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Understanding Carbon Markets

Keslio Team
 minute read  
May 6, 2024
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Introduction to Carbon Markets

The increase of greenhouse gas emissions has drastically affected global temperatures. This global concern has led to countries pledging to keep rising temperatures below 2°C. Solutions such as transitioning to renewable energy and adopting energy efficient or low-carbon technologies have developed overtime, creating a growing industry dedicated to decarbonization.

Carbon markets were developed to put a price on carbon emissions, financially disincentivizing organizations and encouraging them to apply sustainable and low-carbon strategies and technology into their operations. With this scheme and with policies and goals focused on decreasing emissions, companies are pushed to offset their carbon emissions by purchasing carbon credits. Through establishing a carbon market, regulating bodies are able to slow down the impact of climate change and measure the decline of carbon emissions.

How Carbon Markets Work

How does a carbon market work?

A carbon market observes a “cap and trade” system. Usually managed by governments or international organizations, these institutions establish a cap or the maximum amount of carbon emissions all entities under the regulating body can emit over a period of time. Yet this isn’t a free-for-all. This cap is split into allowances, creating a marketplace for carbon, which are distributed or auctioned off to participating entities. Through these allowances, businesses are given a certain amount of carbon emissions they can produce.  

Now, what happens when a business exceeds their allowances? This is where the trading system comes into play. Organizations who exceed their limit can purchase unused carbon allowances from other entities who did not use up all their credits. This transaction thus offsets their excess emissions.

Eventually, over the years, as climate change continues to persist, the cap decreases and the price of carbon credits rise, paving the way for businesses to innovate and create solutions towards a low-carbon economy.

Compliance and Voluntary Markets

Participating in carbon markets are usually dependent on laws and regulations. With the growing urgency to mitigate the impending impact of climate change, governments and economic unions have implemented laws and regulations related to decarbonization through carbon markets.

Compliance Carbon Markets

Compliance or mandatory carbon markets are products of government action. Here, the carbon market is regulated and allowances are distributed on a national or regional level. For example, countries like China, South Korea, and New Zealand have their own established compliance carbon markets. In addition, the European Union has the EU emissions trading system, which includes participation from all EU member states, and Iceland, Liechtenstein and Norway, as well as Northern Ireland. Participants in a compliance carbon market usually consist of individual companies, plants, and facilities.

Taking part in a compliance carbon market also requires monitoring and reporting carbon emissions. In addition, verifying emissions is a significant requirement as it ensures the accurate reporting of data and minimizes the risk of inaccuracies in tracking nationwide progress in carbon reduction.

What about entities who do not fall under mandatory participation in a carbon market? What happens as well if an individual is interested in reducing their carbon footprint?

To address this concern, voluntary carbon markets were developed.

Voluntary Carbon Markets

A voluntary carbon market allows businesses, organizations, and even individuals to make an impact towards net zero emissions. While compliance markets have a limited number of allowances, a voluntary carbon market allows participants to purchase carbon credits to offset their carbon emissions. This decentralized structure encourages more businesses to be accountable and take initiative for their emissions.

In a voluntary carbon market, a carbon credit is equivalent to one metric ton of CO2. The CO2 in a carbon credit is sourced from project developers who create carbon reduction or removal initiatives like process improvement or environmental projects. These voluntary carbon credits are then verified and tracked by a registry, which also regulates the carbon market. Once in the market, businesses are free to purchase carbon credits, which will now be labeled as retired and no longer in use.

Carbon markets are continuing to grow and develop as more countries are setting up their own voluntary carbon markets and creating laws and nationwide targets on carbon emissions reduction. International organizations have also been established to allow countries to collaborate and support each other towards their goals in reaching net zero carbon through decarbonization initiatives like carbon markets or renewable energy.

Through putting a price tag on carbon, businesses and countries are pressured to take immediate action against climate change.

The Future of the Carbon Market

The carbon market industry is fairly new. It has gone through many challenges, criticism, and in response, continuous development and improvement. Carbon markets have been questioned for its integrity and accuracy in monitoring and reducing carbon emissions. There have been concerns about double counting a credit for more than what it is equivalent to. Other concerns include the quality of these carbon credits and its impact on reducing emissions. Carbon credits have also been perceived as a way for organizations to take part in decarbonization without making their own efforts to reduce their carbon footprint.

With all these concerns, where is the carbon market heading so far?

Recent discussions in COP28 pushed for further strengthening of carbon market policies and operations through a carbon market regulated by the UN. Yet disagreements, concerns, and clashes occurred during conversations on Article 6 of the Paris Agreement, which details voluntary cooperation between nations in reaching climate targets. No agreement has been made on the future of a UN-manned carbon market during COP28, leaving uncertainties in the future of the carbon market industry.

Still, voluntary carbon markets are being developed by both private and public sectors. A carbon market continues to create meaningful impact in the fight against climate change. Policies have yet to be improved, and reporting needs stronger assurance and credibility. Amidst views on carbon markets being an easy way to say one has practiced accountability in their emissions, one should remember that participating in a carbon market should go hand-in-hand with developing one’s own decarbonization initiatives and strategies. A carbon market is here to encourage businesses to be accountable for their actions. These markets speed up progress by encouraging businesses to reduce their carbon emissions or else suffer both financial and long-term environmental consequences. Through putting a limit and a price on carbon emissions, businesses are set down a path towards sustainable innovation.

At Keslio, we are deeply passionate about sustainability, equipping us with the expertise and extensive network needed to guide clients through their sustainability journey effectively and efficiently. Our expertise is particularly valuable for companies looking to embed sustainability practices into their businesses and investors looking to integrate ESG and impact into investment portfolios. To learn more about how Keslio can assist your organization on its sustainability journey, please don't hesitate to get in touch with us.

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