[Explained] carbon credit markets

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Climate change is the talk of the hour and comes with that the talk about green finance of climate action of and solutions. Carbon credits trading is one of the ways to be largely adopted in the coming years to address the issue of climate change.

Only recently, the Egyptian government has launched the first African voluntary carbon market, on the sidelines of COP27, in the presence of world leaders. This market will serve as a platform that helps economic entities operating in various fields in Egypt and Africa to reduce carbon emissions and benefit from the issuance and sale of carbon certificates. Trading of carbon certificates in that market is set to start in the second quarter of 2023, according to the chairman of the Egyptian stock exchange (EGX), Ramy El-Dokany, as reported by Asharq Business.

But what do we know exactly about carbon credit? And what should we expect in this market in the coming years?

Carbon credit explained

Carbon credit is credit that allows a company to emit a certain amount of greenhouse gases. Each credit unit allows the emission of one ton of carbon dioxide or other greenhouse gases. Each company gets a certain number of credits, and if it could reduce its greenhouse gas emissions, it would have an excess balance it can sell, hence, make a profit.
The companies that buy these credits are often incapable of reducing their emissions, and that’s usually due to the nature of their industry.

All of this has prompted the creation of carbon credit markets whose main mission is to encourage companies to reduce their emissions. The climate summit of 2021, COP26, has set the very first basis for carbon credit trading, where it was agreed to establish a global carbon credit market.

First, let’s take a look at the two types of carbon markets: compliance and voluntary. Compliance markets are created as a result of any national, regional and/or international policy or regulatory requirement. Voluntary carbon markets (whether national or international) refer to the issuance, buying, and selling of carbon credits, on a voluntary basis, according to the UNDP Climate Promise.

In 2005, the European Union launched the first international emissions trading system (ETS) in the world, and in 2021, China launched the world’s largest. “It’s estimated to cover about one-seventh of global carbon emissions from the burning of fossil fuels,” says Climate Promise. “The Clean Development Mechanism (CDM), adopted under the Kyoto Protocol in 1997, is a well-known example of an international compliance market,” it adds.

When did the term ‘carbon credit’ first appear?

It appeared for the first time in 1997. It was developed by the Intergovernmental Panel on Climate Change (IPCC) of the United Nations to reduce carbon emissions worldwide in the 1997 agreement ‘Kyoto Protocol’. This agreement set binding targets for reducing emissions in participating countries. Another agreement known as the ‘Marrakesh Accords’, a set of agreements reached at the 7th Conference of the Parties (COP7), determined the rules for how the system of carbon credit works.

Carbon credits are distributed to several countries based on estimates of potential emissions for each country, and once quotas are determined, they can be distributed further locally by each country. These carbon certificates are traded similarly to the buying and selling of stocks and financial bonds. In regulated and voluntary carbon credit markets, third-party auditors verify, collect, and analyze data to confirm the validity of each offset project. Many organizations also provide a carbon footprint calculator which is used to determine exactly how many carbon offsets an organization needs in order to be carbon-neutral.

Understanding the difference between ‘carbon credits’ and ‘carbon offsets’

These two terms are frequently used interchangeably, but carbon credits and carbon offsets operate on different mechanisms. Carbon credits, also known as carbon allowances, work like permission slips for emissions. When a company buys a carbon credit, usually from the government, they gain permission to generate one ton of CO2 emissions. With carbon credits, carbon revenue flows vertically from companies to regulators, though companies who end up with excess credits can sell them to other companies. Offsets flow horizontally, trading carbon revenue between companies.

Which countries are leading on carbon markets?

Currently, countries that are rich in forests, such as Costa Rica, are looking into ways of strategically engaging in carbon markets in the context of delivering nationally delivered contribution “NDC” (each country’s part in the Paris Agreement, a legally binding international treaty on climate change).

“In Southeast Asia, Cambodia has extensive experience with the voluntary carbon market in the forest sector. In line with its updated NDC and ambitious Long-Term Strategy for Carbon Neutrality, Cambodia, through the second phase of the Climate Promise, is strategically considering how the regulated and voluntary international carbon markets can offer opportunities to mobilize investments in priority sectors such as energy, forest and land use,” says UNDP. Meanwhile, countries such as Ghana are already leading the implementation of carbon market instruments developed through voluntary cooperation among countries under Article 6.2 of the Paris Agreement.

What to expect in the future of carbon credit

The market for carbon offsets is expected to grow substantially over the next few years, according to a report from Coherent Market Insights. “This market is expected to grow at a compound annual growth rate (CAGR) of nearly 31 percent from 2020 through 2027, with a value reaching $2.4 trillion. In 2019, the market was valued at $211.5 billion,” reports Environmental Leader.

Challenges along the way

Like any new solution for any given problem, carbon credit comes with a downside. Human Rights Watch says that many carbon credits traded in those markets do not actually represent permanently removed carbon or avoided emissions. It adds, “These ’hot air‘ credits undermine climate action when they are used to “offset” pollution, as no overall emissions reductions actually take place”.

More serious concerns about carbon credit markets are related to possible double-counting of greenhouse gas emission reductions, human rights abuses, and greenwashing (when companies market their green credentials on a false basis. For example, the misrepresentations of climate-neutral products or services). In order for carbon credit to grow and be successful, these concerns must first be addressed.

Those supporting carbon credit say that carbon finance is crucial for the implementation of NDCs in the Paris Agreement. Interest in carbon markets is significantly increasing, as 83 percent of NDCs state the intent to make use of international market mechanisms to reduce greenhouse gas emissions.

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