How we use Money to make sure the environment is taken care of

Person holding a sign with Innovation written on it

If you live on planet Earth, you’ve probably noticed a mainstream concern about the quality of the planet our future generations will live on.

Greenhouse gas (GHG) emissions are the reason why the climate is warming. The problem is that we depend on the human activities responsible for adding those gases to the air.

That leaves us with the option to optimize our processes to be environmentally friendlier or stop engaging in those activities.

Once we have gotten used to a particular way of living, the human tendency is not to be particularly eager to change it.

So how can we motivate ourselves to take this problem seriously?

Money!

Keep reading to find out how we use Money within three different carbon market instruments that achieve one or both of those objectives:

Forcing companies that emit GHG to pay for it
Giving entrepreneurs an incentive for developing green innovations

We’ll use Money to portray the growth of carbon markets worldwide and talk about their future. But first, let’s make sure we understand the carbon markets clearly.

Carbon markets

Every product or service you buy has a market.

Market = The total of all buyers and sellers around a product or service.

To have a market, you need sellers and buyers. Without potential buyers, no enterprise will go through the trouble of creating something.

When entrepreneurs sense that a new market could be created, they are motivated to develop products and services to meet the desire of potential buyers. Note that participating in an emerging market can represent a considerable risk because of the uncertainty of future demand.

Governments can create some markets. When there is a service that everyone benefits from, e.g., police forces, firefighters, and garbage collection, regulators will gather taxpayers’ money to allow someone to provide it profitably.

How are the markets created when it comes to reducing the amount of greenhouse gas in the atmosphere?

In a perfect world, carbon markets are there for firms and people to reduce their impact on the environment in the near term while they work toward developing green alternatives.

Carbon markets can be divided into two different categories. One is on a voluntary basis, and the other one is mandatory.

Compliance markets

Handcuffed person in front of a police car

Compliance markets are created by government regulation pushing companies to be greener. Those regulations can form under one of two carbon pricing instruments.

Carbon tax – Emissions trading system (ETS)

Depending on the participating countries, they can be implemented at a regional, national or international level. Here’s a map detailing the territories where different carbon pricing instruments are either already implemented or under consideration.

Figure 1. Countries and territories with active or scheduled mandatory regulation on GHG emissions

As of April 2022, 68 active carbon pricing instruments existed, and three were scheduled to join. None of those 71 programs cover 100% of the greenhouse gas emissions of their territory (1). Specific industries are targeted, usually the ones responsible for a vast share of emissions.

“An industry is a group of companies that are related based on their primary business activities.” (2)

The countries with the highest share of emissions covered by government policies are South Africa, Singapore, and Canada, with around 80%. Carbon tax and ETS cover approximately 23% of global emissions (1).

Carbon tax

A government implementing a carbon tax puts a price tag on GHG emissions.

1 ton of CO2 emitted = x $

Industries forced to pay for their emissions are incentivized to reduce them through process optimization and innovation.

Putting a price on CO2 for companies = Investment to reduce CO2 emissions

A higher price on GHG emissions leads to companies directing more resources toward reducing them, leading to more reduction.

Et voilà!

Emissions trading system (ETS)

Under the carbon tax system, the price of CO2 emissions is fixed, and the amount of emissions is variable.

The emissions trading system does the opposite. The government fixes the number of emissions, and the industry’s market determines the carbon price.

An ETS works under a cap-and-trade system. Let’s break that down into its two main components.

Cap:

A maximum amount of emission is allowed. This cap is reduced over time, pushing companies to find ways to reduce their emissions.

Let’s use an example.

Imagine there are three companies in an industry. A cap of 300 tons of CO2 is imposed on the industry for the year. Each company has a limit of 100 tons. They will all receive 100 allowances.

One allowance = the right to emit 1 ton of CO2

What happens if they emit more than that? That’s where the trade part comes in.

Trade:

Companies within an industry can trade their allowances with each other. That creates a financial motivation for them to lower their emissions.

Let’s say company A evaluates that by optimizing a specific process with minimal cost, they can reduce their emissions by 30 tons of CO2 during the year. In turn, they will be able to sell those allowances to company B, which needs them because they will bust their budget of 100 allowances for the year.

If the cost of reducing the emissions is lower than the profit from selling the allowances, it is now financially desirable for a company to reduce its carbon footprint.

Depending on the regulations governments decide to use in their carbon pricing instrument, companies may be allowed to trade credits instead of allowances to ensure they don’t bust their emissions budgets.

Credits are similar to allowances; they represent a fixed amount of CO2 emissions, usually one ton. They come from yet another carbon pricing instrument called the Carbon crediting mechanism.

Carbon crediting mechanism

That instrument differs from the carbon tax and ETS because it doesn’t require that enterprises pay for their emissions. On the contrary, they can generate revenue from it.

Companies can submit projects to organizations that review them and can create carbon credits for deserving initiatives. If they can demonstrate that their activities contribute to a reduction of x tons of GHG emissions, x credits will be created in the name of that project.

They can achieve that either by sequestration from the air or reduction, then sell those credits to willing buyers.

The supply side of carbon credit markets falls under three crediting mechanisms: International, Domestic, and Independent. Those are the three types of organizations that create carbon credits, and they have different types of buyers.

International mechanisms

Credits created by international mechanisms respond to a demand from international agreements, i.e., The Kyoto Protocol and Paris Agreement.

Countries use carbon credits to achieve their Nationally Determined Contribution (NDC) targets.

NDCs are part of the Paris Agreement of 2015. Every participating country pledges to respect a maximum amount of emission.

Domestic mechanisms

As stated earlier, some governments have policies allowing companies to trade carbon credits to pay for their emissions. Companies choosing to respond to a carbon tax or an emissions trading system with the purchase of carbon credits typically go through their domestic mechanism.

Independent mechanisms

The independent market largely responds to the demand from voluntary markets.

Voluntary markets

Three persons joining hands over a world map

The overwhelming demand for carbon credits within the voluntary market comes from corporations. More and more companies pledge to a net zero emissions goal. They purchase credits from independent mechanisms to achieve this goal.

Some companies decide on their own to offset their emissions. Motivations can vary, from legitimate environmental concerns to bragging rights.

Voluntary markets are increasingly taking up space. With societies getting more concerned with the environment, more companies opt to offset their emissions for good publicity.

Sectors of the economy where voluntary offsets are in the highest demand as of late are Energy, Consumer Goods, Finance/Insurance, Events/Entertainment, and Food and Beverages (3).

Cheat sheet

Figure 2. Relationship between carbon pricing instruments and type of market

Carbon credit mechanisms:

International = used by countries to meet emissions targets pledged in international agreements

Domestic = used by corporations to meet emissions targets set by their domestic government

Independent = used by entities to reduce emissions voluntarily

The current state of carbon markets

Overall, carbon credits grew by 48% in 2021. A large part of that growth comes from voluntary markets. Credit issuance from the independent markets grew by 88% in that same time frame (1).

Figure 3. Share of carbon credits issued per type of mechanism in 2021

As you can see, nearly three-quarters of all carbon credits supplied in 2021 came from projects registered with independent mechanisms.

Strong growth in demand for carbon credits is forecasted for the future, led mainly by an increasing number of corporations committing to net zero emissions. Compared to 2021 demand, a 15-fold increase is expected by 2030 and a 100-fold increase by 2050 (1, p.41).

We can already notice this trend when looking at the following graph.

Figure 4. Value of traded carbon credits in the voluntary carbon market in recent years.

The market increased nearly four-fold in 2021, year over year, to a value of almost USD 2 billion.

Although the markets created by carbon credits are rapidly growing, they are marginal when compared to the revenues governments gain from the carbon tax and ETS carbon pricing instruments.

Figure 4. Global carbon pricing revenues from carbon taxes and emissions trading systems

Source: World Bank, p.27

You can see here that income from pricing carbon has been increasing more steeply within ETS regulation lately. This primarily has to do with the fact that the price of carbon emissions is rising more rapidly than through implementing a carbon tax.

A large share of that money is directed toward environmental and development projects.

The increase in revenues from those two systems is also bound to grow significantly with time. That’s because initiatives from governments all around the world are getting stricter on GHG emissions. More than 70 countries have pledged to reach zero emissions (4).

Conclusion

chalk drawn person climbing toward a lighted bulb on a board

Putting a price on carbon emissions has been a thing for decades, first introduced by environmental organizations calling for governmental intervention.

Carbon markets are on an impressive upward trend as the opinion that global warming is becoming a pressing issue gains traction.

At the international and national levels, governments are putting more pressure on corporations to reduce emissions through carbon tax and emissions trading systems.

Companies are increasingly buying carbon credits, realizing their operations impact the environment, and someone must pay for those impacts, whether now or decades from now.

At the societal level, growing concern for our biodiversity and the well-being of future generations is bolstering these initiatives.

In turn, increasing amounts of money are invested with the main target of reducing GHG emissions. This trend will likely not only continue upward but increase exponentially in the coming decades.

Since a large part of this money will be channeled into fueling demand for innovations to reduce emissions, many emerging markets will explode. Opportunities are seemingly endless.

Direct air capture – Point capture – Electrofuels – Advanced biofuels – Grid-scale electricity storage – Underground electricity transmission - Zero emissions-cement, steel, plastics, fertilizers, coolants, and alternative to palm oil – Nuclear fusion and fission – Geothermal energy – Flood and drought tolerant food crops – Thermal storage – Pumped hydro – Plant and cell-based meat and dairy – Green and blue hydrogen (5)