What are carbon markets and what role do they play in the energy transition?

The carbon markets are regulatory instruments designed to reduce greenhouse gas (GHG) emissions through the allocation and trading of emission permits. Its purpose is to economically incentivize the reduction of emissions and encourage investment in clean technologies, thus contributing to the fight against climate change. These markets were born in 2005 as a result of the Kyoto Protocol, the first international commitment to reduce GHG emissions. Today, they cover 23% of global CO2 emissions, according to a Cepsa report.

The objective of carbon markets is to contribute to the fight against climate change through economic incentives to reduce emissions and encourage investment in clean technologies. For this, there are two main systems. On the one hand, there are the systems of cap and tradewhich we can translate as “cap and trade”, although it is known as “carbon credit market”. It consists of establishing an emissions limit and allowing companies or governments to buy and sell rights to these emissions. These rights can be mandatory or voluntary and cover 18% of global CO2 emissions. On the other hand, there are systems based on carbon taxes to discourage emissions of pollutants. In total, they cover 5% of global CO2 emissions, according to Cepsa's work.

In 2005, the European Union implemented the EU Emissions Trading Scheme under Directive 2003/87/EC. With this framework began andThe largest carbon market in the world, which covers about 40% of the EU's total emissions. This works under a system cap and trade, in which emission rights are assigned to companies and they can trade with them. The fees are free, but decrease each year depending on the reduction coefficient set by the EU (currently 0.62%).

Impacted sectors include electro-intensive industry, electric power generation, oil refining, aviation and maritime transportation. In 2027, it will be expanded to cover road transport, construction and small industry. The European carbon market generated revenues of nearly €40 billion in 2023 (multiplied by 7 since 2017) to finance policies and aid from the European Commission.

Analysis of emissions markets in the world

In the world there are 32 operational carbon market systems, divided into three main modalities: regulated by the authorities, sovereign at the national level and voluntary. Most are located in Europe and North America, although emerging economies are also adopting these mechanisms.

  • In USA, the first market was the Regional Climate Action Initiative (RGGI) of 2009, followed by the California Cap and Trade market in 2012 and the Washington State Cap and Invest Program in 2023. The RGGI covers states on the East Coast, while that the others are at the state level. In addition, the RGGI focuses on the generation of electrical energy. California and Washington markets include electro-intensive industry, oil refining, land transportation, agriculture and construction. They are based on a system of cap and trade with minimum prices and adjustments in the amount of rights available.
  • In China The regional pilot markets began in 2017 and there is a national system that started in 2020. Its geographical scope covers the entire country and more than double the emissions than the European one. It is made up of the electric power generation sector, electro-intensive industry and oil refining. It works with free emission rights with an additional purchase option on the market.
  • In Canada, the first regional market was born in Alberta in 2007 and the most recent in Ontario, in 2022. They have had a national market since 2019. The latter covers electric power generation and electro-intensive industry. Regional ones include oil refining, transportation, construction and agriculture. In this case, the national system is voluntary for high-emitting industries, with variations in regional systems cap and trade.
  • Lastly, in United Kingdom There has been a national market since 2021, after Brexit. It includes companies in sectors such as electric power generation, electro-intensive industry, aviation and oil refining. It has a peculiarity: it is based on regular auctions of emission rights, although the allocation is free for electro-intensive industries.

This scenario poses challenges and opportunities for carbon markets. On the challenges side, we find price volatility (markets are sensitive to economic cycles and regulatory intervention is occasional), the fact that they can maintain liquidity (avoiding speculation) and a technological challenge (decarbonization technologies must accompany the reduction of rights to avoid inflation).

But these challenges also present opportunities, such as future market convergence. The report detects potential to create a global carbon market, facilitated by Article 6 of the Paris Agreement. It could also include new sectors such as land transport, buildings and agriculture to accelerate the energy transition. Finally, there is an opportunity for innovation, since income from emission rights incentivizes new technologies to reduce emissions.

Once the situation is identified, What will the future of these mechanisms be like? Some of them are almost 20 years old and their future path will be defined by certain variables. The first will be the degree of international convergence: Although there is a desire to unify prices, today there are great differences and prices do not converge. There is no clear path to a global price for carbon.

Another factor will be the incorporation of new sectors into carbon markets, which can cause an inflationary effect that reduces social acceptance. Therefore, redistributive effects must be monitored. Finally, in the European market there is a risk of relocation of industries to countries without regulation. The European border carbon tax (CBAM) seeks to prevent these carbon leaks by making the import of products (such as electricity, fertilizers or materials such as iron) produced in countries that do not tax carbon emissions more expensive.

In short, carbon markets are crucial tools in the fight against climate change, with a significant impact, but with considerable challenges to overcome. Its evolution and effectiveness will depend on how these challenges are addressed and opportunities are taken advantage of in the future.