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OPINION

The VCM faces a liquidity paradox

Carbon credit traders want to secure the integrity of the voluntary carbon market while encouraging speculative trading that could fix its liquidity problem.

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Whether nature-based or technology-driven, carbon avoidance and removal projects need more funding, and the market fundamentals of the voluntary carbon market (VCM) should work towards that goal.

But are efforts to mitigate greenwashing reducing incentives for speculative trading and dampening liquidity?

The VCM has boomed in the past three years. Global traded value quadrupled between 2020 and 2021, to nearly $2 billion this year. That’s still relatively small considering that the compliance carbon markets reached $851 billion in 2021, but interest in carbon-offset mechanisms is driving growth in the market. The Taskforce on Scaling Voluntary Carbon Markets (TSVCM) estimates that demand for carbon credits could increase by a factor of 15 or more by 2030 and by a factor of up to 100 by 2050.

On the supply side, credit issuance is yet to catch up. It is down in 2022, with 174.4 million new credits issued this year down from 353.8 million in 2021. However, that supply is more diverse, as methodologies become more sophisticated and new issuers come to the market.

The Integrity Council for the VCM (ICVCM) published its draft core carbon principles in August to address some of the concerns expressed by market participants around double counting, governance and information asymmetry.

Meanwhile, the global registries are trying to police the marketplace. A temporary ban has been placed on the use of tokenization to ensure that carbon credits are adequately tracked and linked to the actual removal or avoidance of metric tons of CO2.

These efforts to standardize the market are welcome. Buyers want greater visibility on the origination of credits to avoid the risk of being called out for greenwashing. They are also careful about how they advertise their involvement in the VCM, eager to be seen as treating carbon offsetting as a supportive tool in their transition journey and not a silver bullet. As a result, qualitative metrics such as additionality and permanence have a notable influence on credit prices.

Yet all these efforts to bring integrity to the VCM are proving to be an obstacle to the one thing the market is missing: liquidity.

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Photo: Pixabay

Shallow waters

For the carbon-offsets market to grow, the market needs infrastructure developments with multiple exchange platforms and data providers. Recent launches such as Climate Impact X (CIX), the bank-driven project Carbonplace, or Web3 venture Toucan Protocol show that the VCM is moving beyond tradition commodity trading to make room for a more diverse range of participants.

But greater liquidity is needed.

Exchanges and registries are necessary building blocks, but greater trading volume is needed to support new platforms, because credits are issued and bought for the purpose of being retired in the short term for immediate emission offsetting.

Exchange-traded funds (ETFs) and other investment funds may have a role to play here – treating carbon credits like any other asset class and trading accordingly.

What matters in the case of the VCM is whether carbon credits can be traced from issuance to retirement, and that this mirrors quantifiable carbon removal or avoidance happening at project level

These types of buyers could pick up the slack when demand slows, as it did in March after Russia’s invasion of Ukraine. If speculative trading can guarantee demand on the VCM, it can also drive funding into credit-issuing projects and secure a steady supply of credits irrespective of a market downturn.

This already happens in the compliance carbon markets, where emissions allowances are bought and sold multiple times, including on the secondary market. On the European Union Emissions Trading System (EU ETS), for example, pricing has risen nine-fold since 2018, reaching an all-time high of €98.49 per tonne in February.

Recently, the EU ETS has come under fire from European stakeholders and governments on the basis that excessive speculation and non-compliance participation was preventing industrials from meeting their compliance requirements.

Yet European Central Bank (ECB) calculations showed little evidence of the effect of speculation on compliance market pricing. For the ECB, pricing reflects structural determinants such as higher energy prices and climate ambitions. “Investment funds overall continue to represent a very minor share of outstanding open positions, and this has only increased marginally – from 0.6% in 2020 to 0.7% in late 2021,” it states in its third Economic Bulletin of 2022.

What non-compliance participation does bring is more dynamic capital flows across the market.

Impact on quality and verification

There are, however, some key differences between the voluntary and compliance markets. The price hike on the compliance side reflects tighter green agendas globally and decreasing allowances year-on-year, and should, in theory, incentivize decarbonization practices.

On the VCM, price variations are still a source of confusion for stakeholders, and not yet a reliable indicator of how carbon credit trading is mitigating emissions. This leaves the VCM in a challenging situation, in which it needs a greater level of regulation and less intervention.

The TSVCM has a mandate to improve liquidity in the market by creating benchmark contracts and promoting the development of forward curves.

Bloomberg’s 2022 VCM outlook suggests that this top-down approach could negatively impact pricing. “Many stakeholders have concerns that […] the mandates […] will make all carbon offsets the same and actually forfeit quality, rather than give it a boost,” the report states.

The aim isn’t for all credits to be trading at the same price, but rather to ensure that there is enough liquidity so that trends are the result of market fundamentals and that capital flows reach trustworthy credit-issuing projects.

What matters in the case of the VCM is whether carbon credits can be traced from issuance to retirement, and that this mirrors quantifiable carbon removal or avoidance happening at project level. Speculative trading itself is not an issue, but it will be if any offsetting claims are made at the time of sale and not retirement.