Explained | What are carbon markets and how do they operate?

The story so far: The Parliament passed the Energy Conservation (Amendment) Bill, 2022 on Monday, December 12, declining the Oppositions demands to send it for scrutiny to a parliamentary committee and amid concerns expressed by members over carbon markets. The Bill amends the Energy Conservation Act, 2001, to empower the Government to establish carbon markets in India and specify a carbon credit trading scheme.

What are carbon markets?

In order to keep global warming within 2°C, ideally no more than 1.5°C, global greenhouse gas (GHG) emissions need to be reduced by 25 to 50% over this decade. Nearly 170 countries have submitted their nationally determined contributions (NDCs) so far as part of the 2015 Paris Agreement, which they have agreed to update every five years. NDCs are climate commitments by countries setting targets to achieve net-zero emissions. India, for instance, is working on a long-term roadmap to achieve its target of net zero emissions by 2070.

In order to meet their NDCs, one mitigation strategy is becoming popular with several countries—carbon markets. Article 6 of the Paris Agreement provides for the use of international carbon markets by countries to fulfill their NDCs.

Carbon markets are essentially a tool for setting a price on carbon emissions—they establish trading systems where carbon credits or allowances can be bought and sold. A carbon credit is a kind of tradable permit that, per United Nations standards, equals one tonne of carbon dioxide removed, reduced, or sequestered from the atmosphere. Carbon allowances or caps, meanwhile, are determined by countries or governments according to their emission reduction targets.

A United Nations Development Program release this year noted that interest in carbon markets is growing globally, ie, 83% of NDCs submitted by countries mention their intent to make use of international market mechanisms to reduce greenhouse gas emissions.

What are the types of carbon markets?

There are broadly two types of carbon markets that exist today—compliance markets and voluntary markets.

Voluntary markets are those in which emitters— corporations, private individuals, and others— buy carbon credits to offset the emission of one tonne of CO 2 or equivalent greenhouse gases. Such carbon credits are created by activities which reduce CO 2 from the air, such as afforestation. In a voluntary market, a corporation looking to compensate for its unavoidable GHG emissions purchases carbon credits from an entity engaged in projects that reduce, remove, capture, or avoid emissions. For Instance, in the aviation sector, airlines may purchase carbon credits to offset the carbon footprints of the flights they operate. In voluntary markets, credits are verified by private firms as per popular standards. There are also traders and online registries where climate projects are listed and certified credits can be bought.

Structure of compliance markets. | Photo Credit: Land Trust Alliance, United States

Compliance markets— set up by policies at the national, regional, and/or international level— are officially regulated. Today, compliance markets mostly operate under a principle called ‘cap-and-trade’, most popular in the European Union (EU).

Under the EU’s emissions trading system (ETS) launched in 2005, member countries set a cap or limit for emissions in different sectors, such as power, oil, manufacturing, agriculture, and waste management. This cap is determined as per the climate targets of countries and is lowered successively to reduce emissions.

Entities in this sector are issued annual allowances or permits by governments equal to the emissions they can generate. If companies produce emissions beyond the capped amount, they have to purchase additional permit, either through official auctions or from companies which kept their emissions below the limit, leaving them with surplus allowances. This makes up the ‘trade’ part of cap-and- trade. The market price of carbon gets determined by market forces when purchasers and sellers trade in emissions allowances. Notably, companies can also save up excess permits to use later.

Through this kind of carbon trading, companies can decide if it is more cost-efficient to employ clean energy technologies or to purchase additional allowances. These markets may promote the reduction of energy use and encourage the shift to cleaner fuels. Since government-regulated trading schemes provide a clear trajectory, indicating how emission limits would be made tighter and allowances made decreasingly available, they may prompt companies to innovate, invest in, and adopt cost-efficient low-carbon technologies. The World Bank estimates that trading in carbon credits could reduce the cost of implementing NDCs by more than half — by as much as $250 billion by 2030.

Other national and sub-national compliance carbon markets also operate around the world — China launched the world’s largest ETS in 2021, estimated to cover around one-seventh of the global carbon emissions from the burning of fossil fuels. Markets also operate or are under development in North America, Australia, Japan, South Korea, Switzerland, and New Zealand.

Last year, the value of global markets for tradeable carbon allowances or permits grew by 164% to a record 760 billion euros ($851 billion), according to an analysis by Refinitiv. The EU’s ETS contributed the most to this increase, accounting for 90% of the global value at 683 billion euros. As for voluntary carbon markets, their current global value is comparatively smaller at $2 billion.

The UN international carbon market envisioned in Article 6 of the Paris Agreement is yet to kick off as multilateral discussions are still underway about how the inter-country carbon market will function. Under the proposed market, countries would be able to offset their emissions by buying credits generated by greenhouse gas-reducing projects in other countries. In the past, developing countries, particularly India, China and Brazil, gained significantly from a similar carbon market under the Clean Development Mechanism (CDM) of the Kyoto Protocol, 1997. India registered 1,703 projects under the CDM which is the second highest in the world. But with the 2015 Paris Agreement, the global scenario changed as even developing countries had to set emission reduction targets.

What are the challenges to carbon markets?

The UNDP points out serious concerns pertaining to carbon markets- ranging from double counting of greenhouse gas reductions and quality and authenticity of climate projects that generate credits to poor market transparency. There are also concerns about what critics call greenwashing—companies may buy credits, simply offsetting carbon footprints instead of reducing their overall emissions or investing in clean technologies.

As for regulated or compliance markets, ETSs may not automatically reinforce climate mitigation instruments. The International Monetary Fund points out that including high emission-generating sectors under trading schemes to offset their emissions by buying allowances may increase emissions on net and provide no automatic mechanism for prioritizing cost-effective projects in the offsetting sector.

The UNDP emphasizes that for carbon markets to be successful, “emission reductions and removals must be real and aligned with the country’s NDCs”. It says that there must be “transparency in the institutional and financial infrastructure for carbon market transactions”.

What does the Energy Conservation (Amendment) Bill, 2022, say about carbon markets and what are the concerns?

The Bill empowers the Center to specify a carbon credits trading scheme. Under the Bill, the central government or an authorized agency will issue carbon credit certificates to companies or even individuals registered and compliant with the scheme. These carbon credit certificates will be tradeable in nature. Other persons would be able to buy carbon credit certificates on a voluntary basis.

Opposition members pointed out that the Bill does not provide clarity on the mechanism to be used for the trading of carbon credit certificates—whether it will be like the cap-and-trade schemes or use another method—and who will regulate such trading. Members also raised questions about the right ministry to bring in a scheme of this nature, pointing out that while carbon market schemes in other jurisdictions like the US, United Kingdom, and Switzerland are framed by their environment ministries, the Indian Bill was tabled by the power ministry instead of the Ministry of Environment, Forest, and Climate Change (MoEFCC).

Another important concern raised is that the Bill does not specify whether certificates under already existing schemes would also be interchangeable with carbon credit certificates and tradeable for reducing carbon emissions. Notably, two types of tradeable certificates are already issued in India— Renewable Energy Certificates (RECs) and Energy Savings Certificates (ESCs). These are issued when companies use renewable energy or save energy, which are also activities which reduce carbon emissions. The question, thus, is whether all these certificates could be exchanged with each other. There are concerns about whether overlapping schemes may dilute the overall impact of carbon trading.

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