It is difficult currently to open the daily newspaper or scroll through social media channels without seeing the words emissions trading, carbon finance, cap and trade and the carbon markets referenced within those pages. In this short introductory piece, we would like to set the stage for a series of upcoming articles by us in which we will examine, explore and critique the emerging carbon finance markets in Canada and globally. In this first piece of our series, we will introduce key concepts in carbon finance and place the carbon markets within the broader sustainable finance field. The topic is very extensive and, as a result, we cannot cover everything within the general framework of carbon financing in one single post.

In recent years, a subset of conventional financing and investment known as “sustainable finance” has emerged. The aim of sustainable finance is to invest in, and finance, initiatives that support sustainable, clean or ‘green’ development. With the rapid success of many economic, social and environmental impact projects, integration of sustainable financing and green practices has become the prime focus of many governmental, financial and private organizations.

When one thinks about emerging green practices by individuals and businesses, one cannot help but think about greenhouse gas (GHG) emissions and the related green innovations aimed at reducing carbon emissions. Carbon financing, a subcategory of sustainable financing, is an inventive and innovative funding method that has the result of giving carbon emissions a monetary value. The monetary value of a ‘carbon credit’ relates, in large part, to the inherent price of carbon imposed by regulatory bodies on their constituencies and the cost or burden of compliance by such constituencies in meeting the emissions limits imposed by the regulatory bodies (among other factors and inputs). The attribute purchased and sold in a typical carbon financing transaction is called a carbon credit (which can be procured by a regulatory body or created by a sustainable project developer). The purchase and sale of carbon credits allows companies wishing to offset their own emissions (on the one hand) to buy carbon credits earned from sustainable projects and allows the holders of such credits (on the other hand) to receive an investment return for the sale of a carbon credit that such holder does not currently need for its own regulatory purposes. Carbon credits are transferable instruments, certified by government or third party entities, in the form of a permit or certificate representing a reduction in GHG emissions. Each credit typically represents one metric tonne of carbon dioxide (CO2). In short, carbon finance is based on the value of avoided carbon emissions that can be traded on carbon markets, giving the holder of the credit the ability to offset emissions where such emissions are capped or regulated.

There are currently two types of global carbon markets: mandatory (compliance) schemes and voluntary programs. Compliance schemes, commonly referred to as cap-and-trade programs or allowance trading, is a market-based approach to carbon emission reduction. While other GHGs such as methane can also be considered in emissions trading, the major platforms for emissions trading involve CO2. The voluntary markets, on the other hand, allow private companies, non-profit organizations, banks and even individuals to purchase carbon credits (offset) on a voluntary basis from third parties that have created such carbon instruments from certain activities.

The biggest interest in the carbon market comes from energy intensive entities – this includes those companies, for example, that operate in an industry that is covered by a regulatory emission standard or limit and such company needs to procure a carbon attribute to meet its regulatory burden. The company may need to procure a carbon attribute from a seller because reductions in emissions obtained through changed business activities or behaviours by such company will alone not be sufficient to meet or satisfy the compliance burdens imposed on said business. Voluntary or not, most market participants, use carbon credits to either satisfy their regulatory obligations or gain a positive financial return.

You might be asking yourself, how does this help the environment? With the trading of carbon instruments, simply stated, is the world becoming a cleaner, greener and less polluted placed? The answer is nuanced but, in the aggregate, a robust carbon market places a price on carbon. If there is a cost to emit carbon and that cost can be evidenced in the value of carbon credits traded in the markets, businesses will increasingly have important decisions to make about things like the fuels they use, their manufacturing processes, the suppliers they engage, etc. Those decisions will be informed by the cost of complying with a carbon regime (and paying the associated carbon taxes) or procuring carbon credits from sellers. If the cost to comply with a regulatory regime or purchase carbon credits is not an immaterial amount, businesses will over time change their methods and “clean up” their acts. The price of carbon, whether in voluntary or compliance markets, presents a signal to businesses and that signal will inform business decisions in meaningful ways.

In our view, over time, the simultaneous trading of carbon credits and carbon offsets mitigates, at least in part, the environmental calamities associated with GHG emissions while creating new market opportunities for investors and corporations alike. The trading of carbon can also create transparency by showcasing forward-oriented or progressive entities’ efforts in meeting their obligations and moving towards sustainable objectives. Environmentally conscious players (who may be voluntary carbon market participants) can demonstrate that they are doing their part to combat climate change while contributing to the carbon market growth.

There are many topics of interest surrounding the carbon market such as: How is the trading of carbon regulated in Canada and abroad? How do businesses produce carbon credits and who verifies, audits and authenticates the credits? How does offsetting emissions work? What are the benefits of carbon financing in the long run and how does it work in practice? In the upcoming months, we wish to cover these topics and bring your attention to the opportunities and challenges associated with carbon financing.

Our next article will focus on the main Canadian carbon markets, which exist both at the Federal and the Provincial levels, and we will offer a brief comparison with analogous markets in the US and Europe.