The Carbon Market and the Role of the Financial System
What is the carbon market?
The carbon market is the result of a public or private cap-and-trade system. The World Bank, through the publication "Emissions Trading in Practice: A Handbook on Design and Implementation," sets out a 10-step process for implementing a system of tradable allowances, which necessarily includes defining the scope of the market, the emissions limit (cap), the allocation of allowances, and their transactions within the market (trade).
It is worth noting that the initial allocation of tradable allowances is under the responsibility of the authority in charge of the market, and it can be auctioned, distributed equally among firms, assigned to sectors based on emissions limit criteria, or allocated through another mechanism suitable to the authority. The criteria selected impact the pricing and volume of transactions in the market.
After that, firms may engage in transactions in order to lower their marginal abatement costs. For instance, if all firms hold allowances for 10 "emission units" of carbon dioxide, and one firm emits only 8 units, it can transact its excess allowances with a firm that emits 12 emission units. As firms reduce emissions and generate carbon credits, the market authority revises the emissions limit.
Evidently, this is a general view of the implementation and operation of a carbon market, which is based on a set of theoretical assumptions that regulators must follow. The process in practice could take years.
Voluntary market and financial institutions
While there is no regulated market, firms may be able to participate in the voluntary carbon market. In 2021, preliminary data indicated that the voluntary market was worth approximately $2 billion worldwide and is expected to grow over the next few years.
The increase in transactions within the voluntary carbon market has motivated financial institutions worldwide to develop solutions and services to facilitate and encourage carbon credit transactions. In 2021, for example, Itaú, in partnership with the Canadian Imperial Bank of Commerce (CIBC), the National Australia Bank (NAB), and the NatWest Group, launched its own carbon offset platform called Project Carbon. The platform aims to promote transparency as to the prices charged in the voluntary market and the amount of transactions carried out, and is expected to operate as a marketplace for carbon negotiations.
Such initiatives highlight the key role of financial institutions (FIs) in promoting a properly functioning carbon market. By developing solutions that connect buyers and sellers of carbon credits, financial institutions not only increase their range of services, but also help companies from various sectors to meet their greenhouse gas emission reduction targets.
In addition, FIs can also perform a role as liquidity and risk management providers within a tradable allowance system. In the voluntary market, the diversity of the allowances traded also enables the spread of knowledge about the prices and risks of each asset, thereby providing companies with the means to identify the appropriate strategies to achieve their sustainability goals.
Regulated market - international experiences
Regarding a regulated carbon market, it is possible to examine the role of Financial Institutions in the international scenario. In 2021, the "Refinitiv Carbon Market Year in Review" estimated that the European carbon market, the European Emission Trading System (EU ETS), was worth €683 billion in 2021, accounting for 90% of the global value of regulated carbon markets, and transactions within the European market reached €12.2 billion.
The EU Allowances are treated as financial instruments. As such, banks, credit institutions, investment funds, and other financial institutions are key parties to the proper operation of the European carbon market. In general, providing services that facilitate agents' access to the carbon market tends to reduce transaction costs within the market, ensuring that companies reach an optimal level of buying and selling tradable allowances.
In recent years, it has been assessed whether there is a speculative potential on the part of financial institutions in the European Union, especially with the growing participation of investment funds in transactions involving carbon credits. For now, there is no evidence that financial activities have significantly and artificially impacted the pricing of allowances in the European market. Still, there is evidence that reducing transaction costs promoted by the offered financial services helps stabilize prices in the EU ETS.
In a newly established carbon market, as is the case of the China ETS, the financial sector involvement is still modest. The Chinese carbon market was fully implemented in January 2021 and is the largest in the world in terms of emissions covered. In just six months of transactions, the market has moved about €1 billion.
Currently, financial institutions are not allowed to operate under the China ETS. As such, transactions occur electronically by mutual agreement, and the creation of financial instruments based on tradable allowances or carbon credits is not permitted. However, institutions may be authorized to operate in the market as the country's operation evolves.
It is important to note, however, that Article 6 of the Paris Agreement, which occurred in 2021 during the COP26, provides for the establishment of a carbon market on a global scale. In this sense, the integration of regulated markets is expected to occur still in this decade, which increases the business opportunities derived from carbon credit transactions.
Financial institutions are therefore expected to have opportunities to operate on a global scale within the scope of tradable allowance transactions. To this end, it is essential to monitor the development of regulation and implementation of carbon markets worldwide and assess the potential for innovation in sustainable financial services.
As financial institutions perform a key role in established carbon markets such as the European one, facilitating transactions, promoting access to information, and managing risks are expected to be even more critical for a market on a global scale. Moreover, building a global decarbonization asset transfer infrastructure can benefit from the expertise of financial institutions around the world.
The Brazilian scenario
In Brazil, the National Policy on Climate Change (PMNC) mentioned the Brazilian Emissions Reduction Market (MBRE) in 2009. However, a proposal to regulate this market emerged only in 2021 through Bill 528, sponsored by Congressman Marcelo Ramos (PSD/AM).
The bill was submitted on February 23 and is still under consideration by the House of Representatives. As the discussion has extended, the Executive Branch has published Decree 11,075 of 2022, which sets out the procedures for preparing Sectoral Plans for Mitigating Climate Change and establishes the National System for Reducing Greenhouse Gas Emissions (Sinare). At the time, the decree’s publication was expected to speed up discussions in the Legislative Branch, which did not occur. Now, the Senate is analyzing bill 412/2022, and the Federal Government should take a position on the issue still in 2023.
In the country, for example, the expertise that the financial sector has acquired with data sharing, promoted by Open Finance, can facilitate the development of sustainable solutions that attract more participants to the carbon market by promoting transparency and risk management in its operation. In addition, the implementation of a favorable environment for the development of Fintechs enables the creation of innovation in products based on carbon credit transactions, which can support the operation of a regulated market in the country.
The creation of products based on newer financial assets, such as crypto-actives and NFTs, and the use of blockchain and artificial intelligence, on the other hand, is still in a nascent state. So far, market participants do not seem to opt for transactions involving these assets in a tradable allowance system. However, this gap in the market can also become an opportunity for financial institutions.
Thus, implementing carbon markets offers a good opportunity for the financial sector to also be a catalyst in meeting countries' decarbonization targets. Furthermore, solutions already created around the world are good examples of how financial innovation and climate risk mitigation can go hand in hand.
This article was written by BMJ Consultores Associados, a Brazil-based consulting firm specialized in International Trade, Government Affairs, Tax Analysis, Strategic Communication and Regulatory Affairs. BMJ is an Official Knowledge Partner of the Annual Investment Meeting.
