Why Carbon? Compliance Market History

March 26, 2024

The market for carbon credits, which represent greenhouse gas (GHG) emission reductions or deposits equal to 1 metric ton of carbon dioxide equivalent, is growing rapidly. In this article, the first of a series on why carbon markets exist, we will take a look at the historical milestones of governmental carbon market initiatives and their results.

The history of carbon markets can be seen as an evolutionary response to the global challenge of anthropogenic climate change. The first markets developed in part from political pressure to reduce GHG emissions. Regulatory caps on pollution led to increased demand for the government-issued credits necessary for businesses whose emissions exceeded the cap to continue operations. Compliance markets are designed to achieve emission reduction targets set by governments or international bodies by giving entities that reduce emissions below their cap the ability to sell surplus credits, incentivizing emissions reduction.

The Timeline: International Milestones

  • Intergovernmental Panel on Climate Change (IPCC): Beginning in the late 20th century, the scientific community increasingly recognized the risks associated with anthropogenic GHGs. This culminated in the establishment of the IPCC in 1988.
  • UN Framework Convention on Climate Change (UNFCCC): In 1992, the international community adopted the UNFCCC at the Earth Summit in Rio de Janeiro with participation from 154 nations. This convention set the foundation for future international negotiations and actions on climate change and has since been ratified by nearly all nations worldwide.
  • Kyoto Protocol (1997): Under the continuation of the UNFCCC, the Kyoto Protocol was adopted in 1997 and entered into force in 2005 after ratification by Annex 1 countries of the UNFCCC representing 55% of CO2 emissions for 1990. It established legally binding emission targets for developed countries, notably exempting India and China. The Protocol also introduced three market-based mechanisms:
  • International Emissions Trading: Allows countries with emission reduction units (ERUs) to spare to sell them to countries that are over their targets.
  • Clean Development Mechanism: Allows a country with an emission reduction target under the Kyoto Protocol to implement emission reduction projects in developing countries.
  • Joint Implementation: Allows a country with an emission reduction target to earn ERUs from an emission reduction project in any other country.
  • Regional and National Carbon Markets: Outside of the international mechanisms, several countries and regions developed their own carbon pricing initiatives. For example:
  • The European Union Emissions Trading System (EU ETS): Established in 2005, the EU ETS is the world’s first and largest carbon trading system, covering approximately 11,000 installations across the EU, including power generation, manufacturing industries, and airlines. It operates on a cap-and-trade principle, where a cap is set on total GHGs, and excess allowances are traded among these regulated entities​​.
  • UER Certificates: UER certificates represent certified upstream emission reductions achieved by UER projects approved by the German Environmental Agency. These certificates allow companies subject to the Energy Tax Act to comply with GHG reduction quotas. From 2020 onwards, obligated parties can use UER certificates to meet up to 1.2 percentage points of their quota.
  • The Regional Greenhouse Gas Initiative (RGGI): Initiated in 2009, RGGI is the first mandatory market-based program in the United States to reduce GHG emissions. It is a cooperative effort among Northeast and Mid-Atlantic states, including Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, Vermont, and Virginia. The program caps and reduces CO2 emissions from the power sector.
  • California Cap-and-Trade Program: Launched in 2013, this program covers major sources of GHG emissions in the state, such as power plants, industrial facilities, and fuel distributors.
  • China National ETS: Launched in 2021, China’s ETS is now the world’s largest carbon market by volume, covering about 4.5 billion tonnes of CO2 per year, which accounts for approximately 40% of China’s total emissions. Initially focusing on the power sector, the scheme aims to expand to cover eight key industries, including petrochemicals, chemicals, building materials, steel, nonferrous metals, paper, power, and aviation.
  • United Kingdom Emissions Trading System (UK ETS): Established post-Brexit to replace the EU ETS within the UK, the UK ETS started in 2021. It covers energy-intensive industries, the power generation sector, and aviation. Similar to the EU ETS, it operates on a cap-and-trade system, with the long-term goal of reducing the UK’s GHG emissions.
  • Paris Agreement (2015): The Paris Agreement marked a significant milestone in global climate policy. While it did not formally set up a global carbon market, it laid the foundation for countries to use internationally transferred mitigation outcomes (ITMOs) to achieve their nationally determined contributions (NDCs) under Article 6, providing a framework for potential international carbon trading.

Continued Evolution:

There have been many scientific, political, and economic factors that have defined the parameters shaping the conversation about climate change and incrementally developed solutions to evolve carbon markets to where they are in 2024. Compliance markets are central to international agreements like the Kyoto Protocol and the Paris Agreement, ensuring that participating countries and companies adhere to their carbon emission commitments through a structured and enforceable mechanism. Since the Paris Agreement, there have been continued evolutions and expansions of carbon markets. Some countries and regions have sought various ways to participate in climate actions such as introducing carbon taxes, expanding existing cap-and-trade systems, linking emission trading systems, or integrating carbon markets with national policies.

At the same time, voluntary carbon markets have also grown, allowing companies and individuals to register and purchase carbon offsets even if they aren’t legally required to do so. Many publicly traded companies have made commitments to be net-zero, which could obligate them to make good faith attempts to offset their emissions.

The next article in this series will go over how the volunteer carbon market has developed and evolved.

This article was written by Nathan Murphy, Registry Manager.

Disclaimer: This blog post is for informational purposes only and should not be considered as financial or investment advice.

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