The Convergence of Voluntary and Compliance Carbon Markets

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Environmental asset markets are extremely complex. This causes confusion on how the voluntary carbon market (VCM) and the compliance market are related: how they overlap, and where they differ. To an extent, this confusion is warranted since the two domains have always been intertwined and will continue to be in the future. Understanding the distinctions and similarities is fundamental to participating and investing effectively in these markets. In this article, we examine the history of voluntary and compliance regimes and explore their evolution and relationship.

At a high level, the VCM and the compliance markets are different segments of the global carbon market. They operate under distinct guidelines and principles, but share the ultimate goal of reducing greenhouse gas emissions (GHGs). The VCM allows organizations to voluntarily offset their carbon emissions by purchasing carbon credits, which are generated by carbon reduction projects. The compliance markets, on the other hand, are regulated markets that operate under government-mandated emissions reduction targets and incentive schemes. Compliance markets often take the form of cap-and-trade programs or carbon taxes. 

Both markets aim to reduce GHGs but differ critically in the incentive mechanism used to do so. Cap-and-trade programs or carbon taxes disincentivize carbon emissions, i.e. attempt to limit unsustainable activity, while voluntary credits issued for reforesting an area or direct air capture incentivize carbon drawdown, i.e. attempt to promote sustainable behavior. 

Limiting bad versus promoting good is a critical distinction that impacts the scope of activity a given schema can cover. It would, for example, be difficult to set up a cap-and-trade program or a carbon tax that ensures that we don’t lose the Amazon rainforest. Conversely, it would be challenging to set up a crediting system under a registry that ensures that a country’s energy sector doesn’t emit more than X tons of carbon in a given year. While their incentive mechanisms operate differently, the histories of the voluntary and compliance markets are closely intertwined and will likely increasingly be linked as both markets evolve and mature.

History of compliance markets

Compliance markets are currently worth around $979 billion, after experiencing more than 2.5x growth since 2021. Forecasts put them at more than $2.5 trillion by 2028. 

This near trillion-dollar market was born in 1997 with the signing of The Kyoto Protocol. While the protocol didn’t enter into force until 2005, it is generally regarded as a landmark international treaty under the United Nations Framework Convention on Climate Change (UNFCCC). Under “Kyoto”, as it is commonly called, industrialized nations and economies in transition committed to reducing their combined GHGs by 5.2% compared to 1990 levels. Kyoto set legally binding emissions reduction targets that emphasized the historical responsibility of developed countries to lead climate change mitigation efforts. 

When countries or regions set a limit on GHG emissions they create something of value: the right to emit. This right is subject to market logic and can be bought and sold. Kyoto allowed developed countries to meet their commitments by, in addition to reducing their own emissions, funding sustainable development projects in developing nations that reduced CO2 in the atmosphere. These projects generated Certified Emission Reductions (CERs) under the Clean Development Mechanism (CDM). These CERs were then traded internationally, enabling industrialized countries to “offset” their emissions by essentially paying for emissions reductions in developing countries. The CDM and CER trading spurred the beginnings of the compliance carbon market, with the EU ETS emerging in 2005.

Research on anthropogenic climate change advanced throughout the 2000s. A scientific consensus emerged that more radical global action was required to course correct, and the Kyoto Protocol came to be seen as too limited, static, and short term to drive broad climate action at the necessary pace. The Paris Agreement was the response to this. It takes a more holistic and ambitious approach compared to Kyoto and requires action from all countries, both developed and developing, rather than just mandating emissions reductions from industrialized nations. It aims to restrict global warming to well below 2°C and preferably to 1.5°C above pre-industrial levels through rapid, deep decarbonization. Compared to Kyoto's modest reduction target, Paris sets much more ambitious goals.

Article 6 of the Paris Agreement has emerged as the guiding light for carbon markets. It is the rulebook governing how countries cooperate with each other to achieve the GHG reduction targets set out in their Nationally Determined Contributions (NDCs). Following six years of negotiations post-Paris, countries finally agreed on a package of rules to govern and implement international carbon market mechanisms in 2021. 

Within Article 6, Article 6.2 allows countries to trade emissions reductions and removals with one another through bilateral or multilateral agreements. These traded credits are called Internationally Transferred Mitigation Outcomes (ITMOs). ITMOs are already available for trade and some countries, such as Japan and Switzerland, have concrete projects in place to buy various credits and count them toward their NDCs. However, they are trailblazers: it is a lengthy process for countries to conclude bilateral agreements under Article 6.2 and it will take a number of years until ITMOs are widely traded between countries.

Article 6.4, on the other hand, updates the Kyoto Protocol’s CDM, establishing a mechanism for international transfer and trade of GHG reductions between countries to provide flexibility in meeting national climate targets. Unlike Kyoto, which aimed at simply offsetting emissions, Article 6.4 prioritizes the delivery of overall mitigation in global emissions, with a portion of reductions going toward global drawdown efforts beyond counting as offsets for any one country. The mechanism aims to stimulate global climate action and to incentivize public and private entities to reduce emissions while advancing sustainable development.

Compliance market structures and dynamics

Compliance markets enshrine sovereign and regional efforts to limit GHG emissions via legal mandates that limit emissions and put a price on carbon. The structure of that legal enforcement can take several forms: either a cap-and-trade program or carbon taxes.

Under a cap-and-trade program, a government sets an overall emissions cap and issues tradable allowances up to that cap, which regulated entities must acquire and retire to cover their emissions. The trading market creates incentives to cut emissions to the level of the cap:

The basic premise of cap-and-trade is that government doesn't tell polluters how to clean up their act. Instead, it simply imposes a cap on emissions. Each company starts the year with a certain number of tons allowed—a so-called right to pollute. […] Each year, the cap ratchets down, and the shrinking pool of allowances gets costlier. As in a game of musical chairs, polluters must scramble to match allowances to emissions.

As previously noted, the first fully functional cap-and-trade scheme was the EU ETS, which is now the largest mandatory carbon market in the world, covers around 45% of the EU's emissions, and is linked with the Swiss ETS. It operates in all 27 EU Member States plus Iceland, Liechtenstein, and Norway. The scheme caps emissions from over 11,000 heavy energy-using installations across the power sector and energy-intensive industries like oil refining, iron and steel, cement, chemicals, and aviation. Companies can trade allowances to comply with their caps. The program has gone through several phases, with the caps getting progressively stricter over time. The EU ETS is currently in Phase IV (2021–2030), which aims to support the EU’s commitment to reduce covered emissions by 43% below 2005 levels by 2030. Many EU Member States use the revenue generated from auctioning allowances to finance climate and energy-focused projects, both within their borders and in developing countries.

Over its four phases, the EU ETS has experienced significant price volatility, ranging from periods of almost complete collapse to recent dramatic spikes upwards of €100. During Phase I (2005–2007), an oversupply of allowances led to a price crash at times to near zero. Phase II (2008–2012) saw more stabilization between €10 and €20 initially, but the financial crisis and influx of CERs combined to create another permit surplus, driving prices down to under €5 again. Phase III (2013–2020) included interventions to tighten supply, including backloading auctions and then establishing the Market Stability Reserve in 2015 to reduce the oversupply of allowances. This helped push prices up to around €25 by 2020. Under the current Phase IV, additional reforms have contributed to surging prices that have topped €100 at points, which is a price more likely to provide stronger incentives for decarbonization across Europe. 

Source: Trading Economics, EU Carbon Permits, October 18th 2023

In general, the reach of carbon markets is expanding, despite the difficulties in setting up functioning ETSs. According to the latest data from the World Bank's Carbon Pricing Dashboard, total emissions coverage under mandatory carbon pricing has increased from about 15% in 2018 to the current 23%, as more regional, national, and subnational schemes have been implemented.

While the Kyoto Protocol and Paris Agreement popularized cap-and-trade systems, carbon tax schemes are also being adopted in countries like Colombia and Singapore. There is an active debate on which mechanism will work most effectively. However, the different regulatory approaches share a common aim. In the words of the Brookings Institution:

Under either a carbon tax or a cap-and-trade program, the desired result is a level of CO2 abatement which equates the cost of abatement with the estimated benefits of abatement.

Under a carbon tax, emitters face a set tax applied to their emissions, with the aim of incentivizing emission reductions to lower the tax burden. These emissions taxes, which are levied based on the GHGs an entity produces, are distinct from taxes on goods or services that are generally carbon-intensive. As of 2021, 35 carbon tax programs have been implemented worldwide. In general, carbon taxes provide a high level of certainty about cost but not about the level of emissions reduction to be achieved, as they are essentially “uncapped”.

The emergence of the VCM

Bayon et al (2009) date the first carbon offset deal to 1989. It was between energy company AES and international NGO CARE International and involved the former donating $2 million to a CARE project in Guatemala in which 40,000 farmers would plant some 52 million seedlings intended to absorb a quantity of CO2 roughly equal to the amount generated at AES’s newest power-generation facility over its 40-year life-span. In the early 1990s, more such offset purchases began emerging despite a lack of legal mandates requiring them, mainly carried out by environmentally conscious companies and individuals. This behavior planted the seeds for a carbon market based on discretion rather than legal mandates. The establishment of standardized offset methodologies and independent verification through certification standards like Gold Standard in 2003 and the Verified Carbon Standard (Verra) in 2005 laid the foundation for a more professional voluntary carbon market.

These standards took inspiration from the Kyoto Protocol’s CDM and attempted to build out credible certifications of emissions reductions. In doing so, these new standards also increased the scope provided by the CDM, incorporating a broader range of eligible project types and methodologies. While they improved certification quality, these standards have gone through several cycles of methodology improvements and expansion, as measurement and verification technology advances and scientific consensus on carbon offset quality solidifies.

A key distinction between the credits issued under voluntary standards relative to compliance market allowances or taxes is their incorporation of non-carbon considerations. These tend to be aligned with the UN’s Sustainable Development Goals (SDGs) such as biodiversity and poverty alleviation, among other considerations. They are usually referred to as credit co-benefits. Ongoing debates continue around balancing carbon project rigor with the prioritization of co-benefits, touching on deeper questions around the purpose of carbon markets: is this purely about carbon dioxide reduction, or should it have a wider scope such as ensuring ongoing biodiversity and liveable habitats? Some of these debates are covered in our recent blog post about the role of project developers in the VCM:

The wide range of methodologies allowed under these standards and the variation in co-benefits results in a wide price spread in voluntary markets. Prices have ranged from under $1 per ton to over $1,000 per ton, averaging $3 to $5 per ton historically. Prices rose sharply in the late 2010s and early 2020s as demand surged, only to fall again over the last 18 months (World Bank Group, "State and Trends of Carbon Pricing 2023").

While the VCM has gone through a few boom and bust cycles, it has steadily emerged from scattered early offset efforts to become a robust parallel structure to compliance markets. As the market has matured, engagement in voluntary markets is becoming increasingly involuntary as consumers demand sustainable products and investors use sustainability metrics to guide their capital allocations. Further cementing its involuntary nature, compliance regimes have started to emerge around the VCM. There is now significant momentum behind the integration of voluntary credits into compliance schemes to create a unified global carbon market. 

The birth of a global carbon market

As detailed above, the voluntary and compliance markets started bifurcating in the early 2000s with the founding of the non-CDM registries (Gold Standard, Verra, etc.), even though some carbon offset projects continued to supply credits to both markets for years. The VCM started to grow rapidly around 2006/07 as more and more organizations wanted to reduce emissions beyond what was legally required. By the 2010s, compliance markets focused on carbon credits issued by governments (e.g. CERs), while voluntary markets favored credits verified by independent certification bodies like Verra and Gold Standard. Despite these differences, there are significant overlaps in various domains and, in fact, signs that the apparent walls between the compliance and voluntary markets will further collapse in the future.

The International Civil Aviation Organization’s CORSIA mechanism is a pertinent example. CORSIA is a compliance mechanism created to keep international aviation emissions below 2020 levels. However, the scheme relies on eligible VCM credits from Verra, Gold Standard, and other standard bodies. It’s a clear example for how VCM credits can be integrated into compliance markets. 

Similarly, Australia's Carbon Farming Initiative began as a VCM project, allowing farmers and land managers to accumulate carbon credits through land-based carbon sequestration or GHG reductions. However, these credits evolved to become an integral part of Australia's Emissions Reduction Fund, which is a government compliance mechanism. The transition demonstrates how high-quality voluntary actions can seamlessly become part of the compliance landscape.

Colombia and Singapore take this integration a step further. Colombia levies a carbon tax on certain fossil-fuel-based emissions of $5 per ton and allows entities to offset a portion of their tax liabilities using VCM credits. Singapore, too, exhibits a blend of voluntary and compliance efforts. With the Singapore Carbon Pricing Act 2022, Registered Persons and market intermediaries can use eligible carbon credits to offset up to 5% of their total taxable emissions. These countries’ integration of voluntary credits into compliance schemes seem to be indicators for how these markets will evolve in the future.

In the EU, the new Carbon Removal Certification Framework (CRCF) paves the way for the EU to incorporate CDR into its climate policies and eventually establish a registry allowing a market-based trading of CDR “units.” Under the CRCF, certified carbon emissions removals following specific methodologies will be listed in a registry set up by the EU Commission. Eventually this could lead to the integration of these CDR credits into the EU ETS system, the largest carbon trading scheme with a market cap over $900 billion.

Beyond individual jurisdictions, it is now clear that Article 6 will allow certain VCM credits to be used to fulfill country-level commitments on a global level. These offsets would be achieved via corresponding adjustments between countries and Authorized Emissions Reductions (AERs) that originate in voluntary markets. Their specific use, however, has yet to be outlined and agreed upon by participating nation states. 

Recognizing the potential here, Verra recently introduced labels that signal whether its credits are authorized for specific uses under Article 6. Verra applies labels to its Verified Carbon Units (VCUs) when it wants to indicate that a unit meets the requirements of other (non-Verra) standards programs or qualifies to be traded in specific markets. The new Article 6 labels therefore serve as guideposts in the evolving landscape of VCM and compliance market convergence. The three available Article 6 labels are:

• Article 6 Authorized – NDC use: This label indicates that the VCUs associated with a specific carbon reduction project can be used by a country to fulfill its NDC commitments under Paris.
• Article 6 Authorized – International mitigation purposes: This label is meant for projects that generate VCUs that can be used as ITMOs.
• Article 6 Authorized – Other purposes: This label is for projects that generate VCUs that can be used for purposes other than NDCs or international mitigation purposes.

It is because of developments like these that Alexis Leroy, CEO of Switzerland-based project developer Allcot, recently told us that: 

The voluntary carbon market is really a pre-compliance market.

There is a widespread belief that credits generated in the VCM will increasingly be seen as viable tools for compliance schemes, both because of consensus around quality factors and the impetus from Article 6. A merger would force emitting entities to both ‘limit the bad’, i.e. stop emissions as supported by compliance regimes, and ‘do good’, i.e. support reforestation or other positive projects as supported by the VCM.

Integrating the compliance and voluntary markets into a unified global carbon market will mobilize a broader range of private sector participants, provide regulated entities flexibility in meeting obligations, improve transparency and oversight to enhance credibility, and drive greater and more predictable financial flows to project developers. This fusion could also bring about more credible and consistent pricing.

Some distinctions will likely persist due to differing regulations, contracts, and buyer motivations across the compliance and voluntary realms. Similarly, challenges in coordinating standards and policy frameworks across the diversity of carbon assets, buyers, and use cases will remain. In fact, the Oxford Institute for Energy Studies goes so far as to argue that:

The heterogeneity and the complexity of carbon markets should be embraced as there is increased understanding that delivery of emission reductions and removals occur in highly varied types of supply chains.

Ideally, a truly global carbon market will emerge that combines the efficiency gains of a unified market while catering to and respecting the specifics of the different emissions reduction supply chains. Overall, the goal has to be what Paris laid out in 2016: to restrict global warming to below 2° Celcius, and to ensure that this planet will continue to be liveable for humans, flora, and fauna alike.