Carbon Markets and Pricing

Module 4: Carbon Markets and Pricing

The Economics of Carbon Pricing

Climate change is often described as the greatest market failure in history. Greenhouse gas emissions impose costs on society—through climate impacts—that aren't reflected in the prices paid by emitters. This is an "externality" in economic terms.

Carbon pricing aims to correct this market failure by putting a price on carbon emissions, creating a financial incentive to reduce them. When emitting carbon has a cost, businesses and consumers factor that cost into their decisions, naturally shifting behavior toward lower-emission alternatives.

Types of Carbon Pricing

Carbon Tax

A direct tax on carbon emissions, typically expressed as a price per tonne of CO2 equivalent:

How it works: Governments set a tax rate on carbon content of fuels or emissions. Emitters pay based on their emissions.

Advantages:

• Price certainty for planning and investment
• Simple to implement and understand
• Revenue can fund climate programs or tax cuts

Disadvantages:

• No guarantee of specific emission reductions
• Politically challenging to implement
• May need adjustment over time

Examples: Sweden ($130+/tonne CO2), Canada (rising to $170 by 2030), British Columbia

Emissions Trading Systems (ETS)

Also called "cap-and-trade," these systems set a limit on total emissions and allow trading of emission allowances:

How it works:

1. Government sets a cap on total emissions
2. Issues allowances (permits to emit) up to the cap
3. Emitters must hold allowances equal to their emissions
4. Allowances can be traded between parties
5. Cap typically decreases over time

Advantages:

• Certainty about emission outcomes
• Price discovered by market
• Flexibility for emitters to find lowest-cost reductions

Disadvantages:

• Price volatility can complicate planning
• Complex to design and administer
• Risk of oversupply reducing effectiveness

Examples: EU ETS, California Cap-and-Trade, Chinese National ETS

Major Emissions Trading Systems

European Union Emissions Trading System (EU ETS)

The world's first major carbon market, launched in 2005:

• Covers power generation, industry, aviation
• About 40% of EU emissions
• Allowances allocated through auctions and free allocation
• Current price: approximately €80-100/tonne CO2
• Part of EU's 2030 climate targets and Fit for 55 package

Chinese National ETS

The world's largest carbon market by covered emissions, launched in 2021:

• Currently covers power sector
• Expanding to other industries over time
• Intensity-based allocation system
• Lower prices than EU ETS currently
• Significant potential as market matures

California Cap-and-Trade

North America's most significant carbon market:

• Linked with Quebec's system
• Covers about 80% of California's emissions
• Price floor prevents prices falling too low
• Revenue funds climate programs

Other Systems

• UK ETS (post-Brexit replacement for EU ETS)
• South Korea ETS
• New Zealand ETS
• Regional Greenhouse Gas Initiative (US Northeast)
• Pilot markets in various countries

Carbon Credit Types

Allowances

Permits issued by governments under compliance markets (ETS). Each allowance represents permission to emit one tonne of CO2 equivalent.

Offsets

Credits generated from projects that reduce or remove emissions outside the cap. Can sometimes be used for compliance or sold in voluntary markets.

Types of offset projects include:

• Renewable energy projects (displacing fossil fuels)
• Energy efficiency improvements
• Forestry and land use (carbon sequestration)
• Methane capture from landfills or agriculture
• Industrial gas destruction

The Voluntary Carbon Market

Beyond compliance markets, a growing voluntary carbon market allows companies and individuals to offset emissions voluntarily:

Market Size and Growth

The voluntary carbon market has grown rapidly, reaching over $2 billion annually, though still much smaller than compliance markets.

Buyers

• Companies making net-zero commitments
• Companies offsetting specific products or services
• Events seeking carbon neutrality
• Individuals offsetting personal emissions

Project Types

Avoidance/Reduction: Credits from preventing emissions that would otherwise occur (renewable energy, avoided deforestation)

Removal: Credits from actively removing carbon from atmosphere (reforestation, direct air capture)

Removal credits are increasingly valued as essential for net-zero claims.

Standards and Registries

Major voluntary market standards include:

• Verified Carbon Standard (Verra)
• Gold Standard
• American Carbon Registry
• Climate Action Reserve

These standards certify that projects deliver real, additional, permanent emission reductions.

Quality and Integrity

Not all carbon credits are equal. Quality concerns include:

Additionality

Would the emission reduction happen anyway? Projects that aren't truly additional don't deliver real climate benefits. This is one of the most debated aspects of carbon markets.

Permanence

Will the carbon stay sequestered? Trees can burn down, releasing stored carbon. Some projects offer "buffer pools" or insurance to address permanence risks.

Leakage

Does protection in one area simply shift emissions elsewhere? Protecting one forest may lead to deforestation in another.

Measurement

Are emission reductions accurately quantified? Methodologies vary, and some have been criticized for overstating benefits.

Co-benefits

Quality credits often deliver co-benefits: biodiversity protection, community development, improved air quality.

Initiatives to Improve Market Integrity

Integrity Council for the Voluntary Carbon Market (ICVCM)

Established Core Carbon Principles to define high-quality credits:

• Effective governance
• Robust quantification of emission reductions
• Additionality demonstration
• Permanence assurance
• No double counting

Voluntary Carbon Markets Integrity Initiative (VCMI)

Focuses on how companies should use carbon credits:

• Credits should complement, not replace, emission reductions
• Clear claims guidance for corporate users
• Transparency requirements

Science Based Targets Initiative (SBTi)

Sets standards for corporate climate targets, including guidance on how carbon credits fit into net-zero commitments.

Carbon Market Mechanisms

Auctions

How allowances are sold in many ETS:

• Governments auction permits
• Prices determined by supply and demand
• Revenue used for climate programs or returned to economy

Free Allocation

Some allowances given free to industries at risk of "carbon leakage" (relocating to avoid carbon costs):

• Based on emissions intensity benchmarks
• Declining over time as carbon prices become more global

Banking and Borrowing

• Banking: Saving allowances for future use
• Borrowing: Using future allowances now (limited in most systems)

Market Stability Mechanisms

Tools to manage price volatility:

• Market Stability Reserve (EU ETS)
• Price floors and ceilings
• Automatic supply adjustments

Article 6 of the Paris Agreement

Article 6 enables international cooperation on carbon markets:

Article 6.2

Bilateral cooperation between countries:

• Internationally Transferred Mitigation Outcomes (ITMOs)
• Countries can trade emission reductions
• Must avoid double counting

Article 6.4

A new UN-supervised carbon market:

• Successor to Clean Development Mechanism
• Generates credits for international use
• Still being operationalized

These mechanisms could significantly expand global carbon markets and improve efficiency of emission reductions.

Corporate Carbon Pricing

Many companies use internal carbon prices even where no compliance market exists:

Types of Internal Carbon Pricing

Shadow Price: Used in investment decisions but doesn't involve actual financial flows

Internal Fee: Actual charge on business units that funds efficiency or clean energy

Implicit Price: Derived from cost of achieving internal emission targets

Benefits

• Prepares for future carbon regulation
• Identifies risks and opportunities
• Drives efficiency and innovation
• Informs investment decisions

Over 2,000 companies now use internal carbon pricing.

Criticisms and Debates

Carbon markets face legitimate critiques:

Effectiveness Debates

Have carbon markets actually reduced emissions? Evidence is mixed:

• EU ETS has contributed to emission reductions
• Some markets have had excess allowances, limiting impact
• Price volatility can undermine investment incentives

Environmental Justice

Carbon markets can concentrate pollution in disadvantaged communities if companies buy credits rather than reduce local emissions.

Offset Quality

Many offset projects have failed to deliver promised benefits. Studies have found significant problems with additionality and permanence.

Complexity

Carbon markets are complex, creating opportunities for gaming and making verification difficult.

Should Polluters Pay or Just Trade?

Some argue carbon taxes are more straightforward and effective than trading systems.

The Future of Carbon Markets

Carbon markets are evolving rapidly:

Coverage Expansion

More countries and sectors are being covered. Carbon Border Adjustment Mechanisms (like EU's CBAM) extend carbon pricing to imports.

Price Increases

Carbon prices are rising as caps tighten. Many analysts project $100+/tonne prices will be needed to drive deep decarbonization.

Market Linking

Connecting different carbon markets can improve efficiency and reduce leakage concerns.

Technology Integration

Blockchain and digital MRV (measurement, reporting, verification) may improve transparency and reduce costs.

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Next, we'll explore sustainable banking and lending—how banks are integrating sustainability into their core operations.