Voluntary Carbon Offset Markets – How Do They Work?

Carbon finance has emerged recently as a major talking point for a wide range of industries.

New entrants into the voluntary carbon markets were seen – where hedge funds, oil and gas majors, and banks were seen to be the most active throughout in resolutely taking positions. Many other sectors of the economy then followed suit in pursuit of their pledges to reduce carbon footprints.

Many political entities like the EU and UK already have mandatory carbon markets covering specific industry sectors and gases. These, along with other actions, are an integral part in achieving the Paris Agreement targets of limiting global heating to +2°C above pre-industrial levels and the much more recent Glasgow Agreement on temperature increases.

Other sectors have seen these compliance schemes in action and decided to pledge to offset their own greenhouse gas emissions by voluntarily participating in carbon markets. These voluntary carbon markets allow large carbon emitters to offset their emissions by purchasing carbon credits emitted by projects targeted at removing or reducing greenhouse gases from the atmosphere.

These credits correspond to one metric ton of reduced, avoided, or removed CO2 (or another equivalent greenhouse gas) and can be used by a company/organisation/individual to compensate for the emission of one ton of CO2 (or equivalent greenhouse gas). When used for this purpose, it becomes an offset and is subsequently moved to a register for retired credits and is deemed no longer tradeable.

The way in which private companies can participate in voluntary carbon markets differs between individual entrants and as part of industry-wide schemes. An example of the latter would be the Carbon Offsetting and Reduction Scheme for International Aviation, set up by the aviation sector to offset their considerable emissions.

The compliance markets are limited to specific regions, whereas voluntary carbon credits are seen to be much more fluid – not constricted by boundaries set by nation states or political bodies. Another defining factor is their ability to be accessed by every sector of the economy.

The value of the carbon credit market is set to continue growing, with projections estimating a market value upwards of $50 billion USD by 2030.

The Five Main Participants In Carbon Markets

Project Developers

Representing the upstream part of the market, project developers set up projects issuing carbon credits. These can range from small community-based initiatives like clean cookstoves, to large-scale industrial projects like high-volume hydro plants.

These projects hold the aim of destroying, reducing, or managing the direct emissions resulting from industrial processes such as fugitive emissions management, ozone-capture or destruction of ozone-depleting substances, or wastewater treatment. Nature-based project aim to avoid deforestation, soil sequestration, or afforestation. Other types may include tech carbon capture such as direct air capture. This category in particular is exciting to observe the rapid growth with new categories being added constantly.

Each credit issued will hold details on the year in which it was issued and the specific delivery date (when the credit will be available on the market). Credit projects can also generate additional ‘co-benefits’ which may help to meet some of the UN’s Sustainable Development Goals.

End Buyers

Representing the downstream market, end buyers are often categorised entirely by companies/organisations that have committed to offset part or all of their greenhouse gas emissions. Individuals do occur here, but it is not common.

Early buyers of carbon credits included household tech company names like Apple and Google, but since then this has expanded to oil and gas majors, airlines, and is further expanding to include other sectors on their own net-zero journeys.

Recent UN Climate Conferences ( COP26 ) set the rules for a crediting mechanism to be used by the agreeing parties of The Paris Agreement in an attempt to reach emission reduction targets and nationally determined goals. The agreement outlines the possibility of countries buying voluntary carbon credits.

Retail Traders

As is the case with many markets, there are brokers and retail traders who obtain their revenues from linking supply and demand. Traders will operate by purchasing large amounts of credits directly from suppliers and bundling them together into portfolios with the intention of selling these bundles onwards to end buyers with some form of commission included.

The majority of these transactions happen in private conversations and over-the-counter deals, but some exchanges have been emerging. These exchanges have been attempting to simplify and speed up the trading of carbon credits, which is an incredibly complex task given the number of factors affecting their price. This is done by creating standard products ensuring basic specifications are respected.

Credit trading under certain labels are guaranteed to have a pre-determined set of characteristics. An example of this would be the type or category of underlying project and a recent vintage. These products are preferred (especially those for forward delivery) by traders and financial players who seek to buy and hold in anticipation of rising carbon credit demand.

On the other hand, end buyers that need to purchase credits to offset emissions generally prefer non-standardised products. This allows them to be able to look into the specific characteristic of each underlying project and check on the quality of the credit being purchased. This, ultimately, protects against accusations of greenwashing.

Brokers

A relatively self-explanatory player in the voluntary carbon markets are brokers. Brokers will buy carbon credits from retailer traders and attempt to market them to end buyers, almost always with a form of commission involved.

 Standards

The final player in the carbon markets are Standards. These are simply organisations which certify that a particular project meets its stated objectives and stated volumes of emissions.

Standards have a set of requirements for each type of carbon project – an example of this would be a reforestation project following specific rules when calculating levels of CO2 absorption in a planned forest (which directly affects the number of carbon credits produced over time).

Certification from Standards ensures that the core requirements and principles of carbon finance are adhered to:

Additionality: The project should not be legally required, common practice, or financially attractive in the absence of credit revenues.

No overestimation: CO2 emissions reduction should match the number of offset credits issued for the project and should take account for any unintended GHG emissions caused by the project.

Permanence: The impact of the GHG emission reduction should not be at risk of reversal and should result in a permanent drop in emissions.

Exclusive claim: Each metric ton of CO2 can only be claimed once and must include proof of the credit retirement upon project maturation. A credit becomes an offset at retirement.

Provide additional social and environmental benefits: Projects must comply with all legal requirements of its jurisdiction and should provide additional co-benefits in line with the UN’s SDGs.

Acquiring Carbon Offset Credits

There are trading exchanges that facilitate the offset credit transactions, but most transaction occur ‘off-exchange’ which can make price discovery incredibly difficult. Pricing varies massively for offset credits, ranging from under $1 to over $35 USD. Prices are varied with project type and generally small differences between offset credit labels.

Although offset credit buyers do not need to be familiar with every carbon offset program rule and procedure, they should have a basic understanding of how carbon offset credits are generated, transferred, and used. Purchasing options can depend on where in this “lifecycle” a buyer gets involved. In general, the earlier in the lifecycle, the better the nominal price and terms will be – but the greater the delivery risk and the longer it may take to actually receive offset credits.

A Basic Lifecycle For Carbon Offset Credits

Methodology development

Before any greenhouse gas reductions can be certified for carbon offsetting use they must demonstrate adherence to strict carbon offsetting quality criteria. The process for this requires a methodology or protocol specific to the type of offset project that is generating the reductions. Most carbon offsetting programmes will have a bank of approved methodologies that will cover a huge spectra of project types, however project developers may also propose new methodologies for approval and adoption.

Project development, validation, and registration

Project developers will design offset projects that are financed by investors, validated by independent verifiers, and then registered with a carbon offset programme. The official registrations demonstrates that the project is approved by the programme and thus eligible to start generating carbon offset credits after it begins operation.

Project implementation, verification, and offset credit issuance

Offset projects are then implemented and most importantly, monitored. They too are periodically verified to determine the quantity of emissions reductions that have been generated over time. The time between individual verifications can vary but most commonly it is a year.

Carbon offsetting programmes then approve verification reports and issues a number of carbon offset credits equal in weighting to the verified CO2 (or equivalent) greenhouse gas reductions. The credits are then usually deposited into the project developer’s account in a registry system which is also administered by the offset program.

Offset credit transfer

Once issued, carbon offset credits can be transferred to different accounts in an offset programme’s registry. Such transfers are generally undertaken as a result of a purchase or trade, so following a purchase the offset credits will be transferred from the project developer’s account into an account designated by the buyer. Offset credit buyers may then use the offset credits which then retire them, hold onto them, or even transfer them onwards to other accounts. Offset credits can change hands multiple times in a short space of time before being used and retired.

Offset credit retirement

The offsetting credit holders must ‘retire’ their credits in order to use them and claim the associated greenhouse gas reductions towards their specific reduction goal. This retirement occurs according to a process specified by each carbon offsetting program’s registry. Once a credit has been retired, it exits circulation and cannot be transferred or used further.

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