Everything you need to know about the carbon markets

As leaders from countries around the world gathered to discuss climate change at the 26th Conference of Parties (COP26) in November, carbon markets were high on their agenda. A key point of attention was Article 6 of the 2015 Paris Agreement, which allows countries to partially meet their climate targets by buying offset credits representing emission cuts by others. At the conference a final deal for setting rules on carbon markets was adopted by almost 200 countries that means carbon markets may play an increasingly important role in both mitigation and adaption of climate change.

Carbon emissions are a major contributing factor to global warming and reducing the amount of greenhouse gas (GHG) emissions companies release into the atmosphere is essential for limiting the damaging impacts of climate change.

One way governments, banks and companies are collectively tackling this is through regulated and voluntary carbon markets. We asked Francois Carré, carbon market portfolio manager at BNP Paribas, to explain what carbon markets are, how they work and how they can contribute to positive environmental impacts.

What are carbon-pricing mechanisms?

Carbon pricing is an instrument that measures the external cost of GHG emissions and passes that cost back to the emitters. The costs of emissions that society at large absorbs, from damage to crops, through to flooding and sea level rise, are calculated, usually in the form of a price on the emitted CO2. These costs are then passed back to the companies emitting CO2. In this way, carbon pricing incentivises companies to reduce their emissions and shift to a more sustainable business strategy, such as using renewable energy. If they fail to do so, they are subject to costly fees for their carbon emissions.

More than 60 countries have already implemented such mechanisms and a large number have expressed interest in using carbon pricing to meet their emission reduction targets, also known as Nationally Determined Contributions (NDC), as set out in the Paris Agreement.

The Paris Agreement

The Paris Agreement also provides a framework designed to enable voluntary international co-operation on climate action offering the possibility of trading emissions reductions between countries. For example, while countries implement carbon-reducing strategies, which can take some time to put in place, they can purchase emission reductions from other nations that have already cut their emissions below their target, helping to keep a limit on overall global emissions.

The proposed framework is meant to provide a clear set of rules for carbon pricing and increase transparency in emissions accounting between countries. This framework could provide the foundations for an international carbon market but due to the complexity of the matter, it has yet to be implemented. COP26 finalised the rules around carbon markets, whilst also tackling adaptation, as it was agreed that 5% of proceeds from offsets will be collected towards an adaptation fund for developing countries.

There are a number of carbon pricing mechanisms available, which are either regulated or voluntary. Regulatory pricing mechanism can take the form of:

• A carbon tax or fee – applying a flat and predefined rate on all carbon usage
• A cap-and-trade system, also called Emission Trading Schemes (ETS) that depends on government allotments of permits. ETS are created and regulated by mandatory national, regional or international carbon reduction regimes

How do Emission Trading Schemes work?

As an example, the European Union Emission Trading Scheme (EU ETS) is one of the biggest ETS in the world covering around 40% of European emissions. The EU ETS regulates around 11 thousand installations across different sectors from power and heat generation to energy intensive industry sectors, for which a reduction of emission is expected.

The system works by putting a limit on overall emissions from regulated installations, which is then reduced every year, making it a moving target. Within this limit, companies can buy and sell emission allowances (EUAs) as needed. For example, a company emitting more carbon than the limit can buy EUAs from companies below the limit. In this way, the amount of carbon emissions can be regulated and gradually reduced each year as companies implement strategies to reduce their carbon emissions.

Cap-and-trade system

In a cap-and-trade system, the cap constitutes a finite supply of allowances, which creates a scarcity and drives the demand and price for allowances. A cap-and-trade system aims to internalise the costs of emissions, and thus drives carbon emitters to seek cost-effective means to reduce their emissions.

One of the challenges in a cap-and-trade program is to determine the appropriate level at which to set the cap, which should be stringent enough to induce the desired level and rate of change, while minimising overall economic costs. This cap-and-trade approach aims at giving companies the flexibility they need to cut their emissions in the most cost-effective way.

There are many other ETS implemented around the world. Carbon tax and ETS cover around 22% of global emissions , and those mechanisms continue to expand in geography and scope.

How do voluntary carbon markets differ?

Carbon pricing mechanisms are not all imposed by a mandatory regulation. For example, some can take the form of voluntary action such as:

• An internal carbon pricing
• An offset mechanism

Internal carbon pricing is a tool used by a firm to guide its decision-making process in relation to climate change impacts, risks and opportunities. An offset mechanism is where companies that have exhausted all other options to reduce emissions, offset any that remain, against activities or projects that avoid, stock or remove carbon from the environment.

‘Carbon offsets’ allow companies to compensate for any residual, unavoidable carbon emissions. These offsets can be used to meet compliance under an international agreement, domestic policies or corporate citizenship objectives related to GHG mitigation. Voluntary carbon markets allow companies to go further with their emission reductions than is stated by regulation.

Carbon offsets are becoming more and more relevant to clients, in light of their commitment to compensate for their residual emissions. Compensation can be one pillar of a sustainable strategy that is based on monitoring emissions, reducing emissions, and taking responsibility for those emissions which could not be avoided as of yet. It is a voluntary strategy that many can benefit from.