Fundamental Analytics would like to introduce our inaugural monthly issue of Carbon Market News Roundup, the goal of which is to introduce our audience to a new asset class market in the making: the carbon market.
As more and more companies pledge to combat climate change, they find their own greenhouse gas emissions difficult to eliminate at the scale and speed needed to meet their goals. For these firms, it will be necessary to use carbon credits in order to offset emissions they can’t avoid by other means. Carbon credits represent carbon dioxide that has been reduced, avoided, or removed from the atmosphere, with each credit equaling one ton of CO2. Projects that reduce, avoid, or remove carbon can generate credits and sell them to polluting companies, which then may ‘retire’ these credits to offset the firm’s unavoidable emissions.
The value of the global carbon credit market reached $978.56 billion in 2022. This is the reality: That even if we do not espouse environmental degradation, a new asset class is being created that involves carbon securities. Due to the dearth of regulation and oversight of carbon markets, owing to their recent emergence, there is a lot of fluctuation in prices in both securities and carbon credits themselves. It is here, on the ground floor, that great risks exist alongside great opportunities. We, at Fundamental Analytics, believe it is best that our audience is kept informed.
But first, the basics must be understood. For instance, there are two broad markets for carbon trading: the voluntary carbon market (VCM) and the compliance market. What do these terms mean?
Understanding the Compliance and Voluntary Carbon Trading Markets
Tim Archer & Hemal Pandya, Deloitte
The architecture under which carbon trading occurs is dual in nature; comprising of compliance markets and the voluntary carbon market. Compliance markets are regulated by national, regional, or international bodies and usually target heavily polluting industries such as iron and steel, oil refineries, power generators, airlines, and processing companies. The voluntary market, however, does not currently involve any direct government or regulatory oversight.
A good example of a compliance market is the world’s first: the European Union Emissions Trading System (EU ETS), which was established in 2005. It functions as a cap-and-trade system, where a cap (a limit) is set on total greenhouse gases that can be emitted or else a fine is imposed. The cap decreases over time, which incentivizes firms to work towards decreasing their emissions over the long run.
Entities regulated under the EU ETS are given ‘allowances’ that they must surrender to cover their yearly emissions, and if they are able to reduce their emissions, they are able to sell their extra allowances to other parties that are short. This is the ‘trade’ part of cap-and-trade programs. These EU Allowances (EUAs) are classified as derivatives and can be traded in spot, forward, and future markets.
The voluntary carbon market (VCM), on the other hand, is made up of incentive-based markets that allow both individuals and businesses to purchase carbon credits to compensate for carbon emissions on a voluntary basis. Each credit represents one ton of CO2 that is reduced, removed, or avoided, and each credit is independently verified by certification entities like Verra, Gold Standard, and others. These credits are often traded directly on these certifiers’ registries and must be ‘retired’ for a company to claim their associated emissions offset.
The current size of the global compliance market, of which the EU ETS makes up around 90%, is over $800 billion, while the voluntary market is $2 billion and projected to grow exponentially – Morgan Stanley expects the VCM to reach $250 billion by 2050. To more fully grasp where this money will go, we must first know more about carbon credits themselves: What kind of credits are there?
Removal, reduction, and avoidance credits explained
Julio Friedmann & Matthew D. Potts, Carbon Direct
There are three types of carbon credits on the voluntary carbon market: reduction, removal, and avoidance. Carbon reduction is an action that decreases greenhouse gas emissions; carbon removal is an action that removes CO2 from the atmosphere and stores it; and carbon avoidance is an action that prevents carbon emissions in the first place. For each of the three types, credits are issued by certification entities through rigorous measurements and estimations of how much carbon is offset compared to a project’s baseline – the level of greenhouse gases that would be emitted without any action.
Carbon reduction credits come from projects that work to measurably reduce the volume of emissions and can include reducing the use of fossil fuels through improved fuel efficiency, or projects that reduce methane generated from farms or municipal waste processing. Around 22% of the VCM is made up of reduction credits.
Removal credits come from projects that physically remove carbon from the atmosphere and are generated through different solutions. The vast majority come from nature-based projects, such as reforestation initiatives where the trees that are planted work to absorb CO2 from the air, while other projects are comprised of innovative technologies such as direct air capture (DAC) and storage, which trap carbon and process it for long-term storage. Removal credits make up 3% of credits on the VCM today.
Finally, avoidance credits are based on emissions that would have occurred if not for a project’s existence based on potential emission estimates using historical data, contextual information, and statistical models. Examples include projects that avoid deforestation, such as land preservation initiatives. These projects have the potential to bring money to underdeveloped regions of the world that hold large swathes of undeveloped forests. While these projects’ definitive impacts are more difficult to measure, new methodologies and techniques are beginning to provide more certainty. Avoidance credits make up 75% of the VCM.
Fundamental Analytics believes that this burgeoning market has incredible potential. We hope to focus more attention on this arena, as well as to keep you updated on important news items and developments. It is crucial, in our current age of change and transition, that we keep an eye on frontiers that can provide new and innovative opportunities.