The international carbon market is a strategic mechanism in the global effort to mitigate climate change. The market creates financial incentives for industries, governments, and individuals to reduce greenhouse gas (GHG) emissions by assigning a monetary value to carbon emissions. Before a monetary value is assigned, the offset emissions are quantified in units of carbon credits. Carbon offsets are projects or investments that use recognised methods for avoiding, reducing or removing GHG from the atmosphere. The system of quantification and sale of offsets fosters a transition toward cleaner energy, encourages investment in low-carbon technologies, and supports projects that enhance carbon sequestration, such as reforestation and regenerative agriculture. It also supports international cooperation and the achievement of other sustainable development outcomes. As more economies integrate carbon regulations and trade into their climate policies, whether compliance or voluntary, carbon markets are increasingly instrumental in shaping global emissions reduction strategies. Beginning with a background on its evolution, including recent insights from the 29th Conference of Parties (COP29), this article provides an overview of the international carbon market.
Evolution of the International Carbon Market
Carbon markets have been shaped by decades of transitioning global policies, economic innovation, and growing urgency to curb greenhouse gas emissions. The World Bank reports that since the inception of regulatory frameworks for trading carbon offsets, an increase from 7% to 24% of global emissions is now covered by carbon taxes and Emissions Trading Systems (ETS). Initially conceptualized as a market-based solution to climate change, carbon trading mechanisms have evolved from voluntary initiatives to structured compliance frameworks backed by international agreements. The idea behind carbon markets is rooted in economic theory – by putting a price on carbon emissions, polluters are financially motivated to reduce their environmental impact, either by cutting emissions directly or by purchasing carbon credits that fund emissions reduction projects elsewhere. Even though the latter has remained largely controversial, carbon markets have become critical in climate governance, influencing national policies, corporate sustainability strategies, and global trade over time. The evolution of these markets has been marked by key milestones such as the Kyoto Protocol, which introduced structured emissions trading; the Paris Agreement, which established a more flexible and inclusive carbon market framework; and the ongoing refinements seen in COP negotiations, most recently at COP29. Understanding this evolution helps assess how carbon markets function today and how they can be strengthened to meet global climate goals.
Pre-Kyoto Protocol: Prior to the Kyoto Protocol, which marked the beginning of international regulatory frameworks to jointly combat climate change, voluntary efforts toward carbon offsets existed. One of the first carbon offset projects dates back to 1989, when the Applied Electricity System (AES), a private sector operator in the US with technical support from the World Resource Institute (WRI), invested in an agroforestry scheme in Guatemala. The scheme’s objective, implemented by an NGO, CARE/Guatemala, was to plant over 50 million trees, primarily to offset greenhouse gas emissions from a coal-powered plant constructed by AES. The Dutch Electricity Board (SEP), constituted by about five electricity companies, like AES, invested in an afforestation scheme to offset emissions from its coal-powered plant around the same period. However, in addition to the absence of regulatory frameworks at the time, there were uncertainties around the project’s models, the quantity of carbon offsets generated, and the viability of similar schemes.
The Kyoto Protocol: In the 1990s, the United Nations Framework Convention on Climate Change (UNFCCC) came into force. The goal was to provide a framework for the international trading of carbon credits to curb GHG emissions mostly caused by industrialised countries. Following the establishment of the UNFCCC in 1997, over 80 countries signed the Kyoto Protocol, emphasizing their commitment to set individual targets, now referred to as Nationally Determined Contributions (NDC), through mitigation policies and measures. The agreement involved two mechanisms viz-a-viz Joint Implementation (JI) targeted at industrialized economies and economies in transition, while the Clean Development Mechanism (CDM), through a sustainable developmental approach, involved offset projects in developing countries. Methodologies for Monitoring, Reporting, and Verification (MRV) were also developed, marking the beginning of the world’s regulated and non-voluntary carbon markets.
Emergence of the Voluntary Carbon Market: While voluntary carbon projects pre-date the Kyoto Protocol, the international agreement created a remarkable change in the approach to carbon offset projects. The Joint Implementation and Clean Development Mechanism frameworks under the Protocol mainly involved national governments and regulated companies until 2005, when the Voluntary Carbon Market (VCM) emerged. This re-emergence of voluntary efforts was motivated by independent organisations realizing the demand for carbon offset schemes. The VCM has continued to grow rapidly since then, with companies investing in projects to either offset their GHG emissions or for other reasons, such as meeting Corporate Social Responsibility requirements.
The Paris Agreement: The signing of the Paris Agreement in 2015 was yet another milestone in the international carbon markets. With the legally binding treaty between parties representing different countries, more mature rules were introduced to improve the compliance market. The agreement also introduced the concept of Nationally Determined Contributions, where countries must report climate adaptation and mitigation plans to meet net-zero targets every five years. Article 6 – a subsection of the agreement developed to avoid double counting – was also introduced. This implies that while the agreement encourages cooperation among countries through the transfer and sale of carbon credits, the introduction of Article 6 ensures that efforts towards mitigation are not recorded by both the selling and buying countries (double-counting). The agreement also provided a framework for cooperation through technology, finance, and capacity building, especially for developing countries with lower capacity to address climate change.
COP24 – the Paris Rulebook: At the 24th Conference of the Parties (COP24) held in Katowice, Poland, in December 2018, nations adopted the Katowice Climate Package, commonly known as the Paris Rulebook. However, resolutions on carbon markets required to finalise the Rulebook were reached during the COP26 held in Glasgow in 2021. This comprehensive set of guidelines operationalizes the Paris Agreement. In line with set objectives, it details how countries should plan, implement, and review climate actions as indicated in their NDC. The Rulebook establishes robust transparency frameworks, standardizes reporting requirements, and sets mechanisms for tracking progress, ensuring that all parties are accountable to their commitments, thus enhancing international cooperation and ambition in addressing climate change. Figure 1 shows a timeline of milestones for climate change mitigation from adopting the Paris Rulebook in 2018 to 2050.
Figure 1: Major Milestones from Adopting the Paris Rulebook to 2050. Source: World Resources Institute (n.d.)
COP29 – Refinement of Article 6: The 29th Conference of the Parties (COP29) was another defining moment for international carbon markets. While previous climate summits focused on refining emissions trading mechanisms, COP29 sought to enhance transparency, standardize rules, and scale carbon markets to drive global decarbonization efforts. One of the most significant outcomes of COP29 was the finalization and full operationalization of Article 6 of the Paris Agreement, which governs international carbon trading. Delegates agreed to the following:
- Operationalise Article 6.2 to allow for the transfer of mitigation outcomes or credit
- Operationalise Article 6.4 to ensure carbon credit transfers between nations follow strict transparency rules to avoid double counting through the Paris Agreement Crediting Mechanism (PACM).
- Under Article 6.8, it was agreed that non-market mechanisms, such as capacity building, would be adopted for climate change mitigation.
It was also agreed that climate finance provided by developed countries to developing countries be tripled to at least $300B every year beginning in 2035. Despite coming after several deliberations, these moves strengthen bilateral carbon trading and the new global carbon market mechanism, improving credibility and encouraging participation from developed and developing nations.
How International Carbon Markets Work (Carbon Market Segments)
Many factors necessitate international carbon markets to combat the challenge of climate change. According to Newell et al. (2012), these factors include the global scale and nature of the climate problem since the effects of emissions in one region are not restricted to that region. Other factors include that GHG emissions, unlike other pollutants, are long-lived and could remain in the atmosphere for decades; there are numerous GHG pollutants with different potency levels; the large market size of GHG owing to high energy (mostly fossil fuel) consumption globally. The world’s dependence on fossil fuels as a singular factor creates a huge problem for achieving net-zero GHG emission levels. Additionally, Baranzini et al. (2016) indicate that the occurrence of emissions from the beginning to the end of a product’s value chain (production to waste disposal) and the nature of climate as a public good complicates efforts toward mitigation. However, offsetting these emissions through international policies provides an option to address the challenge significantly.
International carbon markets are primarily categorized as compliance markets and voluntary markets. This distinction is based on whether participation is legally mandated or undertaken voluntarily to offset emissions. Compliance markets function under national or international regulatory frameworks like the Paris Agreement, while voluntary markets operate independently, driven by the sustainability commitments of the private sector and consumer preferences. Both markets play a role in climate change mitigation, but their mechanisms, governance structures, and impact on emissions reduction differ significantly. A closer look at each segment will provide deeper insights into their functionality, key players, and evolving global carbon trading roles. Figure 2 below reflects the diversity of domestic, government, private sector, and international actors interacting in voluntary and compliance markets.
Figure 2: Diverse actors in the international carbon market Source: UNEP (2021)
Compliance Carbon Market: Compliance carbon markets are regulatory systems designed to reduce greenhouse gas emissions by setting mandatory limits, or caps, on emissions for specific sectors or entities. These markets operate under frameworks established by governments or international agreements, compelling participants to adhere to prescribed emission reduction targets. A prevalent mechanism within compliance markets is the cap-and-trade system. In this approach, a governing body sets an overall emissions cap and allocates emission allowances to covered entities or auctions emissions. Entities that reduce their emissions below their allotted allowances can sell excess allowances to others exceeding their limits, creating a financial incentive for emission reductions. This market-driven strategy promotes cost-effective emissions abatement across the economy.
Compliance markets are typically governed by national or regional regulatory authorities responsible for setting emission caps, monitoring compliance, and enforcing penalties for non-compliance. For instance, the European Commission manages the European Union Emissions Trading System (EU ETS), which oversees the issuance of allowances, monitors emissions reporting, and ensures adherence to the system’s rules. Similarly, the California Air Resources Board administers the California Cap-and-Trade Program, which regulates the state’s GHG emissions and facilitates allowance trading. Compliance carbon markets have significantly expanded over the past decade, covering approximately 20% of global GHG emissions, up from just 5% ten years ago. In 2023, revenues from carbon pricing mechanisms, including compliance markets, reached a record $104 billion, with over half of these funds allocated to climate and nature-related programs. As a prominent example, the EU ETS has driven emissions reductions within the European Union, contributing to a 47% decrease in emissions from covered sectors since its inception in 2005. These markets incentivize industries to adopt cleaner technologies and generate substantial financial resources for further climate mitigation efforts.
Voluntary Carbon Market: Unlike in compliance markets, participants in VCM act of their own free will and are under no obligation to meet any set targets. The VCM is also less centralized than compliance markets. While there are questions about the integrity of carbon offsets generated in this market, the VCM have mostly been used to mobilize private sector investment in climate change mitigation. In VCM, carbon credits are generated through nature-based projects and other projects involving reforestation, avoided deforestation, renewable energy installations, and methane capture initiatives. These projects, which form the market’s supply side through CO2 removal or reduction, are typically developed by private entities or non-governmental organizations and undergo verification by third-party standards to ensure the credibility and quantifiable impact of the emissions reductions. Organizations such as the Integrity Council for the Voluntary Carbon Market (ICVCM) have emerged to establish core principles and threshold standards aimed at enhancing transparency and trust in the market. In July 2023, the ICVCM published ten broad principles with detailed requirements to guide the market toward high-quality credit issuance. These principles address aspects such as effective governance, robust quantification of emissions reductions, and clear documentation of project impacts.
Over the years, VCM has experienced significant growth, with the market value reaching approximately $2 billion in 2021, quadrupling from the previous year. Projections suggest that by 2030, the market could expand to around $40 billion, reflecting increasing corporate commitments to net-zero emissions and the rising demand for credible offset options. However, the market has faced challenges regarding the quality and credibility of certain carbon credits. In 2023, public criticism and concerns over the integrity of some offset projects led to a slight decline in market value, underscoring the need for stringent standards and verification processes to ensure that purchased credits correspond to genuine and additional emissions reductions. While VCM offers a flexible avenue for entities to voluntarily mitigate their carbon footprints and channel investments into sustainable projects, the effectiveness of these markets in achieving real emissions reductions depends on robust governance, transparent verification, and the continuous enhancement of credit quality standards.
Significant Transformations Leading to Growth
The international carbon market has undergone significant transformations over the past years, particularly following the recently concluded COP29, which introduced much-needed reforms to enhance transparency, prevent greenwashing, and expand participation in carbon offset activities. As these mechanisms evolve, private sector engagement and technological advancements will be crucial in scaling effective climate solutions. While challenges remain, particularly concerning market integrity and equitable access, especially in the voluntary carbon market, the future of carbon markets looks promising. With well-implemented regulations, financial incentives, and strong governance frameworks, these markets can drive the world toward achieving net-zero emissions by 2050. However, despite international carbon markets’ importance in offsetting greenhouse gas emissions, it is important to remember that these markets are only a means to an end. More significant results will be achieved when more of the activities are targeted at reduction and avoidance rather than only relying on removing emissions.
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