The world is in the early stages of a multi-decade transformation. Reaching net zero by 2050 is crucial to the survival of the planet. It’s also an incredibly tight deadline by which to save it.

By greenlighting voluntary carbon trading, the Paris Agreement galvanized public-sector collaboration and private-sector participation.

The first and most important priority — decarbonisation — could take decades. For a world that has, according to The Economist, already sailed past the totemic 1.5°C target, ‘decades’ is not affordable. Nor, however, is phasing out entire industries on which society depends.

The terms of the Paris Agreement require a reduction of six gigatons of CO2 reduction annually. That’s the weight of all petroleum produced today. If society and the economy are to continue functioning — hospitals and homes and schools, to keep their lights on — carbon offsetting has an “unavoidable” place in transition plans, according to the IPCC.

Recent criticism threatens to do more than undermine two decades of market progress. The prospect of net zero hangs in the balance.

Growing a Market

The first and most important priority — decarbonisation — could take decades. For a world that has, according to The Economist, already sailed past the totemic 1.5°C target, ‘decades’ is not affordable. Nor, however, is phasing out entire industries on which society depends.

Seeds from the 1970s (or, early market formation and innovation)

Carbon credits have their roots in carbon neutrality, which gained ground in the 1970s. Human-induced global warming was just beginning to dawn on the public. Seeking to mitigate what negative climate impact they could, companies and individuals turned to ‘offsetting’ (as it was then known) as a promising solution.

The concept was simple — and compelling. If an increase in harmful emissions in one place could be offset by equivalent removal or reduction in another, then net additional global greenhouse gas (GHG) emissions would be kept to zero.

The first carbon offset project by a private company was documented in 1989. US power company Applied Energy Services planted 52 million trees in Guatemala to mitigate emissions generated by a plant in Connecticut, over 3,000 miles away. Seeing the potential power for market mechanisms in the fight against climate change, it wasn’t long until policymakers entered the fray.

In 1997, over 150 member nations of the UN Framework Convention on Climate Change (UNFCCC) signed the landmark Kyoto Protocol. The treaty introduced per-country emissions caps, embedding government climate action within a framework of international collaboration.

Just as important as why was how. Instead of regulating carbon emissions, negotiators made a marketplace out of them. The idea was to make decarbonisation cost-effective and efficient by creating financial flexibility and incentive, respectively.

Compliance carbon markets — so called because participation is mandated — had two mechanisms:

• Under emissions trading or so-called cap and trade schemes, a country with excess permits could trade with a country exceeding its emissions targets.
• Under offsetting, a country exceeding its emissions targets could purchase a compensatory credit from an emissions-reducing project.

It wasn’t without precedent. In 1994, the US introduced sulfur and nitrous oxide markets in an attempt to reduce acid rain. Pollution came down along with the cost of reduction, proving that cap and trade could be the win-win solution policymakers had hoped for.

In 2005, the Kyoto Protocol was ratified and the EU Emissions Trading System established. Meanwhile, the voluntary carbon market (VCM) – so called because, well, you guessed it — was just getting started.

• Under emissions trading or so-called cap and trade schemes, a country with excess permits could trade with a country exceeding its emissions targets.
• Under offsetting, a country exceeding its emissions targets could purchase a compensatory credit from an emissions-reducing project.

Sprouts from the 2000s (or, consolidation and strengthening)

Unlike the compliance carbon market, which is designed for and regulated by (supra) national carbon reduction regimes, the VCM caters to private sector companies seeking to meet emission reduction targets with offsets or credits. In the two decades following Applied Energy Services, their volume, type, and buyer grew gradually.

Despite being a different type of market — and notwithstanding its failures — the Kyoto Protocol catalyzed two private-market developments that would fuel VCM growth.

First, its programs proved that there could be serious demand for carbon credits beyond regulated countries. Second, it amplified the gravity of climate change to a global audience. And investors were listening.

The term ‘environmental, social, and governance (ESG) investing’ was coined in 2005. In 2006, the United Nations launched the six Principles for Responsible Investment framework to guide investors on how to “incorporate ESG issues into investment practice.”

From there, it took two decades for ESG to not only enter but define the mainstream. Catering to this new breed of shareholder were a growing number of Corporate Social Responsibility (CSR) programs and emission reduction commitments among publicly listed companies. They needed to offset their carbon footprints to meet their targets, and the VCM evolved to comply.

Governed by standards rather than governments, a market framework was coming into focus. Between the 1990s and 2000s, four credit registries emerged. The American Carbon Registry (ACR), Climate Action Reserve (CAR), Gold Standard (GS), and Verified Carbon Standard still dominate the market today.

It wasn’t until 2016, however, that the market really took off. Enter: The Paris Agreement.

Sapling from the 2010s (or, mainstreaming)

The Paris Agreement catapulted the VCM into the heart of the 21st Century economy, marking the final chapter in its transition from green niche to global necessity.

What next for the voluntary carbon market?

In our last blog, we traced the origins and first three decades of growth in carbon markets. This week, we’re looking ahead. How did the Paris Agreement propel the voluntary carbon market (VCM) into the mainstream, and which headwinds could yet drive it off course?

Carbon credits are at a crossroads

On the one hand, interest has never been higher. In under a decade, the VCM has earned a foothold in the discourse around decarbonization. For myriad reasons outlined last week, people are more willing to accept that any realistic road to net zero is paved with carbon credits.

This the VCM owes, in large part, to the Paris Agreement.

Negotiated by the United Nations Framework Convention on Climate Change (UNFCCC) in 2015 and ratified in 2016, the Paris Agreement took a radically different approach to that of its predecessors (Kyoto, Copenhagen).

Instead of binding its signatories to international law, the treaty is mostly voluntary. Provided they work towards the same general coordinates, governments were and are free to set their own nationally determined contributions (NDCs) to net zero.

One major lever at their disposal is international carbon trading, the foundational terms of which are spelled out in Article 6 of the treaty.

Recognizing the need for an established and regulated VCM, the Paris Agreement changed the course of the decarbonization movement. Early estimates suggest it could reduce the cost of implementing NDCs by more than half ($250 billion by 2030), facilitating the removal of 50% more emissions.

By greenlighting voluntary carbon trading, the Paris Agreement galvanized public-sector collaboration and private-sector participation.

By the Numbers

In the years that followed, negotiators sought to develop a governance structure capable of upholding a standardized, commoditized, and universally recognized market. Meanwhile, organic demand and price exploded.

Ecosystem Marketplace calculated the VCM was worth $2 billion by 2021. In its review of the year, Refinitiv admitted it was “running out of superlatives to describe the surge in carbon trading.” The value of the VCM may reach $180 billion in 2030, according to McKinsey, soaring to $800 billion by 2050.

Bloomberg puts the figure closer to $1 trillion by 2037 — if, that is, the right rules are in place.It’s a big ‘if’. Despite encouraging progress, standardization remains elusive. Amid its bullish predictions, McKinsey warns that the VCM is “fragmented and complex… with low to no regulation, different accounting methodologies with varying degrees of rigor and a variety of industry-created standards.”

Healthy frameworks make for happy markets. Green in more ways than one, the VCM is finding success a double-edged sword, as the infrastructure required to service (overwhelming) demand is still in development.

And it is in development. Behind the scenes, ratings agencies, standard setters, and integrity bodies, such as the Voluntary Carbon Markets Integrity Initiative (VCMI) and Integrity Council for the Voluntary Carbon Market (ICVCM), are working tirelessly towards best practice guidelines for buyers and suppliers of carbon credits.

In 2022, for instance, the ICVCM launched a Public Consultation for Core Carbon Principles to provide a framework for identifying high-integrity and high-quality carbon credits that create additional and verifiable impact. Based on ICVCM guidance, we expect the Core Carbon Principles to be issued this month. (Watch this space.)

Fly in the Ointment

Building market integrity takes time. As our CEO Chris Slater told Carbon Pulse this month, integrity bodies are “all trying to solve the underlying problem, which is risk mitigation.”Long-term risk mitigation is important, but what about immediate risk protection for corporate buyers?

Hoping for the best isn’t a solution. Thanks, in part, to eroding trust, the VCM grew more slowly than anticipated in 2022. In early 2023, allegations of over-crediting spawned negative headlines about and a retreat from forestry projects, foreshadowing more confusion ahead.In theory, all carbon credits should be created equal. In an opaque and fragmented market yet to reach maturity, however, some — as our CIO Laura Fritsch will explore in more detail next week — are better than others.

That complexity makes the VCM difficult to navigate, deterring companies for whom reputation is a growing concern. Chief Sustainability Officers don’t have the bandwidth to conduct due diligence on every carbon credit they purchase to meet those plans.

Equally and understandably, company management may not want to gamble with stakeholder expectations. To preempt damaging accusations of greenwash for outcomes they can’t control, they may choose to ‘greenhush’ or pull back from commitments.

Given the importance of carbon credits in meeting NDCs and so net zero, there’s more at risk than reputation; planetary health is on the line, too. Insurance, however, can help, representing a much-needed de-risking solution to both problems.

The VCM needs insurance. Pricing and transferring risks will ease the pressure on buyers, bringing credit demand back on course and much-needed liquidity to emission-reduction projects.

History shows that market and risk-transfer mechanisms depend on one another. Or, as CEO Chris Slater told Carbon Pulse: “Insuring carbon credits will play a critical role in evolving the voluntary market, as insurance has done for other sectors for hundreds of years.”