April 19, 2023 | Renewables & Decarbonization
There are two leading carbon trading or carbon offset mechanisms:
The EU ETS (European Union Emissions Trading System) is a mandatory cap-and-trade system established by the European Union to reduce greenhouse gas emissions from industrial and energy sectors cost-effectively. The system limits the total amount of greenhouse gas emissions that specific industries, such as power generation, manufacturing, and aviation can produce. It allows companies to buy and sell emission allowances within the limit. Companies that emit less than their allocated allowances can sell their excess allowances to companies that emit more than their allocated allowances, providing an economic incentive for companies to reduce their emissions. The EU ETS is the largest carbon market in the world, covering all EU member states and Iceland, Liechtenstein, and Norway.
Voluntary carbon trading, also known as voluntary carbon offsetting, is a market-based mechanism where individuals, organizations, and companies voluntarily purchase carbon offsets to mitigate their greenhouse gas emissions beyond what is required by regulations or law. Unlike compliance carbon trading, which is mandatory and legally binding, voluntary carbon trading is not subject to government regulation, and companies and individuals participate voluntarily.
The voluntary carbon trading process is similar to compliance carbon trading. Participants buy carbon credits, which represent a reduction or removal of greenhouse gas emissions that have been independently verified and certified by a third-party standard, although these standards are not uniform. These credits can then offset their carbon footprint, or they can be traded on the voluntary carbon market. However, ensuring the quality and legitimacy of carbon offset projects is essential. There have been concerns about the effectiveness of some voluntary carbon offset projects and the risk of greenwashing.
Whether mandated by government regulations or corporate strategies, companies that do not fall within the mandatory ETS Trading mechanism resort to voluntary carbon offsets to claim they have reduced their emissions. Despite the intention, voluntary carbon offsets are far from an ideal solution in their current form for various reasons:
Voluntary carbon offsets reward wrong behavior – instead of incentivizing the companies to reduce emissions, offsets offer an easy alternative and allow companies to spend some money on yet questionable assets.
VCMs lack transparency and accountability – while the Greenhouse Gas Management Institute and the Stockholm Environment Institute have put forward the guide on what the offsets should look like (additional, not overestimated, permanent, not claimed by another entity, not associated with significant social and environmental harms) there is no credible body actively verifying, scrutinizing and maintaining a public record of whether these offsets indeed contribute to long term reduction in the emissions. Nor is there an approved science-based methodology for calculating the credits and comparing apples to apples.
The somewhat chaotic framework can lead to greenwashing and corruption and may ultimately harm global greenhouse reduction if international players take advantage of the system's loopholes.
To make the global carbon offset market a proper tool for reducing global warming, more rigor, standardization, and heavier government involvement are needed:
Standardization – there is an opportunity to develop a science-based framework of how carbon credits should be calculated, regulated, and treated in the long term. Perhaps an international convention stipulating the standards, describing adequate project criteria, and defining the funding and trading mechanisms should be implemented. One of the upcoming UN Climate Change Conferences could be the platform to discuss and agree on such a convention.
Regional oversight – Similar to the EU, other regional economic zones include the Gulf Cooperation Council, Central American Common Market, Mercosur, and African Economic Community. Like the EU provides oversight of the mandatory ETS, it is recommended to establish other regional mechanisms with adequate tools and the authority to provide scrutiny and oversight of the projects which should qualify for carbon offsets. Binding stipulations of the single convention should be applied to all participating countries equally.
Trading – instead of allowing bilateral offsets, it is recommended to have a single trading platform where regional players can register after due scrutiny. Trading should be transparent, and the integrity of the process should be ensured.
Qualified projects – subject to passing scrutiny by the regional authorities, only projects satisfying the internationally agreed strict criteria should be made available for trading (mandated by the convention or other).
Funding – the flow of funds should be monitored to ensure that only the qualified projects become recipients. Perhaps there is room for a unified funding mechanism that disburses tranches according to the completion milestones for each project. This would ensure the funds would not go missing without completing the project.
End-of-the-project oversight – a system should be in place that monitors the continuity of the offsets. For instance, it should not be allowed to keep cutting and replanting the trees on the same plot once every few years to claim the offset benefits.
Cap and trade – while this element of the offsets would go against the principles of the voluntary trading scheme, some form of capping the emissions for participating companies should be implemented to incentivize them to reduce their emissions. Perhaps there is a way to tie the number of permitted offsets relative to the actual reduction in own emissions.