Global Carbon Markets Now Let Governments, Companies Trade Emissions Rights

Carbon markets are built on a simple idea: if emitting carbon dioxide costs money, businesses will find cheaper ways to cut their emissions. In practice, the mechanisms that have been built to achieve this are complicated, contested, and still evolving. Understanding how they work helps explain why a factory in Germany, a power station in South Korea, and a forest in Brazil can all be part of the same financial system.

The two main types of carbon market

Compliance markets are created by governments and are mandatory. Companies in regulated industries, typically power generation, heavy industry, and aviation, must hold a permit for every tonne of carbon dioxide they emit. Governments issue a capped number of permits each year and reduce the cap over time, so that total emissions fall. Companies that reduce their emissions below their permitted level can sell spare permits to companies that need more. The European Union's Emissions Trading System is the largest and most established compliance market in the world.

Voluntary carbon markets operate alongside compliance systems. Companies that want to offset their emissions beyond what regulations require can buy carbon credits generated by projects that reduce or remove emissions elsewhere, such as reforestation, renewable energy, or methane capture. These markets are less regulated than compliance systems and have faced scrutiny over whether the credits they sell represent genuine emissions reductions.

How the price signal works

When the carbon price is high, it becomes financially worthwhile for a company to invest in cleaner technology rather than pay for permits or credits. When the price is low, the incentive weakens. Carbon prices vary enormously between jurisdictions. The European Union's price has been high enough to shift investment decisions in the power sector. Other markets set prices that are lower and have had more limited effect.

A global carbon price, which economists broadly regard as the most efficient tool for reducing emissions, does not exist. Different national and regional markets operate independently, with different rules, prices, and coverage. The Paris Agreement encourages international carbon trading but leaves the design of markets to individual countries.

Australia's carbon market

Australia operates the Safeguard Mechanism, which requires large industrial facilities to stay within an emissions baseline or purchase Australian Carbon Credit Units to offset their excess. The scheme has been tightened over time to require facilities to reduce their baselines annually. Australia also participates in discussions about linking its carbon market with those of trading partners, though no formal link exists yet.

What it means for Australia

Carbon border adjustment mechanisms, which the European Union is introducing, will impose a carbon cost on imports from countries with weaker carbon pricing. Australian exporters of steel, aluminium, cement, and other emissions-intensive products to Europe will need to account for the carbon price embedded in their products or face additional charges at the border. This creates a financial incentive for Australian industry to reduce emissions, linked directly to export market access.

For Australian investors and superannuation funds, carbon market policy also affects the valuation of assets in fossil fuel sectors. As carbon prices rise globally, the long-term earnings outlook for high-emissions assets changes.

The bottom line

Carbon markets are an attempt to put a price on a problem that markets previously treated as free. Whether they work depends on whether the price is high enough and the rules are tight enough, two conditions that remain works in progress.

This article was compiled by AI and screened before publishing. See our editorial standards.