Understanding the rise of carbon markets

As the world accelerates its transition to a low-carbon economy, carbon markets stand out as strategic tools for aligning environmental and economic goals. By allowing the trading of emission reductions (credits) and emission allowances, carbon markets create financial incentives for decarbonisation.

The outcomes of COP29 in Baku highlighted the importance of global carbon markets, with leaders agreeing to establish a standardised international framework for implementation. This agreement aims to enhance market transparency, prevent double counting, and ensure the integrity of traded carbon credits. Nations also pledged to mobilise US $300 billion each year by 2035 in implementing cost-effectively climate plans. Key advancements include the finalisation of Article 6 mechanisms under the Paris Agreement, such as a centralised UN-regulated carbon market (Article 6.4) . These efforts are designed to streamline processes, strengthen Monitoring, Reporting, and Verification (MRV) systems, and enhance market credibility.

The role of carbon markets in emission reduction

Carbon markets emerged as a response to climate change, offering a system where emissions reductions are quantified, traded, and incentivised. In 2023, global carbon pricing revenues reached a record US $104 billion, supported by 75 carbon pricing instruments in operation worldwide—an increase of nearly 247% compared to US $30 billion in 2013. The voluntary carbon market, valued at around US $2 billion in 2022, is expected to reach US $100 billion by 2030 and approximately US $250 billion by 2050.

Introduced under the Kyoto Protocol in the early 2000s, the Clean Development Mechanism (CDM) allowed developed nations to earn carbon credits by funding emission-reduction projects in developing countries, laying the foundation for today’s compliance and voluntary carbon markets. Compliance markets are government-regulated with legally binding targets, while voluntary markets enable businesses and individuals to voluntarily offset emissions to achieve mitigation targets. Due to their purpose and structure, compliance and voluntary carbon markets differ significantly as shown in the comparison below.

Table 1: Comparative analysis of compliance V.S. voluntary carbon markets

Aspect	Compliance markets	Voluntary markets
Regulation	Government-mandated	Market-driven
Participants	Regulated entities	Businesses, individuals
Scope	Regional	Global
Type of Credits	Allowances, certified credits	Verified carbon credits

Challenges facing carbon markets

Despite their potential, carbon markets face challenges that threaten their effectiveness and credibility. Among the most critical issues is the lack of effective Monitoring, Reporting, and Verification (MRV) frameworks and global standards. MRV frameworks are crucial for ensuring the credibility, transparency, and accountability of carbon markets by providing accurate emissions data, preventing double-counting, and building trust among participants. However, implementing robust MRV systems faces challenges globally, such as financial limitations, weak institutional capacity in developing countries. Even developed countries struggle with inconsistent standards and difficulties in verifying emissions across industries.

In addition to MRV challenges, carbon markets struggle with carbon leakage —where emissions shift to regions with weaker regulations, undermining global reduction efforts. Furthermore, the misuse of forest credits such as overestimating carbon sequestration or using them to avoid carbon taxes, raises concerns about environmental integrity. Addressing these issues are critical, but without MRV challenge remains a fundamental barrier to the effectiveness and credibility of carbon markets.

Strengthening carbon markets through MRV

As highlighted in COP29, the evolution of carbon markets depends heavily on the implementation of effective MRV frameworks to ensure credibility and impact. Compliance carbon markets, such as the EU Emissions Trading System (EU ETS), and the application of the Verified Carbon Standard (VCS) in Brazil’s voluntary carbon market proves to be beneficial in addressing the challenges faced by MRV frameworks.

EU Emissions Trading System (EU ETS) provides a strong example of how effective MRV systems can be implemented in compliance carbon markets. EU ETS, the world’s largest cap-and-trade carbon market, generated~ US $44.8 billion in revenue in 2023. It covers power, industry, and aviation sectors. By capping emissions and allowing companies to trade surplus allowances, it incentivises emission reductions. In 2023, the EU ETS achieved a 15.5% reduction in emissions, facilitating to cut down emissions to approximately 47% below 2005 levels, aligning with the EU’s 2030 target of a 62% reduction. As of October 2024, EU ETS’s carbon price was around ~ US $64.1 per ton of CO₂, with analysts projecting a rise to ~ US $114 per ton by 2027 . This market mechanism drives the green transition by creating predictable carbon price and incentivise emissions reductions projects focused on renewable energy, energy efficiency, and industrial decarbonisation in Europe.

The EU ETS has addressed several MRV challenges in carbon markets by implementing standardised protocols for emissions measurement, reporting, and third-party verification, enhancing transparency and accountability. It has successfully tackled challenges as:

The EU ETS has established a uniform system within the EU to set clear rules and standards for emissions tracking
By accurately tracking emissions, the EU ETS ensures that allowances are allocated and traded transparently, fostering market confidence
Automated data tracking systems and periodic audits help ensure that allowances are allocated and traded transparently, ensuring companies follow the compliance
The EU ETS generates significant financial resources through carbon allowance auctions, which are reinvested into climate-friendly projects and technical support
Independent third-party verifiers play a crucial role in validating reported emissions data, reducing inaccuracies and discrepancies

While the EU ETS has made significant progress in strengthening emissions monitoring and market transparency, further improvements are essential to enhance its effectiveness.

On the other hand, voluntary carbon markets, supported by robust MRV unlocks private investment for global climate action. It enables businesses and individuals to issue, buy and sell carbon credits from initiatives like reforestation, renewable energy, and blue carbon projects. Brazil, for example, is leveraging its natural resources to create credits through reforestation and forest preservation to potentially meet 48.7% of the global demand for voluntary carbon credits by 2030, possibly generating US $120 billion in revenue from both voluntary and regulated markets. By 2030, Brazil could produce 90 to 220 million metric tons of CO₂ equivalent (MtCO₂e) in voluntary carbon credits, accounting for 15% of the world’s carbon offset capacity using natural climate solutions, as voluntary carbon markets are expected to grow to US $250 billion by 2050.

Brazil’s progress in MRV implementation has helped address key challenges by ensuring more reliable and credible emissions data. It has successfully tackled challenges as:

Brazil has implemented internationally recognised frameworks such as theVerified Carbon Standard (VCS) , ensuring the reliability and credibility of carbon credits
By adhering to VCS, Brazil’s voluntary carbon market has attracted private sector investment and enhanced market transparency

Despite progress in VCS adoption, Brazil’s voluntary carbon market faces challenges in enforcement and ensuring transparency, which lead to inconsistencies in reporting and validation. There is still a need for stronger governance capabilities to effectively manage and regulate the growing voluntary market.

Carbon markets are integral for climate action, with compliance systems like the EU ETS driving renewable energy and decarbonisation through robust MRV frameworks. Voluntary markets, including the blue carbon market, attract private investment by monetising coastal ecosystems that sequester 50% of the ocean’s carbon, offering economic potential of US $190 billion annually through innovations like blue bonds. By providing funding for low-carbon technologies and improving MRV systems, carbon markets are powerful tools to combat climate change and build a sustainable future.

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