Last updated:
May 24, 2024

Compliance Market

What is the Compliance Carbon Market?

The compliance carbon market is a regulatory system where governments enforce emission reduction targets on entities. This market operates under a cap-and-trade system, setting a limit on overall emissions and requiring entities to hold emission permits (or credits) equivalent to their emissions. The fundamental distinction from the voluntary market lies in its mandatory nature, driven by governmental policies and regulations.

Who Partakes in the Compliance Market?

  • Emission Reducers: These are typically large-scale industrial companies and power producers that are significant sources of greenhouse gas emissions. These entities are required to either reduce their emissions to meet the cap or purchase additional allowances to cover their emissions.
  • Traders and Investors: The market also includes traders and investors who participate in the buying and selling of emission allowances. These participants may include financial institutions, investment funds, and specialised trading firms. They play a vital role in the market by providing liquidity, enabling price discovery, and facilitating the efficient allocation of allowances.

Difference Between Compliance and Voluntary Markets

In contrast to the voluntary market, where participation is driven by corporate choice, the compliance market is regulatory and obligatory. Entities in the compliance market are legally bound to adhere to emission caps, with non-compliance resulting in legal repercussions. Conversely, the voluntary market is guided by market dynamics and individual corporate objectives, focusing on environmental responsibility and brand reputation.

How the Compliance Carbon Market Works

In the EU, the  European Emission Trading System (EU ETS) works on a cap and trade principle via a carbon market. This system imposes an overall emissions cap, which is progressively lowered over time. It allows for the trading of emission permits, encouraging reductions in emissions and fostering innovation in green technologies since it gives companies monetary incentive to lower their own emissions by selling their unused emissions to other companies and traders.

How an emission trading system works
In the context of the compliance market, carbon credits represent emission allowances.

Regulation in the Compliance Market in the EU

  • The EU ETS launched in 2005 and operates in different trading phases. The system is currently in its fourth phase, running from 2021-2030. The legislative framework behind this can be found in the ETS Directive.
  • In order to keep the system in-line with the broader EU climate goals, the EU ETS legislation gets revised periodically, with the most recent revision occurring in 2021 to align with the European Green Deal.
  • The cap on emissions covered by the EU ETS is set to decrease by 62% of 2005 levels by 2030.
  • In 2021, the European Commission presented the Fit for 55 package, which is intended to reform EU policy surrounding climate and energy, including the EU ETS. The ETS-related proposals were adopted by the European Parliament and Member States in the Council of the EU in June 2023, and are now a part of EU climate regulation.

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