Carbon markets, explained
Oct 28, 2022
Carbon markets can’t wait because climate change won’t and as the drive to curb global warming gathers pace, building efficient voluntary carbon markets is a step on our path to net zero. As carbon markets are still in their infancy in Asia, here we provide our stakeholders with the basics to help them embark on their journey.


How did carbon markets emerge?

When the Kyoto Protocol was adopted in 1997, it committed industrialised countries and economies in transition to limit and reduce greenhouse gas (GHG) emissions in line with agreed individual targets.

The Protocol allowed countries to meet their emissions reduction targets through the transfer or trading of emission reduction credits, i.e. carbon credits, and established three market mechanisms for carbon trading: the Clean Development Mechanism, International Emissions Trading and Joint Implementation.

What is the Paris Agreement and why is it important to the development of carbon markets?

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.

What kinds of carbon markets are there?

There are two types of carbon market: compliance and voluntary markets.

Compliance markets, usually referring to emissions trading schemes, are regulated by governments, who issue carbon allowances to companies.

Voluntary carbon markets are aimed at financing activities that reduce greenhouse gas (GHG) emissions.

On voluntary carbon markets, participants can purchase carbon credits from sellers to offset their emissions.

Why are carbon markets important?

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.

How large are global carbon markets?

Compliance markets, or emissions trading systems, covered 17% of global GHG emissions in 2021 and the total turnover of carbon credits on emissions trading systems reached USD 851 billion in 2021, according to Refinitiv data.

Voluntary carbon markets are much smaller, with carbon credit transaction volumes of 500 million tonnes of CO2 in 2021, with a market value of around USD 2 billion, according to Ecosystem Marketplace.

Carbon markets are rapidly developing in Asia, with platforms in China, South Korea, Japan, New Zealand, Australia and Singapore emerging in recent years.

What are the potential carbon market opportunities for Hong Kong?

Hong Kong has capacity to add value to global carbon markets because of its ability to facilitate the two-way flow of capital between China and international markets.

Hong Kong’s robust infrastructure, internationally aligned regulatory regimes, globalised ecosystem, transparent markets, deep pools of talent, and unmatched connectivity with China underpin its very special and unique position as a leading international financial centre.

What is an emissions trading system?

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.

How are carbon prices determined in the compliance market?

There are two ways to price carbon: either through an emissions trading scheme (ETS), or through carbon taxes.

Through an ETS, governments establish a market mechanism for emissions allowances, provide a capped amount of emissions allowances and then prices for carbon are determined via supply and demand in the ETS market.

Through carbon taxes, governments sets a taxation level on the use of fossil fuels, determined by their carbon content.

What is a voluntary 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.

What is a carbon credit?
A carbon credit represents the removal or avoidance of a tonne of carbon or greenhouse gas equivalent, as a result of the undertaking of projects.

What is the lifecycle of a voluntary carbon credit?

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.

How are carbon prices in the voluntary market determined?
Prices for carbon credits derived from individual carbon projects vary widely depending on the project’s attributes and co-benefits. Attributes include project type, vintage, geography, and additionality.