Our subcommittee spent six months consulting with economists and climate policy experts to try to identify carbon markets’ role today. The role of carbon markets goes back to the Kyoto Protocol in 1997, which sought to put an emissions cap on richer countries. No global market resulted, although the creation of the European Union ETS [Emissions Trading System, the internal system that European nations use among themselves] was a major achievement. The Paris Agreement later moved towards promoting voluntary participation by countries including by “nationally determined contributions,” which may involve carbon pricing and compliance markets, typically domestically.
In our work we also explored what we would call the voluntary carbon market, which is the main market through which cost-effective abatement options from low-income countries get traded.
How do you see carbon markets advancing the goal of reducing emissions globally? And why have they fallen short in the decade since the Paris Agreement?
Rohini Pande: To limit global warming we need to reduce greenhouse gas emissions. And most greenhouse gas emissions are linked to fossil fuels, the most common energy source in most countries. There is also a pretty much 1-to-1 relationship between increases in GDP or economic prosperity and energy use. And so, the main reason it’s been hard to consider transitions away from fossil fuels has been the belief of a huge trade-off between economic growth — especially for lower-income countries — and energy consumption.
Renewable energy sources are cheaper now, showing more promise. However, these energy sources have large upfront costs, which makes them particularly difficult for low-income countries. One of my colleagues on the report found that the countries with the most sunshine are the ones with the least solar power: they’re closer to the equator, low-income, and have a high cost of financing.
How can carbon markets help solve these problems? Well, a specific reduction in emissions into the atmosphere — or removal of greenhouse gases from the atmosphere, say one tonne of CO2 in each case — has the same climate benefit, wherever it takes place. And since we have limited funding for investment in decarbonization, we can best reduce climate damage by investing in the best value decarbonization projects — the ones that achieve the biggest reduction in CO2 per dollar spent — first. That’s best done in a global market that lets buyers compare all decarbonization projects.
That’s the theory. In practice, it’s difficult to measure reduced emissions — and often the buyer is not in a position to know what happened across the globe. If I buy a tonne of lead, for example, I can have it delivered to my door. I can weigh and inspect its quality. If I invest in reducing carbon emissions by one tonne — or reducing atmospheric carbon by the same amount — often I can’t observe that reduction directly. And often it’s hard to measure what would have happened in a world where I hadn’t paid to curb deforestation, or how to handle a forest fire in an area I paid to preserve.
If I want my market to be credible, everyone involved must be certain that market participants’ measurements and calculations are correct — and that there are ways to fix unexpected problems. This requires standardizing measurement and verification procedures — and preventing systemic conflicts of interest.
So identifying ways to have a carbon market that spans rich and poor countries could have significant benefits. This would enable climate financing for high-return, low-cost choices like renewable grids and deforestation prevention in these countries. But you have to solve these questions of measurement, implementation, and credibility — often in low-income contexts, with low state capacity. So that’s what we’re trying to do.
How are market forces uniquely equipped to address the complex economic, political, and geographic challenges of climate change?
Pande: First, while low-income countries offer low-cost abatement opportunities that can help the whole world, we need to ensure the growth they need to pull their populations out of poverty isn’t hurt. So, for example, if reducing future emissions involves shutting down one low-productivity carbon-intensive economic process — like deforestation — we also need to ensure that that economic process is replaced by a cleaner one that provides an equivalent growth path.
Second, if we want to use a market to hit global emissions reductions targets by decarbonizing globally at the lowest cost, we need a market structure that enables that. And that would be a compliance market with a required, coordinated cap, not a voluntary market.
Explain the difference. What are some examples of the kind of trading you might find on the voluntary carbon market? And in a compliance market?
Pande: Well, in the voluntary market, let’s say a company like Meta or Google decides to offset emissions from large data centers by reducing emissions somewhere else in the world. They might approach, say, a Brazilian company that’s in the business of reforestation and say, “Can we pay you to reforest enough land that it actually, over the next 30 years, reduces emissions by X amount?” And that would then be the amount they can offset their own emissions.
One drawback with this model is that it’s completely voluntary: companies must decide to participate, and there’s no mandate for how much these companies should bring down their own emissions over time. Even if a company hits its own net-zero target, this doesn’t take us to a global net zero. Further, emissions could go up if the firm changes their mind or if they pay for a program that doesn’t work out as intended. This feeds into the challenge I mentioned earlier that buyers often can’t check the quality of the product. The consequence of all these issues is that credits trade at very low prices — and the market just doesn’t enable investment at scale.
Contrast this with compliance markets like EU-ETS [the European Union’s Emissions Trading System]. Here a set of companies — usually large industrial firms — are required as a group to maintain their emissions under a legally mandated cap, that reduces every year towards an agreed target. Firms are issued or buy permits to pollute and can trade them. This market structure — combined with the fact that industrial emissions are relatively easy to measure — ensures that the best-value decarbonization projects are funded and happen first and that targets are hit. The problem is that, right now, these markets only exist at a national or regional scale. And they either don’t include, or allow only small quotas of, nature-based or renewables projects. This is because of the fear that the problems of measurement and implementation I’ve mentioned linked to these projects will reduce the credibility of the entire market.
Our ultimate aim is to bring together all these piecemeal elements in one unified global compliance market.
Why do you think it’s possible to build a unified global carbon market now, when it hasn’t happened so far?
Pande: The market that was put in place in the Kyoto Protocol was a first attempt at building a global compliance market, but we didn’t know how to do it well and didn’t have all the technology we do today. But now we’re in a better place. First, we see that a lot more countries — both rich and lower-income — are putting in place the basic architecture for compliance markets. In addition, we have seen what we would describe as a measurement and credibility revolution in the sciences and social sciences, whereby we can use better satellite imagery, better remote sensing techniques, machine learning, and data science. And I think there is a better understanding of how to construct counterfactuals [hypothetical models that simulate climate outcomes without human interference] to measure a project’s emissions reduction potential. It’s also much easier to share data for transparency.
A financial economist on our team noted that there have also been advances in the kinds of financial contracts you can write so that risk can be managed. People talk about measurement reporting and verification, but not enough about risk management in this market. And the moment you bring in things like nature-based projects or renewables — or, for that matter, trade between countries at different points in their development and institutional structure — you need to think about risk management.
In the case of the hypothetical data center I mentioned earlier, those kinds of companies are not in the business of checking up on the maintenance of forests. And companies don’t want to wager money on uncertainty. So, we’ve suggested using the same tools that the financial markets use — things like risk insurance and bundling elements that have higher and less risk — and bringing those into the markets to assure that companies are getting what they’re paying for. All of these factors combined can now help move us towards a unified global market.
What are some of the next practical steps that will be needed to move in this direction?
Pande: We’re trying to set up a longer-term architecture, but we also want to better understand how to make these kinds of systems operational in the shorter run. The longer term architecture really aims to move towards a unified carbon market in which you can have an overall cap that over time heads towards a global net zero, for everyone, but also allows countries in the shorter run to first engage in the most cost effective abatement opportunities — especially in a world where we know climate financing is limited.
One of the most common phrases I heard at COP 30 was the need to “unlock climate finance.” There is growing recognition that governments have tighter budgets right now, and less interest in directly providing climate financing. Carbon markets, if they’re global, can provide some of the architecture to achieve it.
While we were in Brazil, President Lula also announced an open coalition for compliance carbon markets [regulated government systems that require specific industries to meet greenhouse gas targets]. In making that announcement, their statement said that the medium-term hope is that this open coalition will move towards interoperability [which would allow institutions to share data and services]. That opens the door for global carbon markets. But in the short term, we’re hoping to work with a few countries that are initiating domestic compliance markets — or already have domestic compliance markets — to determine the kinds of standardization that would be needed to move towards interoperability.
What we hope is that some of them decide to take the lead in coming up with systems that they believe can also be adopted by others. As an example, Korea’s Global Green Growth Institute, along with the [United Nations Framework Convention on Climate Change], announced that they would develop a set of standards that would be more generally applicable.
We’ve also proposed testing how to integrate nature-based and low-income country projects into a broader marketplace with a “sandbox approach.” This could, for instance, allow researchers to work with market regulators to identify the best measurement and implementation methods to ensure the same credibility as the industrial firms already participating in these markets.
Creating a unified system will ultimately require buy-in from multiple partners, of course. What will it take to achieve the scale needed to solve what is a global challenge?
Pande: The market we’re proposing is an opt-in market for localities (such as states or countries) and sometimes also for firms. So, we’re looking at voluntary sign-up to a long-term compliance system. Why would countries do that? Mostly because it’s a win-win.
For high-income countries — which are now seeing costs of billions of dollars from the first stages of climate breakdown and the extreme weather that that generates, to the point where, in some places, it’s impossible to get insurance — joining this market is the most effective way to spend the limited funds they have available to decarbonize the planet. For low-income countries, they’ll commit to limit their long-term emissions, but the market will also give them the investment they need to set their economies on a low-carbon growth track (which they otherwise couldn’t afford) whether that’s by allowing investment in renewables at scale or by allowing alternatives to deforestation.
If we can get this right, everyone benefits. And that’s the kind of policy leaders are eager to pursue.
