Introduction to different carbon pricing mechanisms
There are three mechanisms that enable corporates and financial institutions to integrate the cost of carbon emissions into business decision-making: compliance mechanisms, voluntary carbon markets and internal carbon pricing.
- Compliance mechanisms are enforced upon specific sectors or types of emissions by national or international regulatory bodies. There are two primary types:
- Carbon tax. Price per tonne of carbon set by governments and applied to certain sectors or activities.
- Emissions trading systems (ETS). Governments set the total amount of emissions that can be released by a subset of sectors, and issues allowances to companies which are gradually reduced over time. This allows the market to set the price by trading portions of their allowances.
- Voluntary carbon markets allow carbon emitters to offset their unavoidable emissions by purchasing carbon credits emitted by projects which reduce GHG emissions or remove them from the atmosphere.
- Internal carbon pricing enables companies to put a value on their GHG emissions. This embeds carbon intensity in business decision making, helps de-risk against future compliance mechanisms and raises finance for mitigation initiatives.
A year of rapid progress for carbon markets
Consistently low prices of compliance markets had led to widespread scepticism of them as effective decarbonisation tools. However, in 2021 the EU Emissions Trading System (ETS) exceeded all but the most optimistic price projections. Credit prices rose from around €30 per tonne at the start of the year to over €80 per tonne at the end of December. Other significant compliance market moves where made in China, where the world’s largest ETS was formally established in July, and in the UK, which established its own ETS in January.
Carbon market outcomes from COP26
- Carry over of low-quality credits. Negotiators agreed to limit the use of old low-quality credits from the UN’s Clean Development Mechanism, with only credits registered since 2013 now eligible to use to meet national targets. This means that out of a potential 4bn CDM credits, only 320m will be carried forward, avoiding flooding the market with ‘junk’ credits that erode prices. These old credits will be clearly labelled and avoidable, and four countries (Colombia, Finland, and Switzerland) have already committed to not buying or selling any pre-2020 CDM credits. A new mechanism, likely to be known as the Sustainable Development Mechanism, will be designed to replace CDM.
- Clarified rules around double-counting. At COP26 it was agreed that countries would not be able to both sell credits and count them towards their own climate targets. When countries sell credits, they will have to make ‘corresponding adjustments’ to their carbon accounts. Using ‘adjusted credits’ will be mandatory for nation states using credits to contribute to national targets, and for international schemes such as the aviation industry’s CORSIA. However, a loophole remains regarding voluntary carbon market credits, where implementing this ‘corresponding adjustment’ to prevent both corporates and nation states counting reductions remains voluntary.
- Ensuring carbon markets reduce climate change. When a project is issued with credits, the project will be subject to a 5% levy to contribute to financing adaptation projects in developing countries. In addition, when credits are sold, 2% of the credits will be cancelled to achieve an overall reduction in greenhouse gas emissions. Both measures are an important step but are weaker than hoped as they are not mandatory for bilateral trades between countries nor the voluntary market. However, they send an important signal of best practice to voluntary market participants, and advanced buyers are expected to adopt these levies voluntarily.
Potential impacts on market functioning
Positive initial market reaction. Compliance markets responded well to the Article 6 agreement, with European ETS prices hitting an all-time peak of €66 a tonne the week after the negotiations concluded. The voluntary market was also bullish, with CORSIA-eligible carbon (CEC) credit prices surging by 20% over the course of the conference.
Heighten price spreads. Many factors already impact the prices of voluntary market credits, including project type, credit age, and certification body. These competing influences have resulted in huge price spreads, with Gold Standard credits ranging from $10 to $47 per tonne of carbon. The Article 6 output will further muddy the waters. ‘Adjusted credits’ will likely be considered of higher quality and could be priced at a premium. Indeed, major companies such as BMW have stated they will only source ‘adjusted credits’.
Ease the path for new schemes. The international aviation industry has already established the CORSIA scheme, which will require airlines to offset all emissions produced above a 2019 baseline. The establishment of a clearer rulebook will make it easier to launch new crediting schemes covering specific economic sectors, with shipping looking like a probable candidate.
Solid foundation for further market alignment. Article 6 clarity will support continuing efforts to enhance credit supply, lubricate market functioning and establish clear good practice principles.
Implications for corporates and asset managers
- Impacts on market fundamentals look likely to increase as credit prices rise and mechanisms tighten. A key factor could be initiatives like the EU’s Carbon Border Adjustment Mechanism (CBAM). This creates a border levy on products in high-carbon industries to ensure that domestic producers covered by the EU ETS are put at a competitive disadvantage to uncovered foreign producers.
- Corporates that purchase poor quality credits, have insufficient due diligence and quality appraisal systems, or are overly reliant on offsets already face real reputational risks. These will only increase as best practice becomes more mature.
- Companies with less mature carbon market strategies could be exposed. With credit supply looking scant relative to demand, prices look set to increase. While some corporates have advanced strategies and experienced teams, others could find themselves paying premiums when buying credits spot at the last minute.
- Natural capital projects and asset classes that can generate carbon credits are becoming increasingly attractive to mainstream institutional investors as credit prices increase.