What role can voluntary carbon markets play in mitigating climate change?
This Insight forms Part 1 of a five-part series on voluntary carbon markets, which allow emitters to voluntarily offset their emissions by purchasing carbon credits. So far businesses in hard-to-abate sectors have been particularly interested in carbon credits. This Insight discusses international efforts to cooperate on meeting global net zero targets and sets out the main differences and similarities between compliance and voluntary carbon markets.
Part 2 which will focus on the voluntary carbon market ecosystem discusses the different types of carbon offset projects, the seven stages of a carbon project cycle and the main market participants involved.
Part 3 which will focus on voluntary carbon market developments presents recent market trends and discusses initiatives aimed at improving the functioning of the voluntary carbon market, including efforts to raise trust among market participants.
Part 4 which will focus on voluntary carbon markets needing trust and scale, will present recent policy and private-sector initiatives to develop the voluntary carbon markets.
Part 5 will discuss the role of Article 6 of the Paris Agreement in the development of VCMs and provide a market outlook.
International cooperation to achieve net zero targets
Since the 2015 Paris Agreement, governments around the world have launched ambitious emission reduction targets, with many governments now aiming to reach net zero emissions by mid-century.
Achieving net zero globally will require a dramatic reduction in gross emissions in advanced economies, such as the USA and EU member states, and in rapidly developing emerging economies, such as China and India. For policymakers in these economies, climate change mitigation is the key challenge. One way to reduce emissions is by pricing them – to this end, numerous governments have launched ‘cap-and-trade’ compliance markets. By contrast, in less-developed economies with limited emissions, the key challenge for policymakers is how to adapt to climate change.
As the 2015 Paris Agreement made clear, there is a need for international cooperation to achieve global targets, including the reduction of net emissions. Article 6 of the Paris Agreement sets out how governments could pursue voluntary cooperation to this end, transferring so-called carbon credits earned from reducing net greenhouse gas emissions in one country to help another achieve its own goals, as set out in their nationally determined contributions (NDCs).
While most governments agree on Article 6 in principle, implementation has proved to be difficult, with policymakers failing to make progress on a wide range of issues at COP28 in late 2023. For example, no satisfactory answer has yet been found on how to prevent double counting of emission reduction achievements in their respective NDCs when governments transfer credits between them. We expect that negotiations on Article 6 will continue at COP29 which will be held in Azerbaijan in November 2024.
Transferring carbon credits across borders is not a new idea though. Indeed, voluntary carbon markets (VCMs) emerged in the late-1980s, allowing businesses to offset some of their gross emissions by purchasing carbon credits issued by projects aimed at reducing gross or net emissions. VCMs are international in nature and most businesses which purchase carbon credits are based in advanced economies, while the projects issuing these credits are typically based in emerging economies.
Governments have so far only played a minor role in these markets, but this is changing as policymakers increasingly recognise the role VCMs could play in achieving global net zero targets. How could these markets be developed? And how should they be treated – if at all – in the formal Article 6 negotiations?
We will address these and other questions in parts two to five in this Insight series. Part one (this insight) starts by comparing compliance and voluntary carbon markets.
Voluntary carbon markets are distinct from compliance markets
Compliance (mandatory) and voluntary carbon markets are very different
Compliance markets are set up by governments (regional, national, cross-border) and are generally in the form of ‘cap-and-trade’ schemes where participating polluters can purchase and trade emissions allowances. Cap-and trade schemes and carbon taxation are the main market-based policy instruments available to policymakers to deal with climate change mitigation. These market-based policies complement other policy instruments available to policymakers such as regulation and financial incentives.
The number of allowances available in a compliance market is set by governments or government agencies (e.g. in carbon budgets) in line with climate targets. Governments also decide which businesses will have to participate in the compliance market. This decision can be based, for example, on sector, on size of business or contribution to national emissions. The EU Emissions Trading Scheme is a prime example of a compliance market/cap-and-trade scheme. The chart below, which is based on our upcoming Carbon Pricing Scheme Database, shows which countries currently have compliance schemes.
Voluntary carbon markets function on a completely different basis. They have their roots in philanthropic projects in the late-1980s and were developed under the Kyoto Protocol, which introduced market-based mechanisms in the form of International Emissions Trading, the Clean Development Mechanism and the Joint Implementation.
Voluntary carbon markets exist to trade carbon credits
Voluntary carbon markets are based on projects which aim to achieve a net reduction in greenhouse gas emissions, either by reducing actual (gross) emissions, avoiding otherwise inevitable nature loss, or supporting nature-based or technology-based emissions removal. The emissions ‘saved’ can be traded as a carbon credit, where the unit of credit is generally equivalent to 1 tCO2e. In principle, there are no limits to the amount of carbon credits available as new projects could always be developed.
Businesses are not required to participate in the voluntary carbon market. They often do so to meet their own emission reduction targets which might be more ambitious than what is required by an existing compliance market (e.g. to meet shareholder expectations) or fill the gap left by the non-existence of such a market. Participation in the voluntary carbon market is particularly attractive for businesses in hard-to-abate sectors such as aviation, which might struggle to reduce their own gross emissions.
Compliance and voluntary carbon markets can work together
Compliance and voluntary carbon markets generally operate independently of each other but there have been attempts to integrate them, for example by allowing businesses to count purchased carbon credits against their compliance targets. For example, since the beginning of 2024 Singapore-based companies covered by the Singapore Carbon Pricing Act can use high-quality international carbon credits to offset up to 5% of their taxable emissions.
In summary, this Insight provides an overview of voluntary carbon markets, comparing them to compliance markets and highlighting their distinct characteristics. It explains how voluntary carbon markets function, their key participants, and their role in achieving global decarbonisation targets.
In part 2 of this series we will discuss the different stages of a carbon offset project from initial plans to registration on a carbon registry and the market participants involved making up the ‘voluntary carbon market ecosystem’.
