Scaling environmental markets: consigning voluntary to history

Environmental Markets are multi-faceted. When it comes to the preservation of the atmosphere, it’s time to ditch carbon market labels so we can focus on their purpose and let economics and markets go to work.

This article has been a long time in the making. And oxymorons lie at the heart of it.

The origin of this article was a discussion in late 2021, with a fellow carbon market veteran, about whether the voluntary carbon market was an oxymoron. The 2021 UN Climate Change Conference (COP26) had just concluded where the Article 6 Rulebook was “agreed”, and The Taskforce for Scaling Voluntary Carbon Market had created a buzz and sense of optimism for carbon markets.

I argued there would be no ‘voluntary’ market because if the price of carbon credits gets too high, companies would simply stop taking financial responsibility for their physical emissions. My friend countered with the fact that a growing number of companies are publicly committing to carbon neutrality targets. Yet, any company that retracts Net Zero greenhouse gas emission targets - or fails to set them - could face financial and reputational fallout. Such repercussions mean there is little that is ‘voluntary’ about the voluntary carbon market (VCM).

The purpose of environmental markets: helping reach Net Zero

Staying on a Net Zero pathway and limiting the worst impacts of climate risk means we need to balance a finite atmospheric carbon ‘budget’. In this budget, carbon emissions represent ‘expenditure’ and burning through too much of our carbon allowance makes it harder to meet a given temperature target.

Markets can incentivize behavioral change, by ensuring that people and companies bear the true costs or benefits from the effects of their actions. In economics this is known as internalizing positive and negative externalities1. Environmental markets put a price on greenhouse gas emissions, incentivizing us to balance the finite atmospheric carbon budget in the most efficient way.

Voluntary labelling: a symptom of a wider market problem?

I’ve never been a fan of the voluntary label for carbon credits. To me, it’s symptomatic of the desire to treat carbon credits differently to other markets rather than letting the market go to work. The market is where we collectively agree quality through price. The market is the ultimate test of where you think value is - if something is cheap you can buy it; expensive, don’t buy it or even sell it.

In the three years that have passed since COP26, the VCM has been bogged down in what could be described as “green-on-green violence”—a landscape marked by internal conflicts, competing priorities, and a failure to reach consensus on quality. Stakeholders have spent years debating methodologies, governance frameworks, and market mechanisms, but in doing so, have lost sight of the essence of a market: a platform where we collectively define and signal value through price discovery.

The lack of focus on the true essence of a market has left the atmosphere as the ultimate casualty: a resource still freely exploited for greenhouse gas emissions in the absence of a cohesive system to measure, price, and internalize the cost of using it.

One of the hurdles to legitimizing environmental markets involves scrapping the arbitrary distinction between ‘voluntary’ and ‘compliance’ carbon markets. In this article, we explore arguments as to why the term ‘voluntary carbon market’ should be consigned to history and the focus re-centred on allowing the market to get to work.

The case for ditching arbitrary labels for carbon

Of all the stakeholders that could incentivise behaviour change, “the only one that is able to coerce generally is the state”2 and taking financial responsibility for physical emissions remains largely the purview of government mandates. But it doesn’t need to be: there are examples of markets that work with and without government intervention.

Clearly, government intervention can help incentivise a demand signal and create markets.

The decision to mandate versus voluntarism often hinges on the perceived scale and urgency of the risk, alongside its externalities—how much one person’s (in)action affects others, but whatever the reasons for the differences, we don’t label other markets voluntary or compliance.

Carbon markets operate with the same tension between voluntary and compliance frameworks, shaped by risk perception and externalities. The need for widescale co-operative action around climate risk is critical and the actions of individuals affect everyone else.

Voluntary action has not been forthcoming enough to avoid climate tipping points. The risk of inaction is seen as manageable or distant for individuals and the immediate societal costs of voluntary inaction are harder to quantify. In fact, the challenge is that even those who volunteer, participate for reasons like reputation rather than taking financial responsibility for their physical emissions and the economic risk this presents.

Let’s look at another market segment which spans the compliance and voluntary domains: insurance.

Driving a car without insurance is illegal in the UK. At a minimum, you must have third-party insurance to drive in public places, and penalties for driving uninsured are sufficiently steep to motivate widespread compliance. These enforceable penalties are the reason government mandated programs are complied with. On the other hand, home insurance is not legally required in the UK. However, building insurance is typically mandatory if you have a mortgage, as lenders require it to secure the property. This is an example of a market where compliance has been mandated by a stakeholder other than a government: in this case, to help price and manage risk. For contents insurance, which is entirely voluntary, we must weigh up the costs (risks) and benefits (rewards) before deciding whether to purchase this or not.

Much like how insurance markets do not distinguish between voluntary and compliance-driven actions, the division of the carbon market into these categories appears increasingly anomalous. The labels for ‘compliance’ and ‘voluntary’ markets emerged from the need to distinguish between companies which were mandated by governments to compensate for emissions, and those which were not. Several developments make these labels misnomers.

First, mandates on companies regarding greenhouse gas emissions don’t have to be the exclusive domain of governments. Companies can be ‘mandated’ or pressured by other stakeholders which include shareholders, customers, employees, lenders and the media, to develop sustainable business practices. Already, the influence of these stakeholders has resulted in a groundswell of corporates making Net Zero commitments.

Secondly, project developers initiate, design, and manage carbon credit projects and bear the associated financial cost. Therefore, they need clear economic incentives to invest in projects aimed at reducing or removing greenhouse gas emissions. This is hardly something that qualifies as a voluntary act when it comes to successfully managing investment in carbon credit projects.

Thirdly, the line between ‘voluntary’ and ‘compliance’ is blurred when it comes to the application of environmental market instruments and incentives which exist around them. This means that explicitly labelling an instrument is often inaccurate.

These examples illustrate the confusion created by the arbitrary labels of ‘compliance’ and ‘voluntary’ markets.

Fourthly, and perhaps most importantly, the language we use to describe environmental markets is vital in legitimizing their role. Whilst environmental markets have been around for decades, their use has not been widespread, nor has the general understanding of their mechanics. As the urgency to address climate change increases, it is critically important to understand the structure, benefits and limitations of environmental markets. Therefore, it is critically important that the terminology used in these markets must communicate the seriousness of non-compliance, regardless of whether the consequence is a government fine or fallout from investors.

Measuring, communicating and internalizing risk

The distinction between voluntary and mandatory actions hinges on how risk is measured, communicated, and internalized. Once we have these details, we can start deploying risk management strategies.

In the realm of insurance, markets handle risk by assessing, pricing, and spreading it across a pool of policy-holders, where the distinction between voluntary and compliance-driven behaviour is largely irrelevant; premiums reflect risk regardless of the motivation behind obtaining coverage.

Ultimately, just as insurance protects individuals and communities, carbon markets must be positioned as essential tools for climate risk management at all levels of society. Today, carbon pricing is perceived more as a tax, which is not a levy that motivates any level of participation. Other factors include historically low carbon prices and the impact of free allocation which dilutes the impact of the cost, so even mandated entities have maybe not paid as much attention as they should to risk management. Consequently, is the exposure not (yet) big enough to register at the C-Suite?

Critically, the perceived lack of a direct, widespread measurement of climate risk feeds broad ignorance around the need for risk management. This gap can obscure the real urgency of managing climate risk compared to more tangible risks (e.g. car accidents or property damage) where tools like insurance are well established. The fundamental issue is a failure to integrate climate risk into economic and financial systems in a way that equates it to measurable, insurable risks. To address this issue, climate risk must be made visible, measurable, and integrated into financial systems, much like insurers price premiums based on assessed risks. Treat carbon markets like insurance: a tool that shifts risks into manageable financial mechanisms. A shift toward treating climate risk as immediate and tangible is critical. Mandating risk quantification (and pricing it in markets) by recognising climate risk provisions through counting physical emissions and taking financial responsibility through carbon pricing would fundamentally change the game.

Carbon credits and emission allowances; same but different

The value of externalities can be measured with different environmental market instruments. These vary from carbon allowances, carbon credits and energy attribute certificates. Regardless of their name, they all share a common trait: providing price signals, measuring the supply and demand of carbon savings which inform decisions about how best to conserve the finite atmospheric carbon budget.

Setting aside labelling debates means we can focus on correcting misconceptions about the mechanisms of environmental markets. For example, the terms carbon credits and carbon allowances are often used interchangeably. Yet, a carbon credit represents an atmospheric reduction or removal of greenhouse gases (a positive externality) while carbon allowances under cap-and-trade programs represent a government issued unit, certifying that physical emissions have been paid for (a negative externality). Here, Cap-and-Trade programs are the only mechanism which can directly control the quantity of greenhouse emissions released - as a failure to buy and retire a permit result in a financial penalty.

Therefore, one could argue that the most effective approach to achieving Net Zero emissions would be a global cap-and-trade program. At first glance, a global cap-and-trade program may seem untenable for developing countries, as paying for pollution could impose significant costs on emerging economies. This challenge could be addressed through the free allocation of allowances, enabling these countries to raise finance for decarbonization efforts by selling excess allowances in the market.

However, given this doesn’t seem politically feasible, carbon credits provide another mechanism to facilitate this, by allowing developing countries to generate funds by producing reductions or removals. These efforts are often produced at a lower cost compared to mitigation outcomes in developed countries, making credits a vital component in delivering global climate goals efficiently.

Carbon credits which help to reduce and remove greenhouse gas emissions are therefore needed to stay on track for the Net Zero target. Companies taking financial responsibility for their emissions by buying and retiring carbon credits, are applying carbon-pricing discipline in their business models. This incentivizes them to seek abatement opportunities that are more cost effective than continuing to pollute. This results in a situation where companies which are not subject to government mandated emissions reduction targets - yet publicly commit to Net Zero targets - are de facto establishing non-government cap-and-trade programs. Instead of recognizing the cost of pollution by acquiring a carbon allowance, they are taking responsibility for their physical emissions and pricing the cost of carbon by buying and retiring carbon credits.

From origin to publication, who got it right?

Almost four years on from this article’s origin we barely started buying. And whilst many more companies committed to Net Zero targets, there are no tangible consequences for failing to meet them.

In hindsight, my argument back in 2021 that a market will not function because of a reduction in demand (to zero) due to high prices was moronic. Instead, the essence of any market is summarised perfectly by Javier Milei: “if the goods or services offered by a business are not wanted, the business will fail unless it adapts to what the market is demanding. They will do well and produce more if they make a good quality product at an attractive price. So, the market is a discovery process in which the capitalists will find the right path as they move forward.”

The counterargument - that we don’t need governments to mandate behaviour change - was far more defensible. When it comes to carbon markets, however, nobody outside a government has chosen to act at scale. Yet there is already evidence that climate risk is being reflected in asset prices. Ultimately, this will have implications for Asset Owners, companies and individuals.

There is no market failure. Putting a price on the utilisation of the atmosphere to incentivize abatement creates a feedback loop which reflects society’s collective valuation of the atmosphere, which still remain free as an unlimited resource for emitting greenhouse gases with few consequences.

Climate risk is too big and complex a problem for it to be solved on its own. Environmental markets offer the mechanism to quantify, reduce and price carbon emissions. However, climate risk is not yet fully integrated into economic and financial systems. Is CORSIA (Carbon Offsetting and Reduction Scheme for International Aviation) the first example of the home insurance model, and will others, like the financial industry with a closer nexus to the home insurance model follow? If we can move to a contents insurance model and adopt volunteerism, the environmental markets can truly complement policy intervention and help solve for Net Zero through price bybalancing supply and demand to preserve our atmosphere - the ultimate scarce resource.

Price gives us choice.