Global carbon markets need price transparency, rule harmonization to mature

Global carbon markets are evolving as more countries select carbon dioxide trading schemes to help meet their nationally determined contributions under the Paris climate agreement, but work remains on standardizing rules and transparent pricing, market experts said Sept. 24.

"Price transparency is the building block for any institutional commodity business and without price transparency we can have no confidence in the value of our positons," Ariel Perez, head of environmental products at merchant commodities firm Hartree Partners, said during a virtual New York City Climate Week event hosted by IHS Markit.

Without that confidence "you can't finance inventory" and without that it is very difficult to finance projects that reduce greenhouse gas emissions, Perez said.

A major bottleneck to the development of a voluntary carbon market where institutional pools of capital are looking to generate emissions reductions that could be sold to voluntary buyers is the fact that they do not really know the true value of the commodity they would generate through their investments, he said.

Having pricing reference data enables the creation of price benchmarks and thus the creation of new products like futures swaps, Nick Godec, index product manager for tradable indices at IHS Markit, said.

But in the grand scheme of commodity markets, carbon trading markets are still nascent and have dramatically evolved in recent years, Katie Sullivan, managing director at the non-profit International Emissions Trading Association.

"Governments are moving forward with leaning into the role of emissions trading, markets or cooperation and linkage to reach their mid-term climate change targets," Sullivan said.

In 2014 and 2015 around 100 countries had committed to using international trading markets to reach their intended nationally determined contributions or enhance their level of ambition toward climate change goals, she said.

NDCs represent efforts by each country to reduce national emissions and adapt to climate change impacts. The Paris Agreement requires each party to "prepare, communicate and maintain successive" NDCs that it intends to achieve, according to the United Nations Framework Convention on Climate Change.

Some countries may be able to meet their NDCs, but require financing through exporting carbon credits, Sullivan said.

Article 6 of Paris Agreement

Article 6 of the Paris Agreement allows for countries to cooperate though markets to reach their NDCs and this has been a point of negotiation over the past few years as countries work to streamline the rules around the global climate agreement, she said.

"Operationalizing Article 6" will be a main point of focus at the Conference of Parties in Glasgow next year, Sullivan said, which is important because there are over 30 emissions trading systems or carbon markets around the world which are like islands with their own rules, assets, compliance tools and tracking systems.

It can be challenging to comply and operate across these diverse markets as participants face different levels of exposure, pricing, rules and accounting, so ideally going forward there will be more fungibility across these systems as they evolve, she said.

Asked about what is needed for carbon markets to mature, Perez said the fundamental price of a carbon permit should be linked to the price at which a company can reduce its demand and not need to buy a carbon permit, or abatement price.

The same logic holds true for an investor who is long a portfolio of companies that have emissions and are under regulatory regimes. Carbon market investments are probably "the cleanest climate hedge that exists" because it represents the price polluters have to pay to pollute, he said.

For investors trying to minimize carbon exposure there are limited ways to slice and dice a portfolio and re-weight it to the "good guys versus the bad guys" and at some point there will be a residual exposure that can be cleanly eliminated by hedging with carbon permits, Perez said.

Sullivan said IETA did some modeling with the University of Maryland around the cost of meeting country NDCs through carbon trading versus going it alone that found the use of carbon markets could save $340 billion dollars per year.

And while she feels "optimistic" about the negotiations around COP 26 and reaching a resolution on Article 6, "there is still a ton of work to do."