What Is Carbon Finance? A Comprehensive Overview

Carbon finance can mean multiple things to multiple people. And that’s never a good sign. To help you navigate the murky waters of what Carbon Finance is and is not, we’ve put together a comprehensive overview below. You will discover the differences between carbon finance and climate finance, how carbon credits, allowances and taxes work, and the nascent carbon economy. We’ll also look at different carbon finance project types and more exotic terms like blue carbon finance.
‍

- What is carbon Finance
- How carbon finance works
- Financing the carbon economy
‍

What is carbon Finance
‍

‍A definition of carbon finance‍

In its most restrictive version, carbon finance is the name given to financial resources (loans, investments, subsidies) given in order to acquire greenhouse gas emission allowances. Because these allowances give their holder the right to emit one ton of CO2 or another gas of equivalent warming effect (CO2-equivalence, or CO2-eq), they are referred to as “carbon rights” or simply carbon.
‍

The volumes of carbon finance

About 20% of the world’s 50 billion tons (gigatons) of CO2 emitted annually is covered by emissions allowances. In other words, about 10 billion allowances must be acquired by CO2 emitters every year. Because these allowances have a price, they must be financed. Carbon finance is the name of the resources used to acquire these allowances.

A term used in climate investing

We will see however that other markets - such as carbon credits - have started using the term, with the backing of international institutions. If the European Investment Bank (EIB) solely mentions carbon allowances acquisition as an example of carbon finance, the United Nations High Commissioner for Refugees (UNHCR) or the World Bank both include carbon credits as well.

And carbon - the CO2 molecule this time, not the allowance nor the credit - is also a commodity used in many industrial processes which, in turn, need to be financed. That could also be considered carbon finance.

‍

Carbon finance, a misused term

In the service of these multiple markets, different financial actors - banks, funds, asset managers, brokers, and exchanges - have emerged. With them, various financial products have also been developed.

So much so that from a fairly well framed definition, carbon finance now encompasses multiple different ideas.

‍

Carbon finance as a subset of climate finance

What is climate finance?

Often used interchangeably, carbon finance is a subset of climate finance rather than a synonym.

According to the UNFCCC (the United Nations Framework Convention on Climate Change), Climate Finance is the financing that seeks to support abatement, mitigation or adaptation actions addressing climate change. This can be from local, national, or transnational levels and from public, private, or alternative funding sources.

Climate finance or carbon finance?

Carbon finance on the other hand - regardless of the definition - systematically involves greenhouse gas emissions. So while funding biodiversity projets could be considered climate finance, they wouldn’t be considered carbon finance unless these projects had a substantial impact on emissions reductions.

‍
Different carbon markets: carbon offsetting and carbon pricing

In a slightly wider definition than the one in our introduction, we could consider Carbon finance as the name of the financial resources used to finance carbon markets. And there are two distinct carbon-based systems which are entirely different and do not overlap: carbon offsetting and carbon pricing.

What is carbon offsetting?

Carbon offsetting is a project-based system. Project developers around the world put in place ways to either avoid CO2 emissions, or absorb CO2 emissions already in the atmosphere. For example, planting trees absorbs CO2 while replacing wood fired cook stoves with solar cookstoves avoids CO2 that would otherwise have been emitted. Companies seeking to offset a part of their own emissions can purchase carbon credits from these project developers. There are as many carbon credits as there are developers: thousands around the world. Each carbon credit is traded at a given price point. By doing so, they finance the carbon absorption / avoidance projet, and compensate their own emissions. These financial flows are examples of carbon finance. They represent approximately 500 million dollars per year.
‍

What is carbon pricing?
‍

Carbon pricing is a compliance-based mechanism, implemented and enforced by jurisdictions. Itcan be tax-based, where the price is fixed. Or it can be market-based, where there is a fixed supply of carbon allowances but its price is free-floating and adjusts itself based on demand. A tax is simpler, but less effective than a market-based mechanism. The idea behind carbon pricing is to ascribe a price to each emission: every time a polluting entity emits one tonne of CO2-eq, they pay the tax or purchase the allowance. Carbon pricing schemes have trading volumes close to a trillion dollars annually, making them 200x larger than carbon offsetting systems.

‍

Article 6 of the Paris Agreement

Carbon offsetting markets are voluntary in the sense that they are unregulated programs led by public actors. However, since the Paris Agreement, countries have looked for a way to create international carbon markets between governments and public institutions in stead of between private actors. Article 6 is supposed to spell out the international trade rules of this new market. So far, some bilateral trades have happened between countries, but many issues remained unsolved.

‍

A Blue Carbon side-note

Blue carbon is the name given to carbon flows and carbon storage that happens in marine systems. For example, tidal marshes, mangroves, and seagrasses have a high carbon burial rate per unit of area, accumulating carbon in their soils and sediments. As such, they can sequester carbon efficiently, even if that carbon would be released if the ecosystem were to be degraded. Financing such projects is an example of carbon finance, as the carbon-component of the project is dominant.

‍

‍

How carbon finance works

Understanding carbon pricing: taxes and emissions trading schemes

We’ve seen that there are two main types of carbon pricing: taxes and market based. The market based systems are called Emissions Trading Systems, or ETS.

Carbon finance imposes a maximal carbon budget

Taxes are directly imposed by jurisdictions and sets a fixed price on CO2 emissions. Emissions trading on the other hand creates a free market, in which participants trade allowances under an overall emissions cap. There is an equivalent number of allowances to the cap, as each allowance represents the right to emit one tonne of CO2. It is the supply and demand for allowances which sets the price.

How does carbon finance bring emissions down?

Both instruments internalize the cost of emissions, and shift that cost back to the initial polluter. By doing so, they create an incentive to lower emissions and shift to low-carbon solutions. The greater the price, the greater the incentive. At the same time, the proceeds from these instruments generate fiscal revenues for the jurisdictions, which can then be redistributed to finance climate abatement or mitigation projects, particularly in low-income households or communities.

Carbon prices supporting decarbonization worldwide

The ability to reduce emissions is directly linked to the price level of these carbon pricing schemes. While they are considered to be the most efficient mechanism to reduce emissions at scale, they only work insofar as a strong price is supported.

There are currently 73 carbon pricing initiatives implemented, covering 39 national jurisdictions and 33 subnational jurisdictions. Out of these, 36 are Emissions trading schemes, representing that largest schemes (9 Gt.CO2 out of 12 Gt.CO2).

The EU ETS as an illustration of carbon finance
What is the EU ETS?

The European Union’s Emissions Trading Scheme (EU ETS) is the world’s most mature and sophisticated carbon pricing scheme. It has been around since 2005, and covers 45% of the bloc’s emissions, or 1.5 Gt.CO2. Since its inception, it has reduced emissions by 40%.

The EU ETS main characteristics

It is also a liquid, efficient market, with about 4 billion euros in daily trading volume, and a price oscillating around 70€ at time of writing. Its scope is wide and increasing, covering sectors like electricity and heat production, cement and lime, steel and metal, petrochemicals, paper, glass, or ceramics and expanding to maritime and air transportation.

The actors of the EU ETS

Given its scope and size, the EU ETS is a full-fledged market. It involves all the compliance entities of course, but also banks, brokers, traders, and exchanges that serve the market. Over time, multiple financial actors have started participating in the market to offer derivative products such as swaps, options, and futures in order to transfer risk efficiently throughout the market, stabilize prices, and bring liquidity.

We can consider the EU ETS to be the most ambitious and successful example of carbon finance globally, both from a financial perspective measured by market stability and breadth, but also in terms of climate impact measured by the amount of emissions reduced.

‍

‍

Financing the carbon economy

One more definition of carbon finance

A last potential definition of Carbon Finance could be the use of financial resources to finance the carbon economy. That is, the use of carbon dioxide as a resource for industrial processes rather than simply an externality to be traded, shifted, priced-out, or transferred.

CO2 is used in the fertilizer industry in the production of urea, foods and beverages, plant growth in greenhouses, oil and gas, or metal production to name a few. CO2 can be used as a preservative or in carbonated drinks, but also to stun cattle in slaughterhouses.

Carbon Capture, Utilization, and Storage (CCUS)

Carbon Capture, Utilization, and Storage (CCUS) is a growing industrial trend where carbon dioxide is captured before being released in the atmosphere, and then used as an input for another industrial process. This opportunity creates impetus to expand the applications for CO2 and their numerous climate co-benefits. Options like construction materials (carbon injection in concrete), CO2-based polymers and plastics, synthetic fuels and many more are all being explored.

While less often discussed, all these applications, research, industrial processes, and future companies could very well be considered to fall under the umbrella term “Carbon Finance”.

‍

‍

Sources:

The World Bank, 2023. Carbon Pricing Dashboard.
The UNFCCC, 2023. What is the United Nations Framework Convention on Climate Change?

‍