Carbon Talk: An Introduction to the Global Carbon Markets

Time to Listen: 10:24 Practices: Asset Management ESG, Asset Management, ESG, CSR and Business and Human Rights

On this inaugural episode of Ropes & Gray’s podcast series, Carbon Talk, asset management partner Jeremy Liabo and associate Anne Fox provide listeners with an introduction to the global carbon markets. Throughout their discussion, Jeremy and Anne outline the chief differences between mandatory carbon markets, on the one hand, and voluntary carbon markets, on the other hand. As part of this overview, Jeremy and Anne address a variety of topics including the different types of carbon “credits” and how they are each generated or issued, purchased by primary market participants and traded on the secondary market.


Jeremy Liabo Jeremy Liabo: Hello, and welcome to the inaugural episode of Carbon Talk, a Ropes & Gray podcast series focused on the global carbon markets. I’m Jeremy Liabo, and I’m here with my colleague and co-host, Anne Fox. Today’s episode is an introductory discussion of the carbon markets. Anne, I thought I would kick things off with a very basic question: What are carbon markets?
Anne FoxAnne Fox: Thanks, Jeremy. Big picture, there are two overarching types of carbon markets—compliance carbon markets (or “CCMs”) and voluntary carbon markets (or “VCMs”). It is also worth noting that there are carbon derivatives markets, which we will cover in a later episode.

Jeremy Liabo: Great. Let’s start by drilling down on the compliance markets—what are they?

Anne Fox: The compliance markets—sometimes also referred to as emissions trading systems (or “ETS”)—are constructed by government regimes with the objective of reducing CO₂ emissions in the relevant country, state or other geographic area. The most common example of a compliance market program is the “cap-and-trade” model, where the relevant governmental authority sets a cap of the aggregate amount of CO₂ that the covered entities in an industry sector may emit during a given reporting period. This cap is lowered period by period over time. Entities that are covered by the cap-and-trade program, generally emitters in a given industry sector of a certain size, are required to surrender to the government a number of carbon allowances equal to their carbon emissions during the compliance period.

Jeremy Liabo: Anne, are these carbon allowances carbon credits?

Anne Fox: The term “carbon credit” is typically used to refer to instruments generated by private sector projects and traded in the voluntary markets—they’re also referred to as “carbon offset credits” or “carbon offsets,” and we’ll discuss them in more detail later on. However, it is not uncommon for the term “carbon credit” to be used to refer to carbon allowances in the compliance markets as well.

Jeremy Liabo: Got it—thanks for clarifying. How do emitters acquire carbon allowances?

Anne Fox: Each compliance period, the government issues the number of carbon allowances that corresponds to the cap for that compliance period—sometimes via free allocation to operating companies in the sector, but typically via an auction process. Each carbon allowance permits its owner to emit one ton of CO₂. The initial acquisition of carbon allowances by market participants is referred to as the “primary market,” and the price is subject to certain controls set by the relevant governmental authority.

Jeremy Liabo: What happens if participants in the primary market need additional allowances or want to sell excess allowances?

Anne Fox: That is where the “secondary market” comes into play. The “secondary market” for compliance carbon allowances allows market participants to buy and sell these government-issued allowances to meet their individual needs. In the secondary market, the price of the government-issued allowances is determined by supply and demand. For example, Corporation A may have purchased enough allowances via the auction process to cover more than its actual emissions for the reporting period, and, therefore, choose to sell its excess allowances on the secondary market to Corporation B, whose actual emissions for the period have unfortunately exceeded the emissions permitted by the allowances that it has in its possession.

Jeremy Liabo: These compliance markets, they have been around for a while, right?

Anne Fox: That’s right—there are currently around 30 compliance markets globally, with more in development, and they date back as far as 2005 coming out of the 1997 Kyoto Protocol and the 2015 Paris Agreement. The largest compliance market is the EU ETS, but there are also sizeable compliance markets in the UK, North America—which includes the California and Quebec compliance markets (those two are linked)—and China. And these markets are pretty massive compared to the voluntary carbon markets—they’re around $850 billion in total globally, while the voluntary markets are hovering around $2 billion worldwide. We’ll talk more about the voluntary markets a little later.

Jeremy Liabo: Is it just operating companies that emit a lot of carbon that participate in the primary and secondary compliance markets?

Anne Fox: No, actually, while the operating companies are the main participants in these markets, there’s also a lot of participation by financial entities, especially in the secondary markets. These financial entities might be banks acting as intermediaries for operating companies looking to buy and sell allowances, or other voluntary participants like hedge funds looking to acquire allowances for speculative purposes. Since the governments lower the cap on emissions period over period, the value of a single allowance is expected to increase over time, so you can imagine that there are folks out there hoping to capitalize on that investment opportunity. In fact, we have a few fund clients participating in these markets already.

Jeremy Liabo: Anne, we also have clients who participate in the voluntary markets. How do the voluntary markets differ from the compliance markets?

Anne Fox: Unlike the compliance markets, which are the product of government mandates, the voluntary markets are a private sector “project-driven” construct. Participants in the voluntary market purchase what we’ll refer to as “carbon offset credits” from individual project developers.

Jeremy Liabo: What do these projects look like?

Anne Fox: Generally, the projects fall into one of two categories. The first category is avoidance projects, which avoid CO₂ emissions, such as projects that prevent deforestation or others that promote alternative power sources to avoid reliance on fossil fuels. The second type are removal projects, which permanently remove CO₂ from the atmosphere, such as direct air capture projects that remove greenhouse gases from the air and store it. For each ton of CO₂ avoided or removed, the project developer can issue one offset credit. Unlike a carbon allowance, which permits its end purchaser to emit one ton of CO₂, a carbon offset credit is used by its end purchaser to “cancel out” CO₂ being emitted by that end purchaser.

Jeremy Liabo: If I was the purchaser of a carbon offset, how do I know that the relevant project actually avoided or removed the stated amount of carbon?

Anne Fox: Great question. The voluntary markets rely on third parties in order to verify the claims made by the project developers. These third parties include standard-setting bodies, such as GoldStandard and Verified Carbon Standard (or Verra), that set minimum requirements for the credit issuance, due diligence and auditing. Other third parties involved in this market are the service providers that conduct the actual due diligence and auditing processes, and there are also financial intermediaries in the voluntary markets that help distribute offset credits from project developers to end purchasers.

Jeremy Liabo: Got it. Who are the end purchasers in the voluntary markets? Presumably not the same entities that are required to participate in the compliance market programs, right?

Anne Fox: That’s right—the end purchasers here are mainly private sector companies looking to support their corporate social responsibility goals by reducing carbon output or reaching “net zero.” A lot of times they’re purchasing the offset credits to offset their carbon footprints while they separately endeavor to restructure their operations so that less carbon is produced in the first place. But individuals like you and I can purchase voluntary offset credits as well—for instance, you’ve probably seen an option to tack on offsets when purchasing airfare the past few years. Voluntary offset credits generally can’t be purchased by companies to satisfy the requirements of compliance carbon regimes, so the two types of carbon instruments—voluntary offset credits and compliance allowances—really aren’t interchangeable.

Jeremy Liabo: Got it. It seems like there have been some doubts about the authenticity of the voluntary markets lately. What have your observations been?

Anne Fox: The voluntary markets have been in the news a lot recently—but that’s really nothing new. There are inherent challenges in the voluntary markets due to how they’re structured. For example, unlike the compliance markets, which are geographically discrete, the voluntary markets truly are global. A company located on one side of the world can purchase offset credits from an intermediary located in a completely different continent, where the offset credits themselves were generated by a project located in yet another completely different area. There’s not always a lot of visibility into the verification of private projects, so it can be difficult to accurately price voluntary offset credits. Offset credits tied to carbon removal projects are generally priced higher than those tied to avoidance projects because carbon removal is viewed as easier to measure than carbon avoidance, but in both cases measurement is imperfect.

There’s also a lot of concern about fraud and lack of integrity in the voluntary markets due in part to the perceived lack of sophistication of the market players, the relative immaturity of the market itself and the lack of a central regulator. That said, there are a number of independent, non-governmental organizations like the Integrity Council for Voluntary Carbon Markets (or ICVCM) that have stepped up to establish guidelines and more rigorous standards that can be universally relied upon in the voluntary markets. The advancement of new technology that can more accurately measure the carbon removed (or the emissions avoided) by projects that issue offsets will hopefully provide more stability in the future as well. As the voluntary market grows, so will the outside investment in its structural integrity.

It’s also important to remember that the intended role of both the voluntary and the compliance carbon markets is really to ease our current economy through its transition to a low-carbon economy that is sustainable long term. Carbon allowances and offset credits are not the end-all solution to the climate crisis—but they’re incredibly helpful tools that can and should be properly utilized as part of broader efforts to save the planet.

Jeremy Liabo: Thanks, Anne, and thanks to all of our listeners. For more information on the topics that we have discussed or any other topics of interest to the asset management community, please feel free to visit our website at ropesgray.com. And, of course, we can help you navigate any of these topics that we have discussed, so please don’t hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to your podcasts, including on Apple, Google, and Spotify. Thank you again for listening, and we hope you join us for the next episode of Carbon Talk.

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