OPINION: Is the drive for standardisation in carbon markets causing more fragmentation?

11 Apr 2024

Quantum Commodity Intelligence – Ellery Sutanto is head of exchange at Singapore-based exchange Climate Impact X.

Standardisation has played a pivotal role in the evolution of global commodity markets. Commodity-based markets are believed to have originated from early civilisations, between 4500 and 4000 BC, and since then, traders have sought ways to simplify and standardise trade terms. Fast forward a few millenniums, the global commodity market is estimated to be $131 trillion in 2022.

Though still in its infancy, the voluntary carbon market (VCM) plays a critical role in channelling climate finance to solutions that help with carbon removal and reduction. Sadly, this market is often hampered by opacity, uncertainty and high execution cost.

Lack of standardisation

This is in no small part due to the lack of standardisation – regulatory, classification, financial alike. Encouragingly, numerous initiatives are emerging organically to emulate the standardisation successes seen in other commodity markets.

This has promoted us to ask two questions: Is the drive for standardisation in carbon markets a fool's errand? And is it inadvertently causing more fragmentation in the market?

Anything worth doing is worth doing well. A crucial starting point is to consider whether standardisation is even possible in carbon markets.

Unlike tangible commodities which could be evaluated and graded by measurable standards, the value of carbon credits is tied to a set of complex, intangible environmental attributes and externalities.

This inherent complexity makes it hard for any one standard to accurately capture the diversity and impact of carbon reduction or removal efforts.

This is not to say that standardisation is a force fit for the carbon markets – other commodities such as oil and grain are similarly nuanced. Over time, these markets have successfully developed industry-accepted classifications and settled into pricing varying classifications as differentials to one another, most often against a 'basis grade' of the commodity.

Taking a leaf from established commodity markets, standardisation of the carbon markets should start with creating basis grades of carbon. This requires balancing between the representativeness and selectiveness of the pool of eligible projects to form the 'base'– most commonly manifested as on-exchange standard trading instruments.

A broad pool

Too broad a pool of eligible projects and the base loses selectivity and fungibility, making it difficult for buyers to trade the standardised instruments with confidence; too narrow a pool and the base loses representativeness and liquidity, making it difficult for sellers to deliver into the standard instruments.

It takes a whole orchestra to play a symphony. Carbon credits are too varied to have one carbon standard to rule them all. Standardisation requires concerted efforts around regulatory and industry-accepted standards to catalyse the evolution of carbon credits as an asset class.

First, raising the integrity bar on carbon credits. Initiatives such as the International Civil Aviation Organization's Carbon Offsetting and Reduction Scheme for International Aviation (Corsia) which acts as a proxy for Article 6 credits, and the Integrity Council for Voluntary Carbon Markets (IC-VCM)'s Core Carbon Principles (CCP) create a global threshold for high-integrity carbon credits in the market.

This in turn helps mitigate the risk for buyers and builds market confidence. In support of anticipated demand, we announced our intent to launch a set of standard CCP contracts.

Second, improving oversight on the use of carbon credits. An increasing number of international agencies and carbon certification standards are collaborating to develop unified frameworks for improved rigour in the carbon markets, acting as authoritative references for market participants to coalesce.

Orderly functioning

Third, providing guidelines for an orderly functioning of carbon markets. Global regulators and bodies, such as the Commodity Futures Trading Commission and International Organisation of Securities Commissions (IOSCO), have issued guidelines on a fair, orderly and high-integrity carbon market.

Such efforts can advance market standardisation, fostering transparency and liquidity, which is a vision that we share. To that end, CIX has been an active participant in the market consultation for IOSCO's report outlining a set of good practices aimed at promoting integrity and orderly functioning of the VCM.

Fourth, introducing financial standardisation via standard trading instruments.

For carbon markets to be adopted into the mainstream financial market, we need trade efficiency, market liquidity and price transparency that surpasses current market realities, where most trades are taking place over-the-counter and are project-specific.

In order to attract in-depth participation from market actors in a frequent, repeatable action of open price discovery, we will need a level of trade consolidation into standardised instruments.

These conditions underpin the formation of robust benchmarks, which are essential to unlocking risk management tools such as hedging and mark-to-market assessments.

Concentrate liquidity

CIX's standardised contracts and signature pricing sessions, for example, seek to concentrate liquidity, promoting a healthy bid and offer spread that indicates some degree of ongoing financial standardisation in the market.

The most common misunderstanding of disruptive innovation is to overestimate their impact in the short term and underestimate it in the long term

In order to build market efficiency and avoid further fragmenting liquidity, it is crucial that key players and enablers in the carbon services ecosystem work collectively to drive continued innovation on financial standardisation.

We thus welcome industry-wide dialogue with other exchanges and standard setters in ensuring that this market evolves and scales responsibly.

Scaling carbon markets is an ecosystem-wide challenge and no entity can solve for market-building alone.

It is imperative that we focus on building foundations of trust and establishing the right kind of participative environment for price discovery, trading and settlement, and risk management that brings greater comfort and certainty to the community.