Compliance Market

Last Updated:
February 14, 2024
Compliance Market explained
The transition to a low carbon economy is on every CEO's agenda nowadays. The impacts of climate change and responses to it will transform every business sector in the coming decades. Although Climate change will affect a majority of companies, all will be expected to contribute to its solution.
Nevertheless, it is challenging for most companies to devise and implement a credible decarbonisation strategy. The transition requires new ways of doing business, including new ways of displaying capabilities and resources and new ways of thinking. But despite the challenges, companies around the world are scaling up their decarbonisation commitments.
We can see this trend with the number of companies committing to reducing emissions. More than 2000 companies have confirmed emissions reduction targets under the Science Based Target initiative (SBTi). Additionally, more than 370 have committed to The Climate Pledge, pledging to achieve net zero emissions by mid-century or sooner.
For most companies and investors, carbon credits play a crucial role in their Net-Zero strategy. They allow companies to make earlier and more ambitious commitments. Credits allow companies to reduce their current emissions through offsets, while taking cost-effective steps to reduce future emissions through asset rotation and business model development. In the long term, credits can play an essential role in offsetting difficult-to-avoid emissions from products for which no low- or zero-emission options exist.
The growing interest in recent years is also reflected in the Voluntary Carbon Market (VCM), which organises the pledging and trading of carbon credits. In 2022, the demand for carbon credits is at its peak. Prices have increased by more than 140% since 2021 and forecasts assume that demand for credits will increase 15-fold by 2030, to $50 billion per year.
But the voluntary carbon market has a problem. It cannot cope with demand. Access, which plays a crucial role in the global effort to combat climate change, is often limited to large organisations and is characterised by opaque pricing and market inefficiencies. Furthermore, due to a lack of transparency and credibility, it has faced a number of problems in recent years.
This report examines the key role for on-chain carbon credits as part of net zero strategies and the VCM. It was prepared by senken to help business decision makers identify and understand the best use of credits for their business.

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 EU ETS 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.