Despite being used for compliance obligations, ARB offset credits used in the California-Quebec carbon market originate from the voluntary market. The connection between the two markets entails that the development of one may have implications for the other. It is likely that the voluntary market will serve as a means of financing the implementation of carbon removal technologies to the scale needed to help entities across markets achieve decarbonization. It is unlikely, however, that an increase in demand from the California-Quebec market will have a notable impact on the over-supply of credits in the voluntary market.
The growing ambition and adoption of climate targets on a federal and state level in the US, as well as the hundreds of billions of dollars allocated towards decarbonization from the Inflation Reduction Act (IRA), are putting significant pressure and incentive on companies to reduce their GHG emissions. Not only are such trends expanding the appeal of compliance and voluntary carbon markets (VCM) as a means of decarbonizing, but they are expanding the means in which companies can reach their sustainability targets.
The VCM represents the demand of companies and institutions that purchase offsets for their residual emissions to fulfil independent and voluntary goals as well as for strategic purposes. Contrarily, the California-Quebec compliance carbon market allows the use of approved offset credits to meet a portion of a regulated entity’s compliance obligations.
The intersectionality between California and Quebec’s cap-and-trade program and the VCM stems from the potential for regulated entities to use offset credits that originate from the voluntary market to comply with their emission reduction obligations. These offset credits can be sourced from projects that are registered and verified according to recognised standards and come from registries that are utilized in the voluntary market. The connection between the two markets means the future development of the VCM will be reflective, albeit in part, to the development of offset regulations in the compliance market.
This linkage allows regulated entities to invest in offset projects outside of the sectors covered by their cap-and-trade program, providing a more diverse and flexible means of decarbonization. It also creates a market-based mechanism for recognizing and valuing emission reductions achieved through voluntary actions. The relationship between the two markets will particularly play a key role in the funding and wide-scale implementation of removal technologies for achieving GHG reduction targets in the VCM and the ETS program.
In order for an offset credit to be issued, the project must go through a series of steps for verification. Although the two markets follow a similar review process for credit issuance, the ARB-tagged offset credits go through a second round of review in comparison to those retired for voluntary purposes.
In California, compliance entities are allowed to use offset projects to satisfy 4% of their compliance obligations. Within the 4% margin, 50% of the offset credits must come from projects with direct environmental benefits to the state of California.
In Quebec, compliance entities are allowed to use offset projects to satisfy 8% of their compliance obligations, with no specification that requires a percentage to have direct provincial benefits. In addition to the utilization of California Air Resources Board (ARB) offset credits, Quebec’s ETS (SPEDE) has an internal offset registry in which entities may register and obtain offset credits for compliance purposes.
In both the compliance and voluntary markets, the demand for offsets is contingent upon abatement costs. Although the cost of compliance in the California-Quebec ETS has gone down in recent years, offset projects remain a highly attractive and more affordable means to satisfy compliance obligations. In the linked-program’s third compliance period (2018-2020), both jurisdictions had an 8% offset allowance, of which Quebec used an average of 7.6% and California used an average of 6.3%. In the VCM, trends in companies’ participation in the market are reflective of credit prices – with higher activity when companies can pay less.
Comparatively, offset usage in the VCM is far less consistent than in the North American ETS. This is due, primarily, because of non-binding targets that lie at the core of the VCM. Demand in the VCM is driven by companies’ decarbonization targets and is heavily influenced by a lack of transparency and public debate about its credibility. The demand by companies in compliance markets, however, stems from regulatory allotments and abatement costs.
Despite not being the primary driver of the VCM, regulations in the compliance market still play a role in the issuance and cancellation of offset credits. As three of the four largest registries in the VCM are used in the ARB offset issuance process, compliance demand influences voluntary demand. In 2022, more than 154M credits were retired across the largest VCM registries (ACR, CAR, Gold Standard and Verra).
Out of the four eligible registries, CAR and ACR are the two that are most connected to the North American ETS. In CAR, 6.2M credits were cancelled in 2022 – 90.74% of which were explicitly cancelled for ARB purposes. Meanwhile, 98% of the 6.2M credits cancelled in the ACR were converted into ARB offset credits.
The preference and motive for specific offset projects in the VCM generally parallels those of the California-Quebec compliance market. In both markets, the majority of offset projects pertain to forestry. The draw towards forestry projects mainly stems from their public appeal, socio-environmental co-benefits, and marketability. Recent criticism over the efficacy of forestry projects – particularly those intended for conservation purposes, in conjunction with greater investment in carbon capture and storage (CCS) technologies will, however, likely shift buyers’ preference in both markets away from forestry and towards CCS. The Inflation Reduction Act prioritizes the growth, affordability, and utilization of CCS technologies as a means of decarbonization and allocates over USD 40 billion towards its wide-scale implementation. California and Quebec regulators have also emphasized their interest in incorporating more carbon capture, removal, utilization, and storage (CCUS) programs in their planned updates to strengthen their respective cap-and-trade programs. CCS will, therefore, be a highly valued means for companies to comply with tightened emission caps, while also taking on internal abatement at a pace conducive to maintaining operations. Depending on its design and implementation, the potential inclusion of a CCUS program may also entail a greater dependence on credits originating in voluntary registries.
The voluntary carbon market has been an attractive place for private sector investment and financing for removal technologies. When participants purchase carbon offsets, the revenue generated can be used to support the development, deployment, and scaling up of removal technology projects. The funding currently coming from large corporations like Microsoft, JPMorgan Chase, and Boeing will help cover the costs of research and development, infrastructure, operational expenses, and ongoing maintenance of such technologies. The revenue generated through the sale of carbon offsets can act as a revenue stream and support the viability of the large-scale deployment of such projects.
On the 14 June 2023, regulators from California and Quebec met to discuss a series of potential updates to the joint carbon market to better align it with the jurisdictions’ decarbonization targets. In addition to adjustment to allowances and emissions caps, regulators are considering updates to offset utilization by compliance entities. California highlighted that the VCM still lacks the cohesion and strength necessary to play a stronger role in the state’s compliance market. It is, therefore, likely that there will be tighter regulations surrounding the offset allowance for compliance entities as a result of the program updates – in attempts to pressure greater internal abatement. This does not entail a drop in demand for offsets from registries, rather a likely curtailing of a future increase in offset allowance (where business as usual calls for a 2% increase in offset allowance in 2026 to 6%).
The short-term funding of CCS technologies will facilitate their wide-scale deployment and utilization across companies in the compliance and voluntary markets in the long term. Companies in compliance markets will rely on these technologies particularly for hitting their jurisdictions’ 2030 targets. If the joint carbon market officially extends its program beyond 2030, CCS will play a diminishing role in helping achieve 2045 and 2050 GHG reduction targets as abatement becomes more economically feasible for compliance entities. It is, therefore, likely that any sort of offset or removal programs incorporated in the cap-and-trade programs will be gradually phased out post-2030.
The over-supply that currently plagues the VCM will be only marginally affected by evolving regulations in the compliance market. There are currently initiatives such as the Core Carbon Principles (CCPs) and the Claims Code of Practice (CCoP) that are geared towards increasing the transparency, strength, and reliability of high-quality credits in the VCM that will attempt to create an equilibrium between supply and demand. If demand for credits increases in the compliance market as removals begin to play a larger role, there will subsequently be a greater demand for credits originating in the VCM. The extent to which this demand will reduce the over-supply, however, will be largely limited to the ACR which makes up only 2% of the global VCM.
Despite the different drivers of the VCM and the California-Quebec market, the development of one market will have tangential implications for the other. If regulations currently being placed in the VCM effectively work to reduce supply and increase the strength and viability of the market, it may play a stronger, more direct role, in the California-Quebec compliance market. Although offsets will likely continue to play a role in the compliance market through 2030, the limited impact ARB credit conversion has on total VCM issuance will unlikely affect the current over-supply of credits in the voluntary market. The ease with which compliance entities can successfully acquire the removal technologies necessary achieve their decarbonization targets, however, is contingent, in large, upon the funding coming from corporations in the VCM. As climate ambition increases across the US, the maturity of the two markets will play an increasingly important role in providing companies with the tools necessary to achieve large-scale decarbonization.
Veyt specialises in data, analysis, and insights for all significant low-carbon markets and renewable energy.
