Carbon Markets: Environmental Saviour or Clever Accounting?

I'll admit it - I've been feeling a bit guilty about my carbon footprint lately. Daily picking up & dropping my son to school, the AC running non-stop in this heatwave, my weakness for imported kiwis, and getting off to a holiday by flying to amazing places.

I can keep on going on and on and I will come across as a climate sinner, but I am somewhere in the transition. I am really passionate about climate change and I have changed a lot of my behaviours, but still they are not enough. So when I heard about carbon markets as a potential solution to my carbon footprint I was pumped up. Could buying some carbon credits pardon me of my eco-sins?

Now think of this from a company's perspective, they emit zillions times more emission then us and they have all the incentive in the world to ensure they reduce their emissions sooner else they will have reputational issues and more so financial impacts.

Remember someone said, Climate impact is a financial impact!

So is there a magic pill that can reduce emissions from industries - in comes Carbon Markets to the rescue.

As it turns out, the world of carbon markets is more complex than I imagined. Let's dive into this new world of environmental economics and see if we can make sense of it all.

The Basics: Credits, Offsets, and Markets.

Carbon markets allow the trading of two main "products":

Carbon credits are essentially permits issued by governments as part of cap-and-trade programs. Companies get a certain number of these credits each year, allowing them to emit a specific amount of CO2. Think of them as pollution permission slips.
Carbon offsets on the other hand, are voluntary. They're created by companies or projects that reduce, capture, or store emissions. When you buy an offset (Credit), you're essentially paying someone else to clean up your mess. It's the environmental equivalent of hiring a maid service, but for the atmosphere.

These can be traded on two types of markets, collectively called as Carbon Markets.

Compliance markets: These are the markets where Carbon credits are traded. These are called compliance market as these facilitates trade between government issued credits. For eg: EU ETS
Voluntary carbon markets: Non-regulated markets where companies and individuals can choose to off-set their carbon footprint by buying credits that were created as a result of carbon off-set. For eg: Verra

One credit typically represents one ton of carbon dioxide avoided or sequestered. the prices are generally above 50 euros per ton of CO2 reduction and sometimes much higher. For eg. it was closer to 100 euros per ton of CO2 post-COVID.

In the voluntary market, prices are significantly lower and it depends a lot on the quality of the offset, often around $1 or $2 per ton of CO2 reduction and can be more as well.

How exactly are these carbon offsets created?

Understanding carbon credits in the compliance market is straightforward. But what about carbon offsets?

You might be thinking are these something like Crypto currency that comes out of thin air and then people trade? Not exactly, let me explain the exact process:

Project Implementation: Imagine you're setting up a project that cuts down greenhouse gas emissions. This could be anything from installing solar panels to making factories more energy-efficient. The goal? Achieve a measurable reduction in emissions.

Methodology Development: But how do you know how much emissions you reduced? A specific methodology will be required that will calculate the emissions reduced. This is crucial as it sets the framework for quantifying the CO2 emissions reduced. For example, if your wind farm replaces a coal plant, this methodology will figure out how much CO2 you're saving by using wind instead of coal.

Verification: Until now it sounds logical, but I can cook up the numbers and show more emissions? In comes a crucial step where an independent third party steps in to verify your project's emission reductions. This ensures the numbers are spot-on and that your project genuinely lowers emissions. These verification bodies adhere to strict guidelines to certify that the emission reductions are real, additional, and permanent.

Registration: Once verified, your project is submitted to a registry. Initially, this was mainly done through the UNFCCC's Clean Development Mechanism (CDM), but now many private registries handle this. These registries review your documents and, if everything checks out, issue carbon credits based on your verified emission reductions.

Trading: Now that your credits are registered, they're ready to be traded. Companies or individuals can buy these credits to offset their emissions. The transaction is logged in a registry, ensuring everything is transparent and traceable. The registry transfers the credits from your account to the buyer's, similar to how stock transfers work.

Monetisation: Finally, it's time to cash in. The buyer pays you for the credits, usually through banks or escrow accounts. This financial exchange incentivizes further investments in emission reduction projects.

Carbon markets are like a game of Carbon Monopoly, where players navigate through regulations, trade carbon credits, and invest in sustainable properties to reduce their carbon "footprint" while strategically managing resources.

The Good, the Bad, and the Complicated

In theory, it's an elegant market-based solution. Companies that find it difficult or expensive to cut emissions can still contribute to climate goals by funding green projects elsewhere. And carbon-reducing initiatives get a new source of financing. But as we'll see, the reality has been a bit messier.

There are 2 issues with the Carbon market:

Credibility of the Voluntary carbon markets.

Companies prioritising net zero via offsets rather then emission reductions.

Voluntary Carbon Markets - credibility at stake?

Investigative reports have raised questions about the effectiveness and ethics of many carbon offset projects. There are concerns that some initiatives don't actually reduce emissions as much as claimed, or that local communities aren't seeing the promised benefits.

As a result, confidence in carbon credits took a big hit. The volume of credits traded fell significantly in 2023 as companies got wary of the reputational risks.

But here's where it gets interesting - despite all the bad press, forecasts are calling for massive growth in the coming years. According to Market and Markets, the carbon credit market is projected to expand at a 31% CAGR between 2023 and 2028, potentially reaching a whopping $414.8 billion.

What's driving this expected growth? A lot of it comes down to the increasing pressure on companies to reach net-zero emissions targets. As more countries and corporations set ambitious climate goals, demand for carbon offsets is likely to surge. Of course, projections are just educated guesses.

But even if the real growth is half of what's predicted, we're still talking about a massive market. The key question is whether the industry can address its challenges and rebuild trust. Let's take a closer look at some of the issues.

Problems in Carbon Paradise

The carbon offset system has some inherent flaws that critics argue make it ineffective:

Lack of transparency: It's often unclear where revenues from carbon projects actually go. In one infamous case, only €14 million out of €100 million in carbon credit sales went to local communities as promised.

Verification issues: The process for verifying carbon reductions is complex. There have been cases of projects overstating their impact.

Equity concerns: Many carbon projects are based in developing countries, leading to criticisms that wealthy nations are outsourcing their climate responsibilities.

Additionality questions: It's not always clear if carbon credit projects are truly "additional" - i.e. would they have happened anyway without the credit funding?

These are serious challenges that the industry needs to grapple with. But it's worth noting that many of these issues stem from how carbon credit systems are implemented, not necessarily from fundamental flaws in the concept itself.

In other words, there may be ways to address these problems through better design, oversight, and transparency. There are many startups in this space who are trying to solve this problem. I am pretty sure this is a solvable problem.

Misaligned incentives: Offsets vs Reduction

Some argue that carbon offsets allow companies to avoid making real emission cuts by simply buying credits to reach net zero targets. In principal a company should prioritise reduction first and if it is not possible go to offsets. Sounds logical isn’t it, but companies do not think like this.

I was scrolling through my Linkedin feed the other day when I came across two contrasting headlines about tech giants and their climate efforts.

Amazon proudly announced reaching 100% renewable electricity use years ahead of schedule, while Google admitted its AI operations had increased emissions by 13%. At first glance, it seemed like a clear case of one company racing ahead while the other stumbled.

But as I dug deeper, I realised the reality was far more complex. It turns out how companies pursue their climate goals may be more important than how quickly they claim to reach them.

Let's break this down: Amazon said that it had purchased enough clean electricity to cover its global operations. Looks good in the first instance. A closer look reveals they're relying heavily on renewable energy credits (RECs) and carbon offsets - essentially paying for clean energy produced elsewhere to balance out their continued fossil fuel use. It's like ordering a salad to offset that late-night pizza binge. Sure, you bought some healthy food, but it doesn't negate the calories you actually consumed.

Meanwhile, Google faced backlash for increased emissions from its AI operations. But here's the twist - they've actually adopted a more defensible approach:

Focusing on direct emissions reductions

Investing in carbon removal technologies

Pursuing "24/7 carbon-free energy" to match hourly electricity use with clean sources

It's not perfect, but it's tackling the problem head-on rather than playing accounting games.

Bottom line

Carbon markets are a fascinating attempt to use capitalist tools to solve an environmental crisis. They're complex, controversial, and still evolving. While they're not a silver bullet for climate change, they're an important piece of the puzzle.

Therefore, if you come across a company is claiming net zero, always ask emission reduction or offsets? After all we will only be able to make a better world if we can remove all the emissions from the source, but unfortunately the reality is far from this!