Today’s voluntary carbon markets: More growth, more diversity
No shortage of demand:
Since the first carbon credit was traded under the Kyoto protocol in 1997, the world’s carbon markets have grown at a blistering pace to now span 98 countries. Over only 25 years, the voluntary carbon markets have evolved to be worth USD1.9 billion in turnover in 2022, generating 254 tonnes of carbon reduction last year. (Source: Ecosystem marketplace, November 2023)
The growth of the world’s voluntary carbon markets looks set to continue – driven by much more than the foundation layer of continuing net-zero commitments from corporates of all sizes globally. Today a host of demand factors are at play in the voluntary carbon markets, from the imminent implementation of mandatory reporting under the CORSIA programme (in 2027) to the growing convergence of compliance and voluntary markets under Article 6 and the growing needs for carbon removal in financial institutions’ portfolios and lending books.
Together, these key demand drivers are clearly drawing new people into the world’s voluntary carbon markets in ever-greater volumes, with only 14% of our survey respondents still not planning to enter the market at some stage. On the demand side, 62% of the corporates in our survey plan to enter the voluntary markets in the next three or more years, as do 36% of financial investors (including pension funds, mutual fund managers and wealth managers) – driving a major increase in liquidity and funding to project owners. In parallel, 38% of commercial banks are soon to enter the market, as are 31% of broker-dealers – each providing valuable infrastructure and lending to fuel further market liquidity.
What is still a nascent ecosystem looks set to expand significantly in the coming three to five years – meaning that the market needs to be ready to scale to accommodate more trading, across more products, across more markets than ever before.
Different investment objectives are driving different needs
Yet not everyone is active in the carbon markets for the same reason. As in all financial markets, different players are active with different objectives, meaning that the voluntary carbon markets are evolving to serve a growing diversity of needs.
50% of commercial banks, for example, face the pressing need of decarbonising their existing loans and investment portfolios in order to maintain a ‘balanced book’. Where they have lent to and financed carbon-producing projects in the past, they face an ongoing risk and capital exposure that needs to be offset through greater lending to carbon removal projects. But this can not be done in isolation, as all financing needs to fit into banks’ overall liquidity and maturity spectrum. For this reason, commercial banks are looking for a growing diversity of project tenors that can fit with their short term and long term investment needs.
67% of corporates, on the other hand, are driven primarily by the need to satisfy their shareholders. Under significant pressure to evidence ESG credentials, this is a clear indication that even firms who have not yet made net-zero commitments are under pressure to engage in the voluntary carbon markets as a first step in their investor relations strategy. In this context, corporates are looking for a wide range of contracts that generate the highest possible levels of social impact – prioritising factors such as permanence and additionality (i.e. additional co-benefits of carbon removal projects on the community or on biodiversity, for example) in order to maximise shareholder appeal.
The growing volume of financial investors see the voluntary markets primarily as a new source of investment returns. Whilst there are clear moves towards the use of voluntary credits to decarbonise existing investment portfolios (as we saw for corporates), 45% of pension and fund managers are looking to the carbon markets purely as a portfolio investment, where margin can be made and portfolio performance driven. In addition, 22% of investors are using voluntary carbon credits to offset existing tax obligations – essentially using these credits to drive net performance across the wider investment portfolio.
Whilst there is clearly a green angle to this approach (“we would rather make our returns from green investments than from brown ones”), this pure performance lens puts a sharp focus on project profitability - meaning that investor liquidity will inevitably be driven towards high-margin, high-return projects (potentially at the expense of additionality or permanence).
Are we ready for more diversity?
An increasingly populous marketplace looks set to drive demand not only for voluntary carbon credits overall but, importantly, for an increasingly diverse range of credits. Far from trending towards homogeneity, the direction of different types of liquidity to credits that serve different ends looks set to make the world’s carbon markets more complex. This growing complexity will, in turn, mean greater demands for differentiation in products, in the same way that we have seen risk and yield curves emerge in the fixed income and derivatives spaces.
The pressing question is whether today’s voluntary carbon market are able to cater for these pressures towards complexity and sophistication. Can the market meet these demands in its current form?
