What are Carbon Markets?

Generally, the term carbon market designates a trading system through which entities may buy or sell units of greenhouse gas (GHG) emissions. As carbon dioxide (CO2) is the predominant GHG and other gases can be “converted” into units of CO2 equivalents, these markets are conventionally called carbon markets.

Why do Carbon Markets exist?

We know from economic theory that competitive markets are generally efficient. This understanding is a salient theoretical underpinning of the capitalist societies we live in. Though generically true, this theorem breaks in the presence of certain conditions, such as externalities. For a long time, our society has been burning fossil fuels and subsequently releasing CO2 into the atmosphere with no direct economic consequence to emitters. In the past, this could be justified by the common understanding that those emissions had apparently negligible negative externalities. However, as the impact of excessive atmospheric carbon concentration starts to become transparent and undisputable (namely through the effect on climate change), good capitalism demands that externality to be priced.

There are two ways to force a price on carbon: a carbon tax (“price” mechanism) and a cap-and-trade system (“quantity” mechanism). In ideal settings, both schemes can be thought of as equivalent. In practice, the former tends to be more effective when focusing on the cost to reduce emissions (therefore, the emphasis on the “price” of emissions), while the latter is more effective when the focus is directly on the level of environmental damage (therefore, the emphasis on the “quantity” of emissions). Carbon markets are needed to implement a cap-and-trade system and are the focus of this article.

Note that both mechanisms impose a positive price (cost) on emissions, which in their absence would be zero. Therefore, if well implemented, those mechanisms are critical to curb overall emissions and, thus, facilitate a faster, steadier, and more efficient world transition to net-zero emissions (a state where the amount of GHG emissions emitted into the atmosphere equals that removed from the atmosphere).

How do Carbon Markets work?

There are two main types of carbon markets: mandatory (Compliance Carbon Markets, CCM) and voluntary (Voluntary Carbon Markets, VCM).

In the mandatory markets – such as the European Union (EU) cap-and-trade Emissions Trading System (ETS) –, authorities issue emission allowances. They control the maximum amount of carbon that covered entities can emit over a trading period (usually a year). These allowances can be obtained for free from the authorities or traded through regulated auctions (the Carbon Markets). In this system, companies trade in the market in accordance with their emissions, allowing the most efficient ones to sell allowances and, therefore, incentivizing a race to less polluting production systems. In these systems, the allowances are reduced over time in line with the emissions reduction targets set by regulators. For reference, prices of a ton of CO2 in the ETs have been between EUR 60 and EUR100.

VCM are, as the name suggests, voluntary. In VCM, entities voluntarily buy carbon credits to offset their own emissions. These credits are generated from verified projects that avoid, capture and/or remove emissions from the atmosphere (e.g., reforestation). These carbon credits are typically bought up by companies that made (voluntary) commitments to certain emissions targets (e.g., the commitment to be net-zero by 2050). For reference, prices of a ton of CO2 in the VCM vary widely, from USD 5 to several hundreds of USD. This reflects the very different nature and credibility of the projects in the market. The standardization of the process for the measurement, reporting and verification of the credits associated with each project is work in progress. This development is critical to bring credibility to the VCM and avoid “greenwashing”.

Carbon Markets in Numbers

According to a recent whitepaper from Sylvera (“Compliance vs Voluntary: How Carbon Credit Market Convergence Creates New Opportunities, 2024”), the two sets of markets are quite different in size: CCM are valued at about USD 800 billion per year, while VCM are valued at around USD2 billion a year. Looking at CCM worldwide, there are 28 active cap-and-trade ETSs, plus 8 under development, and 12 under consideration. That translates into almost 33% of the global population, 55% of global GDP, and 17% of global GHG emissions being currently covered by an active ETS. Moreover, active ETSs raised over USD 63 billion last year (ICAP’s Emissions Trading Worldwide: Status Report 2023).

Regarding VCM, as per Trove Research’s “Carbon Credit Investment 2023 Report”, USD 7.5 billion were invested (not traded) in carbon credit projects in 2022, with the largest share of funds being devoted to nature restoration. Currently, the largest share of carbon project investment is in the East Asia and Pacific region. Considering only developed countries, North America is by far the largest destination for carbon credit investment.

The European Union’s leading example

Launched in 2005, the EU cap-and-trade ETS was the first of its kind and is currently the largest CCM in the world. In 2022, it raised the highest share of revenue (close to EUR 39 billion), as per the EU’s latest report on the functioning of the European carbon market. Notably, it is an integral part of the EU’s strategy to be the first net-zero alliance (targeted for 2050).  Those revenues are mostly directed towards climate- and energy-related projects. Covering around 36% of the EU’s total GHG emissions, it is supervised by financial authorities of all Member States, under the coordination of the European Securities and Markets Authority. Today, it aims to reduce the emissions of covered sectors – power, industry, and domestic aviation (the maritime sector is being added this year) – by 62% (compared to 2005 levels) by 2030. There are plans to establish a separate system for the buildings, road transport and other fuel-consuming sectors.

The Social Cost of Carbon

A supplementary topic to that introduced in this article is the determination of the Social Cost of Carbon (SCC). In short, it is an estimate of the sum of all costs (economic, social, and environmental) of the damage done to the planet by each emitting unit of CO2 into the atmosphere.

The concept is an important one – it could help framing the right carbon tax rate or work as a shadow price when comparing similar investments with very different carbon footprints. In the U.S., for instance, the SCC is determined by the Environment Protection Agency (EPA) and used to evaluate public investments and subsidies. The price can, therefore, have a significant impact on the public investment policy and outcomes. The catch? It is extremely hard to measure. Currently at about $190 per ton of CO2, it has been aggressively politicized by both sides of the climate change debate. For instance, under Donald Trump’s administration, this price was estimated to be about $5! As more data and research becomes available, we expect these swings to reduce over time, making the SCC a more operational number.

Have a great and impactful week!

António Baldaque da Silva
Professor of Finance (Adjunct) at CATÓLICA-LISBON
Ex-BlackRock MD, Global Head of BlackRock Sustainability Lab (NY and LDN)

Pedro Duarte de Melo
Master Student of Finance at CATÓLICA-LISBON