Emission Reduction: Can Carbon Trading Succeed in Tackling Climate Change?

Recently, interest in carbon markets has increased worldwide. Around 83% of nationally determined contributions (NDCs)—which are climate commitments and action plans developed by countries to limit global warming to 1.5°C—aim to benefit mainly from international carbon market mechanisms.

Carbon trading, also known as carbon emissions trading, is defined as “the use of the market to buy and sell credits that allow companies or other entities to emit a certain amount of carbon dioxide.” It encompasses several key terms. The fixed price that emitters must pay for their carbon emissions within the carbon market is called a “carbon tax.” On the other hand, “carbon credits” are tradable instruments that allow companies and other entities to offset their carbon emissions by funding projects aimed at reducing or removing carbon dioxide from the atmosphere. If these credits are used to reduce, sequester, or avoid emissions, they become “offsets” and are not tradable.

Governments also allow any entity to emit a limited amount of carbon by issuing “emission allowances,” known as “carbon credits,” granting the holder the right to emit one ton of carbon dioxide. These credits can be traded among regulated companies.

The concept of implementing carbon emissions trading was first introduced with the Kyoto Protocol, the United Nations treaty to mitigate climate change that came into effect in 2005. The idea was to incentivize each country to reduce its carbon emissions while wealthier, larger countries supported poorer nations’ efforts by purchasing their “credits,” or rights to carbon emissions.

Key Determinants

Several key factors help understand the nature of carbon trading, its benefits, and how it works:

Trading Systems for Carbon Credits: Carbon markets are essentially trading systems for buying and selling carbon credits. Companies or individuals can use carbon markets to offset their greenhouse gas emissions by purchasing carbon credits from entities that remove or reduce these emissions. It’s notable that there is no fixed global carbon price, as prices fluctuate by country and market supply and demand conditions.

Diverse and Varied Carbon Markets: There are two types of carbon markets: compliance markets and voluntary markets. Compliance markets are created in response to regulatory policies at the national, regional, or international level. Voluntary carbon markets, both national and international, involve the issuance, purchase, and sale of carbon credits voluntarily. Supply in voluntary carbon markets mainly comes from private entities developing carbon projects or governments developing certified carbon programs aimed at reducing or removing emissions. Demand often comes from individuals wanting to offset their carbon footprints, companies pursuing sustainability goals, and other actors aiming to trade “carbon credits” at a higher price for profit.

Reliance on Cap-and-Trade Regulations: Carbon trading relies on “cap-and-trade” regulations, which successfully reduced sulfur pollution in the 1990s by creating market-based incentives to limit pollution. Instead of imposing specific measures, this policy rewards companies that reduce emissions and imposes financial costs on those that do not.

Incentivizing Innovative Technologies: Proponents view carbon trading as a cost-effective partial solution to climate change, stimulating the adoption of innovative technologies. Aligning with technological advancements, carbon trading has become a fundamental concept in many proposals to mitigate climate change and global warming.

Creating Financial Incentives for Countries and Participants: Supporters argue that carbon markets create financial incentives encouraging countries and companies to develop technologies and initiatives to reduce emissions, such as mechanical carbon capture systems and afforestation, which help lower atmospheric carbon levels.

In recent years, global trends supporting carbon trading have emerged, including:

Diverse and Evolving Carbon Markets Globally: Indicators suggest carbon markets are diversifying and evolving, evident in the variety of services, platforms, advanced technological markets, and improved products. The entry of new investors into this sector points to further standardization of carbon pricing and increased regulatory oversight. According to a recent World Bank report on carbon pricing for 2023, there are currently about 73 carbon pricing tools covering about 23% of global greenhouse gas emissions.

Financial Returns for Governments from Carbon Trading Cooperation: Industry forecasts indicate that demand for carbon credits for offset purposes will grow significantly in the coming years. According to the World Bank’s 2023 carbon pricing report, revenues from carbon taxes and emissions trading services jumped over 10% in 2022, reaching nearly $95 billion globally. A study by the International Emissions Trading Association and the University of Maryland suggests that implementing NDCs cooperatively through international carbon trading, rather than individually, could save governments over $300 billion annually by 2030.

China Launching a National Emissions Trading Program: In July 2021, China launched a national emissions trading program designed to help achieve its goal of carbon neutrality by 2060. This created one of the world’s largest carbon emissions trading markets, with about 2,225 companies in the energy sector—representing 40% of China’s carbon-producing companies—trading their emission rights. By the end of 2022, this market had a cumulative trading volume of over 200 million tons, indicating positive growth in carbon trading in China.

The EU Establishing the First International Emissions Trading System: In 2005, the EU launched the world’s first international emissions trading system. Over the years, this system enabled the EU to become one of the largest carbon trading markets, setting the standard for carbon trading. On July 14, 2021, the European Commission adopted legislative proposals aimed at achieving EU climate neutrality by 2050, including revising the EU Emissions Trading System (ETS).

Signing the Carbon Trading Agreement at COP26: After extensive discussions, global carbon market rules were established at the COP26 climate change conference in Glasgow in November 2021, resulting in a UN global charter. The rules include creating a centralized system for the public and private sectors and a bilateral system for countries to trade carbon offset credits, helping them meet their emissions targets.

Rising Presence of the Voluntary Carbon Market Company in Saudi Arabia: In October 2022, Saudi Arabia’s Public Investment Fund (PIF) established the Regional Voluntary Carbon Market Company with 80% ownership and Saudi Tadawul Group Holding with 20% ownership. This aims to play a key role in expanding the voluntary carbon market, promoting sustainable business practices, and supporting various regional companies in achieving net-zero emissions.

The UAE Carbon Alliance’s Commitment to African Carbon Credits: In April 2023, the UAE Carbon Alliance pledged to purchase $450 million worth of African carbon credits by 2030, aiming to unlock the potential of generating carbon credits in Africa and support climate action on the continent. In February 2023, Blue Carbon, a Dubai-based company, partnered with Zambia and Tanzania to conserve 8 million hectares of forests in each country, generating carbon credits for sale in global carbon markets.

Increased Interest from Forest-Rich Countries in Carbon Trading: Cambodia has extensive experience in the voluntary carbon market in the forestry sector, aligned with its updated NDC and long-term carbon neutrality strategy. Forest-rich countries like Costa Rica are exploring strategic participation in carbon markets within their NDCs. Ghana is also a leader in implementing carbon market tools developed through voluntary cooperation under Article 6.2 of the Paris Agreement.

Remaining Challenges

Despite the advantages and widespread interest in carbon trading, several challenges remain:

The Challenge of Carbon Credit Credibility: Voluntary carbon markets face significant credibility challenges due to the prevalence of low-quality carbon credits, raising doubts about their impact and ability to reduce emissions. This lack of transparency in carbon markets makes it difficult for companies to determine whether they are genuinely reducing their emissions.

Market Fragmentation Issues: Market fragmentation and inconsistency are persistent challenges in carbon trading. Some countries consider carbon credits as expenses, others see them as assets, and a third group views them as commodities. Depending on the legal structure surrounding these assets, this impacts how they are treated from a tax and accounting perspective.

Supply Shortage of Carbon Credits: The entire concept of carbon markets revolves around directing capital to projects that aim to reduce carbon emissions—whether reforestation projects, solar energy, or direct air carbon capture. Investments in these projects create carbon credits. A major problem in carbon trading is the lack of liquidity due to a supply shortage of these credits, necessitating addressing this supply issue and ensuring price transparency.

Few Market Intermediaries: Another gap in carbon trading is the lack of intermediaries. Some bank clients want to purchase carbon credits but prefer transactions through their banking partners and intermediaries like banks, which can source and buy the credits on their behalf. Increasing the participation of intermediaries could generate more activity in the secondary carbon trading market and institutionalize these markets further.

Overall, as global temperatures continue to rise, the urgency to enhance climate policies intensifies, bringing carbon pricing to the forefront of climate discussions. With evolving trends, increasing voluntary demand for carbon trading, and calls for wider adoption, carbon trading is increasingly seen as essential for driving global efforts toward a sustainable, carbon-free future. If carbon trading adheres to high standards of integrity and transparency, carbon markets can help accelerate the necessary transition and achieve the global goal of net-zero carbon emissions by setting an effective carbon price, creating economic incentives to reduce emissions, and generating substantial funds needed to build resilience against the widespread impacts of climate change.

SAKHRI Mohamed
SAKHRI Mohamed

I hold a Bachelor's degree in Political Science and International Relations in addition to a Master's degree in International Security Studies. Alongside this, I have a passion for web development. During my studies, I acquired a strong understanding of fundamental political concepts and theories in international relations, security studies, and strategic studies.

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