Market insight

How can carbon markets make the net zero transition more affordable?

Polly Thompson
August 25, 2022
How can carbon markets make the net zero transition more affordable?
How can carbon markets make the net zero transition more affordable?

This year it’s been hard to avoid stories about heat waves, droughts, and wildfires,  and their link to climate change. It’s becoming scarily clear how severe the impacts of climate change are becoming, even in some of the world’s richest countries.

Not only does climate change have massive impacts on people and nature, but it also results in devastating economic costs. The longer we fail to act decisively, the greater these costs will be. Insurance company Swiss Re estimates the global costs could be as big as $23 trillion by 2050; unimaginable sums of money with unimaginable consequences for people across the globe.

Cost of climate related disasters in 2020

Transitioning to a net zero economy will have short term costs. Decarbonizing energy, transport, and manufacturing, halting deforestation and land degradation, and making global supply chains sustainable will not always be easy or cheap.  The alternative is far worse however. Following a coordinated and ambitious plan to reduce global emissions will not only reduce the costs of climate disasters, but can lead to sustainable growth and net economic gains.

So how do we get there, and how do we smooth the transition? Unfortunately, there is no silver bullet, no one single solution. We will need a variety of tools. Here, we’re digging into just one of these tools: carbon markets. Carbon markets have seen huge increases in investment over the last few years, but how does this help us combat the climate crisis? 

What are carbon markets?

Carbon markets allow the trading of carbon credits or allowances: units representing 1 ton of CO emissions. In the simplest cases, the seller - for example, a carbon project developer - conducts an activity which avoids emissions or removes CO from the atmosphere, and the buyer - for example, a global firm -  pays for the exclusive claim to this carbon saving, usually to compensate for, or ‘offset’ their own emissions.

There are different types of carbon markets. 

  • Regional compliance markets: governments mandate participation, usually for businesses in high emitting sectors. Commonly these take the form of ‘cap and trade’ markets where there is a maximum emissions limit. Companies which reduce their emissions below the number of allowances they own can then sell those excess allowances to companies which need them.
  • Voluntary carbon markets (VCMs): organisations or individuals choose to purchase credits from crediting projects. This allows them to offset their emissions and make claims such as being carbon neutral.
  • International carbon markets: UNFCCC structures (currently transitioning from Kyoto Protocol mechanisms to the Paris Agreement’s Article 6) allow the trading of carbon between countries. These units can also be bought by companies. 

Different types of carbon markets have different rules, incentives, and approaches. Ultimately though, they have the same effect. By enabling the trade of carbon, emissions reductions are achieved more cost-effectively.

How do carbon markets make reducing emissions more cost effective?

Some emissions reductions are more expensive than others. An example would be changing electricity generation from fossil fuels to renewables (relatively low cost, and becoming cheaper all the time) compared to decarbonizing long distance transport (a big challenge, which will need significant investment in research to solve). 

Carbon markets allow us to achieve the easiest and most cost-effective emissions reductions in the short term, increasing the speed and ambition of global efforts to combat climate change. In the simplest case, if it costs $30 / ton for a manufacturing company to reduce its emissions, but $10/ ton to protect rainforest from illegal deforestation, 3x more emissions reductions could be achieved for the same spend. 

This becomes particularly important when we consider marginal abatement costs. Generally, each ton of emissions avoidance becomes more expensive to achieve. Reducing emissions by the first 10% costs less to achieve than the next 10%, and a lot less than the last 10%! 

So emissions reductions in countries like the UK, which has already reduced domestic emissions by 50% since 1990, will be a lot less cost-effective than in countries that are just starting their emissions reduction efforts. 

Remember, climate change is a global issue. This doesn’t negate the responsibility of individual countries, but it does compel us to think at global scales. We need to reduce global emissions significantly this decade, but we’re not acting quickly enough. Cooperating globally to channel finance to the lowest-cost emissions could allow us to achieve significantly more emissions reductions in the short term. This buys us time to invest in research, new technology, and more long term solutions for the emissions reductions that are currently expensive or not technically possible.

Finally, carbon markets are a valuable way to channel funding to emissions reductions activities that otherwise would not be financially viable. A key example of this are nature based solutions: protecting forests, restoring ecosystems, reducing degradation. These need investment to implement effectively, and can present opportunity costs to local communities. Carbon markets are the only mechanism that currently exists at scale to provide funding to these kinds of projects, and without our rainforests, there is no net zero.

Of course, these arguments are simplified for clarity, and careful safeguards need to be in place to avoid perverse incentives or misuse of markets. However, given reasonable safeguards, carbon markets aren’t just a nice theory. Research and economic modelling consistently supports the opportunities presented by carbon markets to accelerate decarbonisation. Cooperative implementation of net zero targets could yield significant financial savings, reducing mitigation costs by $21 trillion between 2020 and 2050 or reduce emissions by an extra 50% by 2030 (~5 gigatonnes CO2/year), at no additional cost. This is echoed by a 2019 study suggesting global emissions trading could reduce the total mitigation cost of meeting Paris Agreement pledges by 59-79%.

The longer we wait, the more it will cost us 

There is no time to waste when it comes to climate change. We are already seeing catastrophic effects, and the slower we act the worse it will get. Carbon markets are no “get out of jail free”card, but we need to be thinking of integrated, global-scale cooperative solutions. That’s why the need for markets was explicitly recognised in Article 6 of the Paris Agreement. 

We can use the infrastructures and incentives of carbon markets to drive decarbonization ambition while also reducing the transition costs, as long as those markets are run with integrity and fairness.

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