Desiree Buchholz, Co-Editor at Deutsche Bank’s corporate client publication flow
“The best way to get someone to change their behaviour is by providing an incentive – and saving money has always been a strong driver for both people and businesses”
“Given that a global CO₂ price is nowhere near becoming a reality in the short-term and action on climate change is needed now, voluntary carbon markets will also have a role to play”
Carbon pricing is essential to combat climate change as it incentivises companies to reduce greenhouse gas emissions. flow’s Desirée Buchholz looks at how regulatory initiatives in the EU could impact global investment flows – and the role voluntary carbon markets play in reaching net-zero commitments
With more than 140 countries having set net-zero targets, including the biggest polluters – China, the US, India and the EU – hardly anybody doubts that fighting climate change is necessary. Yet, the most difficult question remains, how do we turn these commitments into action and substantially reduce global greenhouse gas emissions.
The best way to get someone to change their behaviour is by providing an incentive – and saving money has always been a strong driver for both people and businesses. In simple terms, that’s the idea behind carbon pricing: if burning fossil fuels becomes more expensive, you are incentivised to reduce emissions. Moreover, the revenue generated by carbon taxes or certificates can be used to finance the clean energy transition.
This is why more and more countries are relying on such mechanisms to reach their net-zero targets. As of October 2024, the World Bank Carbon Pricing Dashboard counted 110 carbon pricing regimes globally (see Figure 1). These instruments are of different quality and scope, but in general there are three distinctive approaches to carbon pricing (see Figure 2).
Figure 1: Carbon pricing instruments around the world
Source: carbonpricingdashboard.worldbank.org
Figure 2: Approaches to carbon pricing
Source: Deutsche Bank
To begin, let’s look at the state of play of ETS: according to the International Carbon Action Partnership’s (ICAP) Status Report 2024, there are currently 36 such schemes in force globally, which collectively cover 18% of global greenhouse gas (GHG) emissions. An additional 22 such schemes are under development or being considered.
Revamping the EU ETS
The EU ETS – the oldest and largest system in force – is undergoing a massive overhaul as the EU has committed to become carbon neutral by 2050 and reduce net emissions by at least 55% by 2030, compared to 1990 levels. The union is taking three measures:
- Creating a new emissions trading system called ETS2, which will cover CO₂ emissions from fuel combustion in buildings, road transport and small industry sectors and become fully operational in 2027.
- Expanding the scope of the existing ETS to maritime transport.
- Gradually phasing out free allowances for several industrial sectors.
However, as the latter could incentivise firms to relocate parts of their production to countries with less stringent climate policies, the EU has also introduced a new policy tool to avoid this so-called carbon leakage: the Carbon Border Adjustment Mechanism (CBAM), which imposes a levy on imports from countries without equivalent carbon price mechanisms.
Figure 3: Schematic overview of the CBAM
Source: Institut der deutschen Wirtschaft, Deutsche Bank
Since October 2023, companies must report emissions of imported products that fall under the CBAM. These include iron and steel, aluminium, cement, some fertilisers, electricity and hydrogen and are responsible for 27% of total EU GHG emissions. The obligation to purchase CBAM certificates for the emissions embedded in those goods will start in January 2026.
According to Marion Mühlberger and Ursula Walther, Senior Economists at Deutsche Bank Research, the new carbon border tax could lead to “trade diversion away from carbon intensive emerging market (EM) producers,” they write in their report Transitional phase of the carbon border tax has started – all you need to know, published on 30 January 2024. “Big emerging market economies most affected by the new EU import levies are Ukraine (iron and steel), India (iron and steel), Egypt (fertiliser), Russia (electricity), Venezuela (iron and steel), South Africa, Kazakhstan and Turkey.”
Moreover, they believe that CBAM will benefit countries that can use renewable energy more efficiently due to better geographic location, e.g. hydropower in Sweden. This is likely to affect “new investment decisions rather than leading to relocation of existing facilities,” they specify.
While CBAM will impact global trade flows, the mechanism is expected to only have a limited effect on global emission reduction, as CBAM only covers certain products and goods exported to the EU. Global cooperation on carbon prices would be better to accelerate the green transition, Mühlberger and Walther add. But “any progress with respect to a global CO₂ price will only be part of a wider set of trade policy negotiations among the world’s major trading blocs.”
Voluntary carbon markets
Given that a global CO₂ price is nowhere near becoming a reality in the short-term and action on climate change is needed now, voluntary carbon markets will also have a role to play. As a reminder, these markets allow companies to offset their emissions by purchasing carbon credits from projects that remove or reduce greenhouse gas from the atmosphere. Morgan Stanley Research expects the carbon-offset market to grow from US$2bn in 2020 to around US$250bn by 2050.
Yet, the market has come under severe pressure over the course of 2023 and 2024 as several large companies such as Shell, Nestlé and EasyJet have retreated from carbon offset schemes and prices for carbon credits collapsed. Their withdrawal stems partly from growing scepticism about the effectiveness of these projects, as well as a shift in strategy towards more direct measures to reduce emissions. As these markets are managed by private organisations without regulatory oversight, there are concerns around the actual climate benefits of projects qualified for offsetting.
This is worrying as the purchase of carbon credits is no longer entirely voluntary. Airlines, for example, will soon be subject to carbon offsetting obligations. From 2027 on, all international flights will need to be offset as per the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA). In the EU, this requirement will go beyond the airlines’ CO₂ allowances under the EU ETS.
To address the erosion in confidence in offsetting regimes, the Integrity Council on Voluntary Carbon Markets (ICVCM) – an independent governance body – launched 10 “Core Carbon Principles” (CCPs) in March 2023, defining high-quality credits with a focus on governance, emissions impact and sustainable development. “Voluntary carbon markets are still a nascent field that requires scale, but scale will require integrity,” says Lavinia Bauerochse, Global Head of ESG, Deutsche Bank Corporate Bank.
In May 2024, the world’s largest carbon-crediting programme, Verified Carbon Standard (VCS, operated by Verra), met the CCP criteria. Now, five programmes, which have a 98% share of the voluntary carbon market, have made changes to the way they operate to comply with CCP.
Despite these efforts to make the market more transparent, comparable and credible, carbon offsetting remains controversial. This is illustrated by a dispute in April 2024 when the Board of Trustees of the Science-Based Targets initiative (SBTi) said it would evaluate whether carbon credits can be counted toward companies’ scope 3 reduction targets, which cover up- and downstream emissions. Given that more than 5,000 businesses globally have set emissions reduction targets based on SBTi guidance, the organisation’s judgement is highly relevant for corporate net-zero journeys.
Following outrage amongst its own staff, in July 2024, the SBTi clearly stated that carbon credits “cannot be used as a substitute for the direct decarbonisation of the value chain”. However, it does acknowledge that carbon credits might be used to cover emissions that “go above and beyond the existing requirement” to incentivise additional finance for climate action.
This article is an extract from the flow article “The price of CO₂” published on 25 July 2024: https://flow.db.com/more/esg/the-price-of-co2#3
