HKEX Insight

The Paris Agreement is a legally binding international treaty on climate change adopted at COP 21 in Paris that provides governments with a new set of rules to make carbon markets work and established two new carbon markets to replace the three Kyoto markets.

The key part of the Paris Agreement - Article 6 - outlines how countries can cooperate with each other using international carbon markets to achieve emission reduction targets.

Essentially, Article 6 provides the basis for international carbon markets and enables countries to transfer carbon credits earned from the reduction of GHG emissions to help one or more countries meet their climate targets. Two specific parts of Article 6 stand out:

First, Article 6.2, which sets up a carbon market in which countries can trade GHG emission reductions. For example, if a country targets to reduce emissions by 200 tonnes of CO2 but actually reduces by 220 tonnes, that country would then be able to sell the surplus to another country through a carbon market.

Second, Article 6.4, which establishes a central United Nations-governed mechanism to trade credits from emission reductions projects between countries. For example, country A could pay for country B to build a wind farm instead of a coal plant. Emissions are reduced, country B benefits from the clean energy and country A gets credit for the reductions.

To keep global warming to no more than 1.5°C as called for in the Paris Agreement, greenhouse gas emissions need to be reduced by 45% by 2030 and reach net zero by 2050. The emission gap to achieve net zero by 2050 is significant.

And alongside the decarbonisation journey across the climate value chains, building efficient voluntary carbon markets is a step on our path to net zero. Carbon markets can contribute to the reduction in net emissions through the avoidance and removal of emissions.

Companies may refer to HKEX’s Net-Zero Guide which introduces some of the essential steps they should take to develop a pathway to net zero and contribute to global net-zero targets.

In an emissions trading scheme, a cap is set that limits the total allowed emissions for a given sector. The governing authority then issues carbon credits, or allowances, that allow emissions up to the cap limit, those credits are then allocated either for free or through an auction.

In an emission trading scheme, the number of available permits drops each year, thus reducing the total cap across sectors and, theoretically, increasing the value of the permits, thereby incentivising investment in clean energy to reduce emissions. If companies emit more than their permits allow, they must buy more. If companies reduce emissions below their limit, or allowance, they can sell excess permits on the carbon market.

Voluntary carbon markets (VCMs) comprise buyers (usually corporates) that voluntarily purchase carbon credits generated by projects that avoid or remove greenhouse gas (GHG) emissions to neutralise or compensate for their emissions.

Each carbon credit is usually issued by self-regulated organisations and represents a tonne of emissions avoidance or removal. Carbon credits are seen as one of the essential instruments for achieving net-zero targets.

Multiple players make up voluntary carbon markets, including project developers, end buyers, brokers and verification and validation bodies.

There are also multiple channels for credits to change hands, including on-exchange, bilateral agreements, via brokers or sometimes through platforms set up by credit issuing standards themselves.

The ownership and transfer of credits are recorded at their dedicated registries. Once registered, the credits can then be sold, traded or retired.

If a credit is retired, it will be taken out of circulation. When a credit is retired, it means that the end buyer has offset an equivalent amount of emissions to the carbon captured in the credit and indirectly funded the emission reduction project.