The regulatory focus on carbon markets is increasing.

Governments around the globe have made commitments to limit global warming and reach net zero carbon emissions by 2050 (or sooner) in order to deliver against the targets of the Paris Agreement. Carbon markets have a significant role to play in helping to achieve these commitments by enabling governments and organisations to more effectively manage emissions and emissions reductions limits.

Regulatory focus on carbon markets has been increasing. From a relatively “regulation-lite” starting point, we are now seeing regulators and standard-setters taking steps to assess and potentially better control growing activity.

Financial sector regulation of carbon emissions, trading and disclosure will develop given the fundamental need to reduce gross carbon emissions in order to manage the financial risks of climate change. It is likely that, in the short to medium term, carbon markets will become more highly regulated, in order to introduce greater consistency, reinforce the integrity of sustainability disclosures, and respond to stakeholders’ expectations that sustainability information should be transparent and comparable.

Mandatory and voluntary markets

Carbon markets exist as mandatory (compliance) schemes or voluntary programs.

Cap and trade schemes (also known as emissions trading schemes (ETS)) usually fall into the first category, with participants identified by governments based on carbon intensity, sector or size. Under these schemes, a limit (cap) is set on the total amount of certain greenhouse gases that can be emitted by the companies covered by the scheme — effectively setting a carbon budget. The cap is reduced over time so that the total permitted emissions fall. Within the cap, companies buy or receive emissions permits (or allowances) which they can trade with one another as needed. At the end of each year, companies must surrender enough allowances to fully cover their emissions or incur heavy fines. Where a company reduces its emissions, it can keep any spare allowances to cover its future needs or sell them to another company that requires additional allowances.

The EU ETS is the world’s largest cap and trade scheme, covering just over a third of the EU’s greenhouse gas emissions. The UK ETS went live on 1 January 2021, replacing the UK’s participation in the EU ETS. Other ETSs operate in Australia, Brazil, China and, at a state level, in the US, although the substance of different schemes can differ.

Conversely, baseline-and-credit mechanisms (also known as carbon credit schemes) are largely voluntary and have typically grown organically to meet the demand from organisations which seek to manage their carbon footprint. These schemes allow the purchase or sale of `carbon credits’, which represent a standardised unit of carbon (1 tonne CO2e) being either removed from the atmosphere or not produced. While ETSs cap the amount of carbon that can be emitted by an organisation, carbon credit markets allow companies to manage the impact of their emissions more proactively.

Voluntary markets function independently of compliance markets, and the credits traded cannot be used to meet the legal and regulatory obligations placed on organizations by compliance markets.

Influencing participation

Increasing requirements to make corporate sustainability disclosures and demonstrate progress towards net zero commitments, including through transition plans, may influence organisations’ participation in carbon credit markets.

In the UK, financial and listed firms will be required to report their strategies for transitioning to net zero from 2023. The EU has not yet finalised its requirements but the proposed Corporate Sustainability Reporting Directive (CSRD), which will expand reporting requirements to almost 50,000 firms from 2024, will likely require companies to disclose their transition plans.

The International Sustainability Standards Board’s (ISSB) first two draft standards propose that net zero transition plans be published by all firms, although the pace and scale of adoption is as yet unclear. In the US, the SEC’s proposals for climate-risk disclosures include disclosures on carbon offsets. And the prototype framework published in March 2022 by the Taskforce for Nature-related Financial Disclosures (TNFD) encourages firms to understand and disclose the dependencies of their risks and opportunities on nature, including the sequestration (i.e. capture and storage) and release of carbon into the atmosphere.

However, carbon credit markets should only form one part of a wider strategy towards decarbonisation and transition. The not-for-profit association Carbon Market Watch notes that carbon markets are about national limits and not about the decarbonisation of individual firms, and it has called for a better approach to accelerate the transition, rather than simply passing emissions allowances around the system through offsets.

Guidance has been issued on where corporates should and should not be using voluntary credits. For example, the Science Based Targets initiative (SBTi) makes it clear that carbon credits should not count as a reduction in carbon emissions against science-based carbon targets, but that they could be used to neutralise the impact of residual emissions once those targets have been achieved, or to finance the reduction of greenhouse gas emissions outside of the organisation’s own value

Increasing regulatory focus

The global landscape for carbon markets has developed rapidly leading to a patchwork of regulation and standards.

Standards are heavily influenced by organisations operating in the voluntary markets. For example, the Integrity Council for the Voluntary Carbon Market, an independent governance body, is consulting on Core Carbon Principles (CCPs) and an Assessment Framework (AF) to be issued in Q3 2022. The standards aim to increase transparency in the market and improve the matching of buyers and sellers of carbon credits, which may help to meet the increase in demand prompted by developing climate-related regulation.

Mandatory frameworks are also being reviewed. A consultation is underway until mid-June on developing the UK ETS. Proposals would align the UK ETS cap with the UK’s net zero target, extend coverage to include the domestic maritime and waste sectors, bring methane and other greenhouse gases within scope, and explore the introduction of a Carbon Border Adjustment Mechanism (CBAM). The CBAM would address the risks of so-called “carbon leakage”, where firms take advantage of less stringent and more favourable carbon credit rules to move emissions outside the domestic market, potentially undermining climate efforts. The CBAM would equalise the price of carbon between domestic and imported products.

Under its July 2021 Fit for 55 initiative, the EU put forward a comprehensive set of changes to the EU ETS which aim to drive a reduction of 61% in overall emissions from certain sectors by 2030. This would be achieved by strengthening the current provisions (including aligning the EU ETS cap with net zero) and extending the scope of the scheme, for example to the maritime transport sector. The package also introduced an EU CBAM which is more advanced in its development than the UK CBAM, having been approved by the EU Commission in March 2022 for phasing-in from 2023 with charges applied from 2026.

Activity from financial regulators is also picking up.

ESMA delivered its final report on the EU carbon markets in March 2022, in response to a request by the European Commission for an analysis of European emission allowances (EUAs) and derivatives on EUAs. The report did not find any major deficiencies in the functioning of the EU carbon market, noting that:

Long positions in carbon derivatives are mainly held by non-financial entities for hedging purposes
Short positions are mainly held by banks and investment firms providing liquidity and carbon financing
Positions by investment funds remain limited, with positions principally held by third country funds
The share of high-frequency and algorithmic trading is significant in the carbon market, even if the relevant firms are only holding very small or no actual positions

ESMA’s policy recommendations include measures to provide more information to market participants, regulators and the public such as: 

Extending position management controls to EUA derivatives
Amending EUA position reporting
Tracking the chain of transactions in MiFIR regulatory reports
Providing ESMA with access to primary market transactions

More broadly, IOSCO is undertaking a review of the weaknesses of voluntary carbon trading schemes and is developing an assurance framework for sustainability-related information.

Looking ahead

Within the patchwork of frameworks and national regulations, the cost of a unit of carbon emissions can vary significantly. Some of the highest prices are seen in Europe, while developing nations tend to charge less. The introduction of CBAMs represents a significant step towards levelling up carbon prices. However, as regulators take a greater role in supervising carbon trading frameworks, it will be important that they set suitably ambitious prices to encourage the transition away from carbon-intense operations.

There is not yet an accepted, consistent methodology to define and calculate carbon assets and liabilities, and traditional accounting concepts may not be the most appropriate for carbon emission management. The work of the ISSB may help to define these concepts, driving comparability between trading schemes and paving the way for assurance over carbon metrics.

Voluntary carbon trading frameworks raise another important issue – how to be certain of the existence of carbon units being traded, for example, how to confirm that a carbon offsetting project in a remote part of the world actually exists and isn’t being double counted. Assurance of this information is complex, and without it, a firm engaging in carbon trading could suffer reputational damage or become liable for carbon taxes which it believed it had already offset. Formal adoption of voluntary frameworks into national rules could help delineate responsibilities and reduce the opportunities for inaccuracies and fraud.

The scope of formal regulation looks set to increase. The EU ETS remains the largest carbon market in the world and as such could drive standards. Whichever jurisdiction is first to issue rules may set the tone of regulation globally, with other frameworks either aligning with or building on what has come before. Where firms are already participating, or plan to participate in carbon markets, it will be important for them to engage proactively as regulation evolves.