Let the market help find a solution to climate change

Much of America is baking under record heat or seeing sunlight filtered through the haze of wildfires thousands of miles away. Weather like this is a potent reminder of the need to reduce greenhouse gases to slow the effects of global warming.

One valuable tool that has not yet been used to its fullest extent to accomplish those reductions is trading carbon offset credits.

These trading markets provide a way for businesses to offset their own carbon emissions with a reduction of an equal amount of carbon emissions elsewhere. To achieve this, companies purchase carbon credits issued by projects that aim to reduce or eliminate emissions. Some examples include renewable energy initiatives such as wind farms, forest conservation and afforestation, and carbon capture projects. 

By doing so, they create a market-driven approach to mitigating the growth in greenhouse gas emissions and reduce the impact of the global warming ravaging the planet.

Several markets have been trading offsets in the United States for several years, but their effectiveness has been limited because they are only local or regional in scope. Other countries are currently setting rules for their own carbon markets.

But for offset trading to work, the market needs to be much broader. Climate change is a global crisis, after all, so we need a solution that’s global, too.

Local and regional markets are so small and attract such limited trading volume that they are not taken seriously as an asset class. Reuters reported that voluntary carbon offset markets combined for only $2 billion in trades in 2021. For comparison, average trading value on the New York Stock Exchange is more than $1 trillion every day.

Institutional investors in particular have little interest in such small markets because they offer limited liquidity and make it difficult to invest at scale. To work most efficiently, these markets need to be much larger to attract the attention of investors who have enough capital to make a difference.

Examples of these investors include entities with substantial exposure to climate-related risks, such as insurance companies that are likely to be interested in investing in market-traded carbon credits as a way to partly hedge their exposure. Markets with credible verification standards will help speed this development.   

To fully take advantage of the impact of carbon offset markets, we need to establish a market that allows someone in Germany to trade with someone in the United States to reduce carbon emissions everywhere.

Along with this market would come a global set of standards and regulation for verification so everyone is operating on the same page. A criticism of carbon offsets trading is that it allows polluters to continue polluting without a reliable method of ensuring that the promised offsetting reduction in emissions is in fact achieved.

These markets have also faced additional controversy because some companies are being assigned more credits than they have earned. Having credible verification standards and regulations will help address this concern by providing the evidence that emissions are being reduced. 

But most importantly, a market that is truly global in scope would make carbon offsets a more credible asset class to attract institutions large enough to invest the amount of capital required for successful carbon mitigation efforts.

Development of these markets is currently stuck in rule-making limbo. As fires, floods and heat only get worse, negotiators need to come to an agreement soon so we can take advantage of the markets’ promise in finding a solution.

Ashish Tiwari is professor of finance at the University of Iowa Tippie College of Business.