Using Public Policy to Scale Up Private Investment in Carbon Markets

Since 1988, just 100 fossil fuel companies have generated over 70% of greenhouse gas (GHG) emissions. Yet in 2018 only 18.5 percent of climate finance came from private sector^[1]. Carbon pricing is among the most effective policy tools to direct spending and investment out of dirty energy and into green alternatives. But many countries are reluctant to use this policy lever^[2]. How can public policy channels be used to shift the burden of decarbonization to the private sector? While carbon taxation is the primary fiscal tool, governments can also enhance the use of carbon markets. This encourages the private sector to invest in the transition towards “net zero” GHG emissions.

The potential for private sector participation in carbon markets is huge. Depending on different price scenarios and their underlying drivers, the size of the voluntary carbon market (VCM) is expected to grow to about $100 billion in 2030 and around $250 billion by 2050^[3] . Globally, about 1/5th of the world’s 2,000 largest companies has committed to achieving the “net zero” target by the year 2050^[4].

Despite high demand, the existence of unregulated and voluntary carbon markets in most developing countries presents challenges

Market distrust is growing as lack of transparency and fear of greenwashing prevents private companies from entering low-income countries, where most markets are unregulated and voluntary. Some credits have turned out to represent emission reductions that were questionable at best^[5]. Limited pricing data makes it challenging for both buyers to know whether they are paying a fair price, and for suppliers to manage the risk they take on by financing and working on carbon-reduction projects without knowing how much buyers will ultimately pay for carbon credits. Assessing additionality and determining crediting baselines is inherently uncertain and often controversial, as it requires establishing unobserved scenarios based on assumptions such as future fuel prices and possible policy interventions.

Concerns about a lack of environmental integrity of carbon credits have also been raised. For example, risks of leakage may arise when businesses transfer production to countries with more relaxed emission standards, leading to an increase in those countries’ total emissions. Or there may be failures to address or adequately compensate for the non-permanence and lock-in of carbon intensive technologies. Perverse incentives may also be created – for example, for project owners to generate more GHGs only to mitigate them later, or for governments or companies to avoid adopting ambitious climate policies for fear such actions might jeopardize carbon credit revenues.

Scaling up private sector participation requires stronger government interventions

Even with a high value carbon credit, the underlying project and political risks will affect the ability and willingness of the private sector to enter new carbon markets. The assessment of whether a project meaningfully contributes towards net zero emissions depends on how the host government demonstrates its commitment to global climate action goals.

Here are some of the policy actions that governments can use to mobilize private capital in carbon markets.

• Improve regulations and market standardization: Low-income countries, countries new to carbon markets, and complex projects will need additional support to increase transparency and reduce the costs of measuring, reporting, and verifying carbon credits. One of the ways is to adopt regulations and policies for carbon markets, which can be applied uniformly and conform to the international standards for such markets. For example, governments can work with Climate Warehouse^[6], blockchain platforms, and rating agencies, who can support them in setting up carbon measurement and pricing guidelines aligned with international markets.
• Distinguish carbon removal from avoidance: Governments can identify markets for two types of projects. While the current market is trending towards more carbon avoidance investments (e.g., renewable energy development), it seems highly likely that, beyond 2030, the market will turn towards carbon removal investments (e.g., reforestation and agricultural soil management programs).
• Understand and mitigate project risks: The private sector seeks long-term ring-fenced, guaranteed price contracts. Projects are subject to similar risks as a regular transaction such as political risks, investment risks, climate-related risks, and non-performance risks. The government not only needs to raise the quality level of the carbon credits just like a credit rating, but also mitigate the risks through policies such as government guarantees, regulation, and prudent contract management. Public finance management tools to ensure that fiscal commitments and contingent liabilities are properly managed will play a critical role in coping with these risks.
• Conservation projects: Carbon sequestration projects related to the conservation of forests, grasslands and mangroves are increasingly important and attract financing from the private sector and philanthropic funds. These funds will require financial and regulatory support from the central government and from local governments because of the localized nature of the investment projects.

Governments in developing countries face a challenging task to accelerate decarbonization in partnership with the private sector. As the world accelerates the call to action on climate change, the number of companies pledging “net zero” emissions should double or even triple over the next five years, resulting in an enormous growth in the demand for carbon credits. The policy framework used by governments to regulate carbon markets will need to be ramped up as private investment in carbon markets expands.