Carbon markets
How are emission allowances and carbon credits markets regulated?
One of the instruments that has evolved the most in recent years, carbon markets are emerging as an essential component of climate policy to drive climate change mitigation across different economies, helping to make the transition to net zero emissions more efficient.
Governments and international organisations around the world agree that global greenhouse gas (GHG) emissions must be drastically reduced to curb global warming. But how can this decarbonisation effort be carried out efficiently, sustainably and quickly when each sector and region starts from a different point of carbon dependency?
This is where carbon markets come into play. They provide an economic signal to emitters and help mobilise the investments needed to stimulate low-carbon technological development and innovation, driving new engines of economic growth.
What are carbon markets?
Carbon markets are economic instruments used internationally to incentivise the reduction of greenhouse gas (GHG) emissions, such as CO₂, across different sectors of economic activity. The unit traded in these markets is equivalent to one tonne of carbon dioxide equivalent (tCO₂e). There are two main types: regulated markets, where emission allowances are traded, and voluntary markets, where carbon credits representing voluntary carbon reductions or removals are traded.
Carbon markets: regulated and voluntary
There are two types of carbon markets that function in a complementary manner: mandatory regulated markets and voluntary markets. These two types are very different: their only similarity is the underlying traded instrument, which is a tonne of carbon equivalent (tCO₂e), with significant divergences in their objectives and functioning.
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Regulated carbon market (ETS)
Such markets impose an obligation to pay for emitting. Also called emissions trading systems (ETS), companies trade "allowances" that allow the holder to emit one tonne of CO₂e. A central authority, usually a government - regional, national or supranational - determines an absolute cap or limit on emissions within the ETS and allowances are distributed among the covered business sectors, usually for free or through auctioning, for the amount of emissions equivalent to the cap.
Regulated entities must surrender allowances for an amount equivalent to the emissions they generate, with a choice between implementing internal reduction measures or purchasing allowances on the carbon market, depending on the relative costs of these options. By creating supply and demand for allowances, an ETS establishes a market price for emissions that fluctuates over time. In this way, an economic signal is generated and emissions reductions are incentivised to take place where they are most cost-effective. In addition, these systems are also a source of public revenue, helping to channel funding for the energy transition.
The purchase and sale of GHG emission rights is currently an essential axis for accelerating the decarbonisation of the global economy and a tool that, if properly regulated, has proven to be effective in promoting climate action in large companies and institutions. Putting a price on carbon emissions serves as an incentive to make investment in clean energy more attractive, both public and private, and as a way of rewarding the most environmentally sustainable business choices.
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Voluntary market
Voluntary carbon markets, as their name suggests, respond to a particular and voluntary choice of governments, companies or individuals who can sell or purchase what are known as "carbon credits". It is a transferable instrument, certified by governments or private entities, which represents a tonne of carbon dioxide equivalent (tCO2 e) that a project either avoids/reduces against a baseline - such as preventing deforestation, promoting renewable energies and energy efficiency - or absorbs from the atmosphere - through reforestation (natural sinks) and carbon capture and storage activities (technological sinks).
The buyer of a credit can "retire" it from the market to reclaim the underlying performance towards the achievement of their own climate targets. It therefore allows companies to offset or neutralise their carbon footprint, as part of ambitious reduction strategies aligned with science.
For a project to generate credits, it must be certified to a recognised standard to ensure its quality and avoid double counting. Once issued, they may pass through several intermediaries before they are finally withdrawn from the market by the final purchaser. Unlike regulated markets (ETS), which trade allowances with identical prices and contractual aspects, credits can be highly variable in terms of project type, location, co-benefits and other factors, so buyers must perform due diligence to ensure that credits meet high quality standards.
The largest regulated emissions trading market
The European Union Emissions Trading System (EU ETS) was established in 2005 as the world’s first major carbon market. It remains one of the largest globally, covering more than 12,000 installations, aircraft operators and shipping companies. The EU ETS is therefore the leading example of a regulated carbon market, with the following key features:
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Broad sectoral coverage
It covers around 40% of the EU’s total CO₂ and other greenhouse gas (GHG) emissions from electricity and heat generation, manufacturing and aviation. Since 2024, the market has also covered emissions from maritime transport.
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An increasingly stringent emissions cap
A limit is set on the total amount of emissions permitted each year across the covered sectors in the 27 Member States. To achieve the target set out in the European Green Deal and the European Climate Law of reducing GHG emissions by 55% by 2030 compared with 1990 levels, in line with the climate goals agreed under the Paris Agreement, the EU ETS has been strengthened. The target for reducing emissions in the covered sectors by 2030 has been raised to 62% compared with 2005 levels, up from the previous target of 42%. As a result, the permitted emissions cap will decrease each year until, by 2030, emissions are limited to the level consistent with the market’s new target.
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Free allocation
The EU grants free emissions allowances to certain sectors to help maintain their competitiveness. The market reform provides for the gradual phasing out of free allocation for some sectors at risk of carbon leakage(1), with free allocation to these sectors ending by 2034. This will be achieved through the introduction of a Carbon Border Adjustment Mechanism (CBAM), which will apply a carbon price to imports into the EU, levelling the cost of emissions for certain European and imported products. For sectors not at risk of carbon leakage, free allocation will end in 2030, while free allowances for intra-European aviation will be phased out completely from 2026.
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Auctioning of allowances
The EU allocates a number of allowances to be auctioned among Member States, based on historical emissions, so that participants both subject to and outside the EU ETS can purchase them. Since its launch, the market has generated more than €248 billion in auction revenue. Following the reform, Member States must use 100% of the revenue from these auctions for purposes related to the market’s climate objectives, including the deployment of renewable energy.
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The new ETS 2
The EU ETS 2, a separate market, is due to start in 2027. It will pass the cost of GHG emissions on to suppliers of fossil fuels used in transport, buildings and industrial heating. This new system will be accompanied by the new Social Climate Fund, with €86.7 billion allocated between 2026 and 2032 to protect the most vulnerable households.
The EU ETS is a key component of EU climate policy and its principal tool for reducing greenhouse gas emissions cost-effectively. Since its inception, it has driven emissions reductions in key sectors for decarbonisation, such as power generation and heavy industry. As the world’s most important mandatory carbon market, it also serves as a benchmark for global climate policy.
What is the carbon price of different markets?
In regulated markets, the price of carbon allowances varies depending on the market in which it is traded and the timing, which is driven by supply and demand. The auction price of allowances is not fixed, but it must be robust and predictable for the actors within the sector, and it must increase more or less steadily as a rule so that polluting becomes more expensive.
The following graph shows the evolution of the price of emission allowances in various ETS systems, where a progressive increase in prices since the pandemic can be seen in several systems. The highest prices correspond to the EU ETS, where at the end of 2022 prices reached more than 90 euros for a tonne of CO₂, following a recovery since the Covid-19 pandemic in 2020, when this price dropped to 20 euros.
Evolution of the price of emission allowances in different markets
Data (in euros) obtained from Allowance Price Explorer | International Carbon Action Partnership
External link, opens in new window.
The price of carbon credits on the voluntary market varies considerably depending on the type of project, its age, the size of the transaction and the standard to which it is accredited(2). There are several platforms that offer CO credits2 from various developers with quality criteria and claimants can buy them at a price that is set.
Prices can range from less than $1/tCO2e for older projects with less verifiable co-benefits and lower quality, to more than $20/tCO2e for projects with unique characteristics and specific co-benefits (e.g., biodiversity).
(1) Carbon leakage is when a company decides to relocate its operations to regions with less restrictive climate policies and lower associated emission costs. To combat carbon leakage, special policies such as free allocation of emission allowances are applied for electro-intensive sectors with high emission costs and high international competition, such as steel, steel production, the chemical industry and the paper industry, among others.
(2) The price of a credit in the VCM is fixed per project and disclosure of the price paid is currently optional, as many transactions take place in the OTC market. With over 200 project types, price transparency is one of the biggest challenges in VCM today. However, this is improving with the emergence of more standardised platforms and products in spot and futures markets.
