Carbon markets

Carbon markets and their associated mechanisms and tools are at the heart of mitigation policies that aim to reduce or absorb greenhouse gas (GHG) emissions. We can mention for example the Emission Trading Scheme (ETS) or the emissions allowance trading systems declined in regulated (or organised) and voluntary markets.

Theoretical principles

In an emissions allowance trading scheme, a public authority sets a maximum threshold of GHG emissions over a period of compliance (usually one year). This threshold is normally revised downwards for the next period and applies to a certain number of installations or entities (countries or economic actors). These are obliged by relevant authorities to have enough permits to cover their emissions.

Emissions allowances (or credits) corresponding to this threshold are auctioned or allocated directly by the managing authority on the primary market. The credits can then be exchanged between the obliged entities on so-called secondary markets (marketplaces, direct exchanges, via an intermediary or over the counter), again with the objective of acquiring a sufficient volume of credits over the period. Depending on the markets, there are opportunities to save credits for a next period or to borrow them on a future allocation.

In practice, it is in the interest of each party to reduce their emissions as long as it is less costly than buying further allowances on carbon markets. The higher the price of credits, the greater the incentive to reduce emissions. Carbon prices fluctuate according to regulations (through mechanisms such as the establishment of credit reserves or fixing of minimum and/or ceiling prices), the volume of available allowances – the “offer” – and demand.

Carbon prices in 2018 (USD/tCO2e) 1

On a global scale, the most bankable investments are exploited in principle as priority (regardless of the entity or installation), thus making it possible to achieve the objectives set at lower costs. By its flexibility, this system, called "cap and trade", is theoretically more virtuous than a "command and control" where each party would be required to meet an emission reduction target on its own activities and/or on its own territory of intervention. Three fundamental pillars guarantee the markets’ integrity:
  • An accounting register to record compliance and emissions of each installation/entity;
  • A verification and reporting system to ensure the accuracy of data regarding emissions;
  • A system of penalties for non-compliance with market rules.

Regulation framework

The organised markets are mainly under supervision of the United Nations Framework Convention on Climate Change (UNFCCC). Various mechanisms were established under the Kyoto Protocol adopted at the 3rd Conference of the Parties (COP3) in 1997 and which entered into force in 2005. An international carbon emissions trading system was then created and implemented in different regions and countries. Though there are no formal international implementation frameworks, five industrial sectors are still concerned by this system: power and heat generation, mineral oil refineries, iron and steel, pulp and paper, building materials (cement, ceramics, and glass) 2.

Regional regulations outside Kyoto, with specific standards and allowances, also exist, particularly in the United States, Canada, Australia and Asia. It should be noted that, provided there is an agreement between managing authorities, such as the one existing between the European Union and Switzerland, allowances may also be traded between different ETS.

ETS and carbon taxes in the world 3

In Europe, more than 11,000 sites are covered by the European Union Emissions Trading Scheme (EU ETS), which covers 45% of the EU’s emissions and concerns the industrial sectors mentioned above as well as airlines operating on internal EU routes. Key policy of the EU’s 2020 and 2030 climate and energy packages, the EU ETS is also the world's largest emissions trading market 4

Clean development mechanisms and joint implementation

The Clean Development Mechanism (CDM) and Joint Implementation (JI) are two mechanisms of flexibility of the Kyoto Protocol. They allow each actor to generate Certified Emission Reduction (CER) units by financing mitigation projects in another country. The CER can then be used by beneficiaries to meet their regulatory obligations.

The Clean Development Mechanism applies to projects implemented by entities of so-called industrialised countries (Annex 1 of the UNFCCC) in developing economies (non-Annex 1 countries). Its objective is to help the former achieve their emission reduction targets while limiting emissions associated with the host countries' development process. Emission reductions are calculated using a baseline scenario.

Clean development mechanism 5

Nearly 8,000 CDM projects are listed on the UNFCCC’s 6 website covering 15 areas of intervention: energy industries, distribution and demand, manufacturing and chemical industries, construction, transport, mining/mineral and metal productions, fugitive emissions, solvent use, waste, forestry and the agriculture.

Joint Implementation (JI) works on a similar principle, but projects are here carried out in industrialised countries having mitigation targets under the Kyoto Protocol. The financer's interest is to reduce its emissions at a lower cost than the one it would bear by reducing emissions directly on its territory. While they cannot use for themselves the CERs generated, the hosts benefit, as in the case of the CDM, from investments and transfers of advanced technology and knowledge.

Joint implementation 7

Voluntary carbon markets

Voluntary markets are not "organised", i.e. not constrained by regulations or Kyoto Protocol’s mechanisms. Allowances and targets are freely defined and allow any actor to offset its emissions through the purchase of carbon credits. All the different mechanisms can coexist in voluntary markets, such as:

  • CER credits associated with CDM and Joint implementation projects. CERs are generated by projects following a strict methodology (including monitoring, evaluation, etc.). Once the project is registered, an annual verification process (always conducted by a third party accredited by the UNFCCC) of the emission reductions generated is put in place. This determines the volume of CERs allocated to the project’s holder, who can then resell these on regulated or voluntary markets;
  • VER (Verified emissions reductions) credits, which correspond to carbon credits that have been verified according to a different process that the one imposed by the UNFCCC. Examples include projects implemented in countries that have not ratified the Kyoto Protocol, or those for which the UN certification process is too complicated or for which methodologies do not exist or are not adapted. The most commonly used standards here are the VCS (Verified Carbon Standard) generating VCU (Verified Carbon Units) and the Gold Standard. Emission reductions are still verified by third parties, which are generally the same than those approved by the UNFCCC for CERs. In practice, even if the procedures remain strict, VERs only concern voluntary markets;
  • CFI (Carbon Financial Instruments) allowances, linked to markets set up in the United States;
  • EUA – European Union Allowances from the EU ETS;
  • Tailor-made products on OTC markets (over the counter)

Exemple of products in Voluntary markets 8

 

Text of reference

Main markets

Carbon products

Chicago Climate Exchange (CCX) standard

Voluntary market CCX

 

CCFE - Chicago Climate Exchange Futures

  • Quota CFI (Carbon Financial Instruments)
  • Credits VER, CER
  • Spot, future, option

NYMEX (New York Mercantile Exchange)- Green Exchange standard

Voluntary market NYMEX- Green Exchange

  • Quota EUA (European Emissions Allowance)
  • Credits CER, VER, VCU (Verified Carbon Unit)
  • Spot, future, swap

Voluntary Carbon Standard (VCS)

CDC’s VCS Register

APX

TZ1 (NZX)

·         Credits VCU, CER

 
Voluntary compensation remains an important decision that allows everyone to go beyond the specific objectives imposed on each type of actors by regulators.

By voluntarily offsetting its greenhouse gas emissions on these various markets, each actor or individual contributes to:

  • Reduce GHG emissions overall, by supporting the demand for carbon credits and helping to maintain or increase their prices, and
  • Fund low-carbon mitigation and development projects.

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