A Primer on Carbon Markets
In this post we give a short primer on carbon offsets and the purpose they serve. This is a high level overview of a complex topic – it is not a complete explanation!
A primer on carbon markets
A change in the air
Increasing concentrations of greenhouse gases are causing the Earth's atmosphere to warm up. Over the past few hundred years, human activity – especially industrialization and transport – has caused these the concentrations of these gases, including carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O) and others, to rise to historically unprecedented levels.
Our atmosphere is a part of the "global commons" – a common-pool resource accessible by all. We haven't been able to effectively manage this common-pool resource to avoid overexploitation, and now we need to coordinate to remove greenhouse gases at scale.
This is especially difficult because our society has developed to rely heavily on fossil fuels to power our economy. So we have a doubly tricky task of changing our behavior to reduce our emissions, and removing much of the historical emissions we've released. And we have to do it quickly to avoid the worst effects of climate change.
Carbon offsets
Over the past few decades, a diverse group of institutional stakeholders have developed a financial instrument to help with this transition: carbon offsets. A carbon offset represents one tonne of CO2 (or an equivalent amount of another greenhouse gas) that is not in the atmosphere.
Put simply, carbon offsets are created when a project does something that has caused the avoidance of greenhouse gas emissions, or the reduction of greenhouse gases in the atmosphere. We think of a carbon offset like an economic unit representing a positive externality. Carbon offsets are created when projects can demonstrate they have created these positive externalities (i.e. less carbon dioxide in the atmosphere). They are measured against criteria established by a standard, like Verra's Verified Carbon Standard.
By creating a financial instrument that represents the avoidance or reduction of greenhouse gases in the atmosphere, carbon offsets essentially provide a way for anyone to invest in planet-positive projects. Up until now, demand for carbon offsets has been driven by polluters who wanted to balance their carbon budget to reduce their carbon footprint.
Carbon offsets apply pressure on the climate crisis in two ways. First, by shifting the cost to the source of emissions, polluters are incentivized to reduce their emissions, therefore reducing the amount they need to spend to reach net zero. And second, carbon offsets provide financing to bring down the "green premium" - the extra cost required to bring carbon negative projects to market.
Carbon offsets are not the solution to climate change. In order to exist within the Earth's planetary boundaries, humanity needs to fundamentally change the way we live, work and play. But — especially in the short term — carbon offsets are a key tool to scaling investment in the projects and technologies that will help us minimize the effects of global warming.
Carbon markets
Carbon markets are trading systems where carbon credits can be bought and sold. There are two broad types of carbon markets in the world: compliance markets and the voluntary carbon market. They work differently: compliance markets (sometimes called "regulatory markets") exist at the national level and typically are designed to enforce nationally-set limits to carbon emissions. Different compliance market systems exist, each meant to efficiently allocate the right to emit to companies in their respective markets. [ Something about cross-market trading? ]
The voluntary carbon market is a global, unregulated carbon market for trading carbon offsets, which are typically bought by corporates for corporate social responsibility (CSR) or public relations reasons. The pressure on corporates to develop a climate strategy is growing due — we'll talk about why below.
"Carbon credit" vs "carbon offset"
The Voluntary Carbon Market
The main goal of the voluntary carbon market is to drive finance to carbon projects that reduce greenhouse gas (GHG) emissions. Carbon offsets are the vehicle that connects carbon projects with consumers that purchase offsets to achieve their climate targets. A carbon offset represents a measurable and verifiable removal, reduction, or avoidance of GHG emissions and is denominated in
tCO2e, which means "tonne of CO2 equivalent".Carbon Standards
In the voluntary carbon market, carbon standards set the rules and requirements carbon projects need to follow in order to demonstrate they meet minimum quality criteria. Verra's Verified Carbon Standard and Gold Standard are the two major players, with smaller standards issuing less than a quarter of total offsets each year. Standards are working to improve the criteria, and new, data-driven standards are being developed and coming online with the intention of ensuring that offsets are appropriately priced in the market, depending on the scale of their impact.
Methodologies
The "rules" carbon projects need to follow are a combination of high-level requirements and processes set by the standard and specific accounting methodologies. A methodology dictates things like monitoring requirements and is different for each carbon offset-generating activity. A methodology for protecting forests from deforestation requires different data to be collected than a methodology for wetland restoration. Independent 3rd parties—a list of auditors authorized by each standard—will assess projects against these rules and requirements. Only after a successful verification will the project be issued offsets by the standard body.
Carbon Registries
Each standard maintains a centralized registry with a list of all its projects, and the issued and retired offsets associated with each project. Different entities can have accounts on these registries, and hold, transfer or retire offsets through a web interface. Not everyone can have the account required to hold and trade carbon offsets — [ what are the criteria for who can get an account? ].
After projects have proven that they've removed or reduced GHG emissions they are issued offset credits that are in an active state. Because projects generally don't have direct contact with companies who will buy their offsets to satisfy sustainability claims, they often sell them to intermediaries—brokers, resellers, and retailers. Offset credits can pass from one hand to another without changing their status.
When an end-buyer wants to use the offsets to compensate their GHG emissions for carbon accounting purposes, the offsets need to be retired. Now the offset has fulfilled its "duty" and is permanently removed from circulation, meaning nobody else will be able to claim the carbon removal or reduction for their books. A registry account is needed to trade carbon credits in an active state. These accounts can cost $1000 a year in the case of Gold Standard.
Projects and Vintages
Carbon offsets are issued to a particular project that can demonstrate they've done something to remove or avoid carbon emissions in a particular period, or vintage. Projects are issued offsets roughly for each year they can show carbon impact.
This introduces an element of complexity into carbon markets. Carbon offsets have limited fungibility: offsets from a particular vintage associated with a specific project are mutually interchangeable with other offsets from that vintage, but may be valued differently by the market with offset from another project / vintage. This variation fragments liquidity, meaning trading volume is too low to produce a transparent price signal to the broader market (McKinsey). The market tends to value offsets based on their attributes — characteristics such as the type of carbon project, where it is, what kinds of co-benefits are associated and so on.
Carbon offset attributes
From the Toucan Carbon Pools documentation
A carbon offset represents a measurable and verifiable removal, reduction, or avoidance of greenhouse gas (GHG) emissions - a tonne of CO2 equivalent that is not in the Earth's atmosphere.
It makes a difference whether or not emissions are being drawn down from the atmosphere—commonly referred to as carbon removal—or if the flow of emissions into the atmosphere is being reduced or avoided. The classification into removal vs. reduction/avoidance offsets is a good example of the diversity of carbon offsets and form the core of carbon accounting and reporting best practices.
But within these broad categories, many more differentiating criteria dictate the price carbon projects can expect to get for their offsets. A few important ones are:
Project type. Different approaches to reducing greenhouse gases in the atmosphere are more or less effective - techniques like reforestation, protecting forests from deforestation, renewable energy projects (solar, wind, hydro), methane capture, soil carbon, or carbon capture and storage (CCS) projects.
Country. Project costs are higher in some countries than others, plus offsets from some countries may be perceived as higher-quality than from other countries.
Carbon standard. Some standards are more rigorous than others or demand additional data points to be collected during project monitoring and verification.
Co-benefits. Some projects seek additional certification from standards like the Climate, Community and Biodiversity Standards (CCB Standards), which certifies additional benefits like an increase in biodiversity or specific Sustainable Development Goals (SDGs).
The unique attributes tied to a carbon project results in offsets being traded and sold like differentiated products (e.g. wine) rather than like commodities (e.g. corn or rice). Subsequently, the majority of offsets transactions happen over-the-counter (OTC) and behind closed doors, meaning offset prices remain unknown to the broader market. This makes it hard for end customers to know whether or not they are paying a fair price and which percentage of the money lands in the hands of the initial project developer.
Toucan Carbon Pools allow for some level of commoditization by pooling similar carbon tokens. This is necessary to produce a transparent price signal to the market for different categories of carbon offsets. These standardized carbon tokens can be traded on DEXs (decentralized exchanges) with much deeper liquidity than a single project's offsets ever could.
Conclusion
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