By Pianpian Wang
When we talk about adopting market mechanisms to reduce carbon emissions, what do we really mean? The reality is the following: either create economic incentives for organizations to lower their carbon footprint (the mandatory carbon market), or build a market-based trading platform where organizations and individuals can invest in projects to reduce carbon and promote social well being. The latter is not required by law, and it is also known as the voluntary carbon market.
The trading unit of carbon emissions circulated in both the mandatory and voluntary markets is referred to as a carbon permit and carbon credit, respectively. They are essentially the same concept with different names.
These two markets are different in many ways. However, the market value of carbon emissions matters to both carbon systems. This article aims to explore the factors that affect the markets’ prices.
The Rise of the Mandatory Market?
The EU emissions trading system (EU ETS) has shown a strong increasing price tendency since April 2018, and each carbon permit soared from 8 euros a tonne to around 25 euros. As the first major carbon market started in 2005 that remains the largest, the EU ETS’ trading activities and rising prices have sent a strong signal to those businesses and organizations that advocate market mechanisms as one crucial solution to greenhouse gas reduction. It offers encouragement to people who became cynical of the market mechanism after the collapse of EU ETS during the economic downturn in 2008.
The price increase indicates three important messages. First, more participants are joining the market. Second, emission reductions may become more and more vital to a businesses’ path towards sustainable development. Third, the more capital that flows into the market, the stronger indication there is that the EU ETS will meet its mitigation goals.
The growing trust in the EU ETS lies in the trading system’s recent reforms. Since the financial crisis, the ETS has suffered from an excess supply of carbon permits. However starting in 2021, a new phase aims to take the lessons learned from before by establishing bigger reductions goal and properly adjusting the number of allowances to be placed in the Market Stability Reserve.
The Market Stability Reserve is a measure that removes surplus allowances from the year before. It is also worth mentioning that one of the foci in the new phase is to “help industry and the power sector to meet the innovation and investment challenges of the low-carbon transition”. This will also give participants confidence that the market will provide returns in multiple ways.
It is clear that a stable and well-designed trading environment provided by governmental policies and regulations is the main catalyst to price changes in the mandatory carbon market. We need to keep in mind that a set of policies for mandatory carbon markets usually remains valid from 5 to 10 years. It is the government who decides which industries are obligated to join the market.
The profit margin for project owners would be limited in the mandatory market, and it is safe to assume that the government would intervene when trading prices are abnormal. After all, the government’s ultimate goal is to reduce carbon emissions instead of encouraging highly inflated market prices.
The Strong Potential of the Voluntary Carbon Market
According to the transactions between January to March in 2018, the average price of a carbon credit is $2.4/tCO2e. While Ecosystem Marketplace, a non-profit organization that compiles an annual report for the voluntary carbon market, has tracked average prices ranging between $3-$6/tCO2e, it also has records shown actual prices range from under $0.1/tCO2e to just over $70/tCO2e. The wide price range reflects the flexibility and competitiveness of the voluntary carbon market.
A factor that has led to the price difference is the type of carbon credits generated. According to the Gold Standard Foundation, wind projects’ carbon credits are the cheapest, while energy efficiency fuel switching, ozone-depleting, and agroforestry projects are higher than other types. Carbon credit projects under the forestry and renewable energy categories had more transactions than other projects in the first quarter of 2018 and the year of 2017. This means that these projects are more popular in the voluntary carbon market.
Another factor that contributes to the price of carbon credits is the location of the carbon credit project. According to a survey conducted by Stanford University and Yale University, projects occurring in developing and least-developing nations are significantly more expensive than those taking place in industrialized nations, by an average of nearly 20%.
This is because it is more expensive to provide education and training to staff in least-developing countries. In addition, because such projects are usually developed in remote areas of these countries, this poses more challenges and costs to the developers and local communities in to keep the projects in healthy operations.
Furthermore, policies and regulations indirectly drive the price of the carbon credits in the voluntary carbon market as well. The Yale survey also found that offsets that are certified under the Clean Development Mechanism (“CDM”) or the Gold Standard are more than 30% higher priced than carbon credit projects certified by other standards.
Finally, the private sector’s commitments on emissions reductions could also affect the price of carbon credits in the voluntary carbon market. Currently, many companies have initiated reduction goals in order to be more cost-effective on energy usage, for pre-empting government regulations, or to enhance their corporate social responsibility (“CSR”).
Carbon credits not only reduce greenhouse gases, but also create co-social benefits to the area of the project locations, including but not limited to wildlife conservation, clean water access and improve sanitation level of the community. These co-benefits commonly align with companies’ CSR missions. In practice, companies generally demand carbon credits certified by well-recognized standards and pick projects associated with co-benefits that are relevant to their brand.
Overall, while a well-designed trading scheme is the only factor that affects the market value of carbon permits in the mandatory carbon market, the voluntary market is affected by several factors that influence the price of their carbon credits. This generates a potential for businesses to be a major player in solving environmental and social problems.
A Brighter Future?
Nowadays, countries such as China, Japan, and New Zealand are developing their own national carbon markets for mandatory trading. This helps spread the concept of building emissions goals into governmental policy. Meanwhile, the business sector is trending toward undertaking more responsibilities in playing an influential role in international climate negotiations. This mindset helps engage with the public and other social sectors in the carbon emission reduction movement as a whole.
Eventually, the two carbon markets can stimulate each other’s development, and could bolster a global carbon market that would allow trading carbon emissions between the two.