What do bankers need to know about carbon markets?
The basic concept of carbon markets
Carbon markets turn CO2 emissions (CO2e) into a commodity by giving it a price. These emissions fall into one of two categories: carbon credits or carbon offsets which can be bought and sold on a carbon market. Carbon markets exist under both mandatory (compliance) markets and voluntary markets. Because carbon credits are issued by the government or regulators to entities in certain sectors, e.g., aviation and manufacturing in the UK, who trade among themselves mostly in the intercontinental exchange (ICE). This market is often referred to as the compliance market. Voluntary markets, however, consist of individual organisations or businesses trading carbon offsets.
Compliance markets are created and regulated by national, regional, or sub-regional governments and laws and credits are frequently issued under what is known as a “cap-and-trade” program in compliance markets. Here, regulators set a limit on carbon emissions – the cap. These can be likened to permission slips that allow a company to emit up to a certain set amount of CO2e that year. According to Refinitiv, the total market size of this market was around $261 billion in 2020. The cap-and-trade program exists in various countries around the world – in the UK, this exists as the Emissions Trading Scheme (ETS) program. However, many other jurisdictions host regulated ETS and carbon markets including several Asian countries, parts of the EU (European Union), 10 U.S. states (including California and New York), Canada, and Japan. There are also systems being developed or considered in Mexico, Turkey, Ukraine, Brazil, Taiwan, and Thailand, among others.
Voluntary carbon markets function outside compliance markets and let businesses buy and sell carbon offsets to achieve their own goals. Offsets for carbon operate slightly differently. Companies that engage in activities that lessen the amount of carbon already present in the environment, such as increasing tree planting or utilising renewable energy sources, have the option to offer carbon offsets. These markets are termed voluntary because the purchase of these offsets is optional. However, businesses may mitigate measurably the amount of CO2e they generate even further by purchasing these carbon offsets. Many businesses currently purchase carbon offsetting to counterbalance the CO2e they generate, and this can be leveraged to enable such entities achieve a “carbon neutral” status. While the voluntary carbon market is largely unregulated and challenging to quantify, analysts concur that participation in the voluntary carbon market is expanding quickly. According to Refinitiv, the voluntary carbon offset market is worth around $1 billion. However, the voluntary carbon market would still fall well short of the amount of investment needed for the world to completely reach the targets set by the Paris Agreement, even at the rate of growth shown above.
Why should bankers care? - Understanding the role of banks in carbon markets
There is increasing pressure to develop carbon markets. It is generally understood that these markets play a crucial role in driving the net-zero transition within various jurisdictions, and of course, for the world. For instance, the City UK and PwC report Enabling the net zero transition: the role of financial and related professional services, which seeks to provide guidance on how the financial sector can support and be a part of the transition to net-zero, highlights the importance of developing carbon markets as crucial to achieving a net-zero transition.
Banks typically play a significant role in the compliance markets by offering a liquid market with price certainty and transparency to companies governed by cap-and-trade programs. Banks also play a key role in voluntary carbon markets. A few banks recently joined the Carbonplace project as volunteers to aid in scaling and developing safe infrastructure. By the end of 2022, the banks plan to have it completely functioning. They want to develop a strong ecosystem to support the offset market and increase the delivery of high-quality carbon offset projects, among other things.
In order to give access to a wider range of investors, there are also prospects for other capital market solutions, such as repackaging carbon credits from regulated markets into structured notes. Some banks are also looking into capital market instruments that include voluntary carbon credits into sustainability-linked loans, bonds and derivatives.
Below are some of the major ways in which banks can add value to the carbon market:
- Financing project development – Banks might need to be bold and offer debt financing or blended financing to the project developers creating carbon offsets i.e., to a greater extent or scale than they do today. Many carbon projects are relatively small-scale – with values merely in the hundreds of thousands or low millions of dollars – and so would need to grow quickly to meet demand.
- Financing capacity development – Some market experts feel that the market is not ready for financing at the scale offered by banks. What is needed are more on-the-ground project developers. Beyond financing projects, more capital should be channelled into training people to develop projects.
- Bridging the information gap – Banks play an intermediary role between project developers accessing financial support and the market (businesses, corporates, individuals they transact with in their daily operations), as such they could help manage the information asymmetry between project developers who look to sell their offsets and the market which constantly seeks more understanding and information about carbon offsets.
Although the point on whether the market is sufficiently developed for banks to efficiently engage remains debateable, clearly banks can play crucial roles in developing the current state of the market through core and transformative services. In the UK, while we anticipate broader market-wide changes that would enable banks and other stakeholders to partake in the market, we appreciate recent efforts geared towards market advancement. We’ve recently witnessed the launch of the voluntary carbon market by the London Stock Exchange, which has now established a new market solution to accelerate the availability of finance to projects and support a just transition to a low-carbon economy. Similarly, the government has embarked on initiatives committed to building and promoting local and global efficient carbon markets such as the recently held Carbon Market Development Roundtable organised collaboratively with the Government of Ghana.
Despite the benefits of carbon markets (credits and offsets), it is important to recognise that it should not be entirely relied upon to achieving ‘carbon neutrality.’ More effort from individuals and entities, however, should be geared towards investing in and promoting efficient processes and technologies that can reduce emissions and produce real change in the economic transition.
- What is Carbon Pricing?: https://carbonpricingdashboard.worldbank.org/what-carbon-pricing
- Carbonplace Gets More Banks to Scale Carbon Trading: https://carboncredits.com/carbonplace-carbon-credits
- Understanding carbon markets: https://www.rbcgam.com/en/ca/article/understanding-carbon-markets/detail
- The Carbon Market, a Green Economy Growth Tool!: https://www.environnement.gouv.qc.ca/changementsclimatiques/marche-carbone_en.asp
- Three banks join initiative for voluntary carbon market platform: https://www.reuters.com/business/sustainable-business/three-banks-join-initiative-voluntary-carbon-market-platform-2022-02-15/
- Banks eye opportunities – and risks – in carbon offset boom: https://www.ifre.com/story/3084295/banks-eye-opportunities-and-risks-in-carbon-offset-boom-qjvffgngjz
- UK Brings Carbon Market Experts together ahead of COP27: https://www.gov.uk/government/news/uk-brings-carbon-market-experts-together-ahead-of-cop27?utm_medium=email&utm_campaign=govuk-notifications-topic&utm_source=ea9c807d-adba-4cc0-8ad0-1eff1ebb0d36&utm_content=immediately