Our subcommittee spent six months consulting with economists and climate policy\u00a0experts\u00a0to try to identify carbon\u00a0markets\u2019 role\u00a0today.\u00a0The role of carbon markets goes back to the Kyoto Protocol in 1997, which\u00a0sought to\u00a0put an emissions cap on richer countries.\u00a0No\u00a0global market resulted, although the creation of the European Union ETS [Emissions Trading System, the internal system that European nations use among themselves] was a major achievement. The Paris Agreement later moved towards promoting voluntary participation by countries including by \u201cnationally determined contributions,\u201d which\u00a0may involve carbon pricing and compliance markets, typically\u00a0domestically.<\/p>\n
In our\u00a0work we also explored what we would call the voluntary carbon market, which is the main market through which cost-effective abatement options from low-income countries get\u00a0traded.\u00a0<\/p>\n
How do you see carbon markets advancing the goal of reducing emissions globally? And why have they fallen short in the decade since the Paris\u00a0Agreement?<\/p>\n
Rohini Pande: To limit global warming we need to reduce greenhouse gas emissions. And most greenhouse gas emissions are linked to fossil fuels, the most common energy source in most countries. There is also a pretty much 1-to-1 relationship between increases in GDP or economic prosperity and energy use. And so, the main reason it\u2019s been hard to consider transitions away from fossil fuels has been the belief of a huge trade-off between economic growth \u2014 especially for lower-income countries \u2014 and energy\u00a0consumption.<\/p>\n
Renewable energy sources are cheaper now, showing more promise. However, these energy sources have large upfront costs, which makes them particularly difficult for low-income countries. One of my colleagues on the report found that the countries with the most sunshine are the ones with the least solar power: they\u2019re closer to the equator, low-income, and have a high cost of\u00a0financing.<\/p>\n
How can carbon markets help solve these problems? Well, a specific reduction in emissions into the atmosphere \u2014 or removal of greenhouse gases from the atmosphere, say one tonne of CO2 in each case \u2014 has the same climate benefit, wherever it takes place. And since we have limited funding for investment in decarbonization, we can best reduce climate damage by investing in the best value decarbonization projects \u2014 the ones that achieve the biggest reduction in CO2 per dollar spent \u2014 first. That\u2019s best done in a global market that lets buyers compare all decarbonization\u00a0projects.<\/p>\n
That\u2019s the theory. In practice, it\u2019s difficult to measure reduced emissions \u2014 and often the buyer is not in a position to know what happened across the globe. If I buy a tonne of lead, for example, I can have it delivered to my door. I can weigh and inspect its quality. If I invest in reducing carbon emissions by one tonne \u2014 or reducing atmospheric carbon by the same amount \u2014 often I can\u2019t observe that reduction directly. And often it\u2019s hard to measure what would have happened in a world where I hadn\u2019t paid to curb deforestation, or how to handle a forest fire in an area I paid to\u00a0preserve.<\/p>\n
If I want my market to be credible, everyone involved must be certain that market participants\u2019 measurements and calculations are correct \u2014 and that there are ways to fix unexpected problems. This requires standardizing measurement and verification procedures \u2014 and preventing systemic conflicts of\u00a0interest.<\/p>\n
So identifying ways to have a carbon market that spans rich and poor countries could have significant benefits. This would enable climate financing for high-return, low-cost choices like renewable grids and deforestation prevention in these countries. But you have to solve these questions of measurement, implementation, and credibility \u2014 often in low-income contexts, with low state capacity. So that\u2019s what we\u2019re trying to\u00a0do.<\/p>\n
How are market forces uniquely equipped to address the complex economic, political, and geographic challenges of climate\u00a0change?<\/p>\n
Pande: First, while low-income countries offer low-cost abatement opportunities that can help the whole world, we need to ensure the growth they need to pull their populations out of poverty isn\u2019t hurt. So, for example, if reducing future emissions involves shutting down one low-productivity carbon-intensive economic process \u2014 like deforestation \u2014 we also need to ensure that that economic process is replaced by a cleaner one that provides an equivalent growth\u00a0path.\u00a0<\/p>\n
Second, if we want to use a market to hit global emissions reductions targets by decarbonizing globally at the lowest cost, we need a market structure that enables that. And that would be a compliance market with a required, coordinated cap, not a voluntary\u00a0market.<\/p>\n
Explain the difference.\u00a0What are some examples of the kind of\u00a0trading you might find on the voluntary carbon market?\u00a0And in a compliance\u00a0market?<\/p>\n
Pande: Well, in the voluntary market, let\u2019s say a company like Meta or Google decides to offset emissions from large data centers by reducing emissions somewhere else in the world. They might approach, say, a Brazilian company that\u2019s in the business of reforestation and say, \u201cCan we pay you to reforest enough land that it actually, over the next 30 years, reduces emissions by X amount?\u201d And that would then be the amount they can offset their own\u00a0emissions.<\/p>\n
One\u00a0drawback\u00a0with this model is that it\u2019s completely voluntary: companies\u00a0must decide\u00a0to participate, and there\u2019s no mandate for how much these companies should bring down their own emissions over time. Even if a company hits its own net-zero target, this doesn\u2019t take us to a global net zero. Further,\u00a0emissions could go up if the firm changes their mind or if they pay for a program that doesn\u2019t work out as intended.\u00a0This feeds into the challenge\u00a0I mentioned earlier\u00a0that buyers often can\u2019t check the quality of the product. The consequence of all these issues is that credits trade at very low prices \u2014 and the market just doesn\u2019t enable investment at\u00a0scale.\u00a0<\/p>\n
Contrast this with compliance markets like EU-ETS [the European Union\u2019s\u00a0Emissions Trading System]. Here a set of companies \u2014 usually large industrial firms \u2014 are required as a group to maintain their emissions under a legally mandated cap, that reduces every year towards an agreed target. Firms are issued or buy permits to pollute and can trade them. This market structure \u2014 combined with the fact that industrial emissions are relatively easy to measure \u2014 ensures that the best-value decarbonization projects are funded and happen first and that targets are hit. The problem is that, right now, these markets only exist at a national or regional scale. And they either don\u2019t include, or allow only small quotas of, nature-based or renewables projects. This is because of the fear that the problems of measurement and implementation I\u2019ve mentioned linked to these projects will reduce the credibility of the entire\u00a0market.\u00a0<\/p>\n
Our\u00a0ultimate aim is to bring together all these piecemeal elements in one unified global compliance\u00a0market.\u00a0<\/p>\n
Why do you think it\u2019s possible to build a unified global carbon market now, when it hasn\u2019t happened so\u00a0far?\u00a0<\/p>\n
Pande: The market that was put in place in the Kyoto Protocol was a first attempt at building a global compliance market, but we didn\u2019t know how to do it well and didn\u2019t have all the technology we do today. But now we\u2019re in a better place. First, we see that a lot more countries \u2014 both rich and lower-income \u2014 are putting in place the basic architecture for compliance markets. In addition, we have seen what we would describe as a measurement and credibility revolution in the sciences and social sciences, whereby we can use better satellite imagery, better remote sensing techniques, machine learning, and data science. And I think there is a better understanding of how to construct counterfactuals [hypothetical models that simulate climate outcomes without human interference] to measure a project\u2019s emissions reduction potential. It\u2019s also much easier to share data for\u00a0transparency.<\/p>\n
A financial economist on our team noted that there have also been advances in the kinds of financial contracts you can write so that risk can be managed. People talk about measurement reporting and verification, but not enough about risk management in this market. And the moment you bring in things like nature-based projects or renewables \u2014 or, for that matter, trade between countries at different points in their development and institutional structure \u2014 you need to think about risk\u00a0management.<\/p>\n
In the case of the hypothetical data center I mentioned earlier, those kinds of companies are not in the business of checking up on the maintenance of forests. And companies don\u2019t want to wager money on uncertainty. So, we\u2019ve suggested using the same tools that the financial markets use \u2014 things like risk insurance and bundling elements that have higher and less risk \u2014 and bringing those into the markets to assure that companies are getting what they\u2019re paying for. All of these factors combined can now help move us towards a unified global\u00a0market.<\/p>\n
What are some of the next practical steps that will be needed to move in this\u00a0direction?<\/p>\n
Pande: We\u2019re trying to set up a longer-term architecture, but we also want to better understand how to make these kinds of systems operational in the shorter run. The longer term architecture really aims to move towards a unified carbon market in which you can have an overall cap that over time heads towards a global net zero,\u00a0for everyone,\u00a0but also allows countries in the shorter run to first engage in the most cost effective abatement opportunities \u2014 especially in a world where we know climate financing is\u00a0limited.<\/p>\n
One of the most common phrases I heard at COP 30 was the need to \u201cunlock climate finance.\u201d There is growing recognition that governments have tighter budgets right now, and less interest in directly providing climate financing. Carbon markets, if they\u2019re global, can provide some of the architecture to achieve\u00a0it.<\/p>\n