What are carbon markets and how do they work?

12 July, 2023Joshua Downes

Carbon pricing is intended to reduce greenhouse gas emissions by placing a financial cost on the carbon content of fossil fuels or the emissions themselves. Carbon markets allow businesses and organisations to offset their emissions by buying additional ‘credits’. But how effective have these mechanisms been at reducing global greenhouse gas emissions?

LIBF has produced a whitepaper looking at how carbon markets work and what changesoil market need to be made if they are to be truly effective in meeting the objectives of the Paris Agreement.

What is carbon pricing?

When a company, organisation or commercial entity produces carbon emissions, there is a negative knock-on effect for wider society in the form of increased pollution and climate change. To mitigate this, there are several carbon pricing mechanisms, aimed at reducing greenhouse gas emissions or at least offsetting their effects.

How does carbon pricing work?

There are three main ways for carbon emissions to be priced according to their social impacts.

  • Direct tax. This could be in the form of a sales tax or a fixed duty per unit. While it’s possible to include various emissions in the tax rates, the broader the scope, the more complex it becomes to calculate the appropriate tax.
  • ‘Cap and trade’ emissions quota systems. Emissions trading systems (ETS) involve creating licenses to pollute based on an emissions budget, which can be allocated, sold, or auctioned to companies, enabling trading of unused allowances.
  • Carbon off-sets. A polluter can off-set their emissions by contributing to carbon-reducing investments or other green projects (eg, rainforest preservation).

How effective are carbon markets at reducing greenhouse gas emissions?

Whilst carbon markets have made some impact on reducing carbon emissions, they currently cover less than 25% of global carbon emissions – not enough for the objectives of the Paris Agreement of limiting global warming to less than +1.5°C to be realised.

In addition, without a global price floor for carbon emissions, prices for permits have remained lower than they need to be to incentivize de-carbonisation to the degree required and overall greenhouse gas emissions have continued to rise.

As our whitepaper discusses, there are several obstacles that are limiting the efficacy of carbon markets. These include regulatory inconsistencies, a lack of clear, standardised metrics and price volatility within the markets themselves.

Carbon markets have the potential to help companies drive towards net zero, increase the rewards of emission reduction and enable firms to offset irreducible emissions. However, the issues outlined above will need to be solved if they are to be truly effective in helping meet global warming targets. 

Related content

Read the LIBF whitepaper on carbon markets