An overview of new global policy paradigms and how they will directly and indirectly create linkages between existing compliance and voluntary carbon markets.
The current deacceleration of the voluntary carbon market has coincided with the rapid acceleration of compliance carbon schemes all over the world. This collision is timely.
Emerging economies in Asia are prime example. Energy intensive economies, such as India and Indonesia, are in the early stages of establishing their compliance markets. In these two countries, over 1,000 companies in India and 99 coal-fired power plants in Indonesia are to be covered under the national emissions trading schemes (ETSs). The majority of these companies would have been highly unlikely to reduce their emissions within the same timeframes in the absence of these schemes.
Globally, annual emissions currently covered by compliance markets are approximately 12.8 Gt CO2-equivalent (24% of global emissions). This is compared to 891Mt cumulatively retired in voluntary markets over the course of their more than 20-year history.
Compliance markets globally are now worth an estimated USD $100bln, compared to the VCM at an estimated USD $1bln. Hence, it stands to reason that the collective efforts of the 'decarbonisation industry' should be proportionately directed into bolstering compliance markets now and in the coming years.
However, this will not always be the case.
At some point, compliance markets operating in isolation will be superseded by new policy paradigms, as policy objectives seek to capture economic efficiency and lower cost GHG mitigation outcomes that allow for an upgrade in ambition.
The EU’s Carbon Border Adjustment Mechanism (CBAM) is the most topical and obvious example of one of these new policy paradigms. While many countries in Asia are at the starting point of launching their national schemes, the EU has paved ahead with phasing in its CBAM from 1 October 2023.
Beginning its definitive phase on 1 January 2026, the CBAM (a sort of tax on high-emissions imports into the EU bloc) represents a new paradigm shift because it is a novel policy lever, layered on top of the EU ETS, to further strengthen the efficacy of the ETS. Inevitably, this model will be replicated in other goods-import intensive countries, and is already being seriously considered by the likes of the US, the UK and Australia.
Of course, the CBAM has been highly contentious. Concerns about its alignment with World Trade Organisation rules and a live debate about whether it is a fair and just treatment of less-developed economies are ongoing. This is complex to navigate, and the odds of a mutually happy outcome for all parties is unlikely, if not impossible.
The CBAM is neither the first nor will it be the last evolutionary policy lever to be implemented at a multi-national scale.
A scheme akin to CORSIA is already being considered by the International Maritime Organisation (IMO). Corporate ‘climate-related financial disclosure’ (CRFD) reporting regulations are also either already implemented or being implemented in Australia, New Zealand, Japan, Singapore, Hong Kong, Switzerland, the US, the EU and the UK .
The ‘CRFD’ framework requires corporates to disclose on much broader business sustainability considerations than their interaction with carbon credits (including Executive and Board governance, decarbonisation strategy, investments in emissions intensive industries, and more).
The widespread rollout of CRFD-related regulations therefore highlights that we cannot think about carbon markets only in isolation from other climate and corporate policies, regulations and initiatives. In the busy world of carbon markets and decarbonisation, few business leaders have the time and mental space to be able to foresee other policy evolutions on the horizon.
The future of carbon markets will be inextricably linked with regulations such as these, and these policy levers have the capability to create step-changes in the way economic growth becomes detached from emissions growth.
As they evolve, a function of these new policy paradigms will be that they will directly or indirectly create linkages between all sorts of compliance and voluntary markets.
Linkages are highly topical in carbon markets. Traditionally when we talk about a linkage between one or more scheme, we are only thinking about it within the context of unit eligibility cross-over, or ‘fungibility’. But linkage can be much broader than this.
Let's classify unit fungibility as a 'direct linkage', and 'indirect linkages' as any other overlap between two schemes. This could include linkage (or common adoption) of things such as integrity criteria, reporting and registry infrastructure, physical commodity trade, and so on.
Another example of a direct linkage which is very live for many active in the market is where a multi-national company that has emissions profiles across multiple jurisdictions.
Enabling indirect as well as direct linkages is important because, as it is widely accepted, scheme interconnectivity drives liquidity, investment and scalability. This also goes for interconnectivity between compliance markets and (what we traditionally call) the VCM.
We are already seeing this VCM-compliance market interconnectivity take place through examples such as:
In Queretaro, in north-central Mexico, the sub-national compliance scheme allows offsets from the VCM to be used for up to 20% of a company’s carbon tax liability (with certain caveats). The design of the scheme, which is more stringent than the national carbon tax, has already reportedly spurred on VCM activity in the country.
Hence, we cannot think about individual carbon market schemes in isolation.
Even companies that only engage directly with one scheme must think about carbon markets within the macro carbon market context. The global market context is evolving so rapidly that failure to understand it – at least on some level – leaves companies, and governments, incredibly risk exposed.
One example of this is the 'policy risk' that arises under the almost globally-adopted Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA). Under CORSIA, airlines are required to achieve net emissions reductions from international travel. The International Civil Aviation Organization (ICAO) has a Technical Advisory Body (TAB) which makes decisions on the types of carbon credits that are eligible for airlines to use.
However, being the first such scheme in the world, there is no precedent for how the TAB might revoke decisions already made about CORSIA credit eligibility. If for example, they approved a certain type of project for the scheme’s current phase (2024-2026), which was later found to have questionable integrity, they could move to remove that project type from the CORSIA credit whitelist.
For those familiar with the Australian market, we have seen parallel situations play out in our voluntary and compliance markets here, which have significantly affected the market’s dynamics.
Another parallel, which is highly anticipated but yet to play out, is the political risk around governments with agreements under Article 6 changing their policy stances – i.e., risk of revocation of authorisation for credits to be used by the buy-country.
The issue of revocation is also highly topical at present. Consider the fact that many traditionally classified 'VCM participants', now have significant interest in the topic of Article 6 revocation. This highlights a growing understanding of the importance of Article 6-related activity, due to its potential to maximise decarbonisation ambition through creating an inter-connected market.
This is not just in theoretical or conceptual terms. People understand that these kind of policy changes affect and interact with VCM project viability. But collectively as an industry, there is a limited understanding of the nuance of how these changes will impact the carbon markets (or 'the market' collectively).
Companies with any sort of carbon exposure – supply, demand and intermediaries – need to understand the complexity and dynamism of direct and indirect market linkages in order to remain afloat in this challenging business environment.
Those that do so will prove to be more resilient, agile and profitable. But perhaps most importantly, they will be able to drive significantly more investments into the mammoth decarbonisation transition underway.
To discuss what the above market changes may mean for you, get in touch with our team today.
Beyond local compliance: The interconnected nature of global carbon markets
