Basics of the carbon credit market

Over the last 10 years, carbon emissions trading has become a primary instrument of climate change policies and one of the most innovative commodity markets to date. First proposed by the European Commission in 1999, the trading of carbon emission certificates is based on the establishment of an emission trading scheme (ETS). For the most part, it relies on a “cap and trade” setting for which the total amount of carbon emission certificates is “capped” at a finite number and then allowed to be traded on the open market.

There are 31 ETSs currently in place globally. The best-known ETS is the EU Emissions Trading System (EU ETS), established by the Kyoto Protocol in 2005. As financing solutions to climate change entail the assessment of existing pools of investments for the reduction of GHG emissions across portfolios, investors welcome the introduction of financial instruments that effectively price and mitigate systemic exposures to carbon risk and unveil investment opportunities in green technologies.

With companies stepping up efforts to mitigate their carbon-intensive activities and set science-based emission reduction goals, global carbon markets are likely to provide a natural bedrock for policy development and financial innovation. As a result, financial institutions are increasingly applying carbon pricing scenarios in their disclosure of climate-related risks and opportunities in a variety of sectors.

In 2015, the Paris Agreement marked the world’s first high-level commitment to the mitigation of climate change. It focused on two key areas:

1) The development of targeted national energy and climate policies to achieve average temperatures well below 2°C above pre-industrial levels.

2) A significant increase in capital market flows to fund a low-carbon transition, including, among other elements, the development of climate-resilient infrastructure.

This market-based mechanism aims at incentivizing emitters to reduce CO2 emissions by directly assigning a cost to carbon-emitting operations. The term “carbon credits” refers to tradable certificates of one ton (t) of CO2 or its equivalent greenhouse gasses (GHG/tCO2e).

  • Companies are given a predetermined number of credits, which decrease with time. Any extra credits can be sold to another business.

  • Companies have a financial incentive to cut their carbon emissions thanks to carbon credits. Those that find it difficult to cut emissions can still operate, albeit at a higher cost.

  • The cap-and-trade concept, which was employed in the 1990s to reduce sulfur emissions, is the foundation for carbon credits.

  • The creation of a global carbon credit offset trading market was decided upon by negotiators at the Glasgow COP26 climate change summit in November 2021.

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