An introduction to carbon markets
A brief background
The carbon market was created by the Kyoto Protocol, which was adopted on the 11th of December 1997. It carried forward the principles of the 1992 United Nations Framework Convention on Climate Change, or UNFCCC, that sought to commit parties to the reduction of harmful greenhouse gases.
After a lengthy and complex ratification process, it finally came into force on 16 February 2005. As of 2020, 192 parties support the protocol.
The objective of the protocol is to slow global warming by reducing greenhouse gases in the atmosphere to less dangerous levels. The six greenhouse gases specifically targeted are carbon dioxide (CO2), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), sulphur hexafluoride (SF6), methane (CH4) and nitrous oxide (N2O). These are collectively simply referred to as ‘carbon’.
What is the carbon market?
The carbon market is an emissions trading scheme aimed at reducing the emission of these greenhouse gases cost-effectively. The market deals in ‘emission units’ which are instruments that represent emission reductions. Its aim is to incentivise the major economic stakeholders, like energy and industry, to reduce the amounts of CO2 they emit.
How does the carbon market work?
In essence, the carbon market works pretty much like a stock market. However, instead of buying stocks, entities (a nation or organization) buy and sell the ‘rights’ to produce greenhouse gases.
Carbon has been given economic value – which allows organisations, nations, businesses, or companies to trade in it. Buying carbon credits gives an entity the right to produce carbon emissions. Selling carbon credits means an entity gives up its right to produce carbon emissions.
Carbon’s value is determined by the entity’s ability to ‘store’ it or stop it being released into the atmosphere. Heavily industrialised nations (that find it challenging to reduce their carbon emissions) buy emission rights from other countries that produce lighter carbon emissions and therefore have carbon credits.
What are carbon credits or offsets?
A carbon credit or offset is a certificate or permit that gives the holder the ‘right’ to the emission of one ton of carbon. In effect, carbon credits are mechanisms created in the carbon market to reduce total carbon emissions across the planet as heavy polluters benefit from less heavy polluters.
Caps are set on greenhouse gas emissions by governments or other regulating bodies. Companies that find it difficult to reduce their carbon emissions can buy carbon credits from other entities (whose emissions are below the cap) to ‘neutralise’ their carbon footprint. There is a growing trend to see carbon credits as a good investment.
What types of carbon credits are there?
There are two types of carbon credits – VERs and CERs:
- VER stands for Voluntary Emissions Reduction, which indicates a voluntary carbon credit exchange.
- CER stands for Certified or Compliance Emissions Reduction where a mandate by a regulatory body is involved. Compliance emissions markets are regulated by bodies like the Clean Development Mechanism of the Kyoto Protocol, the California Carbon Market, or the European Union’s Emissions Trading Scheme, or EU-ETS.
Do carbon credits offer attractive investment opportunities?
Forbes believes that they do, and that the ‘smart money’ is investing in carbon credits. This sentiment is echoed by the Wall Street Journal that believes carbon credits, that had long been ‘shunned’ by the financial markets, are now amongst some of the best-performing investments available. Their prices have soared to more than double over the past two years amidst lively renewed interest.
Not that carbon markets necessarily offer a smooth ride to investors, as Redshaw Advisors point out. They are not only complex, highly diverse, and changeable, but carry a significant element of risk along with their great investment potential.
That being said, carbon credits offer exciting and rewarding options to investors who have the vision, courage, and insight to invest in our blue (and hopefully ever ‘greener’) planet’s future.