Carbon market enables efficient climate protection

Carbon markets enable climate change mitigation to be accomplished as efficiently as possible. This is why the German Federal Government considers market-based instruments to be an important approach in the fight against climate change.

Carbon markets develop when market-based climate instruments take effect and carbon certificates are traded. Two different instruments that lead to the creation of carbon markets can be distinguished: emissions trading systems and crediting systems.

An emissions trading system (cap and trade system) sets an upper limit, or cap, on the volume of greenhouse gas emissions to be regulated within the system. Within the area regulated by the system, only a limited number of allowances (pollution rights) are issued. Allowances are freely tradable units that are allocated to the participants of the emissions trading system. Each participant must present an allowance certificate for each tonne of CO2eq (carbon dioxide equivalent) that they emit. The certificates can be freely traded. This allows participants to buy additional certificates or, if they have successfully implemented sufficient mitigation measures, to sell surplus allowances. Through the trading of allowances, a uniform carbon price develops. This price acts as an important signal. The exact price largely depends on how ambitious the cap in the emissions trading system is and how expensive the mitigation measures are to implement.

A crediting mechanism (baseline and credit system) enables emissions savings to be remunerated. Such a mechanism allows tradeable certificates to be issued for actual emission reductions achieved by a participant. These certificates are only issued when the participant is able to prove that actual emissions have fallen below a previously determined reference value (baseline). A crediting mechanism can either be rooted in individual climate action projects and programmes or be designed for entire sectors and parts of the economy. Participation in a crediting mechanism is voluntary. Demand for the certificates must therefore be created though alternative means. This can, for example, include making the certificates in the crediting mechanism eligible for use within an emissions trading system.

The Paris Agreement marks a milestone in the further development of international, market-based climate change mitigation mechanisms. At the same time, a number of countries have introduced their own climate change mitigation instruments like emissions trading systems or greenhouse gas taxes in recent years. The world's first trading system for greenhouse gas emissions rights, the European Emissions Trading Scheme, has since been joined by numerous others. National emissions trading systems have also been launched in countries such as New Zealand, Switzerland, Kazakhstan, South Korea, Mexico, Montenegro, the United Kingdom and Indonesia. Germany and Austria use national emissions trading systems to regulate fossil fuel pricing in the buildings and traffic sectors. In addition, there are a number of sub-national trading systems in operation, for example in California or Quebec. China’s national emissions trading system, introduced in 2021, is the largest in the world in terms of emissions covered.

In addition to their prevalence, the level of ambition of price-based instruments for climate change mitigation such as emissions trading systems is also an important factor in their success. The percentage of recorded greenhouse gas emissions and the price for emissions certificates in emissions trading systems varies widely and determines the extent to which these are able to play a meaningful role in reaching climate targets.

A price for greenhouse gas emissions

Many countries already use carbon taxes to set a price for greenhouse gas emissions. They have been introduced in a number of EU countries, Switzerland, Ukraine, Japan, South Africa, Singapore, Chile, Mexico, Argentina and Colombia. Since January 2019, all provinces and territories in Canada have been obliged to introduce a greenhouse gas pricing instrument that meets a minimum national standard. The introduction of a carbon tax is currently being discussed in multiple African countries, including Morocco, Côte d’Ivoire, Senegal and Botswana. In recent years, this has enabled an increasing share of global greenhouse gas emissions to be covered by carbon pricing. The World Bank provides an overview of the status of the implementation of price-based climate instruments on its ​website .

The new international climate agreement, which was adopted in Paris at the end of 2015 and has been in effect since 2020, has created a basis for the international exchange of mitigation efforts. Article 6 of the Paris Agreement provides for the establishment of a new international market mechanism as well as possibilities to use bilateral mechanisms. These future mechanisms can build on the experience already gained using the Joint Implementation (JI) mechanism and Clean Development Mechanism (CDM) established under the Kyoto Protocol.

The Federal Government considers a functioning global carbon market to be a central instrument of international climate change mitigation.

The Federal Government has thus worked to anchor such carbon markets in a future climate agreement, with the aim of establishing a stable long-term price for greenhouse gas emissions. These efforts have paid off: Article 6 of the Paris Agreement created the basis for the establishment of new carbon markets after 2020. Article 6 of the Agreement enables the contracting parties to allow for higher ambition in their mitigation and adaptation actions and to promote sustainable development through voluntary cooperation.

After years of negotiation, the Parties agreed on a set of rules for Article 6 at the 2021 Climate Change Conference in Glasgow (COP26). Detailed guidelines are available for the three different cooperation approaches.

In addition to the compliance market, i.e. the market where demand is ultimately driven by the climate targets of the participating countries, a market for the voluntary “compensation” or offsetting of greenhouse gas emissions has developed over the past few years.

Here, buyers do not necessarily have to utilise certificates that comply with the international rules of the United Nations, but can also use private certification mechanisms.
One development that has recently given this “voluntary carbon market” significant impetus is the declaration of climate neutrality targets by companies. As most companies will continue to create emissions for the foreseeable future, procuring CO2 certificates will be necessary – at least in the medium-term – to balance ongoing emissions. This creates significant potential for demand for the voluntary carbon market. However, in the view of the Federal Government, a key basic principle needs to be observed here: avoiding and reducing greenhouse gas emissions should always be given priority over offsetting emissions. Providers of emissions compensation should make this priority clear and first provide information about options for avoiding or reducing emissions before talking about offsetting them.

In addition, offsetting should only take place through projects that meet rigorous quality criteria. For example, it should be ensured that the emissions reductions are able to be verified as on-top. It must also be made certain that emission reductions are not counted twice, i.e. for example, by a company using this reduction to balance its emissions while the host country also counts the same reduction towards its climate targets.

After all, it is essential to counter any risk of deceiving consumers. Many companies describe their products or services as climate neutral or carbon neutral because they have reduced emissions and “compensated” for remaining emissions. To avoid these negative impacts as far as possible, the basic principle of avoiding and reducing before offsetting is essential, as is transparent communication.

Details on the implementation of compensation projects are provided in a ​Federal Environment Agency guidebook (only in german).

Preventing double counting

Under the Paris Agreement, all countries are obligated to set national climate targets and implement measures that help meet these targets. If a contracting country implements a climate project, this then reduces the country’s greenhouse gas emissions and contributes towards meeting its national climate target. If a company were then to use the climate certificates generated in order to help reach its own climate neutrality target, the emissions reduction would be used twice. The issue of double counting therefore arises for the voluntary market, the question being: can the effect of the climate action achieved by the project be claimed by both the country and the company? Or should double counting be prevented through robust rules on offsetting emission reductions?

When it comes to the trading of carbon certificates between different countries, the Paris Agreement explicitly prohibits double counting, and since the 2021 Climate Change Conference in Glasgow, a technical solution has been available in the form of ‘corresponding adjustments’.

In the outcomes of the Climate Change Conference in Sharm el-Sheikh in December 2022, corresponding adjustments have now been designated as “mitigation contribution A6.4ER” (i.e. the emissions reduction contributes to meeting the NDC in the project country and is reported by this country to the UN). In this way, the contracting parties acknowledge that there can be two different types of carbon certificate, which opens up the possibility for the voluntary market to report transparently and truthfully on where the effect of the climate action is located. This sends a signal that double counting is not desirable even when carbon certificates are used by private actors in the voluntary market, but does so without completely excluding the possibility. In contrast, the possibility to use these certificates under the “contribution claim” approach is specifically cited and also underlined by the name given to this mechanism.

The Federal Ministry for Economic Affairs and Climate Action was actively involved in designing the approaches for international cooperation set out in the Paris Agreement and is also driving the dynamic development of price-based instruments worldwide. As part of the latter, the Federal Government has worked with its international partners to launch numerous initiatives in the area of international carbon markets. At the same time, Germany supports research activities and dialogue forums aimed at advancing the development of innovative approaches in all areas of the carbon market.