Carbon markets play an important role in ensuring that states and companies deliver on their climate ambitions. The need to finance decarbonisation has led to growth in carbon trade. However, what exactly are carbon markets? Below, we answer some of the most commonly asked questions about carbon trading.

1. What is the difference between compliance and voluntary carbon markets?

While voluntary carbon markets concern the issuance, sale and purchase of carbon credits on a voluntary basis (e.g. as part of a company’s climate commitment), compliance carbon markets are created under a regulatory requirement. Compliance markets are limited to specific regions (based on the national, regional or international regulations that create them). In contrast, voluntary markets are not restrained by borders and can be traded internationally.

Examples of compliance carbon markets include emissions trading schemes (“ETS”). These “cap-and-trade” or “polluter pays” schemes exist in the EU, UK, California and China. Under the EU ETS, allowances equivalent to one metric tonne of CO2 are issued and can be traded. Companies must surrender allowances for the CO2 they emit. However, the whole cap of the allowances is reduced each year to help the EU deliver on the Paris Agreement commitments.

Currently, only high emitting industries such as power stations, refineries, steelworks, cement and lime factories, glassworks, ceramics manufacturers, chemical producers or pulp and paper producers are caught under the EU ETS. From 2024, EU ETS will also apply to maritime emissions. Unlike the ETS, voluntary carbon markets are open to all companies wanting to offset their carbon footprint.

2. What is the difference between allowances and credits?

The difference between allowances and credits is tied to the difference between voluntary and compliance carbon markets. Allowances represent a permission to emit one tonne of CO2 or (for certain types of facilities) other greenhouse gasses (“GHG”). They are traded on the compliance carbon markets.

Carbon credits correspond to one metric ton of reduced, avoided or removed CO2 (or other GHG). Carbon credits are traded on the voluntary carbon markets by companies and individuals to offset their unavoidable carbon emissions. Once a credit is used for this purpose, it is retired and can no longer be traded. Carbon credits cannot be used to comply with the requirements under the mandatory schemes (e.g. ETS).

3. How are the allowances and credits traded?

Allowances are traded on markets and registries created under applicable regulatory requirements. For example, to trade the EU ETS allowances, companies and individuals must create an account within the Union Registry, sections of which are administered by different member states. Compliance schemes may restrict participation in trading. For example, in the EU ETS, there are restrictions on which persons can buy allowances in auctions.

Like other commodities, credits can be traded freely. Project developers, wholesale traders and companies looking for offsets may all participate. Recent years have seen an emergence of carbon exchanges for trading credits. The largest carbon exchanges include AirCarbon Exchange (“ACX”) or the New York-based Xpansiv CBL. Earlier this year, ACX opened the first regulated carbon exchange in Abu Dhabi. In addition, the CME lists carbon credit futures.

The value of carbon credits fluctuates and may depend on factors such as the market, the credit’s vintage or the specific project. There are different types of projects issuing carbon credits – projects focused on reduction, sequestration or avoidance of carbon emissions, or nature-based projects (e.g. projects that aim to avoid deforestation).

4. What are the standards?

Carbon credits will be verified by independent standards; e.g. Verra (the Verified Carbon Standard) or Gold Standard. The standards have methodology allowing them to certify that projects meet their objective to reduce, avoid or remove a specified volume of CO2 or other GHG emissions. Quality is one of the key considerations when purchasing carbon credits. Assurance that a project adheres to a well-regarded standard and that it has been independently verified increases the value of the carbon credits.

5. Is offsetting enough?

Carbon markets play an important role in ensuring that the Paris Agreement commitments are met. However, companies should aim to reduce and replace their carbon and other GHG emissions; only offsetting unavoidable emissions.