^{Chapter 3:}
Creating a
financial market

Chapter 3:

Creating a financial market

This chapter explores the case for evolving carbon credits from operating in a mostly spot and offtake driven market, into a wider financial market characterised by intermediation, price discovery and liquidity. Treating carbon as a commodity can help leverage existing infrastructure for other commodities, creating a more seamless transition to a financial market. The following sections explore the components of a fully functioning financial market, and identify the gaps and solutions to scale such market for VCMs. It is also noted that the ICVCM is concluding their Continuous Improvement Work Program (CIWP) on Market Transparency, Scalability and Standardisation that brought together diverse market experts and stakeholders to identify challenges and propose solutions for market infrastructure, pricing transparency and structured finance. The recommendations from this report will inform the evolution of market integrity and could be considered alongside this white paper for creating a scaled market.

3.1. What makes a financial market and why do carbon credits need a functioning financial market?

A financial market is a sophisticated ecosystem where buyers and sellers exchange financial assets. An efficient market is typically characterised by key features: (1) intermediation, where brokers, exchanges, and custodians connect market participants, matching supply with demand (via automation, as most markets are now digital); (2) liquidity, helping to ensure assets can be bought or sold with minimal price impact; (3) transparency and fairness, providing clear and reliable price information; (4) regulation and oversight, ensuring market integrity and protecting participants. A market is also enhanced by (5) the availability of diverse financial products, enabling risk management and speculation.

Carbon markets are suited to evolve into a financial market. Carbon units, as a tradable asset, exhibit key characteristics of financial instruments. They are, in theory, largely fungible – a carbon unit represents the removal or reduction of a tonne of carbon dioxide (or equivalent) from the atmosphere. Fungibility also requires integrity, accurate measurement and robust standards of credits supplied.

There is an opportunity to create a highly active, traded market. With primary market forecasts showing exponential growth, and 2030 estimates ranging from US$15–US$100b³⁵, there is a potential for a secondary market size of US$45-300b in 2030.³⁶ Although operating in a compliance market, the EU emissions trading schemes (ETS) provides an interesting frame of reference. In 2023, the EU ETS recorded a trading volume of €881b.³⁷ This illustrates how a well-structured financial market (with government regulation) can drive capital flow, ensure liquidity and maintain price integrity.

But to achieve this transformation, the voluntary carbon market should evolve beyond its current fragmented state. Today, carbon credits are often transacted bilaterally, with limited transparency and inconsistent standards. A mature financial market would provide a centralised, trusted environment where carbon credits can be issued, traded and settled with confidence. This chapter explores how this can be achieved.

_³⁵_{US$15b estimate – BloombergNEF}_;_{US$100b estimate – Morgan Stanley}_{³⁶ Using forecast ranges for 2030, and assuming secondary market to be 3x size of primary in 2030
³⁷ ICAP (The prices for EU-ETS were originally denominated in EUR and have been, for comparison, converted to USD using the monthly average EUR/USD exchange rates)}

3.2. The role of financial intermediaries

At the heart of any financial market are the intermediaries; banks, brokers and exchanges, and custodians that facilitate transactions and channel capital efficiently.

Banks and other financial intermediaries bridge capital to project developers, who may face significant upfront costs with a long duration. For example, nature-based solutions such as reforestation projects can take years before trees start sequestering peak levels of carbon, yet developers must secure land, plant trees, and maintain the forest long before any carbon credits can be issued or sold. Financial intermediaries can bridge this financing gap through several financial mechanisms:

Pre-financing agreements: Intermediaries offer financing in advance of credit issuance, secured by future carbon credits. Such agreements allow developers to fund operations without waiting for credit generation.
Offtake agreements: Connect with buyers who commit to purchasing credits at a future date, providing developers with financial security and access to upfront capital.
Structured finance: Offer structured products, such as green bonds or asset-backed securities, where carbon credits serve as collateral.

This ability to access capital is critical to scaling high-quality carbon projects. Without a reliable source of funding, many impactful projects may fail to reach maturity.

Brokers act as agents for buyers and sellers, giving access to the market and executing transactions on their behalf. Exchanges, such as Intercontinental Exchange (ICE) and Chicago Mercantile Exchange (CME), provide a medium for trading carbon credits and carbon credit-related financial instruments (spot, futures, options etc.), offering clients price transparency, other market intelligence, and advice on navigating a complex market. However, carbon credit trading activities on these platforms remain limited, with few users and low trading volume, resulting in a thin order book. Brokers and exchanges should take a more active role in delivering these services, such as price benchmarks, to the market, as this would increase trust, and benefit all market actors.

As the financial market for carbon credits develops, so too does the need for custodians to safeguard carbon credits. Custodians provide a safe, secure and regulated environment for tracking, clearing and settling credits. In some jurisdictions, such as Canada, dealer or bank assets that are not custodied at acceptable locations attract higher capital charges. Depending on the nature of the asset, custodians can also offer other services, such as issuer services and corporate actions.

Recommendation

Banks and financiers could support and bridge the financing gap for project developers, by developing structured products and pre-financing agreements, and facilitating offtake agreements early on in a project’s lifecycle. Market makers, brokers and exchanges should collectively enhance liquidity through price transparency. By developing the role of custodian in a maturing traded market, market participants provide secure and transparent custody of carbon credits.

3.3. The need for a liquid market with price discovery

The backbone of any financial market is liquidity: the probability that an asset can be converted into an expected value within an expected time period.³⁸ VCMs have struggled with low liquidity, in part due to low levels of standardisation. Credits are issued and tracked on different platforms, each with its own standards, methodologies and methods of verification, creating confusion for buyers, and, ultimately, a barrier to trading at scale. Similarly, price discovery is crucial in giving buyers and sellers a transparent asset valuation, to make informed decisions, assess the value of their credits and manage financial risks.

The value of liquidity in VCMs is significant. Greater liquidity helps enable better price discovery, reducing volatility, increasing market confidence and participation and driving efficient capital allocation.

Price indexes are important benchmarks for investors wishing to compare their returns against a broader market. They establish price transparency and reduce information asymmetry, enhancing trade and liquidity. The crude oil market, for example, has different benchmarks for different grades of crude oil, such as West Texas Intermediate (WTI). Carbon markets could benefit from similar benchmarks, with an organisation like the International Organisation for Standardisation (ISO) supporting the development of a classification system.

Recommendation

The market should seek to achieve greater standardisation across methodologies and verification processes. Major exchanges, brokers and market actors should promote price transparency, by regularly publishing prices for spot and other types of transactions. Providers of indexes and benchmarks should seek to develop carbon indexes to drive price transparency.

_³⁸_{Liquidity: Finance in motion or evaporation?}

3.4. Develop diverse financial products and services that allow for risk management and hedging

The insurance industry can unlock value by mitigating project risks. Carbon insurance protects against risks including project underperformance, reversal of carbon sequestration and delivery failure. Insurance does exist today, but, as the market evolves, its role is set to increase, as a prerequisite for certain deals and activities. For example, a traditional credit rating agency may require insurance ‘wrapping’ around a carbon product before providing a rating.

There are different types of carbon insurance products for varying ecosystem participants – buyers, investors and project developers – including:

Delivery risk insurance policy (suitable for buyers, investors or developers): Protects against the non-delivery of credits due to project failure or force majeure events. This is particularly relevant for nature-based solutions, where weather events or disease can impact carbon sequestration. The insurance can be ‘in-kind’ or ‘cash-based’ – the former is preferable as it gives the buyer replacement credits.
Non-payment insurance policy (suitable for investors or initial project financiers): This type of insurance, which is growing in popularity, insures the financier against non-payment of the loan by the project developer.

The premium on these policies depends on several factors, including but not limited to, project size, duration, developer’s track record, financial records and technical risks of the project.

Insurance supports market confidence by de-risking carbon transactions, making buyers more willing to invest, and developers more bankable. It can serve as a powerful risk management tool, by effectively converting delivery risk into counterparty risk (of the insurer).

Recommendation

Encourage the innovation of structured products – such as carbon-backed securities, to broaden market participation. Credit rating agencies should play an active role in the market, providing investment grade ratings for products. Corporates should use hedging strategies to hedge against price and delivery risk.

3.5. Governance and regulatory oversight: aligning carbon markets with existing commodity structures

The final component to a successful financial market is support from robust governance and regulatory frameworks. VCM governance is fragmented; while compliance markets, such as the EU ETS, benefit from clear regulatory frameworks, VCMs lack oversight. However, as VCMs grow, there is a growing need to align with established commodity market principles.

The Commodity Futures Trading Commission (CFTC) in the US has signalled its interest in overseeing carbon markets, recognising them as a form of environmental commodity.³⁹ Similarly, organisations such as the International Swaps and Derivatives Association (ISDA) have begun to develop standardised contracts for carbon trading, enhancing market integrity.

Certain key developments are necessary to enable a formal carbon financial market to effectively scale VCMs. Achieving foundational principles such as liquidity and market integrity is likely to be challenging without the core infrastructure that defines a mature market: full and consistent legal, accounting, governmental and wide ecosystem support. In the next section, these necessary evolutions are explored in detail.

Recommendation

Develop a clear regulatory framework for VCMs as environmental commodities, leveraging existing commodity market principles.

_³⁹_{CFTC Approves Final Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts | CFTC}