Insights

Can the Troubled Voluntary Carbon Market Be Fixed?

ㅣTaehan Kim, COO of KoSIFㅣ

A Market Facing Serious Credibility Challenges — Yet Still Potentially Essential to Financing Emissions Reductions in Developing Countries

Carbon allowances are the right to emit carbon—in other words, the right to pollute.

They are used in emissions trading schemes, also known as cap-and-trade systems. Under these systems, regulators first set a cap on the total amount of greenhouse gases a company may emit during a given year. Allowances corresponding to that amount are then allocated either free of charge or through auctions.

In Korea, these allowances are called Korea Allowance Units, or KAUs. In the European Union, they are called EU Allowances, or EUAs.

At the end of each year, companies covered by an emissions trading scheme must surrender allowances equal to their actual emissions. Companies whose emissions exceed their initial allocation must purchase additional allowances in the market. Those whose emissions remain below their allocation may sell the surplus.

Carbon markets created through regulation are referred to as compliance markets.

What are commonly called voluntary carbon allowances are, strictly speaking, different from a “right to pollute.” Voluntary market instruments represent verified outcomes from activities that reduce or remove greenhouse gas emissions.

Put simply, compliance-market allowances are like certificates issued in advance that permit emissions, while voluntary market instruments are more like recognition awarded after an emissions-reduction activity has been carried out. This is why they are more commonly referred to as carbon credits rather than allowances.

In some cases, carbon credits generated outside a compliance market may be converted for use within one. Korea’s emissions trading scheme, for example, allows offsets to be used for up to 5 percent of an entity’s compliance obligation.

Verified emissions reductions from eligible external projects are called Korea Offset Credits, or KOCs. Once converted for compliance use, they are called Korea Credit Units, or KCUs.

     Voluntary Carbon Credits Are Based on an Abstract Concept

Greenhouse gases may be invisible, but they are measurable pollutants with a physical presence.

Compliance markets verify actual historical emissions based on detailed data. Voluntary carbon markets, by contrast, are based on the more abstract concept of avoided or reduced emissions and are therefore inherently more uncertain.

The amount of emissions attributed to a project is calculated against an assumption about what would have happened in the absence of that project. The number of credits issued therefore depends heavily on how the baseline scenario is established.

Additionality must also be considered.

A project should not receive carbon credits if the activity would have taken place anyway. For example, there is little justification for awarding credits to activities already required by law or to projects that are sufficiently profitable to proceed regardless of their emissions-reduction benefits.

There is another challenge.

Unlike compliance markets, which verify emissions that have already occurred, carbon crediting mechanisms may approve expected outcomes from future emissions-reduction activities. This creates a risk that actual reductions will fall short of the approved plan.

In other words, credits may continue to be issued even when the anticipated reductions have not fully materialized. Annual on-site verification would help address this problem, but in practice it is often difficult to conduct.

     Does Such a Problematic Market Really Need to Exist?

As more companies voluntarily adopt net-zero targets, the voluntary carbon market has gained attention as one possible tool for meeting those commitments.

Global consulting firm McKinsey has projected that the market could grow to approximately KRW 65 trillion by 2030.

As interest in the market has increased, however, a range of long-standing problems has also come to light.

The British newspaper The Guardian reported that 78 percent of the 50 largest voluntary carbon credit projects examined had problems involving additionality or overestimated emissions reductions. The German weekly Die Zeit also reported that more than 90 percent of credits issued by Verra, the world’s largest voluntary carbon credit registry, had failed to deliver the claimed emissions reductions.

Why, then, should such an uncertain and problematic market continue to exist?

Ultimately, the answer comes down to finance.

Reducing emissions requires capital, and someone must bear that cost.

The global economy includes countries, companies, and individuals with substantial financial resources, as well as those with far fewer. Yet emissions are not produced only by wealthy countries and companies.

Meeting the 1.5°C goal requires emissions reductions across developing and emerging economies as well. However, international commitments to finance mitigation in these countries remain far below what is needed, and even those commitments have not been fully delivered.

Private capital is therefore essential, and the voluntary carbon market could serve as one channel for directing that capital toward emissions-reduction activities.

     The Voluntary Carbon Market Requires Social Consensus

The real question, then, is whether this deeply troubled market can be repaired.

Views may differ. My position is that it must be fixed—and that it can be.

The voluntary carbon market originated in the market mechanisms of the Kyoto Protocol. It is not an exaggeration to say that it was largely neglected following the Protocol’s failure to generate sustained demand.

Clean Development Mechanism projects and the voluntary carbon market briefly attracted attention after the Kyoto Protocol entered into force, but then experienced nearly two decades of stagnation.

Who would take an interest in a market with little trading activity? Who would invest in it or devote resources to effective oversight?

When any market falls outside public scrutiny, oversight weakens and opportunities for abuse by a small number of participants increase.

It may therefore be more reasonable to view many of the market’s past failures not solely as structural flaws unique to voluntary carbon markets, but also as problems commonly found in neglected and illiquid markets.

Because the voluntary carbon market trades an abstract product—the “right” associated with emissions reductions—it naturally requires stronger oversight and greater transparency than markets for conventional goods.

The problems now being exposed must be examined and criticized rigorously if a credible market is to be built. There are also numerous cases that cannot escape legitimate accusations of greenwashing.

Criticism alone, however, is not enough.

Governments, companies, financial institutions, and civil society must now come together for a substantive discussion on the role of the voluntary carbon market.

This discussion should address the standards under which suppliers may issue credits, the circumstances in which companies may use them, the types of credits that may be considered credible, and the conditions under which their use would be socially acceptable.