Explainer: Why carbon markets have emerged as a focus at COP27

Carbon markets are trading systems that put a price on greenhouse gas emissions. The US and some African countries have recently launched voluntary carbon trading schemes. (Photo: Chris LeBoutillier via Unsplash)

At COP27, the US unveiled a new voluntary carbon trading scheme. Its aim: to boost private investments in clean energy projects in developing countries. In the long run, it can help poorer countries transition to renewables and build their resilience to the far-reaching impacts of climate change. Nigeria and Chile have already shown interest in the plan, which could be operational from next year.

Also read: Why is India creating a carbon market?

A similar initiative was launched by African countries. They plan to put up carbon credits for sale to unlock billions in climate finance and support economies across the continent.

So, what are carbon markets? And why have they taken centre-stage at COP27?

Let’s find out.

What are carbon markets?

Carbon markets are trading systems. They rely on a concept that we are familiar with: exchange. In this case, greenhouse gas emissions are turned into a commodity by giving them a price.

There are two kinds of carbon markets: compliance (initiated as a result of a national, regional, international policy or regulatory requirement) and voluntary (think of it as companies having made their own net-zero commitments).

Compliance markets are made up of industries whose emissions exceed a specified threshold, or those who operate in sectors such as fossil fuel-fired industries. In some, like the cap-and- trade system used by the EU and California, industries or sectors are given an allowance, or in this case credits, for the greenhouse gases they can emit. If they subsequently reduce their emissions, they can sell their excess credits to other market members whose emissions have increased.

Voluntary carbon markets allow companies or industries to offset their unavoidable emissions by purchasing carbon credits from projects that remove or reduce greenhouse gases from the atmosphere (for example, forest restoration).

Are carbon markets a new concept?

Not really. Carbon markets formally started in 1997 under the UN’s Kyoto Protocol on climate change, when a group of developed countries pledged to reduce and limit their greenhouse gas emissions. It led to the creation of the Clean Development Mechanism (CDM). The CDM allowed countries that failed to meet mandatory emission-reduction targets to fund emission-reduction projects in developing countries and claim the saved emissions.

In 2005, the European Union launched the world's first international Emissions Trading System (ETS). China launched the world’s largest ETS in 2021. It is estimated to cover around one-seventh of global carbon emissions from the burning of fossil-fuels.

India too, as per its most recent energy bill, has green-lighted the creation of a “carbon credit trading scheme”. Polluters will be able to exchange credits equivalent to a certain amount of emissions. The carbon market will be voluntary at first, but there are plans to roll-out a mandatory cap-and-trade system.

Sounds too good to be true?

Yes, there are concerns. There have been instances of double-counting of greenhouse gas emission reductions, human rights abuses, and greenwashing (companies falsely market their green credentials). Critics feel that carbon markets allow polluters to keep polluting instead of reducing greenhouse gas emissions and some offset schemes fail to deliver meaningful carbon impact.

Also read: Greta Thunberg: COP27 an opportunity for "greenwashing, lying and cheating"

At the same time, finance is needed to fight climate change and for the implementation of Nationally Determined Contributions (NDC) that embody efforts by each country to reduce national emissions. It’s why the Paris Agreement enables the use of such market mechanisms through Article 6, though negotiations are still on related to its operation. In fact, 83 percent of NDCs state the intent to use international market mechanisms to reduce greenhouse gas emissions. The biggest advantage of carbon markets, however, is that they can help divert finance to support the most vulnerable countries to adapt to climate change.

When used correctly, carbon markets can be a handy tool in the fight against climate change. Which is why they are back in the limelight at COP27.