Carbon markets have struggled to take off, with trust issues, negative coverage, and bad apples staining the market throughout the years. As financial institutions look at the market with cautious curiosity after a string of regulatory advances, one question loomed large at London Climate Action Week: are carbon markets fit for purpose?
Do countries really believe in carbon markets?
Make no mistake, today’s carbon markets are completely different to those of a few years, and even months, ago. Last November, COP29 agreed on standards to govern an UN-led, Article 6 market. Since then, countries have explored the role of the Voluntary Carbon Market (VCM) in their net-zero strategies, studied how these credits can fit into their overall Nationally Determined Contributions (NDCs), and are even considering how to include VCM and Article 6 credits into their carbon taxes and compliance ETS systems.
In other words, countries are quietly giving a vote of confidence to a market that has struggled to earn the trust of companies and regulators alike. The UK in particular seems ready to fully embrace them. In mid-April, the Government launched a consultation on VCMs to ensure that they “form part of the UK’s clean growth story.” And right as London Climate Action Week was getting started, it announced the creation of the Coalition to Grow Carbon Markets with the governments of Kenya and Singapore to create shared principles for the use of voluntary credits by businesses.
While these announcements are worth celebrating, they also show that there is still work to be done in terms of governance and market development. As regulations progress, market participants will keep advocating for better global standards and will continue the drive for hybrid carbon systems that integrate voluntary credits in national carbon taxes and ETSs. The question remains whether regulators can be pushed further down the convergence path. But while conversations around standards and integration were at the centre of London Climate Action Week, another word also seemed to be in everyone’s mind: liquidity.
Scaling the market, one bank at a time
VCMs’ relative illiquidity is stopping them from scaling. But the tide could be changing. For the first time ever, there is a clear correlation between the price and quality of carbon credits, incentivising better projects, giving greater clarity for buyers and financers, and altogether attracting more financing to the market. As the market matures and project quality rises, there’s likely to be increasing institutional funding.
Key to unlocking this is the growing insurance industry participation in the market. One of the main reasons financial institutions have been hesitant to participate in carbon markets is the risk involved: projects overstating their carbon impact, political risks, and credits not being delivered at all have stopped the involvement of large financial institutions. However, an increased role of insurance providers acts as a stamp of confidence in carbon projects and reduces the risk premium that institutions have to consider before providing their capital. As insurance companies become involved in the market, large financial institutions are poised to follow.
What are carbon markets, really?
Still, there was a different overall debate at the heart of London Climate Action Week, not about how carbon markets could improve, but about what they should be. At their inception, carbon markets seemed to be part of the wider ESG story, where environmental progress and social development went hand in hand. The idea was that funding would flow to projects in underdeveloped parts of the world, employing underserved communities and raising their standards of living.
Now, it seems like the ‘vibe shift’ against ESG may have touched carbon markets too. Are they really an engine for social change, or are they just a financial asset market like any other? Banks, investors, and liquidity providers seem to have a clear answer: a market can’t be effective if you ask too much of it, and solving climate change is a sizeable task by itself. Carbon markets need liquidity and institutional participation to scale and help us reach net-zero, and attaching wider social and developmental goals risks politicisation and failure.
Project developers, verifiers, and buyers have two existential battles to fight. They will have to keep pushing for a new policy agenda that puts the VCM at the forefront of countries’ net zero commitments, while also learning how to speak the language of financial institutions sceptical of the long-told ESG story. As the market matures and more traditional financial institutions hope to participate, existing carbon market players will have to tune their song to the ears of banks, insurers, and liquidity providers who see carbon credits not as an engine for social change, but merely as financial products with positive environmental externalities. Their success in striking the right tone (or lack of it) might determine the future of carbon markets altogether.
