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A Tale of Two Carbon Markets: The Evolution Phase

This article is the second in a series of posts on the history of carbon markets. The first post on the origin stories of voluntary and compliance carbon markets can be found here.


This is where the jargon gets complicated. So many acronyms are essential to know to understand the carbon markets space––here's a handy little jargon decoder to help explain some of these organizations and acronyms in greater detail.


 

The United States Clean Air Act's cap and trade experiment in the 1990s demonstrated the possibility and efficiency of using market-driven mechanisms to solve pollution problems. By 1995, the world's attention focused on climate change and six key greenhouse gases: carbon dioxide, methane, nitrous oxide, and a handful of different fluorocarbons. Over the next two decades, the foundations of carbon markets were taking shape through waves of successes and necessary lessons learned through experimentation.


At the UN Framework Convention on Climate Change's (UNFCCC) first Convening of Parties (COP) in 1995, developed countries agreed that they would set targets and timelines for reducing emissions and offer support to developing countries as they seek to reduce emissions as well. By COP 3 in 1997, The United States had experienced meaningful successes in reducing sulfur and nitrogen emissions through The Clean Air Act Amendment of 1990, its innovative emissions trading system to address acid rain problems in the country. The United States delegation firmly advocated for implementing a similar emissions trading system to achieve the emissions reduction commitments agreed upon several years prior. Naturally, there was pushback against this market-driven approach among many country delegates.


Still, the U.S. coalition was able to build consensus to participate in what is known as The Kyoto Protocol, the world's first attempt at implementing a global emissions trading scheme. The Kyoto Protocol paved the way for developed countries to use emissions trading to achieve their decarbonization targets more cost-effectively, just as the U.S. experienced with The Clean Air Act. Still, The Kyoto Protocol was only fully ratified in 2005 when it finally reached the 55 signatories required to initialize the plan and launch trading in the first commitment period in 2008.


After the Kyoto Protocol was agreed to in 1997, the European Union recognized that the region lacked the policy instruments necessary to deliver these emissions reduction targets. So the EU got to work piloting its own emissions trading scheme, known as the EU ETS, starting in 2003 and operationalized the policy beginning in 2005. The EU had to build every policy nearly from scratch––over time, they built the emissions allowance mechanisms, compliance policies, and monitoring, reporting, and verification (MRV) processes necessary to deliver first-round results with this new policy mechanism. As the EU developed its policies, it knew that the first implementation phase would be a period of "trial and error." From 2003 to 2007, the EU made significant strides in the development of what is now the world's largest ETS and laid the framework for other ETS policies to come online around the world.


But their success was certainly not without its setbacks. The price of EU carbon permits reflects two critical lessons learned by EU ETS policymakers:




Lesson #1: Oversupply of allowance permits can distort the market. A vital component of the EU ETS is the emissions allowances, known as Assigned Amount Units (AAUs), that are provided to each company that falls under the jurisdiction of the ETS policy that covers 50% of the economy, including the steel sector, cement, oil refining, chemicals, glass and ceramics, and others. 


These allowances were distributed based on economic projections of a stable growth rate over time. However, when the global financial crisis hit in 2008, economic growth dropped, as did emissions, and the EU ETS found itself overwhelmed with a surplus of credits. As a result, when the price of carbon permits was supposed to increase over time, the market dropped, and the price remained flat. This reflected too many credits in the market, which meant that emissions were not being reduced according to plan.


Lesson #2: Poor quality credits and bad actors can take the entire market down with them. When the first commitment period of the Kyoto Protocol was launched in 2008, the ETS could now source carbon credits from the Clean Development Mechanism (CDM) and the Joint Initiative (JI) to achieve their emissions reduction targets. 

The EU ETS agreed to allow many of these credits to be utilized in the market. However, by 2012, significant abuses of the joint initiative were taking place by bad actors predominantly located in Ukraine and Russia that were taking advantage of loopholes in the Kyoto Protocol's Joint Initiative. 


These credits were based on scam projects that increased emissions from industries only to remove them and generate credits, curbing coal waste fires, and many projects lacking in additionality (an essential parameter of carbon financing that requires projects to show that they would not have been funded unless through a carbon credit system). 


Millions of "bogus" credits flooded the market and undermined the EU ETS: estimates show that these bad actors ended up setting the EU behind on its climate targets by 600 million tons of carbon emissions––about ⅓ of the region's carbon budget between 2013-2020.


Desperately, the EU had to find a way to regulate and stabilize the market quickly. So, in 2018, the Market Stability Reserve Strategy was implemented, which set a process to remove a proportion of this oversupply from the market over time. This was a considerable improvement, and from 2018 onwards, the price of carbon permits started rising as intended. 


In 2021, when the EU made its net-zero by 2050 commitment of a 55% emissions reduction based on a 1990s baseline legally binding through the European Climate Law, the EU ETS came into its own: it had a functioning market that had fixed significant oversupply kinks and bad quality credits and now had a legally binding mandate that gave additional firepower to lowering the emissions cap over time. Over time and through a lot of experimentation, the EU ETS became one of the world's largest and most impactful emissions trading systems.


Donald Trump: The unintended hero of the Voluntary Carbon Markets


After Applied Energy Services started experimenting with using several afforestation projects in emerging markets to offset the emissions of their coal-based power plants and win the hearts of their climate-concerned customers. The business world took note: AES won a handful of corporate citizenship awards, and the idea of carbon offsets started attracting the attention of massive corporations like Microsoft and General Motors.


Carbon offsets started generating millions of dollars, and as more projects came online, The Environmental Resources Trust realized that there had to be better standards and monitoring of these offsets. So they created the GHG Registry, now known as the American Carbon Registry, to keep a record of which credits were available, purchased, and ultimately retired as a new form of tradeable environmental assets. 


From 1996 until 2015, the voluntary carbon markets saw little traction, but incremental steps forward were helping the market evolve: 

  • The Gold Standard and Verra, two leading standards and verification organizations, launched in 2003 and 2007, respectively.

  • VCMs saw around a 10x increase in transactions during the first commitment period of The Kyoto Protocol between 2008 and 2012, with a considerable boost coming from renewable energy projects in developing countries.

  • The first REDD+ projects, carbon credits from reduced emissions from deforestation and forest degradation projects, came online in 2011.

  • In 2012, Microsoft launched its carbon fee program. This new initiative charged its internal business units a fee for carbon emitted and used that capital to reinvest in renewable projects and offsets.

  • Several companies, including Google and Sky Media, became carbon neutral through offsetting and made commitments to be net zero in the next few decades.

 

One of the most ambitious experiments of this time was the Chicago Climate Exchange, or CCX, which operated from 2003 until it ended in 2010. It was the first of its kind voluntary carbon market that had legally binding contracts among the participants. The CCX established a voluntary cap-and-trade system among 450 members, including top companies such as Ford, Honeywell, DuPont, Motorola, and others who had set climate goals and needed to trade emissions allowances to achieve their goals. Many participants also saw this initiative as a means of engaging with a cap-and-trade system early on in the perceived likelihood of a federal ETS system coming into effect in the near future. 


Over the eight years in operation, the CCX successfully reduced emissions among its participants by 700 million tons, the equivalent of taking 140,000 cars off the road; of these reductions, 88% came from company-level emissions reductions, and 12% came from offset projects. 


The CCX ultimately had to shut operations after offset credits flooded the market, and the price of credits plummeted to less than five cents per ton. Moreover, compared to the EU ETS, which came back to live another day by creating the Market Stability Reserve Strategy, the CCX faced intense criticism after a wave of climate policies in the U.S. failed to move through congress. As a result, the exchange's leadership decided to write off the idea of large-scale cap-and-trade systems in the United States for the near future.


Then the Paris Agreement came into effect: at COP 21 in 2015, 196 countries negotiated a binding agreement to keep global temperature rise below 2ºC with a goal of 1.5ºC. By 2016, 193 countries signed the treaty, bringing it into full effect. Around this time, the Science-Based Targets Initiative (SBTi) was launched to help corporations set climate commitments that align with The Paris Agreement with support from the United Nations, The World Wildlife Fund, World Resources Institute, and the Carbon Disclosure Project. 


For the first two years, SBTi only saw a month-on-month rate of corporate climate commitments of 13 companies per month and barely reached 250 companies committed by 2017, with only a fraction of those having their climate targets approved as being in accordance with the Paris Agreement. 


That was until Donald Trump pulled out of the Paris Agreement. Panic ensued among climate leaders and the public alike. As the second-largest emitter of greenhouse gases and enormous global influence, having the United States remain in the Paris Agreement was mission critical for achieving climate goals.


City by city, company by company, the U.S. public and private sectors issued statements exclaiming "we are still in" and committing to upholding The Paris Agreement. Suddenly, SBTi commitments started rolling in: from 2017-2018, there was a 39% increase in SBTi commitments, and nearly all of them were from U.S. companies. Soon, the United States became the largest represented country in private sector commitments after Trump's actions. 



Science-based climate targets grew almost exponentially from 2015 to 2020, with over 1,000 corporations, including nearly a fifth of Fortune Global 500 companies, committing to adhering to the Paris Agreement. 


Oddly enough, the person most intent on getting rid of any form of climate policy that might interfere with American industry was the catalyst that sparked an exponential wave of corporate activism in climate. With all these corporations stepping into the ring to address climate change in some of the most challenging sectors to decarbonize (such as energy, steel, concrete, and agriculture), the stark realization of how hard the fight would be to change the entire way they––and the rest of the world––do business only just started to sink in.


Why this matters


Some familiar trends resurfaced during this phase of the evolution of carbon markets:


1. Emissions trading systems are powerful tools for emissions reductions; ensuring that they are functioning properly is critical. The cross-pollination of lessons from experimentation––from the Clean Air Act to the EU ETS and the Chicago Climate Exchange––paved the way for better iterations, policy mechanisms, and roadmaps in the future. The EU corrected the market by removing its credit oversupply, and the California Cap and Trade System, established in 2012, also took these lessons into consideration. This experimentation phase was critical to transferring knowledge and improving the efficacy of carbon markets around the world.


2. Integrity and quality are necessary for the success of carbon markets, especially as bad actors seek to take advantage of the system. The case of Russia and Ukraine flooding the market with low-quality credits is undoubtedly not the last time this will happen. Verifications and standards organizations such as Verra and Gold Standard are well aware and have been tightening their verification qualifications accordingly. New organizations have begun to emerge that seek to bring integrity and transparency into the carbon market to ensure its viability as a reputable critical climate solution. That said, there is a tricky balancing act to be managed between ensuring integrity and allowing some degree of leniency for what are highly challenging projects to deliver on the ground. As Robin Rix, Chief Policy and Markets Officer of Verra, stated, "the best can be the enemy of the good." After spending the past month learning from natural climate solution carbon credits projects on the ground in India and Kenya, this is quite often the case given the extreme complexity they have to deal with daily. These realities are rarely translated to a larger audience. While the realities on the ground are challenging, the VCMs must establish better mechanisms for pricing, market information and transparency, and ensuring supply integrity, especially as so many new actors enter the market.



3. Public perception matters and civic engagement will continue to be necessary to hold companies and governments accountable to the targets that they themselves have set. While Donald Trump did not have the impact he might have hoped for, the uptick in public and private organizations entering the fight against climate change is a massive net positive for the climate community. Decarbonizing the entire global economy is no small feat––McKinsey estimates that an additional $3.5 trillion is required in investment annually to hit net zero targets by 2050. The mobilization of resources and talent at this level is unprecedented, and it is up to everyone to contribute wherever they possibly can and hold those in power accountable for their commitments.


By the end of 2020, compliance and voluntary carbon markets had gone through significant iterations that shaped the evolving carbon markets industry––but 2021 and 2022 held big things in store, particularly for Voluntary Carbon markets. That's up next.


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