Forest carbon markets: Carbon pricing mechanisms

Part 2 of the forest carbon markets series, based on the report, "Forest Carbon Markets: How demand for forest carbon credits is shaping wood markets"

Forest carbon markets are quickly evolving as the importance of forests in tackling climate change is increasingly recognized and rewarded – something we are pleased to see and are very excited about.

This is the second of a series of blogs about forest carbon markets as we try to understand what is happening, and how it can impact global forest product markets. The focus of this blog is the rapid growth in carbon pricing mechanisms, including carbon taxes and cap-and-trade systems – for forestry and other carbon credits.

Read part 1 on the role of the forest in climate change

Growth of carbon pricing

To meet the formidable challenge of reducing global emissions of carbon and other greenhouse gases, governments are increasingly putting a price on carbon. Carbon taxes and emissions rights prices begin to reflect the true societal cost of emissions, and create an incentive for abatement – for example, actions to reduce emissions from the use of fossil fuel or to increase sequestration through carbon capture and storage or forestry.

At the turn of the century, there were only a handful of carbon pricing mechanisms globally, representing less than 1% of emissions (Figure 1). In 2022, this has grown to 68 mechanisms covering almost 25% of global emissions. The most recent additions in 2022 include the Ontario Emissions Performance Standards, Oregon ETS, and Uruguay CO2 tax. In addition to these government mechanisms is voluntary purchases of carbon credits.

There are two main types of carbon pricing mechanisms:

  1. Carbon tax: a surcharge levied on emissions or on fossil fuels. For example, here in Sweden the government introduced a carbon tax on fossil fuels in 1991. Today it is around 130 USD/tonne of CO2, the highest rate in Europe (only surpassed by Uruguay’s new carbon tax, at 137 USD/tonne)
  2. Cap and trade: organizations in sectors covered by such a mechanism are assigned an allowable level of emissions (“cap”), and must either reduce emissions to that level, or purchase emissions allowances from another organization within the mechanism (“trade”). Prices are not set but determined by the trade between participants in the system. The largest cap and trade mechanism globally is the EU Emissions Trading System (ETS).

There is a clear trend globally in favor of cap and trade mechanisms (Figure 2). While carbon taxes continue to grow, that growth is far outpaced by cap and trade, which grew almost 10-fold between 2016 and 2021. An advantage of cap and trade systems for governments, is that they set the emissions cap, and successively lower it, in accordance to their national targets and international commitments. There is greater uncertainty with a carbon tax about how the market will respond and how much emissions reductions will result.

Carbon credits

Credits are a unit of emissions, usually one tonne of carbon dioxide (tCO2e), which can be used by organizations to offset their legal obligation to reduce emissions (compliance markets) or purchased by organizations that voluntarily opt to offset their emissions (voluntary market). In some cases, credits can also be used to offset a carbon tax that would otherwise be levied on an emitter, for example as allowed in Colombia, one of the largest markets for forestry carbon credits.

In cap-and-trade compliance markets, such as the EU Emissions Trading Scheme (ETS) and California-Quebec ETS, most of the trade is of emissions allowances (the emissions rights allocated to each participant), but many markets also allow trade of credits from carbon offsetting projects from outside the system, i.e., carbon credits.

Demand for carbon credits arises from four areas:

  1. International compliance markets, e.g., national governments to meet Paris commitments
  2. Domestic compliance markets, e.g., EU ETS, California-Quebec ETS
  3. Voluntary markets, i.e., non-legislated offsetting by organizations and individuals
  4. Non-market buyers, government funding of climate change abatement, e.g., the Norwegian Carbon Credit Procurement Programme

Supply of carbon credits arise from three types of mechanisms:

  1. International government, e.g., the Clean Development Mechanism (CDM) established by the UN under the Kyoto agreement
  2. Regional, national, and subnational government, e.g., the California Compliance Offset Program
  3. Independent (non-government), e.g., Gold Standard, Verra

Of these, independent has grown fastest to become the largest source of credits in 2021, with almost three quarters of supply. It is also the most important for credits for forestry and land-use.

Credits from forestry and land use

Forestry projects are one of the main sources of carbon credits, on all markets. We estimate that their share is almost 20% overall, with a higher share on voluntary markets (~30%) than compliance (15-20%). Forestry is popular with both project developers and credit buyers because the projects are very visible and tangible, and offer significant co-benefits (e.g., biodiversity and erosion control).

Seven of the top ten carbon crediting mechanisms cover forestry projects. This includes both government mechanisms, such as the UN’s CDM and Australia’s Emissions Reduction Fund, as well as independent mechanisms, such as Verra’s Verified Carbon Standard (VCF), Gold Standard, and the American Carbon Registry.

Independent crediting mechanisms are most important for forest carbon credits, representing almost 80% of supply in 2021. These credits are sold not only on voluntary markets but also on compliance markets (many compliance markets accept independent credits). And independent suppliers have clearly favored forestry projects; over the last 5 years, almost 50% of independent credit supply was from forestry and land use. It was the largest category, well ahead of renewable energy (Figure 3). But renewable energy is growing faster, and was the largest source in the first 10 months of 2022. Forestry and land use credits faced headwinds in 2022, with significant negative press around credits mainly from REDD (reduced emissions from deforestation and forest degradation). Addressing concerns about the real value of such credits in addressing climate change will be a key challenge for project develops in 2023.

This is the second blog in a series about the emergence of forest carbon markets. Our previous blog introduced the importance of forests in climate change. Our next blogs will discuss voluntary and compliance markets for forest carbon credits, and implications for wood supply.

Read part 1 on the role of the forest in climate change

What to read next
Fastmarkets’ Director of EMEA mill intelligence, Ville Henttonen, uses a case study to explain how mill intelligence tools can estimate the cost competitiveness and fossil CO2 emissions of energy transition related investments
Part 3 of the forest carbon markets series, based on the report, “Forest Carbon Markets: How demand for forest carbon credits is shaping wood markets”
Part 1 of the forest carbon markets series, based on the report, "Forest Carbon Markets: How demand for forest carbon credits is shaping wood markets"