Historically, carbon markets have fallen broadly into one of two categories: compliance markets and the voluntary carbon market.
Compliance carbon markets, or cap-and-trade systems, are the legally binding emissions trading systems (ETS) that place a cap on carbon emissions which reduces over time through government-run programs, while the VCM is unregulated, involves private sector investment in climate projects that earn carbon credits, and does not guarantee overall reductions in emissions.
Compliance markets involve carbon allowances created by governments, while the VCM involves credits awarded to projects that avoid, reduce or remove emissions.
But a new type of market has emerged known as “compliance offset (or credit) markets” which include elements of both types of market: they are legally binding, requiring entities to participate in a mandatory system, but they involve the use of carbon credits rather than allowances.
The largest and best-known example of a compliance offset market is CORSIA – the Carbon Offsetting and Reduction Scheme for International Aviation. CORSIA is implemented by the International Civil Aviation Organisation – a United Nations body.
It is the world’s first global sector-wide system for offsetting greenhouse gas (GHG) emissions. CORSIA’s pilot phase started in 2021 and the system requires airlines operating international flights to buy and surrender carbon credits to offset any emissions over and above their total annual emissions in 2019.
Airlines to offset post-2019 growth in emissions
The airline industry is growing worldwide, and this means as the sector’s emissions continue to rise, airlines must buy an increasing volume of credits from projects that reduce, avoid or remove emissions elsewhere. This ensures that after 2019, the airline industry’s share of net carbon emissions entering the atmosphere will not grow further.
Administrators at ICAO worked with member nations to agree the carbon market standards for credits that would be accepted for compliance with CORSIA, providing airline companies with clarity on which carbon offset credits they could surrender under the system.
ICAO’s Council approved certain carbon credit standards for eligibility with CORSIA. The standards set out detailed methodologies specifying the requirements for a carbon project, including monitoring, reporting and independent verification to ensure environmental integrity.
Credits allowed for CORSIA eligibility include those from the American Carbon Registry, Architecture for REDD+ Transactions (forest-based credits), the China GHG Voluntary Emission Reduction Program, the UN Clean Development Mechanism, Climate Action Reserve, the Forest Carbon Partnership Facility, The Gold Standard, Verra’s Verified Carbon Standard and others.
Increasing demand for credits
From 2021 until 2026, only flights between countries that volunteer to participate in CORSIA are required to surrender offset credits. As of 2023, most of the countries in Europe, North America, some parts of the Middle East, South-East Asia, Australasia and Africa were part of the scheme.
In a second phase from 2027, all international flights will be subject to the system, and participation will become mandatory at this time. This will bring in notable emerging economies such as China, India, Brazil and Russia. Exemptions are included for the so-called Least Developed Countries – which are mainly the poorest countries in Africa, South America and the Middle East.
This means that as countries join CORSIA and become bound by its requirements, the system is likely to boost demand for carbon offset credits worldwide.
Further sources of compliance demand for offsets
Other compliance carbon markets also create demand for offset credits.
For example, California’s carbon cap-and-trade program allows the use of a limited quota of carbon offset credits to provide flexibility in how companies can comply with the legally binding system. The system’s regulator, the California Air Resources Board, issues credits to qualifying projects that reduce or sequester greenhouse gas emissions according to six protocols approved by the body.
Similarly, in South Korea’s national carbon market, domestic carbon offset credits have been eligible for compliance since the first phase of the scheme from 2015 to 2017. Domestic offsets and international credits have been allowed since the second phase starting in 2018. Qualitative conditions apply to the use of credits, and a quantitative limit on the use of offsets has been set at 10% of an entity’s total compliance obligation.
Market sources have reported a pullback in interest for carbon credits in 2023, (for more on prices, see: Carbon Credit Prices in H1 2024 – Carbonwise) and this may have been partly linked to uncertainty over the environmental integrity of some credits which prompted a more cautious approach among investors.
However, this may be a short-term bump in the road for the VCM. Efforts are underway to boost confidence in the environmental integrity of projects, while at the same time, compliance carbon markets continue to emerge that could open up new sources of demand for credits.
The future and Article 6
Looking ahead, a further potential boost for carbon credit demand is the UN Article 6 market. Article 6 of the Paris Agreement sets out the terms for voluntary cooperation between countries on how they meet their climate targets under the treaty. This may involve investment in carbon projects and cross-border trading of carbon credits in order to achieve emissions reduction targets in a cost-effective way.
The UN will ultimately decide which credits are eligible for meeting each country’s climate target – the so-called Nationally Determined Contributions. This means the upcoming emergence of the Article 6 system could create a two-tier market for carbon credits, with some credits gaining a UN stamp of approval, while those outside the UN market may continue to be used by entities in the wider voluntary market for offsets.
As the urgency of the climate crisis intensifies, further pressure is likely to come to bear on governments to put a price on GHG emissions. Some countries may respond to this pressure by choosing to create new carbon markets, and some of these markets are likely to allow the use of offset credits as a way to offer flexibility to regulated entities.
