What is a market?

In our previous discussions, we explored the growing role of climate finance in reshaping global markets. With over $1.3 trillion in climate finance tracked globally in 2021/2022 (source CPI), both mitigation and adaptation projects have been the major beneficiaries of this financial movement.

However, there's another critical piece to the climate finance puzzle: carbon markets.

Firstly, what is a market anyway? Is it the grocery shop you have next door?

In economic literature, a market is a system or a place where buyers and sellers interact to exchange goods, services, or financial instruments, typically facilitated by price mechanisms. Markets can be physical (such as a marketplace or stock exchange) or virtual (such as online platforms), and they operate under the laws of supply and demand.

Let’s put this now into climate economics, so carbon markets.

Carbon markets are gaining increasing attention as a powerful tool to reduce emissions and provide a vital source of financing for the transition to a low-carbon economy.

📊 For those new to the conversation, I recommend revisiting our previous post where we discussed the basics of adaptation and mitigation finance.

Understanding the flow of climate finance is crucial before diving into the mechanics of carbon trading.

🌍 What are Carbon Markets?

In a nutshell, carbon markets are trading systems in which carbon credits are sold and bought. 

Companies or individuals can use carbon markets to compensate for their greenhouse gas emissions by purchasing carbon credits from entities that remove or reduce greenhouse gas emissions.

Carbon markets allow governments, companies, and individuals to trade carbon credits—permits to emit a certain amount of CO₂ or other greenhouse gases.

These markets are either:

1. Compliance-based, where emissions caps are regulated by law (like the EU’s Emissions Trading System).

2. Voluntary, where companies buy credits to offset their emissions voluntarily.

💡 The beauty of carbon markets lies in their ability to put a price on carbon emissions, creating financial incentives for polluters to reduce their carbon footprint. It’s a simple yet powerful mechanism to channel funding into climate projects and accelerate the transition to a low-carbon world.

In simple terms, carbon markets make pollution expensive and reward companies for cutting down their emissions, helping to fund green projects and fight climate change.

👷🏻How does a carbon market work

Let’s look at an example of how a carbon market works with two companies: Company A and Company B.

Scenario:

• Company A is a manufacturing company that emits more carbon dioxide (CO₂) than is allowed by law. They are over their emissions cap.

• Company B is a renewable energy company that emits less CO₂ than their allowed limit, meaning they have “spare” carbon credits.

So what?

1. Emission Caps: The government sets a cap (limit) on how much CO₂ both companies can emit. Company A exceeds their cap, while Company B is under theirs.

2. Carbon Credits: For every ton of CO₂ that each company is allowed to emit, they receive one carbon credit. Company B, because they are more efficient and use clean energy, doesn’t use all their credits. Company A, on the other hand, has used all their credits and still emits more CO₂.

3. Trading Carbon Credits: Instead of paying fines or reducing production, Company A can buy carbon credits from Company B through the carbon market. Company B, having extra credits, sells them to Company A.

4. Result: Company A meets its legal emission requirement by purchasing credits, and Company B earns money by selling its unused credits. Both companies benefit—Company A avoids penalties, and Company B makes a profit for staying below its emission cap.

In essence, Company A is paying Company B to emit more CO₂, while Company B is rewarded for emitting less.

💸 The Growth of global carbon markets

Carbon markets are expanding rapidly as governments and businesses ramp up their climate commitments. In 2021/2022 alone, the global carbon market hit $851 billion in value and in the future carbon markets are expected to grow by a CAGR of 39.42% between 2024 and 2033, particularly as emerging technologies like carbon capture and nature-based solutions (such as afforestation) become more integrated into these systems.

As we discussed in our post on mitigation finance, private capital plays an essential role in filling the financial gap needed to meet climate goals.

💼 Private investment in carbon markets can take many forms:

• Buying carbon credits to offset emissions and support sustainability goals.

• Investing in carbon-reducing projects such as reforestation, renewable energy, and sustainable agriculture.

With carbon credit prices rising and new markets opening, private investors stand to gain both financially and through ESG (Environmental, Social, and Governance) alignment. For example, the average price of EU carbon permits has risen from around €25 in 2019 to over €80 in 2022, with projections suggesting further increases as carbon caps tighten.

🌐 Carbon Markets: our takeaways

As we move forward, the role of carbon markets will continue to grow, offering both financial returns and critical environmental impact.

• 🌍 Carbon markets are concentrated in developed economies, with the EU and China leading compliance markets, while voluntary markets expand in the U.S. and Brazil.

• 💼 Emerging markets offer untapped potential for private investors, with opportunities in projects like reforestation and sustainable agriculture, which can reduce emissions and improve livelihoods.

• 📈 Carbon markets will play an increasing role in the global transition to a low-carbon economy, offering both environmental and financial benefits.

In the next post, we’ll explore nature-based solutions in carbon markets, where both private investors and governments can drive impactful climate action while unlocking substantial returns.

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