Carbon Markets Have a Long Shot at redemption

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(Reuters Breakingviews) – The United States has grand plans for carbon markets. Washington’s idea, for an Energy Transition Accelerator (ETA) targets one of climate finance’s biggest challenges – the need, to increase clean energy investment in the developing world excluding China sevenfold by the early 2030s, to $1.9 trillion annually. John Kerry, U.S. President Joe Biden’s outgoing climate envoy, has a vision of a workable, large-scale market for emissions trading. It looks promising on paper, but plenty needs to go right for it to work.

Carbon markets involve buyers eager to acquire the right to emit an extra tonne of carbon dioxide from sellers able to restrict or absorb emissions. These schemes usually connect carbon-intensive companies from rich countries, like oil group Shell , with poorer states that have carbon-absorbing assets like rainforests.

They come in myriad forms. “Compliance” carbon markets like the European Union’s Emissions Trading System (ETS) are regulated, and often involve governments mandating, how much companies can emit and then forcing them to acquire credits for the right to do so beyond that level. “Voluntary” carbon markets are largely unregulated. They tend to start with projects like forestry preservation that establish a baseline level of emissions that would have occurred had the project not existed. Any reductions beyond that baseline produce credits which companies that decide to offset their own carbon can buy.

Given that the EU ETS is worth $800 billion and credits fetch $70 a tonne, it’s tempting to assume state compliance markets are the future. By comparison, voluntary markets have over 800 million outstanding credits worth under $2 billion. They have also experienced multiple controversies caused by baselines that were set way too high, allowing projects to create a greater, volume of credits than was justified. This can rebound on buyers: Delta Air Lines faces a U.S. class action lawsuit from a customer who views the carrier’s claim to be “carbon neutral” as greenwashing.

Still, a decade ago compliance markets were also in the doghouse. The Clean Development Mechanism, a United Nations-overseen market established under the 1997 Kyoto Protocol, allowed developed countries to buy credits from poorer states. But shortcomings, like overly generous baselines, saw 2012 CDM prices fall below 1 euro a tonne. Research suggests it may have actually increased global emissions.

Ever since, diplomats have tried to fashion a system integrating voluntary and compliance markets in a global marketplace where countries and companies can buy and sell credits, with the U.N. monitoring the system’s accounting and credibility. But that’s tortuously difficult. At December’s COP28 conference in Dubai, talks broke up without progress.

Kerry’s ETA, a partnership between the U.S. government, the Rockefeller Foundation and the Bezos Earth Fund, is an attempt to short circuit the wrangling by carving out a high-quality, focused carbon market. The aim is to decarbonise the coal-dependent electricity systems of Indonesia, Vietnam and South Africa that collectively spew out 450 million tons of emissions each year. Kerry reckons the initiative could sell carbon credits worth $41 billion tied to projects in these countries by 2035, and mobilise a total of $207 billion for decarbonisation – covering up to 35% of the bill for making the countries’ power sectors carbon-free.

Relative to existing voluntary markets, these are big numbers. But the initial plan suggests a degree of robustness. Major companies like Bank of America, Salesforce and Standard Chartered, all of which have expressed interest in the ETA, will have to prove they’re focused on reducing emissions rather than just offsetting their current output. For example, big companies might acquire credits in a scheme that closes down Indonesian coal plants after 10 years, half their expected life. The ETA would also align with guidance limiting the scope for sellers and buyers to count the same reduction in emissions twice.

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The financing numbers verge on the hopeful, though. Raising $41 billion in revenue means selling credits at $50 a tonne, over 10 times the current price of a typical voluntary carbon credit. An alternative ETA scenario, where fewer credits sell at just $20 a tonne, would only raise $10 billion. That’s insufficient to finance the full cost of decommissioning the coal plants and associated expenses.

The larger $207 billion number, meanwhile, is even more ambitious. It assumes not only that the ETA raises $41 billion by selling credits, minus $13 billion of retirement and transition costs, but that banks and investors then put up seven times that value. That multiple is in keeping with the high end of leverage estimated by the World Bank on development projects from concessional finance. But given the buyers of carbon credits only pay for them when the projects show that real reductions in emissions have occurred, financiers would be lending against advance purchase commitments made by companies like Salesforce. If buyers get cold feet, lenders might too.

ETA insiders stress that their initiative aims to bolster carbon market credibility, pushing up prices, even if it restricts potential credit supply and demand. But if the three countries don’t cut enough emissions – and the current rate of progress in Indonesia has been slow – they might not create enough credits. That would increase the temptation for ETA overseers to set less challenging baselines, as with previous schemes. Even well-intentioned credit creators might also just set the wrong level by mistake.

Kerry will know all this. So will World Bank President Ajay Banga and Monetary Authority of Singapore Managing Director Ravi Menon, who also trumpeted the potential of carbon markets at COP28. The pragmatic argument for rolling the dice on carbon markets is that it’s the best way to help mobilise the $1 trillion that the developed world needs to put up annually to help developing countries decarbonise by 2030.

The risk is that the ETA contains scope for further greenwashing. Alternatively, rival bilateral carbon markets could lower standards, perpetuating buyers’ reservations about the sector and rendering a genuinely global carbon market even less likely. The implicit U.S. wager seems to be that getting decarbonisation cash quickly to poorer states, even in a scattergun way, is better than not doing so at all.