Trends in carbon markets

Trend 1: More emission trading systems

During 2023, some of the world's top emitting countries made big moves toward carbon markets that will lead to more emission trading action around the world.  

The power and industry sectors of Indonesia, where national elections were just held, add half a billion tonnes CO2e to the atmosphere every year. The fourth largest country in the world by population and among the top 10 greenhouse gas emitters, Indonesia saw an intensity-based cap-and-trade system for emissions from power plants enter into force in January 2023. Most stakeholders didn’t hear about the program (which still lacks its critical carbon tax component, as the tax legislation has not been passed yet) until September 2023, when President Widodo unveiled the Indonesia Carbon Exchange (IDIXCarbon) on which the ETS’s compliance instruments and various carbon contracts are to be traded (see our detailed analysis of Indonesia’s program here). 

The lower chamber of the national legislature of Brazil, a country that emits over one billion tonnes CO2e per year, passed in December a bill to create an emission trading system covering nearly all emitting sectors except agriculture. The bill had been “in the works” for over a decade, with various carbon market proposals floated under the previous administration and under current president Lula da Silva’s previous presidency. Its companion legislation in Brazil’s senate passed unanimously in October 2023, and the more controversial version adopted at the end of 2023 now goes back to that body to be voted on again since several key changes were made (see our detailed explanation of this legislation here). 

India, in November 2023, released draft rules for an ETS that, like Indonesia’s, would aim to lower the covered sectors’ carbon intensity or emissions per unit of output. The program, which is not expected to become operational until 2026 (find out why in that year four paragraphs down), would cover industrial manufacturers including producers of cement, steel, aluminium, paper, and petrochemicals. India is the world’s third-highest emitter of greenhouse gases after China and the US. 

China, which has a national ETS that currently covers only the power sector and is similarly intensity-based (see Trend 2 below), is moving towards adding industrial sector emitters to its coverage (see our latest analysis on China’s carbon market here).  

Türkiye is set to launch a national ETS covering the facilities in its power and industry sectors that emit more than half a million tonnes CO2e annually with an absolute (albeit increasing at first) emissions cap starting in October this year. Over 700 large emitters will be affected, starting with a pilot phase for the years 2025-2026. 

The sudden trendiness of ETS among fast-growing economies, that were until recently not in a hurry to pursue market-based climate change mitigation policies, has relatively little to do with their governments’ ambition when it comes to combatting climate change. All of these countries had been “talking about” setting up an ETS or other carbon pricing policies to help achieve their Paris Agreement targets for years under venues such as the World Bank’s Partnership for Market Implementation, (formerly called the Partnership for Market Readiness), getting funded to analyze potential market structures and to set up relevant institutions like bodies that monitor, report, and verify emissions.  

It was the entry into force in 2023 of Europe’s long-awaited and controversial carbon border adjustment mechanism (CBAM - read our in-depth analysis of how it works here) that prompted governments of these countries to follow through on what was until recently largely theoretical plans to implement carbon pricing policies. The CBAM is intended to level the playing field when it comes to emissions-intensive products traded internationally, as producers in countries not subject to emissions caps are able to offer those products cheaper than those in regions where the manufacturers must pay for the carbon emitted in their production. European makers of products such as metals, cement, and fertilizer (as well as their counterparts in other regions that price carbon, such as parts of North America) are at a competitive disadvantage in the global market when the same goods produced in countries lacking carbon pricing are cheaper. The CBAM, therefore, obliges importers of e.g., hydrogen, electricity, fertilizers, cement, iron/steel, and aluminium, to buy and surrender emission allowances for the amount of greenhouse gas caused in producing those goods – this makes up for the difference in production cost between them and their EU counterparts.  

Currently, in a transitional phase in which importers must only report embedded emissions, importers will need to pay for the difference in carbon cost from 2026 onward. To the extent that their home country has its own carbon pricing policy in place, the levy for importing will be correspondingly lower. This is the primary impetus behind rapid progress on ETS establishment in countries previously less interested in carbon pricing as a tool for climate change mitigation: setting up carbon market that covers sectors making products sold to Europe will reduce the carbon price differential and thereby the CBAM’s import levy for those products. Türkiye is one of the prime examples, with the EU being its primary export market for emissions intensive products like metals, cement, fertilizer, etc. 

Indeed, the EU’s just-released communication on achieving its more ambitious 2040 targets (see our analysis of that here) identifies “international climate diplomacy” as a key pillar: it says the EU should “help others replicate the success of the EU ETS by encouraging and supporting other jurisdictions to introduce or improve their own carbon pricing mechanisms.” The communication sees climate diplomacy synergies with the CBAM, which it says already incentivizes governments to use carbon pricing mechanisms. 

We expect rapid development of these emerging markets over 2024 and beyond, especially as pertains to emission-intensive sectors. Whether the resulting ETS in these fast-growing economies actually contribute to their mitigation goals remains uncertain: creating a carbon market does not necessarily bring about or even incentivize net emission reductions, as Indonesia’s program demonstrates.  

Trend 2: Prices rise where ambition is high 

A longer-term trend in carbon markets illustrates precisely that point: allowance prices in the world’s emission trading systems over the past few years have shown that carbon markets “work” where policymakers actually use them to incentivize emission reduction. The markets in which the supply of emissions permits is set to decline significantly (meaning the cap of the respective cap-and-trade program is low/tight/ambitious) saw increasing prices. Those ETS for which it is unclear whether caps will get tighter saw stagnating or declining prices. Prices in Europe, North America, and China went up while those in South Korea, New Zealand, and the UK (relative to Europe at least) are on flat or downward trajectories. 

The North American markets (Western Climate Initiative (WCI) and Regional Greenhouse Gas Initiative (RGGI)) displayed price increases on the back of higher greenhouse gas cutting ambition in their respective regions. The price of the Western Climate Initiative’s emission permits, called CCAs, went from the equivalent of just under EUR 30 to just under EUR 40 over the course of 2023 and have been on the rise for years before that – see Figure 1. This is because the main participant in the WCI, California, adopted a plan in December 2022 to lower the amount of permits available through 2030 in order to help achieve reductions 48% below the state’s 1990 emissions levels rather than the previous 40%. With CCAs being correspondingly more scarce, their price will continue to go up this year in our view.  

The ETS covering power plants in 10 northeast and mid-Atlantic states, known as RGGI, experienced price increases for the same reasons. In 2017, the participating states agreed to further reductions in the collective regional allowance budget, tightening the cap trajectory to a 30 percent reduction from 2020 to 2030. The stricter caps have been reflected in price since then, rising from around $3/short ton in early 2017 to almost $17/short ton currently – see Figure 1. 

Figure 1: Rising prices in North American ETS 

Though China’s national ETS is an intensity-based program, meaning there is no absolute cap on emissions that declines over time, the dynamic of “tightening” the emitters’ requirements over time leading to higher prices still holds for this market. Intensity targets are based on emissions per unit of production, in China’s case power generation. The cap is expressed as a ratio of emissions per megawatt hour generated, with that ratio (the “benchmark”) declining/tightening over time. The benchmark value in the Chinese ETS second compliance period (emissions in 2021-2022) was on average roughly 7% lower (more stringent) than in the first period (2019-2020) and the ratio for the next 2-year period is expected to get tighter still, see Table 1.   

Table 1: China’s emission intensity benchmarks      

Correspondingly, prices for Chinese emission allowances (CEAs) have steadily increased despite an overall surplus in the market: CEAs sold for about RBM 43 back in October 2021 (~EUR 6), for closer to RMB 60 in October 2022 (~EUR 8), and went above RMB 80 around October 2023  (~EUR 10). 

Figure 2: Increasing annual prices in China’s national ETS   

With the past year being an anomaly (see Textbox 1), Europe is the banner example for ambition correlating with price increase, as supply constraints from 2019 and anticipation of tighter targets resulting from an ETS reform caused average EUA prices to more than double between 2020 and 2024 – see Figure 3. Specifically, the EU ETS feature known as the “market stability reserve” – which policymakers had finalized in 2018 to help balance the market by taking surplus allowances out of circulation - kicked in as of 2019 and resulted in a higher demand/supply ratio, which made for consistently rising prices. EU policymakers agreed on stepping up the Union’s overall 2030 climate ambition from 40 to at least 55 percent reduction compared to 1990 levels. This constituted a consistent policy signal that the ambition of the EU ETS would be increased significantly – the question was only by how much. 

Figure 3: Average EUA futures price   

The reform of the EU ETS directive to make it ‘fit for 55’ formally passed in late 2022, and added to the certainty that tighter supply-side parameters will kick in from 2024. Assurance of dramatically declining EUA supply going forward provided somewhat of an anchor for the EUA price throughout 2023, albeit with a less straightforward link between ambition and price increase: the price of contracts for EUAs declined last year due to a range of factors, but would have dropped lower were it not for the certainty of a fast-declining cap.   

Read more on these and other factors in our 2023 ETS recap here.

On 6 February, the European Commission presented its proposal for a 2040 climate target to put the continent on a pathway to net zero emissions in 2050 and involves a net 90% reduction in greenhouse gas emissions compared to 1990. Emissions from the power and industry sectors -the two key sectors under the EU ETS - will need to reduce emissions massively. Extrapolating the program’s cap trajectory based on the existing rules, the last fresh emission allowances enter the market in 2040 – but the proposed headline target of 90% reduction implies a more ambitious trajectory: assuming that the EU ETS covered sectors will have to take on a similar burden as they do under the current legislative framework, we estimate issuance of EUAs to be zero already in 2038. Consequently, we expect the trend of rising EUA prices to continue: currently selling for around EUR 60, we estimate allowances to cost close to EUR 160 by 2030. Read our analysis of the newly proposed climate target here. 

On the flipside, low ambition in other programs made for lower prices in 2023, meaning the ETS was not incentivizing emission reductions in the sectors it covered. In the United Kingdom, for instance, even perceived signals of weakened climate ambition weighed on carbon prices. In mid-2023 the UK government decided on an ETS allowance trajectory that, while tightening the market, was the least ambitious of the options that had been on the table. Prices initially increased but continued to decline over 2023 – and did so more than their EUA counterparts. While the overall target that was chosen by regulators is ambitious in that it is in line with the UK’s climate targets, uncertainty remains over when and how (or even if) the UK ETS cap will be recalibrated to make those changes. This uncertainty has undermined the price signal in the UK market. The UKA price has stayed well below the EUA price throughout 2023, averaging in the EUR 50’s last fall when EUAs were in the EUR 80’s. 

In South Korea’s ETS, initial over-allocation in the early years of the program made for a glut of allowances that has brought prices down – particularly since 2019 (when they were briefly at close to EUR 30/t) to under EUR 7 currently. Korean Allowance Units (KAUs) have declined from around EUR 10 to under EUR 7 over the course of 2023, despite a package of market reforms released in the end of 2022 intended to streamline trading. The reforms were aimed at increasing liquidity and mitigating price volatility by e.g., coordinating banking vs. compliance deadlines and making it easier to use offsets - but they did not tighten the program’s actual cap, illustrating again that carbon markets work best when they are geared at reducing emissions.  

Trend 3: “Reframing the claiming” in the VCM  

The voluntary carbon market (VCM) saw some turbulent times over the past few years: after traded volume in what was once considered a “niche” market doubled from $1 billion to $2 billion in a short time (roughly 2020 to 2022), grand expectations of further growth also brought more attention to the overall concept of offsetting and to specific projects. Some questionable project methodologies were “exposed” by the correlating public scrutiny, with governments as well as consumers becoming increasingly skeptical of companies’ claims that purchasing offset credits can render their products “carbon neutral” or count toward their climate change mitigation targets.  

As a consequence, the VCM’s self-regulatory bodies (its Integrity Council and Integrity Initiative, ICVCM and VCMI) stepped up efforts at standardizing criteria for what constitutes “high quality” carbon credits and how to use them, to ward off accusations that purchasing credits is equal to greenwashing. These were even noted by the EU, which is currently processing a directive banning corporates from making certain environmental claims to protect consumers from misleading “carbon neutral” and “net zero” statements associated with their products. The ICVCM has been developing its latest version of “Core Carbon Principles” to which firms must adhere in order to be able to claim the credits their projects generate are legitimate…at least by the ICVCM’s criteria. As we pointed out in our VCM recap and outlook, prices for carbon credits are likely to diverge according to adherence to the CCP – credits that fulfill the CCP criteria will fetch higher prices on the market going forward.  

As part of this efforts towards perceived integrity, corporates increasingly care about how they characterize their carbon market activity to consumers. Characterizing credit purchases as a tonne-for-tonne transaction that offsets their own emissions (or allows their product to be considered "carbon neutral") is falling out of favor, with claims of making a contribution to mitigation efforts of the country in which the offset project took place being considered more in line with the global climate change mitigation agenda. June saw the unveiling of the VCMI’s Claims Code of Practice, which discourages such direct "climate-neutral" claims. Seven EU countries (the Netherlands, Germany, France, Spain, Finland, Belgium, and Austria) issued a framework addressing corporate claims in voluntary credit purchases that aims to combat greenwashing. It includes the differentiation between contribution and offsetting claims, with the latter requiring corresponding adjustment to a project host country’s emission inventory. 

This claims issue matters increasingly also for mandatory ETS. On the use side, lines are getting blurred between the VCM and compliance application of credits: some country governments and the airline offsetting program CORSIA (read more about CORSIA here) are allowing certain voluntary credits to count as offsets in their mandatory ETS. Particularly the regulators establishing the emerging carbon markets mentioned in Trend 1 are grappling with rules for offset use in their respective ETS. Indonesia’s rules indicate that credits from projects previously sold to companies in the voluntary market may be considered domestic offsets for compliance entities in its ETS - that option is also attractive for Brazil, where many such projects (especially in the forest and land use sector) already generate VCM credits that would then be eligible as domestic compliance units for emitters. 

We foresee the claims discussion continuing into 2024 and beyond, influencing not only how companies market their climate change mitigation credentials but also how regulators in countries setting up emission trading programs choose to structure those new ETSs. 

Trend 4: Carbon removals gaining attention on two fronts  

Tying in with the trend of higher ambition in some carbon markets (notably the EU ETS), we see an expansion of carbon removal techniques and increasing investment in related resources as well as technologies. While emission trading (and carbon pricing in general) is geared toward incentivizing entities to emit less, caps that approach zero (and therefore imply no emissions) require negative emissions - carbon must be removed from the atmosphere. Removal activities involve “capturing” carbon dioxide and storing it - in biomass, through technologies such as direct air capture, or via chemical transformation of raw materials. Storage locations include saline aquifers, old fossil fuel beds, porous rock, harvested wood products, or encapsulated bundles of permanently buried biomass.  

As explained in our previous analyses about what the EU’s more stringent climate target means for industry,  the EU ETS cap being destined for zero as early as 2038 means removals will be necessary: not all emissions that are inherent to industrial processes can be abated. While electricity production can in theory be carbon free given sufficient renewables capacity, certain production processes like cement-making by definition release CO2. This means that for industrial production like cement making to continue in Europe, carbon removals are essential. Indeed, the EU Commission’s climate target proposal of 6 February, as well as its correlating communication on industrial carbon management, outline the road forward for carbon capture and storage, carbon capture and utilization, and industrial carbon removals – see our breakdowns of these documents and their implications here and here. They indicate that removals will play a major role in Europe meeting its climate targets going forward, so we expect to see more research into, and development of removal activities – as well as haggling over what constitutes a removal activity in the first place.  

Removal activities, however, are also increasingly popular carbon credit generators – many offset projects around the world use removal methodologies. Credits from projects that fall under the removals category include nature-based activities like tree planting, direct air carbon capture and storage, as well as storage of carbon in the form of contained biomass “bricks,” in biochar. Such projects often require no counterfactual or baseline scenario: they are inherently “additional” because they remove greenhouse gases from the atmosphere rather than adding greenhouse gases to a lesser extent than a counterfactual scenario would. Given the increased scrutiny over carbon credits generated by comparing a hypothetical emissions scenario to the (purportedly less-emitting) project scenario, combined with new guiding principles for offset use, demand for credits from removal activities looks set to rise further.  

Removal activities remain controversial at the UN level because the former international UN carbon crediting mechanism (the CDM under the now-expired Kyoto Protocol) did not allow them. With the new mechanism being set up under Article 6.4 of the Paris Agreement (see our analyses of that here, here, and here) the role of greenhouse gas removal activities was contentious at COP28 in Dubai. The Supervisory Body of the new mechanism had compiled recommendations on how to include removal activities, but some parties are so opposed to adding these to the list of activities that can generate tradable mitigation units that the recommendations were rejected altogether.  

Meanwhile, the types of credits fetching the highest prices in the voluntary market are those for “engineered” removals such as storage of carbon extracted from the atmosphere in the form of biochar or in geologic formations. Removal credits are scarce and pricy, with those for Biochar applications selling between EUR 110/t and EUR 180/t in 2023 and those for technologies like direct air capture costing over EUR 600. Credits for complex techniques like direct ocean removal are priced at over EUR 1000 in 2023, according to the group CDR.fyi. Nevertheless, we expect demand for this type of credit to increase. Supply will also increase in our view, in part due to financing for e.g., direct air capture from governments at the national and subnational level - however, the demand will increase faster than supply, since it takes years for new removal projects to come online.