Many businesses are making pledges to combat climate change by reducing their greenhouse gas emissions to the extent they can. However, many companies find that they cannot fully eliminate their carbon footprint, or even lessen them as quickly as they would like. This is particularly challenging for businesses that seek to be net-zero emission, that is, removing the greenhouse gases from the atmosphere as they are putting into it. For many the case, it’s necessary to use carbon credits in order to offset emissions that they cannot eliminate through other methods. In the Taskforce on Scaling Voluntary Carbon Markets (TSVCM), sponsored by the Institute of International Finance (IIF) with knowledge support from McKinsey estimates that demands for carbon credits may rise by a factor of 15 in 2030 or greater and by up to 100 by 2050. The carbon credit market could be worth upward of $50 billion in 2030.
Markets for carbon credit purchases by the consumer (rather than for compliance purposes) is significant for other reasons, too. Voluntary carbon credits direct private funding to climate-action initiatives that would not otherwise begin to take off. They can also provide benefits , including biodiversity protection and pollution reduction, public health enhancements, and the creation of jobs. Carbon credits also encourage investments in the research and development needed to reduce the costs of the latest climate technologies. The scale-up of voluntary carbon markets can help in bringing capital to regions in the Global South, where there is the most potential for economically-based projects to reduce carbon emissions based on nature.
Due to the need for carbon credits that will result from international efforts to reduce greenhouse gas emissions, it’s obvious that the world will require a voluntary carbon market that is large accessible, transparent, reliable, and environmentally robust. Today’s market, though, is complex and fragmented. Some credits were found as emissions reductions which were doubtful at best. A lack of pricing data makes it hard for buyers to know whether they are paying an appropriate price, and for the suppliers to control the risk they are taking by financing and working on carbon-reduction projects , without knowing the price that buyers will eventually pay on carbon credits. In this article, which is based on McKinsey’s research for a new report by the TSVCM, we look at these issues and how market participants, standard-setting organizations, financial institutions, market-infrastructure providers, and other constituencies might address them to scale up the voluntary carbon market.
Carbon credits can aid companies meet their climate-change objectives
As part of the 2015 Paris Agreement, nearly 200 countries have endorsed the global target of limiting the rise in temperature averages to 2.0 degree Celsius beyond preindustrial standards and, ideally, 1.5 degrees. Reaching the 1.5-degree target would require that greenhouse gas emissions from the globe are reduced by 50% of current levels by 2030 and decreased to net zero in 2050. Many companies are aligning themselves with this agenda: in less than one year, the total number of companies with net-zero pledges increased from 500 in the year 2019 to over 1,000 in 2020.
In order to meet the net-zero target, companies are required to cut their own emissions as far as they possibly can (while monitoring and reporting on their progress in order to be accountable and transparent which investors as well as other stakeholder require). For certain companies, however, it’s prohibitively expensive to reduce emissions using today’s technologies, though the costs of those technologies may decrease in the future. At certain businesses, certain sources of emissions cannot be eliminated. For example, making cement at an industrial scale typically requires an chemical reaction, called the process of calcination, which is responsible for a large share of the cement industry’s carbon emissions. Because of these limitations the process of reducing emissions to achieve a 1.5-degree warming goal effectively calls for “negative emissions,” which are achieved by removing greenhouse gases from the atmosphere.
A carbon credit purchase is one way for a company to reduce emissions they cannot completely eliminate. Carbon credits are certificates representing the quantity of greenhouse gases which are kept out of the air or removed from it. Carbon credits have been used for decades, the non-profit market for carbon credits has increased dramatically in recent years. McKinsey estimates that by 2020, buyers will be able to retire carbon credits for some 95 million tons carbon dioxide equivalent (MtCO2e), which is nearly two times as much as in 2017.
In the process of decarbonizing the global economy continue to grow the demand for carbon credits will continue to grow. Based on stated demand in carbon credits demand forecasts from experts surveyed by TSVCM, and the volume of negative emissions needed to cut emissions in line in line with 1.5-degree warming target, McKinsey estimates that annual global demand for carbon credits could rise at least 1.5 to 2.0 gigatons of carbon dioxide (GtCO2) by 2030 and between 7 and 13 GtCO2 by 2050 (Exhibit 2). Based on different pricing scenarios and the drivers behind them and their underlying drivers, the market size in 2030 could be as low as $5 billion and $30 billion at a low end and higher than $50 billion at the high end.
While the growth in demand for carbon credits is substantial, research by McKinsey suggests that the demand for carbon credits in 2030 will be met by the potential annual carbon credits supply between 8 and 12 GtCO2 annually. These carbon credits would come through four distinct categories: reduced nature loss (including deforestation) or sequestration of nature like reforestation; avoiding or reduction of emissions , such as methane emitted from landfills and the removal of technology-based carbon dioxide from the atmosphere.
But, a variety of factors could hinder the ability to mobilize all of the potential supply and make it available for sale. The development of these projects would need to accelerate at a rapid pace. The majority of the amount of avoided loss of nature and of nature-based sequestration is concentrated in only a small quantity of countries. Every project has risks and all types of projects will not be able to obtain funding due to the lengthy interval between the initial project and eventual auction of credits. After these issues are taken care of for, the anticipated amount of carbon credits available will decrease by 1 to 5 GtCO2 per year in 2030.
They’re not the only issues that confront sellers and buyers of carbon credits, either. High-quality carbon credits are scarce because accounting and verification methodologies differ and the credits’ benefits that are co-beneficial (such as economic development for communities and protection of biodiversity) aren’t always well-defined. When verifying the quality of new credits – an essential aspect to ensure the integrity of the market–suppliers must endure long time-to-markets. In selling these credit, the suppliers are in a constant state of demand , and are unable to offer cheap prices. In general, the market is characterized by lack of liquidity, insufficient financial resources, inadequate risk-management solutions and the inaccessibility of data.
The challenges are daunting, but not insurmountable. The verification methods could be improved and the verification process streamlined. More clear demand signals could give suppliers more confidence in their project plans and encourage investors and lenders to offer financing. All of these needs could be met with the careful design of a reliable large-scale, voluntary carbon market.
Scaling up carbon markets that are voluntary will require a new framework for action
Building an effective voluntary carbon market requires concerted effort across a number of fronts. In its report, TSVCM has identified 6 areas that span the value chain of carbon credit which could be used to support the development of the voluntary carbon market.
Achieving common standards for defining and verifying carbon credits
The current voluntary carbon market is not able to provide the liquidity necessary for efficient trading, partly because carbon credits are extremely diverse. Each credit is characterized by attributes that are associated with the project it was derived from, like the type of project or the area in which it was executed. These attributes affect the price of the credit because buyers value additional attributes differently. Overall, the inconsistency among credit cards means that matching the buyer’s individual needs to a corresponding provider is a slow and unefficient process, which is conducted in a counter.
The matching between suppliers and buyers could be more efficient when all credit accounts could be described in terms of common characteristics. The first feature has to do with quality. The criteria for quality, set forth in “core carbon principles” would provide a basis to determine if carbon credits are genuine emissions reductions. The second set of attributes would include the other characteristics associated with carbon credits. A standardization of those attributes in a common taxonomy would help sellers market their credits and buyers to locate credits which meet their needs.
Making contracts that have standardized terms
In the carbon market that is voluntary, the heterogeneity of carbon credits means that carbon credits of certain types are traded in quantities that are too small for steady day-to-day price signal. The aim of making carbon credit more uniform would consolidate trading activity around the various types of credit and would also increase the liquidity of exchanges.
After the establishment of the carbon fundamentals and the standard attributes mentioned in the previous paragraph, exchanges may come up with “reference contracts” to trade carbon. Reference contracts could combine one contract, that is based on the fundamental carbon principles, and include additional attributes which are defined in accordance with the standard taxonomy, and priced separately. Core contracts could facilitate companies to do things like purchasing large amounts of carbon credits simultaneously They could also make bids for credits which meet certain criteria, and the market would then aggregate smaller quantities of credits in order to make sure they meet their requirements.
Another advantage of reference contracts would be the development of an unambiguous daily market price. After reference contracts have been established, numerous entities will continue to trade carbon credits over the over the counter (OTC). Prices for the credit that is traded through reference contracts can be used as a starting point for negotiations of OTC trades. Other characteristics priced separately.
