1. Introduction

In a stylized, frictionless world, markets engender the most efficient allocation of scarce resources. Yet, markets in textbooks are based on multiple assumptions and simplifications that do not hold true in reality; hence, markets in the real world suffer from various deficiencies. These market deficiencies imply costs and risks and discourage market participants from active market participation.

Economists have long advocated for the use of carbon pricing to alleviate the negative externalities of GHG emissions. However, to bring this mechanism to full life and harness the benefits of carbon markets, they must function efficiently. While carbon crediting, one of several carbon pricing mechanisms^①, has been implemented with the aim of promoting emission removal or avoidance through price signals, its effectiveness has fallen short of expectations. Inefficient voluntary carbon markets (VCMs), whose operations are based on carbon crediting, have been noted to potentially “undermine climate action” and “risk delaying the urgent near-term mitigation that the market can provide”¹. To better realize the full potential of VCMs, it is essential to address current market deficiencies.

In this article, we take a deep dive into market deficiencies and their underlying causes prevalent in today’s VCMs, and provide some recommendations on how to fix them.

2. The symptoms of deficient VCMs

Despite exponential growth expectations and their potentially vital role in the global net-zero transition, VCMs lack efficiency in their present form. Most notably, today’s VCMs are characterised by low prices of carbon credits^②. While a carbon allowance in the compliance market of the European Union (EU ETS) is traded at a price around € 60-70/tCO2e (in April 2024), carbon credits traded in VCMs are often priced below €1/tCO2e^③.

Unlike other commodity markets with globally consistent prices, there are also significant price discrepancies within VCMs. In 2021, the price of one carbon credit varied significantly, ranging from a few cents per metric ton of CO2e to $15/mtCO2e or even $20/mtCO2e for afforestation or reforestation projects to $100 or even $300/mtCO2e for tech-based removal projects such as CCS. Credit prices are affected by a range of different factors, such as the nature of underlying projects, the volume of credits traded at a time, the geography of the project, its vintage^④, etc.

In addition to a generally low level of prices and significant price discrepancies, VCMs have been subject to frequent volatility during the last years. The Xpansiv market CBL, the world’s largest spot carbon exchange, saw prices of carbon credits fall by over 80 percent in an 18-20 months period in 2022 and 2023².

3. Root causes for market deficiencies in VCMs

3.1 Treasures under veil: the heterogeneity of standards

Carbon credits are originated from a wide range of different projects across the world. Carbon credit projects are either nature-based or technology-based solutions. They can range from large-scale industrial projects like a high-volume hydro plant, to smaller community-based ones like clean cookstoves. Carbon credits in the market could originate from forestry projects, land management projects, methane or carbon captures projects, and others. The proliferation of diverse carbon credit projects presents challenges in terms of comparability and standardization.

Efforts to establish consistent carbon credit standards are underway, yet the landscape remains fragmented. Numerous standard setters have issued multiple carbon credit standards which vary widely in approaches, methodologies, and criteria for measuring and certifying GHG emission reductions/removals. The heterogeneity of carbon credit standards lies in GHG scope, sector coverage, baseline and additionality assessments, permanence and leakage evaluation, co-benefits and safeguards requirements, etc. For example, current standards have different criteria and thresholds for determining additionality which is a key attribute of carbon credits, such as financial additionality, technological additionality, or regulatory additionality.

Moreover, although a handful of registries generate most of the world's carbon credits today, smaller competitors, often NGOs, remain active in the market of carbon credit verification services. This dynamic introduces further complexity, hindering the establishment of a cohesive framework for carbon credit origination. For these reasons, carbon credits in today’s VCMs exhibit highly heterogeneous attributes, with some of them seeming disconnected from additional GHG emission removal/avoidance, which undermines market integrity.

3.2 Hidden reefs lie beneath the waves: overwhelming complexity of carbon credits

Carbon credit verification is a rigorous process that involves various steps to ensure the integrity of the credits. To qualify as a valid carbon credit, it must fulfil a set of key criteria. One of the key criteria is additionality which means the emissions reductions or removals associated with the credit would not have occurred in the absence of the incentive created by carbon credit revenues. Additionality is an attribute that can be hard to evaluate objectively. It is based on a theoretical scenario and therefore cannot be directly observed, which makes it challenging for standard setters to come to consensus on evaluation methodologies and also verifiers on practice. Evaluating additionality and other key attributes of carbon credits requires specialized knowledge and expertise, which may not be readily available to some market participants.

Besides the critical issue of additionality, carbon credits must adhere to further principles that may be hard to evaluate and monitor. For example, carbon credits must ensure permanence, meaning that the impact of the GHG emission reduction should not be at risk of reversal and should result in a permanent reduction in emissions. Also, carbon credit projects must not trigger leakage which means that carbon avoided or removed by a project is pushed beyond its boundaries, thereby undermining the degree of efficacy. Carbon credit projects must also provide additional social and environmental co-benefits in line with the UN SDGs or at least conform to related safeguards. Many carbon credits in current VCMs do not pass muster on these counts.

The level of complexity associated with the evaluation of these criteria opens room for inaccuracies, loopholes and frauds. Inaccurate carbon-related evaluations pose the risk that the scientific claims regarding carbon reduction do not hold up to scrutiny. Furthermore, even if carbon-related claims can be substantiated, there may be other negative impacts, for example preventing indigenous peoples' access to ancestral land. This high complexity creates confusion among buyers as to how to ensure that what they are investing in actually avoids or removes carbon emissions while also aligning with other SDGs.

3.3 Sailing in the fog: information asymmetry and lack of transparency

VCMs are currently unruly with significant information asymmetry among project developers, standards setters, certifiers, and buyers³. There is a lack of transparency in the pricing data and the fundamentals underlying carbon credits. This can be explained by the dominance of over-the-counter (OTC) agreements, which significantly limits transparency on prices and volumes⁴. The disclosure of information accompanying carbon credits is not standardised and remains arbitrary. Trusted market data inventories with comprehensive data sets on carbon credits are yet to be established. Consequently, buyers may not have access to complete or accurate information about the carbon credits being sold, including their origin, quality, or the projects they support. Sellers may withhold or misrepresent information to make their credits appear more attractive. The lack of transparency on the usage of carbon credits complicates efforts to improve the credibility of voluntary arrangements.

The overlapping of roles specific to VCMs further hampers transparency. Many brokers also act as traders, and many financiers have both brokering arms and project development arms. End buyers can also finance their own carbon credit project and keep all or part of the generated credits for their own offsetting needs. These juxtapositions can have an impact on price, and ultimately affect market transparency⁵.

3.4 High seas without guardians: lack of regulation

Currently, VCMs are largely unregulated. For example, VCMs currently fall outside the remit of EU and UK regulators⁶. Even though there are currently 29 government crediting mechanisms with some level of regulation^⑤, there is no unified regulatory framework to regulate various crediting mechanisms (government-led or industry-led) for the eligible generation and credible use of carbon credits globally.

Today, companies are free to purchase any type of carbon credits to meet behavioural and fundamental demand. This includes full flexibility around sector, geography, vintage (age) and whether the project avoids or removes carbon⁷. Furthermore, there is little to no direction or market-wide consensus on how companies can use credits, what claims can be made, and how to report companies’ engagements in VCMs. Without authoritative regulators, the market is left to sort out its own verification activities⁸. The absence of regulatory framework results in risks to market integrity emerging at all stages of the value chain, including issues like double-counting and frauds.

One further critical aspect of VCMs that would require oversight and regulation is the retiring mechanism of carbon credits. Once a carbon credit has been used to offset against a buyer's carbon emissions, it should be retired to reflect the fact that its benefit has been used up. However, there is no clear mechanism for ensuring that a credit sold should not already have been retired. Furthermore, there is a vacuum of regulation with respect to the trading of “legacy” credits. These are credits that rely on projects where investment dates back over a decade when criteria such as additionality were less stringent than today.

3.5 Across oceans and across seas: global scope and sectoral breadth

While compliance carbon markets are currently limited to specific regions, carbon credits are significantly more fluid and less restrained by boundaries set by nation states or political unions. New links and connections between VCMs in different jurisdictions, such as bilateral agreements to exchange credits, are being established, yet much work remains to be done to ensure that the institutional and technical infrastructures supporting market integration is in place, particularly in developing countries⁹.

Furthermore, VCMs also have the potential to be accessed by every sector of the economy instead of a limited number of industries. Compliance carbon markets have been introduced only for selected sectors to reduce complexities for market participants with the goal to expand coverage based on lessons learned. The global nature and cross-sectoral coverage of VCMs adds yet an additional layer of complexity to the development of sound VCMs. Global consensus on technical standards, reporting requirements, market mechanisms, etc. would be essential to ensure market integrity on a global level, yet such consensus may not be reached easily.

4. How to fix the deficiencies of VCMs?

In the preceding sections, we discussed deficiencies of today’s VCMs and their root causes. These deficiencies leave participants with high information costs, transaction costs, reputational (greenwashing) risk, and legal risk, hampering market integrity and liquidity. To fix the above-identified root causes of deficiencies in VCMs, concert cooperation of various actors is needed.

4.1 Consistent standards to unveil real treasures

To address the deficiency of consistent standards for carbon credits, standard setters and registries like Verra, Gold Standard, and others should come to consensus on the methodologies to certify different types of carbon credits. These methodologies must be consistent in nature and compatible with local conditions. To this end, international initiatives like ICVCM (Integrity Council for the Voluntary Carbon Market) have been established, with the goal of ensuring high integrity by promoting harmonization of different standards and integration of marketplaces from a global perspective.

The ICVCM launched the Core Carbon Principles (CCPs) in March 2023, aiming to set a global benchmark for high-integrity carbon credits. The CCPs include 10 principles, clarifying the required attributes of high-integrity carbon credits in three aspects (governance, emission impact, and sustainable development)¹⁰. Standard setters and registries (“carbon-crediting programs” as defined by ICVCM) can now apply to the ICVCM for assessment against the CCPs.

Meanwhile, according to World Bank’s Carbon Pricing Dashboard, there are currently 29 government crediting mechanisms. Governments should also work towards a globally-consistent standard of carbon credits and build market connections, if they want to realize the biggest potential value of carbon crediting. For example, after being suspended for about seven years, China’s CCER market has re-started in January 2024. With CCER having a potential to grow into the world’s biggest VCM, the Ministry of Ecology and Environment of China, which is the regulator of China’s carbon markets, is actively engaging with the ICVCM to promote the internationalization of the CCER market.

4.2 Effective regulation to guard fair seas

Sound and effective regulations should be in place to promote orderly development of VCMs and facilitate the market to reach its potential, especially considering the complex attributes of carbon credits. Due to the cross-board nature of VCMs, it is especially important for regulators of different jurisdictions to cooperate and establish a fair and effective regulation environment globally.

First, regulators should set clear rules on the eligibility and usage of carbon credits. On the one hand, regulations should be in place regarding carbon credit eligibility, such as the types of underlying projects, vintage, certification, etc. To this end, communication and cooperation between regulators and international initiatives like the ICVCM would be beneficial. On the other hand, a rulebook for companies on the credible use of high-integrity carbon credits on the pathway to net zero is also indispensable. This can promote market-wide consensus on how companies can use carbon credits, what claims can be made, and how to report their engagements in VCMs, which helps dispel concerns and improve confidence of potential participants.

Second, regulators should establish information disclosure requirements, mandating transparent disclosure of relevant information by market participants. For example, sellers should disclose detailed information of carbon credit attributes (such as those elaborated in CCPs). And buyers should disclose the usage (and retirement) information of the purchased credits. This can significantly mitigate information asymmetry, improving market integrity and reducing the risk of frauds.

Third, regulators should establish MRV systems and enforcement mechanism. Robust MRV (Measurement, Reporting, and Verification) systems ensure accurate information on the carbon reduction effects of underlying activities. Regulators can establish guidelines and requirements for MRV systems to enhance the credibility of carbon credit projects. Moreover, regulators should establish a mechanism to enforce compliance with established rules and regulations. Penalties for non-compliance should be in place to deter fraudulent activities and ensure market integrity.

4.3 Advanced technologies to sail across oceans

To be compatible with the complicated attributes of carbon credits and the global nature of VCMs, market infrastructures including registries, trading platforms, exchanges and third-party service providers should be equipped with advanced technologies.

First, Internet of Things (IoT) sensors and satellite imaging can help mitigate information asymmetry, improving data transparency and accuracy. IoT sensors can be used to accurately measure and verify carbon reduction/sequestration activities. For example, IoT sensors can monitor forest carbon sink projects by measuring parameters such as tree growth, soil carbon stock, and forest density. Satellite imaging technology can be leveraged to monitor land-use and forest changes, providing real-time data on carbon sink levels. These data can help verify the effectiveness of carbon credit projects and detect any unauthorized land-use changes or deforestation.

Second, artificial intelligence (AI) and machine learning can facilitate the supply of high-integrity carbon credits. AI and machine learning algorithms can analyze large datasets to identify high potential projects to generate high-quality carbon credits, optimize project selection and predict future carbon-related trends. These technologies can also automate the MRV (measurement, reporting and verification) process of carbon credits by analyzing satellite imagery and IoT sensor data of underlying activities.

Third, blockchain technology and smart contracts can help improve market integrity, streamline trading process, and solve issues of double-counting and frauds. Blockchain technology can provide a transparent and immutable ledger for carbon credit transactions, ensuring the market integrity. It can track the entire lifecycle of carbon credits, from issuance to retirement, providing a secure and auditable record for buyers and sellers. Furthermore, smart contracts^⑥ on blockchain platforms can automate the execution of carbon credit transactions based on predefined conditions such as carbon reduction amount, ensuring compliance with high-integrity attributes like additionality and permanence. This can also streamline the transaction process and reduce the need for intermediaries, leading to cost saving and increased efficiency.

5. Conclusions and looking ahead

Carbon crediting has the potential to be an effective mechanism to channel private capital into emission removal/avoidance activities at large scale, especially into high-potential projects in the Global South. However, as described above, today’s VCMs have several significant deficiencies, preventing it from reaching its full potential and from channeling funding into projects with highest carbon reduction or removal potential. To mitigate existing deficiencies and strengthen VCMs, concerted efforts across multiple fronts are needed, among which consistent standards, effective regulation and advanced technologies are fundamental.

The development of well-functioning, globally-integrated and high-integrity VCMs is an ongoing journey which requires cooperation and compromises among multiple stakeholders. While standard setters and regulators are working to fix existing loopholes in the market cornerstone, technology companies, exchanges and other service providers also have import roles to play, by improving market infrastructures with state-of-art technologies.

① The other two are emission trading system (ETS) and carbon tax. (https://carbonpricingdashboard.worldbank.org/)

② In this article, we refer to carbon credit as the asset class being transacted in VCMs, rather than carbon offset which has the same meaning and interchangeable. In contrast, the assets being transacted in the compliant carbon markets are termed carbon allowance.

③Carbon Prices by CarbonCredits.com: https://carboncredits.com/carbon-prices-today/

④ The vintage of a carbon credit is the specific year in which the emission reduction or removal associated with that credit occurred..

⑤ World Bank’s Carbon Pricing Dashboard

⑥ Smart contracts are self-executing contracts with the terms of agreements directly written into lines of code. They are designed to automatically enforce, execute, and enforce the obligations of a contract without the need for intermediaries. Smart contracts reside on the blockchain and use its infrastructure to exist and function.

References：

1.Government of the Netherlands et al. Joint Statement on Voluntary Carbon Market: The Claims Side [R]. December 2023.

2.Carbon Credits. Carbon Prices and Voluntary Carbon Markets Faced Major Declines in 2023, What’s Next for 2024? [EB/OL]. January 2024.

3.Center for Strategic and International Studies. What’s Plaguing Voluntary Carbon Markets? [EB/OL]. February 2024.

4.E.ON. Voluntary carbon markets: A horizon of challenges and possibilities [EB/OL].

5.S&P Global. Voluntary carbon markets: how they work, how they’re priced and who’s involved [EB/OL]. June 2021.

6.KPMG. Integrity issues in the voluntary carbon markets [EB/OL]. January 2024.

7.BloombergNEF. Five Need-to-Knows About the Future of Voluntary Carbon Offset Markets [EB/OL]. January 2023.

8.Carbon Credits. Who Verifies Carbon Credits? [EB/OL].

9.European University Institute. Impacts and evolution of emissions trading systems: insights from research and regulation [R]. January 2024.

10.ICVCM. Core carbon principles, assessment framework and assessment procedure [R]. July 2023.

本期前沿研究原载于北大国发院《气候政策与绿色金融》季报第七期。

本文版权为作者、北大国发院以及宏观与绿色金融实验室所有。侵权必究。