Carbon markets from Kyoto to COP26, explained

The hottest thing on the market right now? Carbon. Well, not quite yet. But if you’ve been clued into happenings since COP26, a new kind of international trading scheme is on the horizon—one where a reduction in carbon footprint can be bargained for. And with climate awareness and urgency for action growing, this kind of market might be exactly what industries and governments need to get on track.

“Many companies are motivated,” Kelley Kizzier, vice president for Global Climate at Environmental Defense Fund, said in a press call last week. “They are getting more and more pressure from their own customers to have ambitious climate goals. I think this is one of the amazing things that’s emerged in the last few years.”

Throughout the years there have been multiple policies to incentivize large companies or countries to slim down their footprints over time. But the one idea that has stayed most relevant is the idea of carbon markets, or “cap and trade” policies. As far back as 1990, the US put in a cap and trade policy to regulate sulfur dioxide emissions from power plants; the first major carbon market program was put in place by the EU, called the EU Emissions Trading Scheme (ETS), in 2005. The Kyoto Protocol laid the ground for the first large-scale carbon market in 2005 involving 36 countries and the EU, but it expired in 2020 after years of debate and ineffectiveness. The US left the project before it even hit the ground running, and the EU more or less backed out in 2012. By 2015, it was found that the scheme was being manipulated by countries like Russia and Ukraine, and had actually increased carbon emissions thanks to bad players and low-quality projects. 

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But with COP26, a globalized carbon market might become a reality after all. In the final days of the Glasgow meetings, leaders hammered out a compromise  to finally prep the policy for the international stage. Here’s how it would work. 

What are carbon markets?

At the end of the day, carbon markets, or at least the “trade” half of cap-and-trade, mostly operate like any other market out there. To revisit Econ 101, in a normal scenario, Player A has a large supply of something that Player B doesn’t. Player A can sell its excess resources to Player B for a nifty profit, and then everyone is happy. But with carbon markets, it’s a little different. Instead of selling a good or service, both parties are working with allowances of carbon emissions, otherwise known as credits. Outside of just countries trading with each other, companies and smaller governmental groups can often get involved depending on the rules of the market. For example, in the EU’s ETS, a certain amount of allowances are allotted for industries with the ability to auction for more if needed. 

An allowance basically means that each country or company has a certain amount of carbon emissions to “spend.” Say Player A is thrifty with carbon, rapidly decarbonizing its grid, powering EV investments, and so on; they’ll have bonus allowances they can sell to their neighbor Country B, who may be taking their time moving away from fossil fuels and other unsustainable practices. And even in the case that Player A isn’t necessarily decarbonizing rapidly—perhaps they’re just a smaller economy that doesn’t produce many emissions to begin with—they can still use that money from the trade to boost their own economies.

Over time, however, the amount of allowances shrinks, limiting total carbon emissions and keeping the market from being saturated. That means everyone, especially heavy carbon emitters, eventually has to get their act together, and it becomes more difficult to make a quick buck off of lowering emissions. Ideally by then, each country or company has used its profits from the trades to develop better technologies and strategies for mitigating and adapting to climate change. Players who don’t meet their promises might be fined, depending on the market.  

Like with all goods and services, there are high-quality carbon credits and low-quality ones. High-quality credits are robust: A buyer knows exactly how much greenhouse gas emissions are mitigated, isn’t double counting credits during the deal, has strong institutions and accreditation systems in place, and produces positive environmental and social impacts. A low-quality carbon credit might be less exact about how much carbon is actually being taken out of the atmosphere and may not result in a permanent fix. The World Wildlife Foundation, Oeko-Institut, and EDF have a long list of rules and guidelines to consider when assessing the quality of a credit. 

Are there any carbon markets out there now? Are they helping?

Cap and trade is hardly a new idea, and there are several markets already in place around the world. Take the EU system: A PNAS study published in 2020 found that the ETS kept around 1.2 billion tons of carbon dioxide emissions out of the atmosphere (just under 4 percent of the entire bloc’s emissions), despite multiple accountability issues over the years. As the authors note, this was about half of what the world’s governments promised to reduce under the Kyoto Protocol. 

Smaller carbon markets have popped up across North America since 2005 as well—notably the Regional Greenhouse Gas Initiative (RGGI) in the Northeastern US, which recently added Virginia, it’s first southern participant, and California’s Western Climate Initiative (WCI), which collaborates with Quebec’s market to make up the fourth-largest carbon market in the world. Across the RGGI region, greenhouse gas emissions have dropped 35 percent since 2009, when it launched. Meanwhile, California’s emissions dropped 5.3 percent in the first four years of the WCI. 

Additionally, China began its own in-country cap and trade program this July after developing it for four years. So far the only participants include polluters from the power industry.

EU-ETS, RGGI and WCI, however, are mandatory, which means the market is regulated by international or regional carbon-reduction schemes. Voluntary markets, like the one borne out of COP26, exist outside of compliance markets and allow companies and countries to buy and trade carbon allowances as they see fit. 

What will the Article 6 carbon market look like?

After the Kyoto Protocol’s carbon market flopped, the Paris Agreement hoped to build a deal that would actually work with Article 6. Now, six years later, the rules have been more or less worked out through discussions at COP26. But there are some key differences—notably that the new market will be voluntary and that countries themselves won’t be the only participants.

While a voluntary market might seem strange or less effective at first, it actually forces large emitters to seek out strategies beyond cap and trade to meet their emissions goals, says Hugh Sealy, a professor of climate change and water resources management at the University of the West Indies. “There is this rule of supplementarity in the compliance markets where companies can’t buy themselves out of obligations,” he explains. “The mathematical definition is that [carbon market credits] must be less than 50 percent of your efforts … your primary effort will be to reduce your own emissions.”

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However, making the market open to non-EU parties, like corporations, could mean a stream of money for lower-income countries with carbon credits up for grabs. “High-quality credits can accelerate near and medium-term [climate] mitigation, and I think crucially they get private sector capital flowing to developing countries,” Kizzier said on the press call. “But we know that public sector finance is not enough, so we’ve got to use all the tools in our box.”

One other upside to Article 6 is that the Kyoto loopholes that allowed for low-quality carbon credits to sneak through the cracks have been tied up. Countries will be limited from carrying over old credits from the Kyoto Protocol market and double-counting credits toward both the seller and the buyer. But the rule isn’t completely set yet: The 192 countries that signed onto the Paris Agreement still need to work out important details on pricing and ensuring high-quality credits for all participants. Sealy, though, predicts that it won’t be long until trading picks up. While it took eight years to get Kyoto out of the gate, he says, “‘I don’t anticipate [this market] will take that long.”