A plan to scale voluntary carbon markets to address the climate challenge (2023)

More and more companiesthey promise to stop climate change by reducing their own greenhouse gas emissions as much as possible. However, many companies are realizing that they cannot completely eliminate their emissions or even reduce them as quickly as they would like. The challenge is particularly difficult for organizations seeking net zero emissions, which means removing the same amount of greenhouse gases from the air. For many it will be necessary to use carbon credits to offset emissions that they cannot otherwise get rid of. The Task Force on Expanding Voluntary Carbon Markets (TSVCM), sponsored by the Institute of International Finance (IIF) with technical support from McKinsey, estimates that demand for carbon credits could increase by a factor of 15 or more by 2030 and by a factor from 2030 onward to 100 by 2050. In total, the market for carbon credits could be worth more than $50 billion by 2030.

The market for voluntary carbon credits (rather than for compliance purposes) is important for other reasons as well. Voluntary CO2 credits direct private funding towards climate protection projects that would otherwise not take place. These projects can bring additional benefits such as the protection of biodiversity, the prevention of pollution, the improvement of public health and the creation of jobs. Carbon credits also support investment in innovation needed to reduce the costs of emerging climate technologies. And expanded voluntary carbon markets would make it easier to move capital to the Global South, where there is greater potential for profitable nature-based emissions reduction projects.1

Given the demand for carbon credits that may result from global efforts to reduce greenhouse gas emissions, it is clear that the world needs a voluntary carbon market that is large, transparent, auditable, and environmentally sound. However, today's market is fragmented and complex. Some credits turned out to be questionable emissions reductions at best. Limited price data makes it difficult for buyers to know if they are paying a fair price and for suppliers to manage the risk they take by financing and working on carbon reduction projects without knowing how much buyers will pay for CO2 certificates. In this article, based on McKinsey's research ona new report from the TSVCMWe discuss these issues and how market participants, standard setters, financial institutions, market infrastructure providers, and other stakeholders can address them to expand the voluntary carbon market.

Carbon credits can help companies achieve their climate protection goals

As part of the 2015 Paris Agreement, nearly 200 countries have joined the global goal of limiting average temperature increases to 2.0 degrees Celsius above pre-industrial levels, and ideally 1.5 degrees.Reaching the 1.5 degree targetwould require global greenhouse gas emissions to be reduced by 50% from current levels by 2030 and to net zero by 2050. More and more companies are joining this agenda: in less than a year, the number of companies with net liabilities has doubled from zero 500 in 2019 to more than 1,000 in 2020.2

To achieve the global goal of net zero emissions, companies must reduce their own emissions as much as possible (while alsoMeasure and report your progressto achieve the transparency and accountability that investors and other stakeholders increasingly desire). However, for some companies it is prohibitively expensive to reduce emissions with current technologies, even though the costs of these technologies may decrease over time. And in some companies, certain sources of emissions cannot be eliminated. For example, the manufacture of cement on an industrial scale often involves a chemical reaction, calcination, which accounts for much of the manufacturing.CO2 emissions from the cement sector. Due to these limitations, the emissions reduction path towards a 1.5 degree warming target effectively requires “negative emissions” achieved through the removal of greenhouse gases from the atmosphere (Figure 1).

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Buying carbon credits is one way for a company to deal with emissions that it cannot eliminate. Carbon credits are allowances that represent amounts of greenhouse gases that have been locked or removed from the air. Although CO2 certificates have been used for decades,the voluntary market for emission rightshas grown significantly in recent years. McKinsey estimates that by 2020 buyers will receive approximately 95 million tons of carbon dioxide equivalent (MtCO₂e), which would be more than double that in 2017.

With increasing efforts to decarbonise the global economy, the demand for voluntary CO2 certificates could continue to rise. Based on stated demand for carbon allowances, demand projections from experts interviewed by TSVCM, and the volume of negative emissions required to reduce emissions in line with the 1.5 degree warming target, McKinsey estimates that the annual global footprint per CO2 allowance can reach up to 1.5 degrees 1.5 to 2.0 gigatonnes of carbon dioxide (GtCO₂) by 2030 and up to 7 to 13 GtCO₂by 2050 (Annex 2). Depending on different pricing scenarios and their underlying drivers, the size of the market in 2030 could range from $5 billion to $30 billion on the low end and over $50 billion on the high end.3

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While the demand for carbon credits has increased significantly, McKinsey's analysis shows that demand could be met by 2030.potentialannual offer of carbon credits: 8 to 12 GtCO₂by year. These carbon credits would come from four categories: avoided natural loss (including deforestation); nature-based sequestration, such as reforestation; avoid or reduce emissions such as methane from landfills; and technology-based removal of carbon dioxide from the atmosphere.

However, several factors may make it difficult to mobilize and launch the full potential offer. The development of the project would have to be accelerated at an unprecedented rate. Most of the potential supply of avoided natural losses and nature-based sequestration is concentrated in a small number of countries. All projects involve risk and many species may find it difficult to attract funds due to the long time that elapses between the initial investment and the eventual sale of the credit. Once these challenges are taken into account, the estimated supply of carbon credits is reduced to 1 to 5 GtCO₂per year until 2030 (Annex 3).

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These are not the only issues facing buyers and sellers of carbon credits. High-quality carbon credits are rare because accounting and verification methods vary, and because the co-benefits of credits (such as community economic development and biodiversity protection) are rarely well defined. Providers face long lead times when verifying the quality of new loans, an important step in maintaining market integrity. When selling these credits, providers face unpredictable demand and are rarely able to achieve affordable prices. In general, the market is characterized by low liquidity, scant funding, inadequate risk management services and limited data availability.

These challenges are daunting, but not insurmountable. Verification methods could be strengthened and verification processes simplified. Clearer demand signals would help give providers more confidence in their project plans and encourage investors and lenders to finance. And all of these requirements could be met through the careful development of a large-scale and effective voluntary carbon market.

The expansion of voluntary CO2 markets requires a new action plan

Building an effective voluntary carbon market requires a concerted effort on multiple fronts. In its report, the TSVCM identified six areas spanning the carbon credits value chain where action can support the expansion of the voluntary carbon market.

Creation of common principles for the definition and verification of emission certificates

The current voluntary carbon market lacks the liquidity necessary for efficient trading, partly because carbon credits are very heterogeneous. Each loan has attributes related to the underlying project, such as: B. the type of project or the region in which it was carried out. These attributes affect the price of credit because buyers value the additional attributes differently. In general, the inconsistency between loans means that matching a single buyer with a matching supplier is a time-consuming and inefficient over-the-counter process.

Connecting buyers and providers would be more efficient if all loans could be described using common characteristics. The first group of features has to do with quality. The quality criteria defined in the “Carbon Foundations” would provide a basis for verifying that carbon credits represent real emission reductions. The second set of attributes would cover the additional attributes of the carbon credit. Standardizing these attributes into a common taxonomy would help sellers market loans and help buyers find loans that fit their needs.

Development of contracts with standardized terms

In the voluntary carbon market, the heterogeneity of allowances means that certain types of allowances are traded in amounts that are too small to generate reliable daily price signals. A more uniform design of allowances would consolidate trading around some types of allowances and would also promote liquidity on exchanges.

Once the basic carbon principles and standard attributes outlined above are in place, exchanges could create "reference contracts" for carbon trading. Reference contracts would combine a core contract based on basic carbon principles with additional attributes defined according to a standard taxonomy and priced separately. Basic contracts would make it easier for companies to buy, for example, large amounts of allowances at once: they could bid for allowances that meet certain criteria, and the market would pool smaller amounts of allowances to match their bids. .

Another advantage of reference contracts would be the development of a clear daily market price. Even after the development of the reference contracts, many parties will continue to operate in the over-the-counter (OTC) market. Credit prices traded through reference contracts could provide a starting point for OTC trading, with other attributes listed separately.

Development of a trading and post-trading infrastructure

A resilient and flexible infrastructure would allow the voluntary carbon market to function effectively: allow large volume listing and trading of reference contracts and contracts that reflect a limited and defined set of additional attributes. This, in turn, would support the creation of structured finance products for project developers.

A post-trade infrastructure consisting of clearing houses and meta-registries is also required. Clearinghouses would support the development of a futures market and provide protection against counterparty default. Meta-registries would provide escrow services for buyers and suppliers and allow the creation of standardized issue numbers for individual projects (similar to the International Securities Identification Number or ISIN in the capital markets).

In addition, an advanced data infrastructure would promote the transparency of reference and market data. Sophisticated and timely data is essential for all environmental and capital markets. Transparent reference and market data is currently not readily available due to limited access to data and the difficulty of understanding the OTC market. Buyers and suppliers would benefit from new reporting and analytics services that consolidate open access reference data from multiple registries via APIs.

Build consensus on the proper use of carbon credits

Some skepticism accompanies the use of credit in decarbonization. Some observers doubt that companies will cut their own emissions comprehensively if given the chance to offset emissions. Companies would benefit from clear guidance on what would constitute an environmentally responsible offset program as part of the overall effort toward net zero emissions. The principles for the use of carbon credits would help to ensure that carbon offsetting does not crowd out other emissions reduction efforts and result in more carbon reductions than would otherwise be the case.

Following these principles, a company would first determine its need for carbon credits by disclosing its greenhouse gas emissions from all operations, along with its goals and plans to reduce emissions over time. To offset the emissions from the sources it is eventually able to remove, the organization can purchase and "retire" carbon credits (claiming the reductions as its own and taking the credits off the market so another organization cannot claim the same reductions). You could also use carbon credits to neutralize so-called residual emissions that you could not eliminate in the future.

Install mechanisms to maintain market integrity

Concerns about the integrity of the voluntary carbon market are hampering its growth in a number of ways. First, the heterogeneous nature of the claims creates the potential for error and fraud. The lack of market price transparency also creates the potential for money laundering.

One corrective action would be to establish a digital process where projects are registered and loans are verified and issued. Verifiers need to be able to track the impact of a project on a regular basis, not just at the end. A digital process can reduce issuance costs, shorten payment terms, speed loan origination and cash flow for project developers, enable credit tracking, and improve the credibility of corporate claims related to the use of compensations.

Other improvements would include the implementation of anti-money laundering and know-your-customer policies to prevent fraud and the creation of a governing body to ensure authorization of market participants to monitor their behavior and monitor market performance.

Send clear demand signals

Finding effective ways for carbon buyers to signal their future demand would help encourage project developers to increase the supply of carbon credits. Long-term demand signals may come in the form of commitments to reduce greenhouse gas emissions or initial agreements with project developers to purchase carbon credits from future projects. The medium-term requirement can be recorded in a register of emission certificate purchase commitments.

Other possible ways to encourage demand signals are consistent and widely accepted guidelines for companies to agree to the use of carbon credits to offset emissions; more industry-wide collaboration, through which consortia of companies can align their emissions reduction targets or set common targets; and improved standards and infrastructure for the development and sale of consumer-oriented carbon credits.

Limiting global temperature rise to 1.5 degrees Celsius requires a rapid and drastic reduction in net greenhouse gas emissions. While businesses and other organizations can achieve much of the required reduction by adopting new technologies, energy sources, and operating practices, many will need to use carbon credits to supplement their own reduction efforts to achieve net zero emissions. A strong and effective voluntary market for carbon credits would make it easier for companies to find reliable sources of carbon credits and transact on their behalf. Equally important, such a market could transmit signals of demand from buyers, which in turn would encourage sellers to increase the supply of credit. By allowing more carbon offsets, a voluntary carbon market would support progress towards a low carbon future.

About the authors

cristobal blaufelderis a partner in the Zurich office of McKinsey,cindy levyis Senior Partner in the London office,Pedro Manionis an associate partner in the Dublin office andpinner dickonis a senior partner in the San Francisco office.

The authors thank Joshua Katz, Jared Moon, Erik Ringvold, and Jop Weterings for their contributions to this article and McKinsey's research collaboration with the working group.

This article was edited by Josh Rosenfield, Editor-in-Chief of the New York Bureau.

Voluntary carbon markets help companies complement their emissions reduction efforts and finance climate action. The Working Group for the Expansion of Carbon Markets offers you a draft project.

limit global warmingto 1.5 degrees Celsius requires that annual global greenhouse gas emissions be reduced by 50% of current levels by 2030 and reduced to “net zero” by 2050.fast action to reduce emissionsit must start immediately in all sectors of the economy. As more companies commit to achieving net zero emissions, they are expected to show how they intend to achieve these goals with an appropriate mix of direct emission reductions and offsetting through carbon credits.

Voluntarily purchased carbon credits allow organizations to offset or offset emissions that have not yet been removed by funding projects that reduce or avoid emissions from other sources or remove greenhouse gases from the atmosphere. A large and effective voluntary carbon market would help increase the flow of capital for these projects and thus play a crucial role in achieving net negative and zero emissions targets. Recognizing the need for such a market, the Institute of International Finance (IIF) established a private sector working group to expand voluntary carbon markets (see “About the working group” box). The goal of the working group is to create a blueprint for building a voluntary carbon market on an unprecedented scale and to ensure it is transparent, auditable and robust.

Six action points to scale up voluntary carbon markets

With McKinsey's expertise and advisory support, the task force identified six issues that require action and span the entire carbon credit value chain. In defining these themes, the task force drew on various ongoing scaling efforts. The resulting project does not seek to replace ongoing initiatives, but instead articulates an integrated set of priorities, including some that have not been addressed in existing efforts. The six action items are as follows:

1. Basic principles of carbon (PCC) and taxonomy of attributes.These quality thresholds ensure that loans meet the highest level of environmental and market integrity. CCPs must be hosted and selected by an independent third-party organization, which must also define a taxonomy of additional attributes (eg, project type) to classify credits.

2. Basic CO2 reference contracts.The net reference contracts (spot or futures) with a daily price signal will allow the management of price risk and the growth of supplier financing. Information from such reference contracts would also be used as input for the pricing of OTC transactions.

3. Infrastructure: trading, post-trade, finance and data.The robust and scalable infrastructure allows the listing and trading of reference contracts. Clearinghouses and meta-registries support post-trade activities (exchange and over-the-counter) and provide protection against counterparty default. Supply chain financing provides financing to developers. Advanced data infrastructure will increase data availability and strengthen overall market integrity.

4. Consensus on the legitimacy of compensation.The introduction of additional guidance on the appropriate use of carbon credits will ensure that offsetting does not a priori deter efforts to reduce emissions and will clarify the use of offsetting in corporate claims.

5. Market Integrity Guarantee.The integrity of voluntary carbon markets needs to be improved in three areas: eligibility, supervision, and market performance.

6. Demand signals.Clear demand signals would provide the impetus to drive the development of liquid markets and escalating supply.

As voluntary carbon markets begin to grow further, decision makers in all industries should consider their own plans to participate in these markets in the near future.

About the authors

cristobal blaufelderis a partner in the Zurich office of McKinsey;cindy levyis a Senior Partner in the London office;Pedro Manionis an Associate Partner in the Dublin office;pinner dickonis a senior partner in the San Francisco office; YJoe Weatheringsis director of environmental sustainability in the Amsterdam office.

The authors would like to thank Joshua Katz, Jared Moon, and Erik Ringvold for their contributions to this article and McKinsey's research collaboration with the working group.

This article was edited by Josh Rosenfield, Editor-in-Chief of the New York Bureau.