Subscribe to the Homing Bird for exclusive updates on carbon markets, economic news and sustainable investments that make a difference.
A guide on the main difference between the Compliance Carbon Markets and the Voluntary Carbon markets. We explore their effectiveness in fighting climate change, as well as the variety in their structure and regulation.
When discussing carbon markets, we actually encompass two large mechanisms which are entirely different: They don’t overlap, they don’t have the same finality, nor the same nature. Distinguishing between the two is fundamental. Every time you hear about carbon markets, you need to know which mechanism you’re considering : the Voluntary Carbon Market (VCM) or the Compliance Carbon Market (CCM).
The Compliance carbon market covers 20% of global emissions and aims at putting a price on greenhouse gasses: it is a Carbon Pricing scheme.
The Voluntary carbon market covers less than 1% of global emissions and aims at financing individual projects which claim to absorb or avoid emissions: it is a carbon offsetting scheme.
The VCM allows individuals and companies to offset their own emissions by financing projects that reduce or avoid an equivalent quantity of emissions elsewhere. This happens by purchasing carbon credits issued by these projects. One credit represents 1 ton of carbon which claims to have been removed or avoided by that particular project.
The Voluntary carbon market is “voluntary” because neither the buyer nor the seller are legally bound to buy or sell their credits. In the voluntary carbon carbon market, economic agents (companies, individuals, institutions) buy carbon credits to offset their own emissions voluntarily. This could be because of consumer pressure, of shareholder pressure, for marketing purposes, or out of personal conviction. However, it is not to comply with laws and regulations.
It is voluntary in the sense that both the buyer and the seller are unconstrained, and that the trading unit (the carbon credit) is neither regulated nor standardized. There is therefore no limit or control to supply or demand: anyone can be a credit issuer or credit buyer on the market. There are as many different credits as there are individual projects.
Credits are generated, or issued, by private companies which develop carbon avoidance or absorption projects. For example, if a wood-based cookstove is replaced by a solar-powered cookstove, then emissions from burning wood are avoided. The company that replaced the cookstove can issue a number of credits equivalent to the avoided emissions. Another example would be a company planting trees that absorb carbon from the atmosphere. In this case, emissions would be absorbed, and an equivalent number of credits issued. Credits are tradeable goods that one can purchase and use to claim a compensation of their own emissions. However, they are not standardized, and are not investable assets.
The objective of the VCM is to channel funds to these projects (replacing cookstoves, planting trees). There are thousands of projects around the world, each having different price points for the credits they issue. There are also over 150 different project types, according to a study by Ecosystem Marketplace.
The graph below from Abatable shows the wide range of carbon credit prices. REDD+ credits are among the most popular carbon credits.
Allied Offsets, which has the world’s largest aggregated data source for carbon offsetting, shows an average price of the top 500 projects of $3.43 at time of writing, with prices never going above $5 over the past two years.
The existence of thousands of individual projects, across hundreds of project categories, at price ranges going from less than a dollar to over a hundred, and an average price lower than a cup of coffee at Starbucks, has created credibility issues for the voluntary market.
In order to bring some clarity around an opaque and controversial market, registries develop methodologies to score projects across a number of different criteria. Their role is to define the standards, issue and retire credits, and keep a ledger of issuances and retirements.
The largest and most well-known registries are Verra, Gold Standard, American Carbon Reserve, and the Climate Action Reserve. These four issue the bulk of carbon credits worldwide, but the market also has a long tail of dozens of smaller registries.
The voluntary carbon market had a golden age between 2010 and 2014, with the UN-backed Clean Development Mechanism (CDM). At its peak, the CDM issued close to 900 million carbon credits, equivalent to 900 million tons of CO2, or 2% of emissions. The market collapsed on itself in 2014. Currently, the entire market struggles to break 500 million credits, with the CDM accounting for roughly 10% of that.
One of the reasons is the market’s sustained lack of transparency, difficulty to measure the impact of projects, and frequent accusations of fraud. For instance, a lot of projects cannot guarantee the concept of “permanence”. Permanence is the idea that offset claims must last. If one sells carbon credits linked to trees that have been planted, and these trees burn a couple years down the line, then the carbon credits are worthless as the absorption of carbon is canceled out by the fires.
If you’d like to offset the emissions linked to your lifestyle or from your business activity, buying carbon credits is often advertised as one way to do it. However, it is highly controversial. You should first make sure you have avoided all possible emissions, and then offset the emissions you really can’t reduce or avoid.
There are literally thousands of different carbon credits at different prices and with different levels of transparency and credibility. You can find multiple platforms and resellers that will offer some type of carbon credits or another.
Compliance carbon markets are implemented by governments. They create a legally binding obligation for greenhouse gas emitters to purchase an allowance for every tonne of CO2 they emit. The price of the allowance depends on the quantity issued by the government (the supply) and the quantity needed by the polluters (the demand). The carbon allowance is the trading unit of the compliance carbon market.
Carbon markets are widely considered to be the fairest and most efficient policy instrument to reduce emissions. The European Union has the most mature carbon market globally, which acts as a reference for all the other markets. This dashboard by the world bank shows the current implementation stage of compliance carbon markets.
Global warming causes severe damages to societies and ecosystems in the form of degrading health, extreme weather events, lower agricultural yields, or destruction of infrastructure.
Global warming is caused by human activity - the CO2 emissions caused by industrial and agricultural activity are its root cause. This is why regulators have to put an end to industrial carbon emissions: They want to limit global warming through decarbonization.
In Europe, regulators decided to set maximum temperature targets so that climate change can be sustained. Currently, the United Nations Framework Convention on Climate change states that we should keep “global temperature rise this century well below 2 degrees Celsius above pre-industrial levels.” In turn, this means limiting greenhouse gas emissions.
The overarching goal is to achieve zero net emissions by 2050. The authorities recognize that an immediate halt to CO2 emissions is not economically feasible - to facilitate this transition, regulators establish a gradually decreasing carbon budget. They are deciding on the maximum allowable quantity of CO2 emissions from the present to 2050. Every year, the allowed volume of CO2 is decreasing, progressively bringing the economy to carbon neutrality.
Regulators issue carbon allowances (or carbon permits) - where each permit corresponds to the emission of 1 tonne of CO2 into the atmosphere. Polluters need to hold one allowance for every tonne of CO2 they emit.
The quantity of carbon allowances issued is fixed, or “capped”. This quantity diminishes every year as it follows the carbon budget. This results in decreasing amounts of CO2 released by polluters every year. Through this mechanism, regulators can manage and monitor “the consumption of the carbon budget.”
There is a market for carbon allowances. All permits are initially issued by regulators and subsequently tradable between market participants. Participants can engage in buying or selling allowances within the system. In other words, anyone who holds carbon allowances can sell them to other market players. If one wants to enter the market as a buyer, they can either go directly to the issuing authorities, or to an entity that already possesses carbon permits.
Compliance carbon markets are called “cap-and-trade” systems because the number of carbon allowances is capped and they can be traded between market participants.
Compliance Carbon Markets establish clear and specific objectives that correspond to political climate ambitions at a large scale. There are explicit legal compliance obligations that make it impossible to avoid carbon costs - all covered industrials are required to pay for carbon allowances. There are no ambiguities like in the Voluntary Carbon Market - multiple academic and institutional impact assessments verify the effectiveness of the Compliance Carbon Market.
For instance, in the European Union Emissions Trading Scheme (EU ETS), the compliance carbon market of the European Union, carbon emissions of the covered sectors have decreased by 41% since the inception of the scheme in 2005. The scope of this scheme is considerable - it amounts for around 45% of European carbon emissions (around 1.5 Gt.CO2). The trading volumes are also way higher compared to what is going on in the Voluntary Carbon Market: in 2022, the EU ETS trading volume was €751 billion, up 10% from the previous year and representing 87% of the global total compliance carbon markets volume. Read more on the environmental impact of the EU ETS here.
Sources:
Abatable, 2023. What’s going on with carbon credit prices? An update
Allied Offsets, 2023. Prices Overview.
Ecosystem Marketplace, 2022. Today’s VCM, Explained in Three Figures
Start your journey
