Energy prices have been soaring in recent months, reaching record highs in many regions and countries. The main drivers of this trend are the increasing demand and supply gap for fossil fuels, such as oil, gas, and coal, as well as the growing awareness and regulation of their environmental and social costs. These factors have significant implications for carbon markets, which are mechanisms that allow countries and entities to trade carbon credits that represent the reduction or removal of greenhouse gas (GHG) emissions from the atmosphere.

Carbon markets can provide incentives and flexibility for countries and entities to achieve their emission reduction targets and enhance their ambition over time. Carbon markets can also generate financial flows and co-benefits for low-carbon development and adaptation in developing countries. However, carbon markets also pose challenges and risks to environmental integrity, human rights, and social justice. Carbon markets can create loopholes and perverse incentives for countries and entities to avoid or delay real emission reductions, double-count or over-estimate their emission reductions, or undermine the rights and interests of local communities and indigenous peoples affected by carbon projects.

In this blog, we will explore how rising energy prices affect carbon markets in terms of supply, demand, price, and impact. We will also discuss the opportunities and challenges that this situation creates for low-carbon alternatives, as well as for energy security, affordability, and equity.

Supply

The supply of carbon credits in carbon markets depends on the availability and cost of emission reduction projects or activities that generate the credits. Rising energy prices can affect the supply of carbon credits in different ways, depending on the type and location of the projects or activities.

• For projects or activities that reduce fossil fuel consumption or switch to renewable energy sources, such as energy efficiency, solar power, wind power, etc., rising energy prices can increase the supply of carbon credits by making them more attractive and profitable. For example, a study by the World Bank¹ found that higher fossil fuel prices can increase the potential of renewable energy projects in developing countries by reducing their payback periods and increasing their internal rates of return.
• For projects or activities that increase fossil fuel production or consumption, such as oil extraction, gas flaring, coal mining, etc., rising energy prices can decrease the supply of carbon credits by making them less attractive and profitable. For example, a study by the International Energy Agency² found that higher oil prices can reduce the potential of gas flaring reduction projects in oil-producing countries by increasing their opportunity costs and decreasing their net benefits.
• For projects or activities that are not directly related to fossil fuel use, such as forest conservation, waste management, agriculture, etc., rising energy prices can have mixed effects on the supply of carbon credits by affecting their costs and benefits. For example, a study by the Food and Agriculture Organization³ found that higher energy prices can have positive effects on forest conservation projects by increasing their revenues from non-timber forest products and ecotourism, but also negative effects by increasing their costs of transportation and monitoring.

Demand

The demand for carbon credits in carbon markets depends on the willingness and ability of countries and entities to buy them to meet their emission reduction targets or voluntary commitments. Rising energy prices can affect the demand for carbon credits in different ways, depending on the type and location of the buyers.

• For buyers that are subject to mandatory emission reduction targets under a cap-and-trade system or a carbon tax, such as the European Union Emissions Trading System (EU ETS) or the British Columbia Carbon Tax⁴, rising energy prices can increase the demand for carbon credits by making them more cost-effective than reducing emissions domestically. For example, a study by the European Commission⁵ found that higher energy prices can increase the demand for international carbon credits by EU ETS participants by reducing their abatement costs relative to domestic abatement costs.
• For buyers that are not subject to mandatory emission reduction targets but have voluntary commitments or aspirations to reduce emissions or achieve net zero goals, such as multinational companies or subnational governments, rising energy prices can decrease the demand for carbon credits by making them more expensive or less attractive than reducing emissions domestically or through other means. For example, a study by McKinsey & Company found that higher energy prices can decrease the demand for voluntary carbon credits by multinational companies by increasing their budget constraints or shifting their preferences towards other low-carbon solutions.
• For buyers that are motivated by other factors than emission reduction targets or commitments, such as social responsibility, reputation, innovation, etc., rising energy prices can have mixed effects on the demand for carbon credits by affecting their perceptions and expectations. For example, a study by Yale University found that higher energy prices can have positive effects on the demand for voluntary carbon credits by consumers by increasing their awareness and concern about climate change, but also negative effects by decreasing their willingness to pay for carbon offsets.

Price

The price of carbon credits in carbon markets depends on the interaction between the supply and demand of carbon credits, as well as other factors such as market design, regulation, speculation, etc. Rising energy prices can affect the price of carbon credits in different ways, depending on the type and location of the carbon markets.

• For carbon markets that are linked to energy markets, such as the EU ETS or the Regional Greenhouse Gas Initiative (RGGI) in the United States, rising energy prices can increase the price of carbon credits by increasing the marginal abatement cost of emission reduction projects or activities. For example, a study by the International Monetary Fund found that higher energy prices can increase the price of carbon credits in the EU ETS by increasing the opportunity cost of reducing emissions from fossil fuel power plants.
• For carbon markets that are not linked to energy markets, such as the Clean Development Mechanism (CDM) or the voluntary carbon market, rising energy prices can have mixed effects on the price of carbon credits by affecting the supply and demand of emission reduction projects or activities. For example, a study by the World Bank found that higher energy prices can have positive effects on the price of carbon credits in the CDM by increasing the supply of renewable energy projects, but also negative effects by decreasing the demand for gas flaring reduction projects.
• For carbon markets that are subject to external influences, such as political decisions, regulatory interventions, market shocks, etc., rising energy prices can have unpredictable effects on the price of carbon credits by affecting the expectations and behaviors of market participants. For example, a study by Carbon Tracker found that higher energy prices can have positive effects on the price of carbon credits in the EU ETS by increasing the political support for higher emission reduction targets, but also negative effects by increasing the market volatility and uncertainty.

Impact

The impact of carbon markets on GHG emissions, climate change, and sustainable development depends on the environmental integrity, social equity, and economic efficiency of carbon trading. Rising energy prices can affect the impact of carbon markets in different ways, depending on the type and location of the emission reduction projects or activities.

• For emission reduction projects or activities that have high environmental integrity, social equity, and economic efficiency, such as forest conservation, waste management, agriculture, etc., rising energy prices can enhance the impact of carbon markets by increasing their supply, demand, price, and co-benefits. For example, a study by Conservation International found that higher energy prices can enhance the impact of forest conservation projects in developing countries by increasing their revenues from carbon credits and non-timber forest products, as well as their benefits for biodiversity conservation and local livelihoods.
• For emission reduction projects or activities that have low environmental integrity, social equity, or economic efficiency, such as oil extraction, gas flaring, coal mining, etc., rising energy prices can reduce or undermine the impact of carbon markets by decreasing their supply, demand, price, or co-benefits. For example, a study by Carbon Market Watch found that higher energy prices can reduce or undermine the impact of gas flaring reduction projects in oil-producing countries by increasing their opportunity costs and decreasing their net benefits, as well as their risks for human rights violations and environmental damages.
• For emission reduction projects or activities that have mixed environmental integrity, social equity, or economic efficiency, such as renewable energy, energy efficiency, etc., rising energy prices can have mixed effects on the impact of carbon markets by affecting their supply, demand, price, or co-benefits. For example, a study by Oxfam found that higher energy prices can have mixed effects on the impact of renewable energy projects in developing countries by increasing their revenues from carbon credits and electricity sales, but also their costs of installation and maintenance.

Opportunities and challenges

Rising energy prices create both opportunities and challenges for low-carbon alternatives to fossil fuels. On one hand, rising energy prices can create opportunities for low-carbon alternatives by making them more competitive and attractive in terms of costs and benefits. This can stimulate innovation and investment in low-carbon technologies and solutions. On the other hand, rising energy prices can create challenges for low-carbon alternatives by posing risks and barriers in terms of security, affordability, and equity.

This can cause social unrest and resistance to low-carbon transition. Therefore, COP28 should address these opportunities and challenges by providing support and guidance to countries and entities that want to pursue low-carbon alternatives in a sustainable and inclusive way. Some possible actions that COP28 could take are:

• Providing financial assistance and incentives to developing countries and vulnerable groups to access and adopt low-carbon alternatives that meet their needs and preferences.
• Promoting technology transfer and cooperation among countries and entities to share and scale up low-carbon innovations and solutions.
• Enhancing capacity and development of countries and entities to enhance their skills and knowledge on low-carbon alternatives and solutions.
• Establishing standards and regulations to ensure the quality and safety of low-carbon alternatives and solutions, as well as to prevent fraud and abuse in carbon markets.
• Facilitating dialogue and participation among countries and entities to build trust and consensus on low-carbon alternatives and solutions, as well as to address conflicts and grievances arising from low-carbon transition.

Rising energy prices are a sign of the urgency and complexity of the climate crisis, as well as the need and potential for low-carbon alternatives. Carbon markets can play a key role in facilitating and accelerating low-carbon transition, but they also require clear and robust rules and guidance to ensure their environmental integrity, social equity, and economic efficiency. COP28 is a critical opportunity for countries to finalize the rulebook for carbon markets under the Paris Agreement, which has been delayed since COP24 in 2018. 

A successful outcome on carbon markets at COP28 can boost confidence and ambition in global climate action, as well as foster cooperation and solidarity among countries. However, a failure or a compromise on carbon markets at COP28 can jeopardize the environmental integrity and credibility of the Paris Agreement, as well as undermine the rights and interests of local communities and indigenous peoples. Therefore, COP28 should deliver on carbon markets with clarity, robustness, and sustainability.