Demystifying Decarbonisation: carbon markets

What is a carbon market?

A carbon market is a trading system whereby greenhouse gas (GHG) emissions are given a monetary value in the form of a carbon credit. This can be either a 'voluntary' carbon credit representing emissions avoided or removed, or an 'allowance' carbon credit permitting emissions, depending on the system used. Typically one tradable carbon credit equals one metric ton of CO2, or its equivalent amount of a different GHG (CO2e).

Carbon markets use market forces to incentivise industries and countries to reduce or remove CO2e emissions. In so doing, they promote the development of clean energy projects and the evolution of CO2e removal technology. If carbon markets are run effectively, they may play a crucial role in enabling countries to meet their climate goal aims under the Paris Agreement.

There are two types of carbon market: compliance (also known as regulatory or mandatory) and voluntary. Additionally, some countries, such as Singapore, impose a carbon tax on CO2e emissions with some ability to use voluntary carbon credits to offset the carbon tax.

Compliance carbon markets

Compliance carbon markets can be based on a 'cap and trade' system (the most common) or a baseline and credit system.

'Cap and trade'

In a 'cap and trade' compliance carbon market, a regional, national or international authority imposes a cap on the amount of CO2e that can be emitted by specific industries or countries. The regime then divides this overall cap into emission permits (i.e. carbon credits) and then either grants or auctions off these credits to the market participants in the form of 'allowances'. Each of these 'allowance' carbon credits generally represents the right to emit one metric ton of CO2e.

If participants' emissions fall below the cap in a given period, they can sell their unused allowances to other participants whose emissions exceed the cap and who would otherwise have to pay a fine, creating a market for carbon credit.

The overall cap under a 'cap and trade' system is reduced over time which means the demand, and therefore the price, of the carbon credits is likely to increase, unless participants are able to reduce their carbon emissions commensurately with the decreasing cap.

The biggest 'cap and trade' carbon market in the world is the EU's Emissions Trading System (ETS) which applies to carbon-intensive industries such as electricity generation, industrial manufacturing, aviation and shipping, followed by China's Emissions Trading Scheme. The UK runs the UK Emissions Trading Scheme (ETS). In May 2025, the UK and the EU committed to linking their respective ETSs to enable allowances to be traded interchangeably between the two systems. Among other possible benefits, there will be more liquidity in a larger, linked market which should keep the carbon price more stable.

Baseline and credit

In a 'baseline and credit' market, rather than an overall cap on emissions, the regulator sets a baseline for acceptable emissions for a given business activity, project or sector, usually based on historic emissions. Instead of trading allowances for future emissions, companies can trade offsets, i.e. emission reduction units, each representing a ton of CO2e which has been reduced already. Examples of 'baseline and credit' markets are the Safeguard Mechanism in Australia and the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).

Compliance market challenges

Compliance markets use a quantity (i.e. an emissions cap or a baseline) to price carbon – this gives certainty regarding emissions but uncertainty regarding price, which is a challenge for businesses. A carbon tax on the other hand creates uncertainty regarding emissions but certainty regarding price.

A key shortcoming of compliance markets to date has been that the price of carbon credits has been too low to properly incentivise participants to reduce their emissions. It is estimated that to meet the Paris Agreement goals, the price of carbon needs to be in the range of $50-100/tCO2e by 2030 according to the report of the UN's High-Level Commission on Carbon Prices, however the majority of carbon prices remain significantly below this range.

Regulators must also ensure the cost of penalties for non-compliance is sufficiently high relative to the (variable) cost of the credits themselves. As an example, on the EU ETS the penalty is currently €100 per ton of excess CO2e emitted.

What's more, in the absence of global, integrated compliance markets, there is currently a complex patchwork of regimes around the world which make compliance for multinationals challenging or not required at all.

This is one of the drivers behind 'carbon leakage' – where companies relocate their operations to another location with more relaxed rules or a lower carbon price.

Voluntary markets

Voluntary carbon markets by contrast are not subject to government or regulatory oversight; instead the markets involve organisations or countries voluntarily purchasing carbon credits to offset their carbon emissions to meet sustainability commitments. A voluntary carbon credit effectively represents a contractual agreement between a project developer (who creates the emissions reduction or removal) and the purchaser who has existing emissions they wish to offset. The markets rely on global standards registries, such as Verra and The Gold Standard which are run by not-for-profit organisations, to certify projects and create, track and verify carbon credits.

In addition to helping companies meet sustainability goals, voluntary carbon or 'offset' credits (VCCs) can provide a valuable source of additional revenue for the companies that generate them, supporting the development of clean energy and emission removal projects.

The voluntary carbon market was borne out of the UN's 1997 Kyoto Protocol, effectively the precursor to the Paris Agreement, which created 'flexible mechanisms' to help developed countries meet their national emission reduction targets. Among these, the Clean Development Mechanism (CDM) enabled them to invest in projects in developing countries to reduce emissions, in turn generating carbon credits for the developed countries to offset their own. Article 6 of the Paris Agreement carries the baton in this respect, replacing the CDM and providing the rulebook for international carbon markets going forwards.

Avoidance or removal

VCCs can be generated through projects which seek either to avoid CO2e emissions, for example through renewable energy projects or switching to clean cookstoves, or remove them, either through nature-based solutions such as reforestation or technology-based solutions such as CCUS (on which see our article here). As with compliance credits, one tradable VCC is typically equal to one ton of CO2e reduced, sequestered or avoided. Co-benefits of a project, e.g. saving a species from extinction, can also increase the price of a VCC generated by that project.

The typical lifecycle of a VCC is as follows:

1. Project developer proposes project to measurably reduce or remove CO2e emissions following an accredited methodology and submits project to one of the global standards registries for approval.
2. Standard-accredited third-party validation and verification body (VBB) ensures relevant requirements are met through ongoing monitoring, verification and reporting (MVR).
3. Carbon standard certifies project.
4. Carbon registry issues carbon credits with unique identifying serial numbers to project developer.
5. Credits sold to buyers over the counter, through brokers/traders or on exchanges such as the New York-based Xpansiv CBL and the AirCarbon Exchange based in Singapore.
6. Carbon credits are retired once claimed against an emission, and the public record updated.

Voluntary market challenges

The key challenge for the voluntary market has been the variable quality and integrity of the credits issued. Project developers are also not helped by the lack of coherence in the different rules/ methodologies used by the different standards and more critically in the monitoring, verification and reporting process.

The Integrity Counsel for the Voluntary Carbon Market, an independent not-for-profit organisation which was set up as a private sector-led initiative, has sought to address these issues through developing Core Carbon Principles and a governance body to evaluate which standards may issue VCCs labelled with these Principles. These Principles include "Permanence" – to ensure the emission reduction is permanent, and "No double-counting".

"Offsetting" or "insetting"?

Whilst a company can offset its emissions by buying offset carbon credits generated by external projects, it can also choose to 'inset' which involves funding internal projects to remove or avoid emissions in its own operations or its supply chain. If VCC offset prices rise (as seems likely), companies may increasingly seek to generate their own carbon credits and limit the need to transact on the voluntary carbon market.

Future of carbon markets

National compliance markets continue to expand around the world, and it has been estimated that the voluntary carbon market could grow to $250 billion by 2030 and $1.5 trillion by 2050. In time these two markets may converge. It also remains to be seen how the emerging UN carbon markets created under Article 6 of the Paris Agreement will dovetail with the voluntary carbon market, and also to what extent companies will seek to 'inset' rather than 'offset' their emissions.

Ironically the surest sign of carbon markets' ultimate success will be their redundancy. This will only happen once every country achieves net zero emissions and no longer needs to trade emissions or offsets, meaning carbon markets will likely have a role to play for many years to come.

Our energy transition team

At Stephenson Harwood, we have market-leading expertise in three sectors that will be the key pillars in the energy transition:

• energy,
• transportation and trade, and
• the built and natural environment.

Our energy transition team is international, with specialists spread across eight offices in Europe, Asia and the Middle East. When coupled with our strategic relationships with other key independent law firms, this means we can support our clients wherever their business interests are based.

Authored by Harry Wilson, Associate, Nick Dingemans, Partner and Tom Platts, Partner