The UN Climate Change Conference in Glasgow (COP26) brought together 120 world leaders in early November to discuss how to tackle one of the largest challenges of humankind. The solution is in principle very simple: we need to reduce our carbon footprint. The way to implement it though is still very controversial, as disruption will be required in almost every industry.
An interesting way to tackle the problem are carbon credits. The idea is simple: we know how much our carbon emissions must be reduced, but some processes are more carbon intensive than others. So why not use the deficit of the one to ‘fund’ the excess of the other? What the carbon markets do is turn CO2 emissions into a commodity by giving it a price, and let the market mechanics work out the most efficient way to reach net zero carbon economy.
Carbon credits, offsets and markets are not new. The Kyoto Protocol of 1997 and the Paris Agreement of 2015 were international accords that laid out international CO2 emissions goals. Those have given rise to national emissions targets and the regulations to back them. With these new regulations in force, the pressure on businesses to find ways to reduce their carbon footprint grew and eventually carbon markets were introduced.
The exact implementation differs from country to country, but essentially, there are 2 ways to implement it.
1. The carbon tax approach: Governments set a fixed price per kg of CO2 and everyone pays based on their activity. By regulating that tax, the governments can incentivize the use of greener technologies. Typically this tax will be increased every year as we move towards a net zero economy. Companies can try to buy carbon credits to reduce their tax bill.
2. The cap and trade approach: National emission have a hard ceiling target, creating a fixed amount of carbon credits. Every business can then bid to buy those credits and use them for their activities. Companies can then also trade with each other on a free market. Similarly with the carbon tax, the carbon target is reduced every year before reaching 0.
While both solutions have pros and cons, both solutions share an interesting outcome: carbon offsets. Organizations with operations that reduce the amount of carbon already in the atmosphere, say by planting more trees or investing in renewable energy, have the ability to issue carbon offsets. The purchase of these offsets is voluntary, which is why carbon offsets form what’s known as the “Voluntary Carbon Market”. However, by buying these carbon offsets, companies can measurably decrease the amount of CO2 they emit even further. This mechanism has created new business models, where the only revenue comes from carbon offsetting, such as CO2 sequestration plants.
This new market is growing fast. While the voluntary carbon market was estimated to be worth about $400 million last year, forecasts place the value of the sector between $10-25 billion by 2030, depending on how aggressively countries around the world pursue their climate change targets. This creates an unprecedented opportunity for investors in the space.
However, there are still challenges ahead. The intentions of such initiatives are good, but it is still very hard to properly implement and monitor. There are already cased of falsifying CO2 removal numbers and selling fraudulent credits. Moreover, the effect of such measures is limited as they remain regional. Large corporations can always find ways around those regulations by moving the carbon heavy operation in less regulated jurisdictions. However, it looks like governments are starting to align more and more and we are trending towards a unified global carbon market. As is usually the case with brand new markets, there will be challenges early on but it also remains the opportunity set is hard to ignore.
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