Carbon markets were dogged by scandal, political tensions and negative media coverage in 2023. Regulation could help to restore confidence in 2024
Experts have called for carbon markets to be better regulated following a year of turmoil that has undermined buyers’ confidence in carbon credits and has driven down prices.
Carbon markets are broadly divided between voluntary carbon markets, a largely unregulated space that allows countries and companies to trade credits, and compliance markets, which are regulated. The Kyoto Protocol allows countries with spare emissions permits to sell these to nations that have exceeded their emissions targets, while articles within the Paris Agreement set out principles governing the use of credits.
Carbon markets were widely discussed at COP28 and are viewed as a means of helping entities achieve emissions reductions and providing finance to projects that remove carbon emissions from the atmosphere, such as reforestation initiatives. Leaders including US climate envoy John Kerry used COP28 to talk up the potential of the VCM.
“I have become a firm believer in the power of carbon markets to drive increased climate ambition and action, and the VCM is a vital tool to keep 1.5C in reach,” Kerry told a COP28 event, according to several media outlets.
Last year got off to a bad start for the VCM after a joint investigation by The Guardian, Die Zeit and SourceMaterial analysed “a significant proportion” of projects certified by carbon credits verifier Verra and concluded that 90 per cent of rainforest credits do not amount to carbon reductions.
Several experts told Sustainable Views that negative media reports dampened potential buyers’ enthusiasm for carbon credits. “Some of it was quite ideological and just painted voluntary carbon markets negatively with a broad brush,” says non-profit IETA international policy director Andrea Bonzanni.
This negativity played a part in falling prices throughout 2023, although trading volumes picked up at the end of the year.
Buyers also held back at the start of the year in anticipation of standards set by VCM bodies, including the Integrity Council for the Voluntary Carbon Market and the Voluntary Carbon Markets Integrity Initiative, which focus on the supply and demand sides of the market respectively, aimed at shoring up confidence in the space.
Policymakers and regulators also increased their interest in the VCM. The EU banned companies from making favourable environmental claims about products based on their use of carbon offsets, while the US state of California mandated that companies using offsets in claims about progress towards net zero should disclose this practice. And the US Commodity Futures Trading Commission issued guidance in December on the listing of voluntary carbon credit derivative contracts.
“Historically, people have bought credits as a right to tell a story,” says Allister Furey, chief executive of carbon credit rating platform Sylvera, likening this to a “marketing credit”. He argues that “regulation is what gives the credit value”.
The compliance side of the market also faced challenges in 2023. Talks between countries at COP28 aimed at agreeing a UN-stamped mechanism under Article 6.4 of the Paris Agreement collapsed amid tensions between the EU and the US.
Global carbon price needed
While there were setbacks over Article 6, COP28 did achieve some progress for the VCM. Standard-setters including the ICVCM and the VCMI backed greater collaboration and an “end-to-end integrity framework” for carbon markets. The International Organization of Securities Commissions, meanwhile, launched a consultation during the conference with a view to tightening the regulation of carbon markets.
Experts agree that regulation is a way to boost confidence in the VCM. “We would welcome more regulation,” says Rasih Ozturkmen, partner at carbon asset management company Carbonaires.
“It is right that standards become regulated,” says Simon Puleston Jones, chief executive of consultancy Climate Solutions. “I would expect, in time, that the offering for the sale of carbon offsets will become a regulated activity that would bring brokers and other intermediaries into the scope of regulation in the same way they already are subject to regulation in relation to financial instruments.”
Puleston Jones expects the European Commission, the Financial Conduct Authority and the Monetary Authority of Singapore to lead on VCM regulation and build on Iosco’s good practices published at COP28. The CFTC is taking greater interest in carbon credits, and in December published guidance for derivative exchanges on the monitoring, verification and permanence of listed voluntary carbon credit derivative contracts.
The voluntary market exists in the absence of regulation. Should we be regulating it? Certainly, but really what we should be regulating are stronger, more homogenised compliance schemes
Teresa Hartmann, BeZero Carbon
However, not everyone is convinced the CFTC is up to the task of monitoring credits. “I’m not sure it is the right regulator to regulate quality,” says Teresa Hartmann, chief ratings officer at carbon rating agency BeZero Carbon, citing concerns about the commission’s capacity and whether it has the appropriate staff.
A CFTC spokesperson pointed to a statement made in December by its chairman Rostin Behnam, who said that the Commission should act “to strengthen market integrity, transparency, and liquidity for derivatives with an underlying VCC”.
“The voluntary market exists in the absence of regulation,” continues Hartmann. “Should we be regulating it? Certainly, but really what we should be regulating are stronger, more homogenised compliance schemes.” She says that beyond the voluntary market, putting a price on carbon is the most impactful measure governments can take to fight climate change.
“That’s what’s going to make a difference for climate action by creating a level playing field, as opposed to the patchwork of pricing systems that exists in the status quo,” she says.
“A global carbon price sets a price incentive for companies to mitigate climate impact,” Hartmann adds, observing that this could be achieved by creating a single global interconnected market or by linking domestic compliance schemes. “Predictable pricing means we can model investment trajectories into mitigation technologies, which in turn drives down the cost of low-carbon production.”
COP28 trauma
Countries including India and Brazil laid the groundwork for their own compliance markets in 2023. Compliance markets have historically dwarfed the VCM. In 2021, the compliance market was valued at around $850bn, according to Shell, compared with the VCM’s value of approximately $2bn.
But the failure to progress Articles 6.2 and 6.4 of the Paris Agreement at COP28, which would have established principles for countries’ trading of emissions reductions and a compliance mechanism for doing so, was an uninspiring end to 2023 for the compliance market.
“We’re all a little traumatised by what happened at COP,” Hartmann says, though she adds: “If you look at what actually happened, it’s probably not as dramatic as it feels right now.”
She points out that countries are still able to trade credits under Article 6.2 even in the absence of a finalised text. Hartmann had expected Article 6 negotiations to continue into 2024.
If the Article 6.4 mechanism was up and running and functioning well, I think it would have a really strong advantage compared to the independent standards, because it has the UN stamp on it
Andrea Bonzanni, IETA
The Article 6.4 mechanism cannot, however, work without an agreement, which will now have to wait until at least COP29 this year. Article 6.4 would create a global compliance market overseen by the Article 6.4 Supervisory Body. Developers would need to register projects with the UN body, and it, and the country where the project would take place, would need to give their approval.
“The challenge with Article 6.4 is that it seems like it should work really easily in practice, but when you think about it, it’s probably the most complex and elaborate trading mechanism ever dreamed up,” says London Stock Exchange carbon research director Paula VanLaningham.“As a result, it’s going to be complicated to implement, particularly when you have different countries requiring different things and the UN process is primarily ‘rule by consensus’.”
Once established, “there can be competition between the Article 6.4 mechanism and the standards that now operate in the voluntary carbon market”, says Bonzanni.
“If the Article 6.4 mechanism was up and running and functioning well, I think it would have a really strong advantage compared to the independent standards, because it has the UN stamp on it,” he continues. “Its rules are developed by consensus by a large number of countries and it’s also much easier for a country, especially a developing country, to plug into an existing UN process, rather than entering into agreements with private independent standards.
“But because it’s been delayed and delayed, and because the state of the negotiations sends a negative signal to businesses that may want to use the mechanism, the voluntary market becomes more important.”
Demand for quality
Though optimistic, experts do not believe carbon markets will reach their full potential in 2024. It will be “another transition year”, says Puleston Jones. “It won’t be the year where voluntary carbon markets reach their long-term end state,” he adds, expecting the industry to continue establishing its own practices this year, in particular through the end-to-end framework announced at COP28. “We’re on a journey in 2024 and the ultimate destination is years ahead of us,” he says.
A mismatch of rising demand and the low availability of quality credits, in an environment that is placing increasing emphasis on their integrity, is likely to lead to a rebound in carbon prices. Fewer than 10 per cent of projects assessed over four years by platform Carbon Direct have met or exceeded its standards for high quality, according to a report it published last year.
“The supply is really tight for high quality,” says Furey. He suggests demand in the next couple of years, “just from two actors”, is “five to 10 times” higher than the available number of high-quality removal credits, declining to identify these parties.
Carbon Direct notes that two high-volume transactions from Microsoft and Airbus accounted for more than 80 per cent of “high-durability carbon removal purchases” in 2022 and 2023.
With other potential buyers still on the sidelines, regulation is one way to win back their confidence, argues Hartmann, who sees potential for regulation around the quality of carbon credits, corporate claims and market transactions.
“It is a transitional year,” she continues. “Ultimately, we need to build confidence in the market, [show] there are good projects out there that are generating good credits, and that there is good use of those credits. If we can settle that, I see light at the end of the tunnel.”