The Future(s) of Emissions Trading – COP26 and the Voluntary Carbon Offsets Market

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By Gregor Spilker

In short

  • For years, the pricing of voluntary carbon offsets has been highly variable, but it is widely accepted that carbon offset credits could play a key role in moving to a low-carbon economy.
  • The early adoption of voluntary carbon offset futures has helped normalize the market.

Voluntary carbon markets are maturing. With over $1 billion notional value tradedthe market reached an important milestone last year.

While carbon offset credits remain – by their very nature – bespoke instruments, benchmark prices and futures are emerging, bringing a much welcome measure of standardization to the market. At COP26, the United Nations Climate Change Conference held in late 2021, countries agreed on a common approach to Article 6 of the Paris Agreement, which deals with markets international carbon markets. This should give the market new momentum and a higher level of clarity as the international community moves towards a low-carbon future.

The clearing market

The idea behind voluntary carbon offsets is simple. The entities develop projects that have an impact of CO2 reduction on the environment. This CO2 reduction is certified by a third-party registry that will verify that it is a real and permanent additional reduction. The market evolves around project developers and buyers who finance these projects through the purchase of project-backed offset credits. Buyers can seek to deduct their own emissions from these offset credits.

Although the idea behind it is simple, carbon offset credits come in many forms. Broadly speaking, the market can be separated into nature-based and technology-based projects. “Based on nature” includes projects that incorporate natural carbon sinks such as forests, wetlands or other ecosystems. In contrast, “technology-based” projects can involve transitioning to renewable energy sources, capturing methane from landfills, developing efficient cookstoves in rural communities, and more.

Some projects will have additional co-benefits in addition to reduced emissions – a wetland restoration project will not only sequester CO2, but it may also promote biodiversity and help the local community. Different registries may apply slightly different criteria to their certification process. Finally, buyers may have preferences for different geographic locations, project types, and vintages.

Clarity comes to the carbon market

The result is that for a number of years the pricing of voluntary carbon offsets has been highly variable, and nature-based projects with co-benefits have generally attracted higher prices. At the same time, governments around the world recognize the urgent need to transition to a low-carbon economy – and it is widely accepted that carbon offset credits must be part of the solution.

Some researchers estimate that nature-based solutions alone could provide up to 1/3 of the emission reductions needed by 2030 to keep global temperature rise below two degrees. A number of public-private initiatives are advancing and recommending frameworks for voluntary carbon market development – including the Taskforce on Scaling Voluntary Carbon Markets (TSVCM) sponsored by the Institute of International Finance.

The Article 6 negotiations that took place during COP26 also brought more clarity to the market. The implementation of the agreement will take time and a number of questions remain open. It specifies the extent to which legacy offset credits generated under the Kyoto Protocol’s Clean Development Mechanism (CDM) will be allowed for future emission reductions. It also makes a recommendation regarding the double counting of emission reductions.

In the past, an emission reduction result could be counted more than once when claimed by the country in which the project was based and, at the same time, by the entity that ultimately purchased the certified offset. This problem is solved by the introduction of corresponding adjustments (AC). Once implemented, this mechanism should ensure that offset credits can only be claimed once.

Acceptance of carbon offset futures contracts

CME Group entered the voluntary carbon market in 2021, with the launch of two futures contracts in partnership with CBL Xpansiv, a marketplace for spot trading of environmental commodities. Contracts are physically delivered and based on CBL’s Global Emissions Offset (GEO) contract and its Nature-Based Global Emissions Offset (N-GEO) contract.

GEO reflects the market price of carbon offsets eligible for CORSIA. CORSIA, the Carbon Offsetting and Reduction Program for International Aviation, is a framework to support the reduction of emissions offsets from the international aviation sector. Although the contract is designed to be CORSIA compliant, its user base is not limited to just airlines – other entities can simply adopt the same requirements and use CORSIA credits for their own purposes. N-GEO is a product that mirrors the price of nature-based offsets with additional co-benefits (Verra Climate, Community and Biodiversity standards).

Both contracts were accepted, with volumes increasing in both the spot and futures markets. On CBL Xpansiv, the carbon offset volume processed on its platform exceeded 120 million metric tons of CO2 equivalent (mt CO2e), a 288% increase over 2020 levels. Since the launch last year, the total volumes of GEO and N-GEO futures contracts amounted to 47 million tonnes of CO2e in 2021 since the launch last year.

Prior to the December delivery round, open interest in both contracts peaked at over 15 million tonnes of CO2 equivalent. When the December contract expired, the participants fully utilized the physical delivery of the contracts: 5.9 million tonnes eq. carbon offsets were traded between buyers and sellers, with each contract delivered backed by eligible carbon offset projects. In total, more than 6.5 million offsets were delivered between the two contracts in 2021.

Adopt standardized products

Voluntary carbon markets can play a significant role in the transition to a low carbon environment. Once the Article 6 settlement is fully implemented, the role of the corresponding CDM adjustment and legacy projects should provide further clarity to project developers, offset buyers and traders. Spot and futures exchanges help the voluntary carbon market move towards transparency and standardization.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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