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Lindsey Hall: Hi. I'm Lindsey Hall, Head of Thought Leadership at S&P Global Sustainable1.

Esther Whieldon: And I'm Esther Whieldon, a Senior Writer on the Sustainable1 Thought Leadership team.

Lindsey Hall: Welcome to ESG Insider, an S&P Global podcast, where Esther and I take you inside the environmental, social and governance issues that are shaping the rapidly evolving sustainability landscape.

Esther Whieldon: On this podcast, we often hear how achieving the low carbon transition on a global scale will require all tools currently available. Carbon markets are one of those tools that both companies and governments can use.

Lindsey Hall: Okay. Esther, I'm going to level with you here. There are just some things in life that I struggle to get my head around. The rules of American Football is one; what counts as Mid-Century Modern is another; Pokemon, like anything related to Pokemon. And if I'm honest, the carbon market's concept is always a little fuzzy to me.

Esther Whieldon: Well, I can't help you with Pokemon, and I probably know less than you about sports and design history, but I'm hoping that by the end of our 2-part mini-series, you'll have a much clearer sense of the topic of carbon markets, including what they are, how they're used by companies and governments and also how the regulatory environment for these markets is evolving.

We'll also explore some of the challenges and opportunities ahead for carbon markets. To understand these dynamics, I spoke with our colleague, Roman Kramarchuk. Roman is Head of Climate Policy and Market Analytics at S&P Global Commodity Insights. Roman starts off by describing his role and defining the difference between the 2 types of carbon markets that currently exist, which are voluntary and compliance markets. Okay, here's Roman.

Roman Kramarchuk: I had a climate policy and market analytics within Commodity Insights. What that means is really understanding a lot of the dynamics around, first of all, the policymaking that's looking to drive decarbonization on a local, regional, national and global scale.

And in terms of looking at the climate markets associated with that, what we do is we look at and analyze how those are implemented by governments again at a regional, local, national and global scale. And how that translates into efforts to try to set a price on carbon through market-based mechanisms. Think of it as an opportunity to provide a price signal to drive decarbonization within the construct of a market.

Esther Whieldon: And I definitely want to come back to that topic of a price signal. For someone who's just getting to know this topic, what are carbon markets? How are they structured? Where do they exist?

Roman Kramarchuk: If you think of how environmental policy had often been done in the past, it was very much a command and control approach. It is putting limits on activities, mandating particular technologies being very prescriptive. And the thinking behind the push towards markets is to let the corporate entities figure out the best way to get the reductions, given the high level target. And then don't prescribe how that's supposed to be done but rather give them the opportunity to pick and choose how to get those reductions and respond to a price signal that tells them how much a ton of CO2 emitted or a ton of greenhouse gas emitted is worth.

As a system then what the market would drive is towards emissions reductions in a least costs -- in a cost-effective manner. For CO2, markets are particularly effective because from an atmospheric perspective, it doesn't matter whether a ton of CO2 is released in one location or another. What's important is the atmospheric concentration of CO2 overall. So it's really amenable -- CO2 is amenable to a market-based system.

And then where we saw some of the biggest steps towards these markets take place is, we saw Europe, which is often an environmental policy and market leader, implement the EU Emissions Trading System for all of its entities essentially for every stationary large emitter, installations of greater than a certain size and create immediately, we saw a price of carbon being imposed on those sectors and those sectors needing to and actually reducing emissions to hit those targets.

Since then, we've seen those markets spread. And we've seen regions ranging from Northeastern United States to California, to parts of Canada, to Korea, to Australia, to New Zealand and more recently to China and other markets and that list is going to continue to grow. So this has been a major element of country and company plans for decarbonization.

Esther Whieldon: And then so what's the difference between a voluntary and a compliance market?

Roman Kramarchuk: No it's an important distinction to make. The markets that I mentioned earlier, the kind of the one where the EU basically imposed a requirement of regulation on entities. When you have a government imposing a requirement on an entity, that will, by definition, be a compliance market. Those regulations come about through laws and then they were fleshed out through regulations, and that creates the structure of the market that defines how a ton of CO2 is defined, who exactly is covered, where the entities essentially account for their allowances. Allowances can be -- or credits can be the currency through which these markets trade. That's how a ton of CO2 trades. So those are kind of the definitions. And the state, whatever the government entity is or the ones that define the rules of those markets. 

That's different from voluntary markets because voluntary markets are cases where, let's say, a corporation has decided that they want to hit a net-zero target or they want to show progress in terms of emissions or they even want to find a way to set an internal price for their company in terms of internal CO2 price to create the right incentives.

These companies are doing that for a number of reasons. One of the reasons can be really because they believe that they need to be getting down and reaching targets alongside of what the overall global Paris Agreement targets are. Another part of it is really that the companies feel that they are part of a broader community, and they want to represent in front of their customers, in front of their counterparts, in front of their stakeholders or even in front of their investors that they are actively taking steps towards mitigating what is a global problem.

A part of this will also be these companies acting ahead of the curve with the belief that at some point or other compliance markets or compliance regulations will happen. And so part of any sort of voluntary initiative can also be a bit of hedging against what may be a future compliance initiative. To that end, it's also been a much smaller market. The compliance markets are much, much larger right now and the voluntary markets had been growing, but there's still a fraction of the size of the compliance markets.

Esther Whieldon: When you say the compliance markets are much larger, what's the size difference?

Roman Kramarchuk: Yes. I mean there's different ways to measure the size of the markets. But if we say like a voluntary market is in the very low single-digit billions in terms of value, the compliance markets, if you take them all together, end up being closer to, let's say, $1 trillion.

Esther Whieldon: Okay. Yes. That's a pretty big difference. What are the main challenges that's keeping -- you said there was some growth for a time in the voluntary markets, but then that's kind of slowed down. What's been the cause of that?

Roman Kramarchuk: I mean there have been a few causes. If you look at the beginning of the 2020s, so if you look at 2020, 2021, the voluntary markets were really on a major upswing. And it was driven by the fact that an increase in number of companies were taking on long-term carbon goals. They were engaged through efforts like the Taskforce for Climate-related Financial Disclosures. They were making public commitments and they needed to follow through on those commitments, and they saw the voluntary carbon market as part of the strategy for meeting those commitments.

So very strong growth in 2020, 2021. The first thing that kind of slowed things down was Russia's invasion of Ukraine and everything that was appended in the energy markets after that happened, particularly in Europe, but with global repercussions. And then what honestly happened is that the voluntary markets started to recover from that, but then they were hit with the crisis of confidence. 

And if you think about what a voluntary market is, it's and why companies are doing it, they're doing it to demonstrate that they are taking action that has positive consequences. They're doing this to be able to account for something that they're doing that's positive. Essentially, starting in January 2023, there was a lot more scrutiny given to particular elements of the voluntary carbon market and some of the bigger sources of scrutiny were around avoided deforestation credits. And that level -- that shook the market. And then it made people wonder, okay, is this something that we want to engage in if what we're buying is not something that can be verified and guaranteed to actually be a, let's say, a ton of emission.

So if a company wants to use a -- buy an offset or buy a credit to offset a ton of emissions, they need to be absolutely certain that they're actually buying a ton of reductions. And that's where the whole idea of quality of carbon credits really has taken off because there is a sense that not all carbon credits are created equal. And some of them, because of the methodologies and because of the owners and because of the locations and the project types are seen as being much more certain in terms of getting their emissions reductions.

The other part of that is also, as with many things, lawsuits played a role. So there are companies that -- and I'll use the example of Delta Airlines that had been a major purchaser of carbon credits and was then sued by entities that were questioning the claims that Delta was making by purchasing those credits. So certainly, there is a degree of caution in these markets.

Now there's a recognition that there are some problematic credits. There have been efforts to try to bolster that market with both internal and external sort of tools to try to get -- offer a sense of certainty in a sense of quality. But the market is still dealing with that to a degree. If you look at the trade press, if you look at even the general press with the Guardian articles have been common, you've seen other articles that have questioned, not just forestry, but also question the veracity of credits coming from even, let's say, cookstove projects and other project types.

There is that public perception that there have been improvements to methodologies. There's been pushback on some of the criticism. There have been cases where some of the criticisms have been rather unjustified. But overall, if you look at what drives the market for voluntary carbon, it will be driven by public perception of the value and the quality of those credits.

Esther Whieldon: So you've touched on this, but I'd love to hear from you. On a high level, why are carbon markets important when it comes to sustainability and the low carbon transition?

Roman Kramarchuk: There have been a lot of studies on carbon markets as a tool for sustainability, for decarbonization. The thing to remember is that they're a tool. They are one of many possible tools. The elements that they really have going for them are the fact that they leave the decision-making in the hands of the actors and parties that are taking the steps to make their own decisions and be creative and think about how they want to achieve the targets that they set.

The old kind of regulatory tendency was to tell people what to do, tell people specifically what to do. And that comes with cost because if you tell somebody to install this a particular technology that this is what you need to do, it could be that there is a change in process or there is a change in fuel or there's a change in approach that the company can take and it can hit the same targets, but it's actually much, much lower cost.

And in some ways, it also promotes over compliance. If you think about -- and I'll use an example of a cap and trade market, if you have a company that perhaps gets some level of free allocations and it could pollute up to that level of allocations. But if it's creative, if it can get even more reductions, then those are allowances that it can sell to someone else. Having a constant price on something, if you think about just how you respond to prices for anything in daily life, if something is a high price, you'll think about whether you really need it. And if you do need it, you'll think about maybe what are some of the substitutes or what are other things you can use or what are other ways you can do to avoid something that's particularly high price.

To that end, can you decarbonize or can you achieve sustainability without carbon markets and without carbon prices? Certainly, you can. But can you potentially do it in a much more cost-effective manner in a way that doesn't require sort of very command and control and prescriptive regulations? That's where carbon markets can really play a better role because it leaves the decision-making in people who are with the entities that are in the position to be innovative and creative and get these reductions in a way that works for them.

Esther Whieldon: So briefly, how does a cap and trade program work?

Roman Kramarchuk: Sure. I mean it is very much kind of the way it sounds. You have a cap, and the cap represents the total amount of emissions that are allowed to be emitted each year. And the trade part comes from there are allowances that represent a ton of CO2 of emissions that are allowed under the cap. Those allowances, they could be sold off of auction. So there are markets that every week or every few weeks or every quarter have an auction of the allowances. And over the various auctions, if you add up all the allowances sold at auctions that equals the cap and covered entities then get to bid, how much they want to buy from that cap.

There's also -- historically, some of these allocations have been given out for free. I think there are entities that are covered and are exposed to, let's say, trade pressures are particularly challenging to get reductions from, they may get allowances for free. And between the free allowances and the auction allowances, those are the ones that everyone ends up needing to buy or acquire.

And for example, if you are a power generator and it's a particularly hot summer and you have to run your fossil fuel plants a lot harder to meet the demand. you're going to have to probably go out and purchase additional allowances from the market. You need to go a bit more at auction. And if everyone is in the same situation, if everyone is facing a tough summer, then those prices are going to be bid up quite a bit higher because everyone is going to have that higher cost of compliance on their abatement curve to get those reductions.

There's nuances. There are some cap and trade markets that have price caps that if you hit to a certain price cap, some extra allowances can be released into a market. Or if prices go too low, then auction allowances will be pulled from the market. So sometimes these markets and particularly sometimes these markets end up being a little bit more like a central bank, where they kind of try to control and hit a target range. They become a little bit less of a market and they become more a market within certain balance.

But as I mentioned previously, given the political pressures these markets face, there's also a desire not to have prices go too high or too low or be so volatile that they start impacting the daily well-being of the end users and the voters.

Esther Whieldon: So you've mentioned price signals. What is the pricing situation right now for the carbon markets in general?

Roman Kramarchuk: Yes. And that's the thing to call it is carbon markets because we have wide ranges on the voluntary side, and we have wide ranges on the compliance side. On the compliance side, the EU ETS has always been seen as the -- not always, but at least over the past 5 years has been seen as a very much a premium market where tough targets that the EU has set have led to very high allowance prices and allowance prices that have gone up to the triple digits, now that they're somewhat below right now. But that's in contrast to, let's say, the Korean market and the Chinese markets, which are considerably lower.

And then you have markets like the RGGI market in the Northeast that has gone from $5 a few years ago to well over $20 nowadays or the California, Quebec WCI market, which is over $30 as well. So you have a wide range of market prices. On the voluntary side, I think there's both the supply and demand side of things. What we have found is that the credits from the project types that people have started questioning that the press has started questioning, they've certainly seen prices go down. They've seen demand impacted and they've seen the willingness to pay for those types of projects go down even more so in the compliance markets.

Volunteer markets where some of the prices are very low, and then you have prices for things like technology-based carbon capture, carbon removals, which are actually not just avoiding carbon but taking carbon out of the air and sequestering it in some form, be it nature-based or technology-based. Those types of credits are specifically asked for because they are seen as more credible. They are seen as more permanent and you see some key industry players that are willing to pay over $100 our own Platts price for technology-based removals is well over $100.

And we're hearing from the market cases of these types of credit trading in the hundreds of dollars. Very wide range, and it reflects both the costs of getting these reductions, but also request people's willingness to pay for something that they perceive to be higher quality with greater permanence, with greater certainty and part of their goal. The interesting thing about the removals is for companies that -- and I'll use the example of Microsoft that don't just want to go to net-zero, but want to go to net negative. You actually have to be able to demonstrate that you're taking the CO2 or the greenhouse gases out of the air, not just avoiding them.

Esther Whieldon: I see. So like Director Capture can provide that kind of...

Roman Kramarchuk: Yes. Director Capture would be a classic case of a very verifiable and presumably permanent, but also a removal that we've seen companies have a much greater willingness to pay for.

Esther Whieldon: Roman mentioned some of the different carbon markets that exist in North America today, including the California, Quebec, Western Climate Initiative market as well as RGGI. I ask Roman to explain a little bit more about what RGGI is and how it works. Here he is.

Roman Kramarchuk: Yes. The Regional Greenhouse Gas Initiative, it's a collection of states in the Northeast and the Northeastern United States that kind of agreed together to set a target and allow for trading to happen across the whole region. The thing to remember where trading is effective and how trading works, if everybody has the exact same compliance costs, then there really isn't a huge point to trading.

Because if your neighbor can get the reductions for the same amount that I can get the reductions for, then there's no real benefits. But if it can happen where, for example, if there's opportunities to turn off a coal plant in Maryland and dispatch natural gas plant instead and those reductions can be sold to somebody who's having a very tough time hitting their targets in Maine, and that's a way that, as an aggregate, the entire region then gets the reductions they need, and it's done in a way that is cheaper than if you had each individual having to hit the same exact target.

So RGGI is interesting in another way because it also highlights the political challenges of carbon markets because ultimately, what -- by placing a price on carbon, what you're doing is you're increasing the costs of the underlying fossil fuels. And in the case of RGGI, it's increasing the cost of wholesale power because you're adding that CO2 cost to either natural gas or coal-fired power plants that are on the margin setting the power price.

So certainly, it adds power -- it adds cost to power, which ends up impacting consumers. And that's where the states and who leads the states and how they want to go about addressing climate is critical because what we found is that we've had a core -- the core states in the Northeast have been part of this program for well over a decade, actually, since before 2010 actually. But in some cases where you had elections and you have, let's say, a Republican governor in New Jersey, had pulled the state out of the RGGI program.

We've seen that happen with Virginia where a Democratic governor brought the state into the carbon program, into the carbon market. And then a Republican governor was elected and pulled the state out of the carbon market. So it kind of highlights one key challenge around these markets is that they do face political uncertainty. Remember, as a publicly created in a government-sanctioned market, it's -- the faith has to be that this market will be around. And if you have political uncertainties, then you have entities, let's say, in the case of New Jersey, a while ago in the case of Virginia now in the case of Pennsylvania, which is a neighboring state as well that was going to join. The question is, how can you actually make investments in reductions if you don't know if you're going to be facing this carbon price or not from a mandatory perspective. And to be honest, that's a situation where entities may choose to voluntarily get their reductions because they'd rather not deal with that uncertainty of every election changing the rules of the game.

Esther Whieldon: As Roman noted, one of the challenges with the compliance markets is that they can be subject to change with local politics. Given this risk, I wanted to know how does he expect the carbon markets to evolve going forward? You'll hear him mention Article 6 of the Paris Agreement, which involves international cooperation towards decarbonization goals through carbon markets.

If you want to know more about Article 6, we'll include a link to a previous episode we did on that topic in our show notes. But what you need to know for this episode is that while governments have reached a number of agreements on the rules for Article 6, additional negotiations are expected in the upcoming UN Climate Conference of the parties known as COP 29. That gathering is slated to happen in November.

Okay. Here's Roman on how he expects carbon markets to evolve.

Roman Kramarchuk: Yes. I think when we do our long-term scenarios around energy sector and climate developments, we have a scenario called inflections, which is our reference case. We have a discord scenario, which implies what it sounds like, and we have a green rule scenario, which is much more aggressive in terms of its CO2, in terms of its concerted actions around CO2. And carbon markets are really -- I wouldn't say that they're negatively impacted by any of these scenarios. I think even in what we're seeing with these markets is there going forward. I mean we look at some of the fastest-growing largest economies of the world.

I mentioned that China already has set up a carbon market. In terms of emissions covered, it's the largest carbon market in the world. We look at Indonesia has started up their carbon program covering coal-fired power plants. We have India, and we just -- we're publishing the latest developments in terms of the -- how the Indian market is being currently structured. We have the Brazilians also committing to setting up a carbon market. Our neighbor -- the U.S. neighbor Mexico is also -- has had a pilot program and they're looking to move towards a larger and more comprehensive program.

So in a world where you think about how much of the economic activity and also how much of the emissions are taking place in less developed countries or developing countries, some of the biggest ones are really taking on these markets, where there's questions on how it develops is really how fungible will these markets be. And this is where some of the discussions around Article 6 come into play. Because Article 6 was intended as the way for countries to be trading CO2 carbon credits and carbon reductions across borders.

The sense is that, yes, every country can set their own NDC targets to meet their Paris Agreement goals. If there is a sense that you can get for those reductions for more cheaply from projects that are perhaps lower cost. And this can be a form of carbon finance, where you can have either companies or countries financing the development of carbon reduction efforts in other countries and often in the developing world that this is a wave to pay for some of the needed reductions where that finance would otherwise not flow.

So to that sense, when we look at our scenarios, the uncertainties are not really whether the carbon markets will continue to develop and continue to grow because we do expect that to happen in the core 3 scenarios in many countries. The question is how aggressive they'll be, whether they'll be able to talk to each other and whether we'll have this sort of international system for climate finance where the carbon markets will be that mechanism through which the reductions are actually paid for.

The differential will be the level of carbon prices. You mentioned that the carbon prices are often not seen as high enough to get the reductions. Certainly, some of the carbon prices in the lower-value carbon markets around the world are not enough to drive to a 1.5-degree goal, and that's what we're seeing. Our reference case doesn't get us anywhere close to a 1.5-degree goal.

So in order to get to a 1.5-degree goal, you have -- the efforts have to be more aggressive. And then the question becomes how to pay for that. And this is where the international carbon trading side of things can be a form of carbon finance to drive some of those reductions in the developing world.

Esther Whieldon: Great. Well, I think we've covered a ton in today's discussion. Is there anything we didn't get to that you wanted to mention?

Roman Kramarchuk: No. I mean there's always a hundred other things that we can talk about. It's...

Esther Whieldon: Yes.

Roman Kramarchuk: There is -- yes, like I said, I mean, these markets they change on a daily basis because this is a market. There's a different price every day, and there's reasons for prices to go up and there's reasons for prices to go down. There are countries and regions that are setting up their markets for the very first time. There's even markets such as clean fuel standards, which I haven't mentioned, low carbon fuel standards in Canada, low carbon fuel standards in California.

These are all markets that are being expanded. They're being developed, which is why this is so challenging to talk about because back in 2005, the EU ETS would have been the carbon market to talk about. And at this point, we've got 1/4 of the world's emissions now covered by some form of carbon price, and that number is only going to go up.

Esther Whieldon: So today, we heard how carbon markets can play a role in helping find a cost-effective path to decarbonization, for both countries and companies, and can help drive decarbonization in emerging markets.

All right. So Lindsey, at the start of this episode, you said this is kind of a confusing topic for you. How are you feeling after hearing Roman's explanation?

Lindsey Hall: As is usually the case when I talk to Roman, I'm feeling much better informed about the topic of carbon markets. And the difference between compliance and voluntary markets, in particular. How these are a tool for reaching sustainability and decarbonization goals.

Esther Whieldon: Well, we have so much more to cover on this topic. Next Friday, we'll be back with Part 2 of our mini-series, where we'll take a deep dive into the evolving world of voluntary carbon markets. So please stay tuned.

Lindsey Hall: Thanks so much for listening to this episode of ESG Insider. If you like what you heard today, please subscribe, share and leave us a review wherever you get your podcast.

Esther Whieldon: And a special thanks to our agency partner, The 199. See you next time.

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