Carbon tax is a tax levied on firms that emit carbon dioxide (CO2) through their operations.
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In a world increasingly affected by climate change, radical action is needed in order to create a sustainable future. The net-zero equation remains unsolved at present as GHG (greenhouse gas) emissions continue unabated and are not being offset by removals. In a typical year, the world adds 51 billion tons of GHG emissions to the atmosphere, with 16% of those emissions coming from the mobility sector. To this end, several mechanisms such as carbon tax, carbon fines, carbon offsets, carbon insets and carbon credits, have been designed as a result of multilateral agreements with an objective to create an international consensus around reducing global carbon emissions.
In this report, we will cover these four mechanisms with an emphasis on the carbon credits mechanism. Carbon reduction mechanisms are getting stricter with time, pushing the market to reach net-zero eventually and gradually. As such, market standards are still new and evolving and what exists today in the markets may not be suitable for the future. This report provides an introduction and an in-depth view of the carbon credit markets and their implications on the mobility industry. By providing a better understanding of the market’s unique opportunities and challenges, we hope to provide the players within the automotive industry with insights and new possible directions to thrive in this new challenging environment, and to contribute their part in the global effort of fighting climate change.
The physical effects of climate change, and their socio-economic impact, are becoming increasingly evident throughout the world. In the meantime, if the world does not adapt to a changing climate, these effects will continue to grow, until the world achieves a net-zero economy with a balance between the GHG gasses put into the atmosphere and those taken out. However, the net-zero equation remains unsolved at present: GHG emissions continue unabated and are not being offset by removals. Globally, 51 billion metric tons of pollution are produced every year, with 16.2% of those emissions coming from the mobility sector.
According to research conducted by McKinsey & Company, as of December 2021, less than 75 countries account for more than 80 percent of global CO₂ emissions and about 90 percent of global GDP have put net-zero commitments in place, as have more than 5,000 companies, as part of the United Nations ’Race to Zero’ campaign. These commitments are intended to prevent global warming from exceeding 1.5°C above preindustrial levels. Under a scenario with 1.5°C of warming above preindustrial levels by 2030, almost half of the world’s population could be exposed to a climate hazard related to heat stress, drought, flood, or water stress in the next decade. As severe climate events become more common, even in a scenario where the world reaches 1.5°C of warming above preindustrial levels by 2050 rather than 2030, nearly one in four people could be exposed to a severe climate hazard that could affect their lives or livelihoods.
Current estimates are that even if all existing national climate pledges were implemented, global average temperature would exceed 1.5°C above preindustrial levels, increasing the chances that the most catastrophic impacts of climate change would begin, despite the many commitments made by countries and businesses. Furthermore, most of the pledges have not yet been executed or backed by detailed plans. Implementation would also be challenging: solving the net-zero equation cannot be separate from pursuing economic development and inclusive growth. This would require balancing short and long-term risks.
Each pathway comes with uncertainity, marked by the shading from low to high emissions under each scenario. Warning refers to the expected global temperature rise by 2100, relative to pre-industrial temperatures.
Annual global greenhouse gas emissions in gigatonnes of carbon dioxide-equivalents
There are four key mechanisms that aim to encourage reduction of carbon emissions. In this section, we will describe them and provide examples while focusing on the carbon credit mechanism.
Carbon tax is a tax levied on firms that emit carbon dioxide (CO2) through their operations.
Carbon offset is an action or an activity that compensates for the emission of carbon dioxide or other GHG in the atmosphere. The actions or activities associated with carbon offsets are quantifiable amounts so that they can be used in the carbon market to be bought, sold, and traded as a carbon credit.
Carbon fines are penalties for polluting more than the cap that is set by governments and/or international institutions.
Carbon Credits refer to any tradable certificate or permit representing the right to emit one tonne of carbon dioxide or the equivalent amount of a different GHG.
Introducing the concept of carbon credits
Through a capped limit on the amount of carbon dioxide a country can emit, governments require businesses to obtain carbon credits, which are essentially regulatory permits to emit an allotted amount of greenhouse gasses per year (usually one ton of CO2 per credit). Over time, this limit is reduced, and when companies have unneeded credits, they can sell those credits to other companies at a profit. This is the basis of the “cap and trade” system, which provides companies with an added incentive to find ways to reduce emissions so that they can earn revenue from the sale of their extra carbon credits. This accomplishes three goals: reducing a country’s negative impact on the global climate, establishing a price on carbon dioxide, and furthering progress toward a sustainability-focused market in the future.
Carbon credits markets - Compliance and Voluntary
Currently, there are generally two different types of carbon markets - mandatory and voluntary. Mandatory carbon markets are used by companies to offset emissions levels to be compliant with regulated emission targets. So far, about 64 carbon compliance markets are now in operation around the world, the World Bank reported in May 2021. Examples of such markets are the EU Emissions Trading System (EU ETS) and the Regional Greenhouse Gas Initiative (RGGI) in the U.S. The EU ETS is one of the largest trading schemes, and has been successful in its goal of decreasing emissions. Since 2005, emissions have been cut by 42.8% in the main sectors covered, power and heat generation and energy-intensive industrial installations. On the other hand, voluntary carbon markets, as the name implies, are where carbon credits are purchased without the intent to be used to stay compliant. These types of markets are becoming increasingly active as the awareness of global warming is also increasing and private entities desire to be part of the goal set by the Paris Agreement. Although the size of the voluntary offset markets has only just reached 1 billion USD by the end of 2021, compared to a massive 27.8 billion market size of the compliance markets in 2020, it is growing significantly faster. The voluntary market saw a near-60% increase in value in the first 8 months of 2021 compared to the previous year, and now represents 70% of all carbon credits generated in 2019 versus only 15% of those generated in 2015. In terms of trade volume, the voluntary carbon market reached a historical 298.4 million mt CO2e in 2021. Nonetheless, the voluntary markets cover less than 0.5% of the total global GHG emissions, whereas the compliance markets cover around 5.5% of total global GHG emissions.
emission reduction between 2005-2021
Transportation is one of the most polluting sectors among all industries. Using carbon credit markets to reduce emissions from the transportation sector will have a substantial impact on global warming. With a 71% increase since 1990, transport is one of the fastest-growing sources of global emissions, accounting for 16.2% of global emissions . In the United States the transportation sector generates the largest share of greenhouse gas emissions . According to a report published by McKinsey & Company, in order to reach zero GHG emissions in the 27 European Union members alone, €28 trillion will need to be invested. The domestic transportation sector produces 21% of European GHG emissions and represents 40% of the total investment need (€12 trillion), making it a crucial sector for abatement . When it comes to manufacturing, the mobility sector operates similarly to other polluting industries and trades on recognized carbon markets. However, for the vehicles that car manufacturers sell, there are different credits traded in designated markets. The next sections of this report will review key issues regarding carbon reduction in this sector from the perspective of automakers and fleets, two major players when it comes to reducing emissions in this market.
Just as other companies, OEMs are also able to buy, sell, and trade carbon credits in both voluntary and compliance markets. Part of the carbon credits issued by car manufacturers are unique and only can be used by car manufacturers. This uniqueness is reflected in the ZEV (zero emission vehicles) credit program, which started in California and has been adopted by 12 US states. China and Europe also have such a credit scheme, which is a state-level incentive program to promote the production of Zero Emission Vehicles . Programs like this provide incentives for OEMs to achieve their climate goals and serve as a tool for the transition to zero-polluting vehicles. ZEV credits are given by the government they are based in to manufacturers that sell zero-emission vehicles depending on the type and range of the car . These credits are typically purchased by other OEMs in order to avoid regulatory sanctions such as a fine, as they are required to produce a number of ZEVs and plug-in hybrids each year, as a percentage of their total sales. That percent increases by 2.5% per year, ranging from 4.5% in 2018, to 22% by 2025 .
The carbon credits market, despite its promising potential in solving the net-zero equation, is currently limited by some key factors. For one, the market is fragmented and thereby very process-intensive and inefficient. This inefficiency also excludes small and medium sized enterprises from benefiting from the market. Additionally, there is a lack of standardization in the measuring of emissions alongside a lack of regulation and transparency between different players. As the markets grow, these challenges, amongst others, need to be carefully considered in order to fully exploit the mechanism’s potential. Here are some key challenges we identified as crucial for the market success:
1. Fragmented, inefficient and process-intensive market
The carbon credits market is inefficient in many ways, with a complex process that requires documentation, monitoring, and verification that can be both expensive and time-consuming . The many steps in the value chain complicate traceability of the original carbon reduction. Moreover, The market is fragmented with submarkets, without a single global market (neither voluntary nor mandatory). There are high entry costs that have deterred small-scale projects from accessing the voluntary market, contrary to large-scale projects that enable economic viability .
2. No standardized carbon credit accounting rules and measurement process
3. Lack of pricing information
There is a significant lack of information that leads to inefficiency in the market both in terms of supply and in terms of demand for carbon credits. Limited pricing data makes it challenging for 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 .
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