By Daniël Poolen and Karolina Ryszka
- Offsetting carbon emissions through voluntary carbon credits (VCC) plays a role in the transition to a zero-carbon economy
- The demand side of voluntary carbon markets has shifted from regulated markets to companies and individuals
- Offsets generated from forestry and land-use projects are growing in popularity
- Non-regulated sectors like aviation and new emission trading systems are increasing the demand for voluntary carbon credits
- Transparency and standardization of carbon crediting is needed to make voluntary carbon credits a true game changer
CO2 and other greenhouse gas emissions, in combination referred to as CO2 equivalent emissions or CO2e, are warming up the earth, changing the climate and are already causing damage to people, livelihoods and economies. The Paris Climate Agreement from 2015 aims at limiting the global temperature rise to 1.5 degrees Celsius in order to minimize (future) climate-related damage. Zero emission cannot be achieved as emissions from some processes are unavoidable (e.g. in agriculture). In other words negative emissions are needed in order to achievethe goal of the Paris Climate Agreement, negative emissions are needed. A negative emission is the removal of greenhouse gases from the atmosphere by deliberate human activities, i.e., in addition to the removal that would occur via natural carbon cycle processes (IPCC,2019).
In this publication we focus on the compensation of emissions by means of carbon credits, which are gaining in importance as an instrument to transition to a zero-carbon economy. Carbon credits are created in projects where actors implement activities resulting in lower or negative emissions. These credits can be sold by the actor who implemented the carbon reduction and can be traded and purchased by other actors, e.g. companies, to ‘compensate’ for their emissions. The motivations of the actors purchasing these offsets might be to comply with emission standards or regulations, to voluntarily improve their carbon footprint, or to support decarbonization projects. Individuals can also buy carbon credits, e.g. for planting trees to compensate their flight tickets.
The current market for voluntary credits is dwarfed by compulsory carbon markets and prices for voluntary credits remain at a low level. Over the past years voluntary crediting mechanisms have gained pace and are growing. Will voluntary carbon markets become a relevant mechanism in the fight against climate change? To answer that question this report looks at the development of voluntary carbon markets in recent years and gives an outlook with respect to their future development.
What are carbon markets?
Emitting carbon into the atmosphere is what economists call a ‘negative externality’: it is a by-product of economic or other activity that creates damage now and in the future. Companies and consumers do not pay (enough) for these negative externalities and are therefore emitting too much carbon. This is a market failure – the market by itself does not internalize the costs of these emissions and so collective action is needed to obtain the socially desired result. In economic theory, carbon pricing is the solution for such an external effect. This can be done by either introducing a tax on carbon or introducing a marketplace for allowances to emit carbon.
We can distinguish between compliance and voluntary markets. Carbon markets can trade either quotas or credits. Allowances are units of quota issued by the government, or tradable, bankable entitlements to emit pollutants. An example is the European Emission Trading System (EU ETS).
Credits are certificates created when a person or an entity underutilizes a ‘right’ to pollute or creates an opportunity to capture carbon.
Historically, different carbon crediting mechanisms evolved for different purposes. One can distinguish between three categories of voluntary crediting mechanisms:
- international crediting mechanisms
- regional, national and supranational crediting mechanisms
- independent crediting mechanisms
In this article, we focus primarily on the third.
Current trends in voluntary carbon markets
From international crediting mechanisms to independent, regional, national and subnational ones
International crediting mechanisms used to be the most important crediting mechanisms, with most of the demand stemming from compliance with the Kyoto protocol which was enforced in 2005. The credits have been used primarily by regulated entities in industrial countries to reach their emission reductions commitment, e.g. by companies in the EU ETS. Clean Development Mechanism (CDM) is the largest credit issuer to date, with more than 50 percent of credits ever issued; Joint Implementation (JI) is the second largest issuer with 22 percent of all credits ever issued. Crediting activities increased until 2012 (the end of the first compliance period of Kyoto), before crashing in 2013 due to the lack of demand from EU ETS sectors following the financial crisis and to an oversupply of EU allowances (World Bank, 2020).
Since the end of the first Kyoto compliance period, these international crediting mechanisms have been losing their importance. Governments began to recognize voluntary standards for their compliance markets and to enter the voluntary carbon markets as buyers (Ecosystem Marketplace, 2019). Moreover, the future of international crediting mechanisms became uncertain under the Paris Agreement in 2015 (see Box 1).
There has been a surge of independent crediting mechanisms in the past years – they were responsible for 65 percent of the annual credits issued in 2019, compared to only 17 percent in 2015. Regional, national and subnational crediting mechanisms are also gaining importance (State and trends of carbon markets, 2020), since more regional, national and subnational carbon pricing initiatives are being set up.
Supply and demand
Over the years, the situation on the carbon markets has been one of oversupply of credits – accordingly, the average prices have dropped almost every year since 2008 (from USD 7.3 per ton CO2e to around USD 2.7 in 2019), resulting in decreasing market value (Figure 1), despite relatively stable demand for credits (World Bank, 2020).
It should be noted that, despite the relatively low carbon price, the prices differ widely depending on the project category and even within a project category. The lowest average prices are paid for renewable energy projects (USD 1.4 /ton CO2e), whereas projects in forestry and land use see the highest average prices (USD 4.3 /ton CO2e). The lower average prices from 2019 can be attributed to cheap carbon credits from old renewable energy projects, i.e. from 2016, 2017. In 2019, prices for offsets from renewable energy decreased by 16 percent while their volume surged by 78 percent (Ecosystems Marketplace, 2020). These credits are cheap because their additionality is contested. For more information about additionality, see Box 2. Prices of new (nature-based) credits are actually rising: in 2019, prices for carbon credits from nature-based solutions and natural climate solutions rose by 30 percent (Ecosystems Marketplace, 2020).
After the demand side was driven by international climate agreements and demand from regulated markets, a shift occurred towards non-regulated, individuals and regulated demand from regional, national and subnational carbon pricing initiatives. This shift is not only due to a decline in international carbon credits, but is also driven by greater public attention to and concern about climate change.
From industry, waste and renewables to nature-based solutions
These major crediting mechanisms tended to generate most credits from two or three sectors: 70 percent of CDM and JI credits came from projects in industrial gases, renewable energy and leaks or irregular vapors and emissions from sealed surfaces. The shift towards independent crediting mechanisms has also resulted in a shift towards more nature-based solutions: afforestation, reforestation and land-use. Offsets generated from forestry and land-use projects grew by 264 percent between 2016 and 2018, whereas the volume of other offset types grew by only 21 percent (Ecosystems Marketplace, 2019). The volume of offsets through renewable energy and forestry and land use are similar. Figure 2 shows the volume of carbon offsets per project category in 2019.
The future of voluntary carbon markets
The voluntary carbon credits market is rather small when compared to compliance markets and the balance between supply and demand has been hard to find due to credit oversupply. Which raises the question: is there a significant future at all for voluntary carbon markets?
An optimistic scenario
There are indications that this could change in the future. In fact, there has been a steady upward trend in issuances and retirements in the last four years. Also, depending on the specific credit categories, the picture could look very different: as mentioned before, offsets generated from land-use activities grew disproportionally faster than the volume of other offset types. Higher demand could then ultimately result in price increases, thereby improving the business case for other carbon offset projects.
We see an optimistic scenario. Firstly, new emission trading systems are being set up worldwide, which increases the demand for regional credits. Secondly, demand will grow from non-regulated sectors. Large companies and governments tighten their CSR policies, including strategies to offset through carbon credits. From 2021 aviation is supposed to offset all additional emissions compared to a baseline. Aviation accounts for only about 2.5 percent of global CO2 emissions. Nevertheless, emissions are projected to increase strongly over the next years (Ivanovich et al., 2019). See below for details of the impact of Covid-19. Thirdly, there has been a rapid increase in credit issuances and retirements over the last couple of years (Figure 3; Ecosystems’ Marketplace, 2020). This has been the case for nature-based credits in particular. If this growth continues, the market will double in the coming two years.
The Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) is developed by the International Civil Aviation Organization (ICAO) and adopted in October 2016, its goal is to have carbon-neutral growth from 2020. The scheme is voluntary and is supposed to work until 2035 at least. The total demand for those 15 years is estimated at 2,700 Mton CO2eq offsets (Ecosystem Marketplace, 2020b). Ecosystem Marketplace found that there are currently more than enough carbon offset supplies to meet initial demand under CORSIA. Yet some market experts predict possible shortages of supply for offsets generated by removing carbon instead of reducing emissions. Ratings agency Fitch projects that offset demand will surpass supply by around 2025.
There is a trend of large companies making zero-carbon pledges, even in the course of 2020 (Ecosystems marketplace, 2020). The Climate Ambition Alliance launched its “Race to Zero” campaign to encourage countries, companies, and other entities to deliver structured carbon-neutral pledges by the end of 2021, ahead of COP26.
Caveats to the optimistic scenario
Covid-19 has disrupted many aspects of life and the economy. It also has an effect on the carbon offset market, especially with respect to offset demand from air travel. CORSIA design features, such as the baseline against which additional emissions will be compensated, are to be changed due to the pandemic’s impact on the air travel industry. Instead of using both 2019 and 2020 emissions as the baseline for the pilot phase starting in 2021, only 2019 emissions will be used to “safeguard against inappropriate economic burden of aeroplane operators” (CORSIA, 2020). Covid-19 might have a long-term effect on the air travel industry and it may take another few years before the air travel industry recovers. This might curb the carbon offset demand in the short to mid-term future.
Although 2020 has been described as a “year of resilience” (Ecosystem Marketplace, 2020) as demand for carbon offsets was not halted in the first few months of 2020 despite Covid, the question is whether demand will keep up if we find ourselves in a longer-term economic slowdown or recession.
What is needed for the optimistic scenario to materialize?
There has been much criticism of carbon offsets in the past: there have been examples of greenwashing by companies and projects that violate their stated best practices. This needs to change if carbon offsets are to play a major role in bringing about decarbonization. Companies need to be educated on the responsible use of carbon offsets. Offsets should not be treated as an alternative to reducing emissions, but as a means to offset the unavoidable emissions. They should only be used temporarily, to avoid delaying transition to a low- or zero-carbon sector (UNEP, 2020). The Science-Based Targets Initiative (SBTi) released its guidance for using offsets as part of a robust corporate emission-reduction program, contributing to a growing debate over what “carbon neutrality” is and is not. There have been efforts to strengthen the carbon offsetting methodologies in recent years under ICROA. Nevertheless, there is still scope for further transparency and standardization.
Further standardization would also help to increase the size of voluntary carbon markets. To deliver carbon neutrality or negativity at the scale needed to achieve the Paris Agreement targets, carbon offsets must not only generate verifiable emission reductions; they must also evolve beyond a series of bilateral over-the-counter transactions into a real, functioning market. That is the goal of a new global task force launched in September 2020 by former Bank of England Governor Mark Carney. The effort aims to promote standardization and liquidity in voluntary carbon markets with the goal of increasing its size exponentially – perhaps more than 150-fold.
Relatedly, the costs of monitoring, auditing and certification need to decrease substantially. For many projects, these costs are still a bottleneck and hinder the lift-off of these projects.
So far, the supply side of carbon credits has been very decentralized. Developing projects individually and navigating the crediting process individually may not be sufficient to cover a substantially increased demand in the future. One way to meet demand is to move beyond carbon credits generated from individual projects and into those generated by supporting jurisdictional efforts. Jurisdictional programs could help take the tropical forest agenda to scale, for instance, addressing systemic drivers of forest loss across large territories. Some jurisdictions are also preparing to offer carbon neutral commodities, like soybeans.
Several important developments have been observed in voluntary carbon markets over the past 5 years and there is potential for future important changes. Demand has shifted from compliance with the Kyoto protocol and carbon credits generated through industry, waste and renewable energy projects to carbon credits from nature-based solutions demanded by unregulated companies and individuals. There is a chance that these trends will continue in the future, with air travel companies planning to offset their additional emissions and big companies making zero-carbon pledges. This additional demand might decrease the oversupply of credits and finally raise offset prices, making more expensive projects viable. Yet, such a positive outcome is far from certain, given the possible longer-term impacts of the current Covid-19 crisis and the structural need for further standardization in carbon crediting methodologies and accounting.
Carbon offsetting on a voluntary basis could be a game changer, providing funding to projects that avoid and remove carbon from the atmosphere. Yet there is scope to improve transparency of various carbon crediting mechanisms and a need for standardization of crediting and accounting. This would enhance customer trust in the offsets offered, result in higher market volumes and a real, functioning market. Large customers, like airlines and other companies, but also national and supranational governments should demand more standardization and regulation of this market.
This article has been sourced from RaboResearch and can be accessed here