Carbon markets and ESG investing have been in the news for some time now, and global interest in them has only been rising. Over 130 countries have carbon reduction targets of some kind, with new border taxes, reporting schemes and compliance markets being announced regularly.
As carbon markets are new ground for many of us, and even the organisations currently engaging with them often don’t have their usual trading and risk systems in place to manage them, below we have summarised the key information everybody should know when considering whether carbon market activity is right for them.
We break down the key areas and provide a short summary for each to give you a one-stop resource for everything related to carbon markets. We have also included links to relevant Gen10 articles that explore each section in detail if you’d like to know more.
Factors driving carbon markets
A range of stakeholders are pushing commodities players to act to reduce their carbon footprint and engage in carbon markets. On top of carbon legislation, 80% of investors consider ESG policies when making investment decisions, customers are cleaning up their supply chains, and trade finance providers are increasingly offering preferential rates for lower-carbon or more sustainable cargoes.
Carbon markets have evolved to help organisations lower their net carbon footprint. They allow organisations that are not able to fully reduce their carbon dioxide emissions to buy carbon credits that offset the remaining emissions. Each credit is the equivalent of one tonne of carbon dioxide where the emissions have either been removed from the atmosphere (such as by planting a forest) or were prevented, for example by donating renewable power generators or efficient cookstoves to remote villages.
There are also financial incentives to engage in carbon markets. Most compliance carbon markets have a goal of making lower-carbon production a financially viable, or even a cheaper option for industry. And voluntary markets allow producers to offer the lower net carbon products that consumers increasingly demand. These factors combined mean that all commodity producers, traders and buyers need to be prepared to operate in carbon markets.
Types of carbon markets
There are many different carbon markets in existence, and the number is constantly changing as new schemes develop. As carbon markets are still in their early stages, future market consolidation is likely, but this is currently slow to materialise.
The two main types of carbon markets are compliance and voluntary markets, although these can be broken down further. For example, compliance markets can operate as cap-and-trade schemes, or emissions trading schemes (ETSs), where companies trade permits to pollute and scarcity sets market prices. Or they can be baseline-and-credit mechanisms where organisations operating below a given carbon threshold can sell credits equivalent to the difference.
|Mandated by a government or other body.||Established at the organisational level based on their own agenda.|
|Usually overseen by regulators, with clear rules and structures.||There may be some oversight in the form of disclosures or over advertising claims but often less regulated than mandatory offsetting.|
|Credits are generally standardised within a particular scheme.||Each project can be considered on a unique basis, with organisations able to demonstrate improvements against multiple UN Sustainable Development Goals, depending on the projects they choose to fund.|
|In the early stages but moving towards transparency and co-operation between schemes.||Generally more fragmented and less transparent.|
Compliance markets are growing rapidly; they have seen 5 straight years of growth and in 2021 saw record turnover of €760 billion – a 164% increase on the 2020 value. As these compliance markets grow, they are beginning to include some areas of carbon emissions that were previously only served by voluntary markets, but this is not to say that voluntary markets will be phased out any time soon.
Analysts expect market growth in the coming decades, and the optionality when purchasing voluntary carbon credits, as well as the broader mandate of these markets, means that organisations trading in compliance markets may still supplement this activity with purchasing voluntary credits as well.
Realising the full value of voluntary carbon credits
Compliance markets are standardised, with every credit worth the same one tonne of CO2, which can be an advantage in situations where efficiency and faster deal-making is important. But in voluntary markets, the unique attributes of every carbon project can be captured and factored into pricing.
Some factors affecting the price in these voluntary markets are due to the cost of the project, such as its size and location; remote projects may require a larger investment in logistics as an example. But there are other credit attributes that can help sellers command a better price because they are worth more to buyers. These attributes include:
- UN Sustainable Development Goals – projects can deliver other benefits alongside carbon reduction, this could include providing high-quality jobs, clean water, or sustainable infrastructure, all of which could command a higher price.
- Project methodology – projects that remove carbon dioxide are generally seen as more beneficial than those that avoid emissions. Other projects may also realise a price premium for improving health outcomes in deprived communities, such as cookstoves that reduce woodburning.
- Additional services – projects may provide photographs, updates or marketing materials that some organisations find valuable.
- Vintage – the year the credit is issued. Buyers are often wary of purchasing older carbon credits, which can push prices down.
The advantage of voluntary markets is that all of these unique variables can be captured against each carbon credit. This allows sellers to realise the true value of their projects and provides a fair price for procurement teams, who can choose the attributes that matter to their organisation. The enhanced traceability that is inherent in these contracts can also help organisations avoid accusations of greenwashing, as they can show the real-world impact of their offsets.
Transparency will be critical in carbon markets
Because carbon markets are still in their early stages of growth and lack integration, their complexity means that transparency can be a real challenge. There are thousands of projects generating carbon credits, hundreds of participants in carbon markets and many different registries tracking credit production, and credit retirement when they are used to offset a real-world tonne of CO2.
Carbon markets and registries are working to share data and integrate better, but this will take some time and businesses remain exposed in the meantime. For example, one of the major risks of multiple registries is the risk of double-counting, where a single tonne of carbon dioxide from a project is listed and sold on multiple registries. Being able to trace each credit across any counterparties back to its source reduces this risk, as does having effective KYC policies and processes.
Low-quality carbon credits also create reputational risks for end buyers and brokers, as an end buyer purchasing a low-quality credit may not actually be offsetting their complete carbon footprint and risks accusations of greenwashing. Purchasing low-quality credits can even cause net harm as it means money is being diverted away from projects that would have had an environmental impact.
Brokers, too, could be affected if they are not performing due diligence on the projects behind the credits they collate, and not providing transparency to end users, as they could face legal as well as reputational risks.
The benefits of transparency
As well as managing risk, there are many positive reasons why those involved in the carbon credit lifecycle would want to focus on transparency, including the ability to capture the pricing benefits listed above.
It is also important to begin putting transparency and data management in place now so that your organisation is prepared for future disruption as compliance markets develop. Some market developments will arrive sooner than you may expect. For example, the EU has proposed a new carbon border tax that will only be paid from 2026 but includes mandatory reporting from January 2023.
Creating transparency within your organisation will also be important, whether you are engaged in compliance or in voluntary markets. As with any market, decisions need to be based on your organisation’s exposure, positions and inventory so that your people can protect the organisation from risk and create new opportunities.
Creating effective data sharing within your organisation allows your people to respond to changes in any of the diverse markets you are operating in. With faster access to more information, they can make data-driven decisions that can create greater profitability. This is especially important in standardised compliance markets where liquidity improvements will likely cause the market to move faster in future.
Improving transparency therefore means that organisations can function better, respond to change faster, command better prices and become a supplier of choice to clients.
Participating in carbon markets means getting your data in order
Whether you are offsetting your own emissions or trading carbon as a commodity, new markets mean new data to manage. Compliance markets rely on organisations calculating their carbon emissions and linking these to the credits they have purchased and retired. And voluntary markets have the optionality to price in many different credit attributes – if they can record them.
Data is also needed for risk management; with price volatility and rapidly rising prices, organisations need up-to-date position reports to understand their exposure and hedge appropriately. This is particularly important in carbon, where it is entirely possible for organisations to be operating in multiple markets at the same time. And of the organisations that use internal carbon pricing, 2/3 do so as a risk management tool.
Improving transparency systems or technologies can provide better fraud prevention than standard KYC checks as it allows end buyers to understand the provenance of every credit. And brokers who create portfolios from diverse assets need systems that manage credit attributes across their entire operation, whether they are split or combined with other credits.
Providing carbon credit data to supply chain partners can also be an advantage in commodity trading. As organisations gain a better understanding of their carbon footprints and climate obligations, they are growing increasingly concerned with their indirect supply chain emissions, so partners that can carbon offset a given commodity shipment may be at a competitive advantage. And some trade finance providers are improving their own carbon metrics by offering preferential rates in greener deals.
Collating data on new carbon assets has proved to be a challenge for many organisations, but it doesn’t have to be. Gen10’s NetZero OS helps you manage carbon and other environmental assets with complete granularity and advanced inventory management, so that you can originate, trade and trace carbon credits across the entire credit lifecycle. Providing a high level of data and operations management without an administrative burden allows your organisation to create more effective risk management and agility so that you can reap all the benefits of working in carbon markets.
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