Monetary incentives are of course the biggest drivers of most business ambitions. Changemakers realised it early on that if businesses were required to truly contribute to climate action, there had to be a strong incentive – and nothing like a monetary incentive. This is where the idea of carbon markets was born.
There are about 75 carbon taxes and emissions trading schemes in operation, worldwide. As per the recent Economic Survey 2023-24, the global voluntary carbon market is worth over US$ 1.20 billion, and India is the second-largest supplier of carbon offsets that contribute to these carbon markets.
Let us understand what exactly is a carbon market and how does it incentivise climate action.
What are carbon markets? What are carbon offsets?
As explained by the UNDP, carbon markets are trading systems in which carbon credits are sold and bought. Companies or individuals can use carbon markets to compensate for their greenhouse gas emissions by purchasing carbon credits from entities that remove or reduce greenhouse gas emissions.
One tradable carbon credit equals one tonne of carbon dioxide (tCO2) or the equivalent amount of a different greenhouse gas reduced, sequestered or avoided. When a credit is used to reduce, sequester, or avoid emissions, it becomes an offset and is no longer tradable.
Let’s simplify this:
Imagine a Company X that switched from coal-based electricity to solar energy to power its manufacturing operations. Let’s say it helped the company bring down its emissions by 1000 tCO2. If one carbon credit equals one tonne of CO2, the Company would be entitled to 1000 carbon credits.
On the other hand, imagine a Company Y that has a target to reduce its emissions by 2000 tCO2 and is only able to reduce emissions by 1000 tCO2 after many operational changes. In this case, it can buy carbon credits from Company X and thereby ‘offset’ its shortfall. Hence, carbon credits are also referred to as carbon offsets.
Types of Carbon Markets?
Broadly, carbon markets are categorized into two types – compliance and voluntary. Last year, the Indian government introduced both these types of markets or trading schemes:
Ministry of Power notified the Carbon Credit Trading Scheme (CCTS), 2023 (compliance and voluntary)
Ministry of Environment, Forest and Climate Change notified the draft Green Credit Programme Implementation Rules in June 2023 (voluntary)
Based on their working, carbon markets may be also classified into the following two types: cap and trade schemes (or emissions trading systems, ETS) and baseline-and-credit schemes.
Under a cap-and-trade system (or Emission Trading System – ETS), an overall emissions cap is set and permits equivalent to the cap are auctioned or provided to the participants. Any surplus or deficit in permits held by the Company vis-à-vis its actual emissions may be traded in the system.
Incentive: In a cap-and-trade system the restricted supply of permits creates scarcity and thereby drives liable parties to seek abatement opportunities that cost less than the permits. In other words, producers of goods that use processes that emit carbon have an incentive to find lower emission processes to minimise their permit liabilities and thereby reduce emissions. |
The EU ETS (European Union Emissions Trading System) follows the cap-and-trade mechanism.
Under a baseline and credit scheme, an emissions intensity is set for emitting activities (like level of production) against a baseline. Credits are granted to companies that are within the baseline. Companies that have emissions above the baseline have to buy such credits.
Incentive: The ability to generate credits from emissions reductions relative to baseline and the pressure to avoid having to buy credits for emissions in excess of the baseline provide incentives for participants to find lower emission production processes. |
The CCTS India 2023 is a baseline and credit scheme, meaning that it would lead to creation of carbon credits upon achieving reductions below the baseline emissions.
However, there are limitations on using the baseline and credit scheme. Under an ETS, the government has full control over the amount of CO2e which can be emitted, because companies taken together cannot emit more than the total number of permits distributed. Under baseline and credit scheme, the government might set a theoretical emission limit, but companies will be free to emit as much as they want, as long as they buy offsets. This means that companies are paying others to reduce emissions instead of doing the job themselves. Hence, it is possible that there is no net reduction in the emissions at all.
Under the voluntary scheme, entities which are not obligated by the baseline limits may also participate in the carbon markets and buy or sell credits based on their requirement.
The compliance market under CCTS 2023 will be in application from FY 25-26, and is in works currently.
Under the Green Credit Programme, domestic entities will be able to voluntarily buy and
sell carbon credits. Under the draft, eight activities have been identified as eligible for carbon credits:
a. Tree plantation
b. Water Management
c. Sustainable agriculture
d. Waste management
e. Air pollution reduction
f. Mangrove conservation and restoration
g. Ecomark (a government scheme to identify environment-friendly products), and
h. Sustainable building and infrastructure
Further, it should be noted that carbon credits would only be issued after obtaining validation from an accredited, independent verification body. This would ensure that there is no greenwashing and the credits so generated have actually contributed to emission reduction. The infographic below succinctly describes that entire process.
Source: Medium
How are carbon credits priced?
Perhaps the most important success factor for a carbon market is the carbon price. Much like a stock exchange, the prices of carbon credits bought and sold are market-determined. However, a lot of factors influence it such as type of project, quality and credibility of offsets, popularity and regulatory requirements.
Source: Trading Economics
The above chart shows the 5-year movement of the price per allowance unit (carbon credit equivalent) on the EU ETS. The current average price is around EUR 67.86 per tCO2 which is equivalent to US$ 73.46. In a simulation conducted by the World Resources Institute (WRI) with 21 leading Indian companies, representing 9.20% of India’s industry sector GHG emissions, the market clearing price (MCP) for trading cycles ranged between INR 500-1700 per tCO2/ carbon credit. This is equivalent to about US$ 20.30 which is much lower as compared to the world average. This may however not be representative of the actual price, considering the multiplicity of factors that affect carbon market prices.
As is evident from the graph, the EU ETS has seen an upward trend, partly because the EU has been limiting the number of permits every year, meaning lesser permits are available to trade, pushing the prices up. The prices are also affected by other external factors such the Russia-Ukraine war which caused a massive dip in the energy consumption and drove down the prices in 2022. Periodic dips in the recent times are also attributable to carbon reduction opportunities being cheaper than the price of permits. This way companies prefer to reduce their demand for permits and drive down their price.
To bring stability, regulators are applying different price control mechanisms. The Regional Greenhouse Gas Initiative (RGGI), covering many north-eastern states in the US, employs a reservation price or a floor. The State of California extends this mechanism by applying a collar too. The EU ETS uses market stability reserve (MSR) mechanism where it buys or sells permits in trade thereby regulating liquidity and prices.
As the Indian government introduces the scheme, there are multiple factors that will decide the prices in the Indian markets– the most critical factor being the emission intensity baseline itself. It is expected that the baseline would be higher initially and tighten over the years as organisations get accustomed to this market approach. The scheme is likely to first extend to power companies and then target hard-to-abate sectors (such as mining, steel, cement, etc.) in a phased manner.
Until then, organisations must prepare to embrace emission reduction solutions – nature-based or tech-based – and make appropriate budgetary allocations to facilitate the impending changes. Hopefully, with the advent of carbon markets, India will be closer to its vision of being net zero by 2070.
Article Published with CVOCA Association - October 2024 edition.
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