Enhancing the effectiveness of carbon markets

In the drive to support a rapid and orderly transition to net zero, carbon emissions have become a critical piece of information for internal and external stakeholders. To ensure that firms are supporting decarbonisation initiatives, governments and regulators have begun putting into place the regulatory and market infrastructure that is needed to realise net zero. 

The first priority for any firm looking to decarbonise its operations is to reduce, to the maximum extent possible, its direct or indirect carbon emissions. In practice, this may mean switching to fossil-free fuel sources, investing in cleaner manufacturing processes and ensuring the sustainability of raw materials. However, many firms will have some level of residual greenhouse gas (GHG) emissions which cannot be decarbonised. These residual emissions can be offset through the use of carbon credits in either voluntary or compliance markets. 

Compliance markets are government mandated schemes which set limits on the amount of GHGs which can be emitted by individual firms, sectors of the economy or by the economy as a whole. In the EU, the Emissions Trading System (ETS) covers industries such as air travel and will gradually reduce the legally permitted amount of carbon which can be emitted. Similar systems exist around the world, including in the UK.

Other firms participate voluntarily in GHG emissions trading. To offset the impact of non-decarbonised aspects of their business processes, they purchase financial instruments which represent an amount of GHG which has been removed from the atmosphere or prevented from being emitted. These instruments are increasingly sophisticated and include derivative instruments as well as more standardised contracts. For more on the operation of carbon markets, see our previous article.

It has become clear that the rapid and unequal development of compliance and voluntary carbon markets is having an impact on their effective functioning. In response, in November 2022, the International Organization of Securities Commission (IOSCO) launched two public consultations on recommendations for national supervisors and industry organisations to enhance the effectiveness of carbon markets.

In its consultation on Compliance Carbon Markets, IOSCO anticipates that more jurisdictions will begin building compliance market infrastructure in the future, and makes recommendations for their initial construction as well as effective long-term functioning. As a first step, IOSCO recommends that markets should be sufficiently ambitious in scope. A market which offers too many carbon credits or offers them at a low price may not achieve its aim of reducing emissions. As markets mature, it will become more important to maintain confidence in the predictability of market patterns by providing trading information transparently to other participants and ensuring rules are in place to govern any stability mechanisms. 

IOSCO observes that, ultimately, the distinction between compliance markets and voluntary markets may be blurred — and recommends exploring ways to open compliance markets to include a much broader section of the economy, including allowing non-mandated firms to opt in and compete for carbon credits. By increasing the competitiveness of the market, IOSCO suggests that the most carbon-intensive firms would be incentivised to decarbonise at a faster rate than is currently likely. 

However, it is unlikely that voluntary markets will be integrated into compliance markets in the short term. IOSCO's second consultation on Voluntary Carbon Markets notes that further development is required to increase their effectiveness. IOSCO proposes that voluntary markets should be open to broad involvement, but key participants and infrastructures should have effective risk management and governance frameworks. IOSCO also recommends that rules-based market oversight should be established to prevent fraud, manipulation and abusive practices. 

More broadly, IOSCO notes that a carbon market cannot function in isolation and that it will be important to develop holistic, cross-market mechanisms which standardise the global carbon price. This will ensure that carbon-intensive activities are not outsourced to jurisdictions where the carbon price is much lower even though the impact on the climate is the same — a phenomenon known as `carbon leaking'. Voluntary and compliance markets will need to work together to set consistent pricing. IOSCO suggests that regulators may wish to lead in developing cross-border memorandums of understanding, or building the infrastructure for a global, central securing registry system which would facilitate the convergence of global carbon pricing.

The EU has committed to developing a voluntary framework to certify high-quality carbon credits, demonstrating how regulators can provide the tools and impetus to voluntary carbon markets to improve transparency, access and confidence in their functioning. The high-level details released so far indicate that the framework will focus on the removal of carbon from the environment, providing a net climate benefit, rather than rewarding the reduction of carbon emissions. The framework will allow independent assurance of the quality of carbon credits, and the framework's criteria for assurance will align to the EU's other sustainability objectives — including requirements relating to a circular economy, land and marine pollution, and preserving and building back biodiversity.

The EU has also forged ahead in developing its own solution to carbon leaking — the Carbon Border Adjustment Mechanism (CBAM). While the exact details of implementation are still being worked out, the recently agreed levy is ambitious in its scope and goal of reducing global carbon emissions, not just those emitted in the EU. 

Under current plans, the levy will apply from October 2026 to all imports of some of the most carbon-intensive goods, such as metals and cement, although the scope is likely to expand to capture plastics and potentially even finished goods such as vehicles in the medium term. Imports will be taxed based on the difference between the EU's carbon price and any price that has been incurred outside the EU. With the EU's carbon price currently hovering around €90 per tonne and only expected to rise, this levy will not only have a monetary impact on corporates but will have an impact on the credit and market risk profile of investment and lending portfolios, potentially altering the transition risks to which financial services firms are exposed. 

Supporting its ambition of becoming a net-zero economy by 2050, the UK Government is also exploring options for its own CBAM. Although details and potential timelines are currently unclear, a UK CBAM would undoubtedly assist firms in their transition to net zero by removing their competitors' ability to offshore carbon emissions to maximise UK profitability. As firms prepare to make their first transition plan disclosures, their decarbonisation strategy is likely to become an important driver in stakeholder value, as well as impacting their risk profile for banks and other financial investors.

IOSCO's consultation papers set the direction of travel for 2023 — more governments will establish or develop their compliance markets and the voluntary carbon markets will continue to evolve. At the same time, regulatory initiatives to support the effective functioning of these markets are gaining momentum. Careful and efficient regulation will ensure that the carbon markets support an economy-wide transition to net zero.