Analysis: Carbon Market Evolution

Reyhan Menetlioglu
4 min readJan 24, 2024

The global carbon market is becoming an increasingly visible player in efforts to reduce emissions, with its total value growing by 164% last year to a record $851 billion.

Until recently, institutional investors have only participated in these markets to a limited extent due to structural barriers and relatively uncertain market dynamics. Yet, the picture is changing. With the European Union Emissions Trading System (EU ETS) accounting for 90% of the market value, CCMs have stabilized and VCMs, which have at least as much scaling potential as CCMs, offer a more predictable picture for institutional investors with recent market reforms and governance and infrastructure improvements to existing trading systems. Indeed, VCMs operate with a more dynamic market mechanism, where prices are shaped by voluntary supply and demand, making them less susceptible to the dictates of regulatory mandates and policies.

It is vital to build trust in institutional investors as they have the potential to balance supply and demand in both CCMs and VCMs and add liquidity and depth to the market through their capacity to raise, channel and channel important amounts of capital. In CCMs in particular, these investors increase market fluidity and balance the tension between supply and demand by participating in the trading of carbon allowances. In the case of VCMs, their investments, whether through direct injections into carbon credit initiatives or indirect contributions through third-party funds, significantly support global decarbonization efforts, while at the same time guiding the companies in which they invest to prioritize decarbonization and integrate industry best practices into their operations.

Figure 1

Here is the view on how VCMs can be supported by the governments:

  • By centralizing the market

The VCM ecosystem is fragmented, with many standards, rating agencies, projects and brokers, making it difficult to track high quality and low quality credits and creating a major challenge for companies wishing to participate in the space. Governments can use legitimacy and regulatory authority to drive the credit supply and trading infrastructure towards centralization in VCMs.

  • By increasing credit quality through the unification of standards

That is, by helping to mitigate the heterogeneity of supply, supporting companies’ efforts to efficiently identify credit supply trends.

As a case in point, in Australia and Japan, government intervention has unified the market around a main government-issued unit, ACCU and J-Credit, respectively.

  • By targeting buyers

Based on strategic prioritization, procurement eligibility can be narrowed and targeted to a specific technology, project model or location.

  • By dictating demand-side reform

As an example, the ETA, supported by the US State Department, has demanded that purchasers buyers in a system via the VCMI. This initiative seeks to develop a Claims Code of Practice, which serves as a framework for businesses to openly communicate their advancements towards achieving a sustainable Net-Zero goal in the long run.

  • By signaling a long-term role for VCMs

While corporate net zero commitments have increased significantly in recent years and demand for carbon credits has risen in tandem with these commitments, without a clear, long-term vision of the role of voluntary markets in a country’s emissions reduction strategy, investors in many cases have little confidence in the direction and development of voluntary markets. Defining the priority and role of a specific voluntary market that would give a long-term commitment with government support would build confidence in the markets from an investor perspective.

In the face of ongoing challenges, there is an urgent and compelling need to increase private investment to support projects that contribute to emissions reduction and neutralization. These projects are essential components in achieving the net zero target, which is critical in the fight against climate change.

Projections underscore a significant funding gap, with an estimated $4.1 trillion needed by 2050 to effectively address the interconnected challenges of climate change, biodiversity preservation, and land restoration. Given this landscape, the significance of VCMs cannot be overstated; they emerge as crucial channels for directing essential financial resources towards these imperative projects.

It is argued that institutional investors, with their significant financial resources and influence, have the capacity to significantly accelerate the progress of VCMs. They can achieve this not only by directly investing in increasing the availability of superior offset and neutralisation projects, particularly those focused on natural climate solutions, but also by advocating and supporting strict integrity and governance standards in the carbon credits space. This proactive step removes an important barrier to the development of VCMs as it ensures transparency, credibility and accountability in the carbon market.

Furthermore, an important aspect of their role is to steer portfolio companies towards the net zero pathway. By using their influence, investors can support companies in setting, pursuing and documenting their decarbonisation goals, thereby driving meaningful change at the corporate level. They can also ensure that companies take full advantage of the potential of carbon credits, not only to fulfill their core commitments, but also to ambitiously raise their climate targets.

References

  1. Center for Strategic & International Studies (CSIS). Voluntary Carbon Markets: A Review of Global Initiatives and Evolving Models. 2023.
  2. McKinsey & Company. Putting Carbon Markets to Work on the Path to Net Zero. 2021.
  3. Global Environmental Politics, MIT Press. The Evolution of Carbon Markets: Design and Diffusion. 2019.
  4. World Bank. State and Trends of Carbon Pricing. 2022.
  5. National Bureau of Economic Research (NBER). Carbon Markets: Past, Present, and Future. 2012.
  6. World Bank. Climate Stories | Carbon Markets. 2022.
  7. Ecosystem Marketplace. Ecosystem Marketplace’s Data and Insights on Global Carbon Markets. 2023.
  8. MSCI. Introducing the Carbon Market Age. 2022.

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