Volatility has become the easiest target for policymakers eager to “fix” carbon markets. Unstable markets discourage the initiation of long-term projects and make sustainable investments risky for financial sponsors. The natural answer is to seek stability: use financial instruments like Carbon Contracts for Difference (CCfDs) and Power Purchase Agreements (PPAs) to create predictability.

However, an uncomfortable question arises from this effort. Should we even remove volatility from energy transition markets? Volatility is destructive, but it’s also the instructive force that drives market efficiency. Perhaps no market knows this paradox better than the market most reviled by ESG advocates: oil. One of the world’s dirtiest fuels has one of the most liquid and sophisticated markets.

The Case for Carbon Market Stability

For energy transition markets, swings in volatility often have less to do with abatement cost and more to do with political shocks and energy crises. CCfDs and PPAs aim to solve this problem by locking in long-term prices to help investors to more effectively manage balance sheets. Carbon Contracts for a Difference are an agreement between a government and a private company investing in low-carbon technology. The government guarantees the company a fixed cost of carbon, often called a strike price, for a set period. During that period, if the market carbon price falls below the strike price, the government pays the company the difference, allowing the company to still achieve consistent returns. On the flip side, if the market rises above the strike price, the company pays the government the difference. CCfDs eliminate risk, as it allows projects to stay in profitability even during extreme swings in the markets. They’ve already been used in practice, with Germany recently raising over €6 Billion of its climate contracts tender.

Power Purchase Agreements (PPAs) serve a similar function for the energy market. They set fixed prices for electricity over a certain period, and remove price uncertainty for both producers and buyers. PPAs have gained traction in recent years as the AI boom fuels a massive expansion in data center construction across the United States. Amazon, Google, and Meta stand out as the leading drivers of the 66% surge in clean energy capacity contracted by U.S. corporations over the past 12 months. The majority of these contracts were PPAs.

Without financial mechanisms that stabilize decarbonization and energy-transition projects, investors and entrepreneurs are hard-pressed to make long-term, high-capital-expenditure commitments. While wind and solar are now mature industries, many decarbonization technologies such as green hydrogen, industrial carbon capture, and low carbon steelmaking are still in their infancy. These early-stage sectors are significantly riskier, making stable revenues and predictable policy conditions essential to mobilizing capital.

Oil Markets, and The Case For Volatility

Stability buys credibility, but creates the inability to discipline inefficiency. Firms are cushioned from downside risk, which transfers costs directly from private companies to public balance sheets. If market prices of carbon and energy stay low for years, taxpayers may potentially foot the bill for decades. Insulating firms against price volatility also dulls the incentive for efficiency. A fixed cost may create complacency, as downturns pressure regulators while upturns incentivize investment and innovation.

Perhaps no market thrives in volatility better than the global oil market. Crude oil prices have shifted drastically for decades. For example, the price of Brent crude shifted from an all-time high of $147 dollar per barrel in 200 to below $60 by the end of the financial crises. The COVID-19 pandemic also collapsed oil prices so quickly that the U.S. West Texas Intermediate (WTI) crude futures went negative, with expiring contracts free-falling from $18 a barrel to -$37 a barrel in a matter of hours. However, despite this breakneck volatility, trillions of dollars have been invested into projects and refineries, and consumers typically have fuel readily available even during market crashes.

Oil markets don’t suppress volatility, but they do manage it through liquidity and a deep ecosystem of financial instruments. Futures, options, and other derivatives allow the market to hedge against price swings effectively and transfer the risk among a wide pool of players. Airlines and oil producers can hedge costs by selling fuel futures to secure prices for future output and protecting their budget. On the other side, banks and commodity traders act as the counterparty and create market liquidity. To illustrate, in 2022, Asia-Pacific Airlines generated a mark-to-market gain of $2 billion on a hedge against the rising fuel prices during the pandemic, which allowed them to remain profitable while other airlines faced billions in losses.

What Carbon can learn from oil markets is that volatility isn’t necessarily an enemy: illiquidity is. Volatility can be mitigated through a plethora of instruments and large pools of capital to absorb price risk. The EU ETS is the most liquid and has an active future market, representing about 90% of total carbon trading volume. Studies have shown that increased participation by financial institutions helps increase market resilience. Speculators in carbon markets are often looked down upon due to their pureplay, profit-maximizing nature, but their trading can actually serve environmental purposes instead of detracting from them. Many companies with carbon regulations don’t have experience with commodities trading or hedging. Therefore, policymakers should promote greater participation from financial institutions to increase market depth.

In order to mature, carbon markets must learn to embrace volatility rather than design themselves to eliminate it. In all likelihood, there is no such thing as a naturally stable carbon market. Thus, policymakers should not pass laws to architect one. Volatility instead must be made to be manageable. This is not to say that stability focused financial instruments such as CCfDs and PPAs should not be utilized, but rather that taxpayer-backed guarantees should be gradually transitioned into market-based hedging solutions. Risk should not be eliminated, it should be tradable instead.

About the Author

Raymond is currently a sophomore at Columbia College studying Economics and Public Health. He is interested in the relationship between the healthcare, ESG, and finance sectors. He is an avid writer, and has written for, edited, and led over ten different journals and publications since high school. Beyond SFG, he also serves as an Editor for the Emerging Markets Review on campus. Outside of academics, you can find Raymond downtown trying new restaurants, or uptown getting thrown around while training judo.

Why is nature important in reaching Net Zero ?

A “net zero” strategy seeks to cancel out activity-generated pollution by capturing the outgoing greenhouse gases to avoid a net positive addition to the atmosphere. While sophisticated technologies to capture current and outgoing CO2 emissions are under development, natural carbon sinks have been capturing atmospheric carbon dioxide since the beginning of life on Earth. A carbon ‘sink’ or ‘pool’ is any natural or artificial system which absorbs more carbon than it emits. The ocean is the greatest carbon sink, as phytoplanktons absorb 25% of all carbon dioxide emissions and 90% of excess heat generated by these emissions. Next are forests, which absorb 2.6bn tonnes of carbon dioxide annually, followed by soil and the atmosphere. As the global climate continues to warm, ocean acidification and deforestation practices threaten the health of these natural carbon sinks, affecting their capacity to retain carbon.

How can private markets help achieve Net Zero objectives ?

The voluntary carbon market (VCM) is a decentralised private market where buyers purchase project-specific carbon credits from project developers. One credit bought on the VCM represents one tonne of carbon dioxide equivalent (CO2e). By purchasing third-party certified credits, buyers directly invest in projects which reduce, avoid, or remove greenhouse gas emissions. Common projects include afforestation and reforestation initiatives, maintaining mangrove ecosystems, and peatland/wetland restoration.

The VCM is one of the few transitional finance tools that has the capacity to mobilise private capital for carbon removal activities at the necessary speed and volume. Over the past 17 years, the Verified Carbon Standard, one of the leading carbon certification bodies, has secured billions of dollars in climate finance and supported 2,200 climate action projects in more than 95 countries. The World Economic Forum estimates that through emissions reductions and the enhancement of natural capital, VCM funding for NBS can achieve 30% of the mitigation required to limit global warming to 1.5C˚. Lastly, projects in the VCM do more than just reduce emissions: projects directly benefit the communities closest to them by creating local economic activity and engaging local stakeholders.

What are some concerns with the VCM?

One of the barriers to accelerating private financing through the VCM is the lack of regulation in the market. This causes problems with transparency, which hurts investor confidence and credit authenticity. A recent scandal with Swiss carbon developer South Pole created a dent in the VCM with its Kariba project, damaging the overall market’s reputation. The Kariba project in Zimbabwe was South Pole’s largest forest preservation project. In 2023, South Pole was accused of overestimating the amount of carbon credits sold on the market by five to thirty times, according to different estimates. It failed to prove the key criterion of ‘additionality’, which requires projects to prove that they reduce or avoid the release of greenhouse gases into the atmosphere.

Does the VCM need a new governance structure?

The Kariba project illustrates the problems with the lack of regulation in the VCM. As a private and voluntary market, traditional government intervention falls short of the regulation needed to fix its problems. However, like any industry, the market needs an institution to hold its actors accountable. Carbon market stakeholders have formed coalitions, such as the 250 member Task Force on Voluntary Carbon Market (TFVCM), which led to the creation of the non-profit, independent Integrity Council for the Voluntary Carbon Market (ICVCM). The ICVCM’s most important contribution so far has been its issuing of the Core Carbon Principles, which set a global benchmark for high-integrity carbon credits.

The push for greater market transparency comes from the inside, as actors recognise the market’s weaknesses. But outside pressures from investors and companies threaten the integrity of independent regulatory bodies. Company lobbying efforts successfully influenced the SBTi, a demand-side regulator, to ‘dumb down’ its standards, allowing companies to reach Scope 3 emission targets through offset purchases. This decision raises important concerns that companies will dial down on emission reduction efforts and instead use credits to reach climate targets.

A promising solution is for government agencies to bolster independent agency efforts (such as the ICVCM or SBTi) by giving them the legitimacy and resources needed to avoid falling prey to demand-side company and investor lobbying. The US Commodity Futures Trading Commissions set up a government Environmental Fraud Task Force to “address fraud and other misconduct” to help address the market’s challenges. The task force can enforce transparency in the market by taking enforcement action, as it did in its first landmark case against Ikkurty in July 2024. Greater scrutiny will push for actors to increase due diligence efforts and invest in high quality credits to avoid trouble with regulatory bodies.

While governments cannot directly regulate the carbon market, they can use their power to support independent agency’s efforts and punish ill-intentioned companies looking for an easy way to reach climate goals. More government agencies need to act as carbon market watchdogs and use the regulatory power that independent bodies lack to bolster the VCM’s potential to bridge climate finance.

About the author:

Clara is a senior in the Sciences Po-Columbia University dual bachelor’s program, majoring in Sustainable Development. In the context of COP29, her essay explores the potential of the voluntary carbon market to bridge the climate finance gap, highlighting the regulatory challenges that must be addressed to achieve global climate finance targets.

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