voluntary Carbon Markets– which focuses on creating a framework to build integrity in these markets.

• Demand for lower-quality credits will decrease as more scrutiny comes into this space and different entities become better informed. This is an important positive development.
• Voluntary carbon credit pricing is likely to increase as demand will mainly focus on high-quality offsets. That will especially be the case for high-quality vetted projects in developed countries.

A few interesting notes from the Trove Research analytics portal on carbon offsetting:

• Many credits are still held for trading purposes, as opposed to carbon accounting purposes. At least 20% of offsets issued are not being retired, meaning a relevant part of the market is holding these offsets as assets.
• The way the market works currently is that the carbon emissions firstly need to be captured or avoided, and only after that comes the certification by a registry that grants carbon credits.
• This means that, when businesses use those credits to offset their polluting profile, they're actually offsetting it with the pollution that has been avoided or captured years ago.
• If we really want to lower the overall level of pollution, why are we using credits related to 2010 to justify pollution in, for example, 2021?

With the current setup, we're essentially allowing businesses to transfer pollution capacity over time. We believe we need to be more honest with ourselves and the market, and stop pretending we're curtailing overall pollution when all we're really doing is delaying it, a little. There are large amounts of credit allowances from past years being used to offset pollution today, and today's allowances are providing for more pollution in the future... we can, and need to do better than this.

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This article was originally puplished on The Lykeion. You can subscribe to their newsletter here.