Carbon Credit Trading

This article coves the following topics

• What is carbon credit
• What is driving the carbon credit demand
• How is it traded and what is the expected impact
• Future opportunities and challenges

What is carbon credit

Carbon dioxide is a primary green house gas which is leading to the global warming and climate change. Carbon credits are a mechanism to reduce the greenhouse gas emissions. Companies want to trade in Carbon credits as a way to achieve their sustainability objectives. Carbon credits are treated as a commodity and their exchange allows the participants to limit their impact on environment.

A Carbon credit/offset is a transferrable certificate that represents the reduction, avoidance or removal of a certain amount of emissions from the environment. Firms can buy carbon credits to offset hard to abate emissions.

It represents the national/international attempt to reduce the greenhouse gas concentration in environment. Carbon credits are generated by action which either help remove carbon dioxide such as afforestation or help avoid carbon dioxide such as completing an activity in less carbon intensive way.

Carbon trading is an effective way to channel the finance towards emission reduction and removal projects which generate carbon credits.

What is driving the carbon credits demand

Climate ambition - To limit the global warming to 1.5 degree celsius, global greenhouse gas emission needs to be halved by 2030 and reduced to net-zero by 2050.

The energy demand continues on an upward trend and Fossil fuels are still the cheapest way to produce energy which likely means more pollution. To handle this a two pronged approach is needed, first to put a price on the carbon emission and second having a marketplace for carbon trading. Many initiatives have been introduced globally with nearly half of them being around Carbon Tax and others being around the trading of Carbon.

For example Carbon tax has been introduced in Singapore. Industrial units emitting 25,000+ tCO2e annually will be taxed based on their carbon emissions. The carbon tax is set at $5 per tonne of GHG emissions (tCO2e) from 2019 to 2023. The carbon tax rate will be further raised to $25/tCO2e in 2024 and 2025, and to $45/tCO2e in 2026 and 2027, with a view to reaching $50-80/tCO2e by 2030. Companies can utilise high quality international carbon credits to offset their emissions by up to 5% starting 2024.

While there is a push for moving towards greener economy not all industries can do away with emissions specially power plants, manufacturing units etc. Therefore we need a strong carbon trading platform which can support trading of high quality carbon credits and help companies offset hard-to-abate emissions. This in-turn would help channel funds to emission reduction and removal projects which would generate carbon credits.

How is it traded and what is the expected impact

There are two types of Carbon Markets - Compliance and Voluntary Carbon Markets.

The compliance market caters for the trading of emission allowances set by regulatory bodies subject to targets set by national, regional and global regimes. Entities with significant emissions only are covered by the emission control regulations, hence the compliance carbon market is dominated by sectors with high emissions.

Voluntary carbon market on the other hand is not limited by the regulatory requirements. It allows companies to voluntarily buy carbon credits to offset their carbon footprint, even beyond mandatory requirements. An increasing number of companies and Governments are committing to net-zero targets, this trend is likely to continue and grow the Voluntary carbon market significantly in future. Voluntary carbon market size is likely to grow to 2Gt(or more than ~$50 billion) by 2030, a jump of 15 fold from 2020 levels. There is a need for large, trusted, verifiable and efficient market place for trading of voluntary carbon credits.

Carbon credits market place bring together the buyers and sellers in a trusted environment to drive demand. Because of the limited possibility of certain industries like Cement, Fossil fuel powered plants etc to reduce hard-to-abate emissions there is a need for "negative emissions" which remove greenhouse gases from the environment. Buying the carbon credits can help such companies reduce their climate impact which have hard-to-abate emissions. Carbon credits market place also help direct financing to projects which would help the climate action such as afforestation, plantation of mangroves etc. Such projects would find it hard to get financing in absence of a robust carbon market.

Future opportunities and challenges

Mckinsey estimates the requirements for Carbon credits to be around 8 to 12 Gt per year by 2030 to achieve global targets. But there are several factors which impact the ability of bringing carbon credits to market. Lack of transparency and verifiability is an important factor impeding the supply of carbon credits. Most of the potential supply of nature based projects is concentrated in a few countries and many of the projects have a significant lag between the initial investment and sale of credit. Owing to these challenges the potential supply drops to around 1 to 5 Gt CO2 per year by 2030.

Other challenges around high quality carbon credits include varying methodology of accounting and verification and the long duration of the verification process. Sellers are faced with unpredictable demand and uneconomical prices. The market is illiquid, scarcely financed, and lacks sufficient risk management, recorded accurate data.

Limited standardisation in the quality of carbon credits, means each project is valued differently by buyers and the matching between buyers and sellers become difficult, time-consuming and inefficient. Having a common taxonomy to define the quality of the projects would make the matching between buyers and sellers efficient.

Having a vibrant market place for carbon trading which allows large-scale, high-quality carbon credits to be sold through standardised contracts becomes important to address the challenges of carbon trading. CIX in Singapore is one such initiative where institutional buyers can engage in carbon trading in a trusted market place.

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