International carbon trading has received a boost with the agreement on key principles and rules at COP29. That may be the biggest outcome of potential significance for investors and other capital-markets participants among the decisions agreed to at the United Nations (U.N.) climate conference. Countries reached consensus on high-level rules for the trading of emissions reductions between countries and an international market for project-level carbon credits, as envisioned by the Paris Agreement, after nearly a decade.
At the same time, the climate summit in Baku sent mixed signals on the future pace of the energy transition, affirming what investors already expect as an economic transformation that will unfold unevenly across markets.
Though private investments factor heavily into developed countries’ commitments to contribute at least USD 300 billion per year by 2035 to help developing countries shift to greener energy and adapt to a warming planet, barriers that impede the flow of private capital for climate action in emerging markets remain. Finding innovative solutions to unlock private capital at scale will be an ongoing challenge.
For their part, capital-market participants may be front-running the nascent efforts of governments’ adaptation discussions, as they increasingly focus on reducing the multiplying risks that a warming world presents and explore ways to allocate capital today to enhance resilience of their assets across regions.
Below are our takeaways from conversations on the ground in Baku with investors, policymakers, academics and leaders of civil society.
Carbon trading is coming of age
COP29 marked a significant milestone in the advancement of carbon trading, with progress that eluded the two previous U.N. climate summits. An endorsement of new standards for international trading of carbon reductions by countries and companies paves the way for a U.N.-backed market under Article 6.4 of the Paris Agreement, known as the Paris Agreement Crediting Mechanism (PACM). Countries also clarified rules for bilateral carbon trading under Article 6.2 of the agreement, which envisions such trading between countries as a tool to facilitate international cooperation on climate change.
While market infrastructure and specific methodologies remain to be developed, the green light from governments represents a recognition of the potential of carbon trading to lower the cost of decarbonization and allocate capital efficiently, provided projects have high integrity. Data and metrics that help investors, companies and project developers assess the integrity of projects and deliver climate impact will be increasingly important.
Agreement on Article 6.2 and implications for investors
The agreement reached at COP29 finalizes guidance for carbon trading between countries under Article 6.2, which authorizes governments to trade units known as internationally transferred mitigation outcomes (akin to carbon credits). These units count toward another country’s national climate plans, other international climate targets (such as those for international aviation) or can be used in the voluntary carbon market if authorized by the host country. Among other provisions, the agreement:
- Requests that countries provide information about authorizations and bilateral agreements up front;
- Sets rules to limit circumstances where countries could reverse the authorization to transfer mitigation outcomes;
- Outlines how the international Article 6.2 registry will function; and
- Provides (limited) provisions to address inconsistencies in countries’ approaches to ensuring integrity.
Countries will generally be unable to take back credits once transferred, reducing risks for project developers and investors. This clarification could benefit the carbon market in a number of ways, including by:
- Creating opportunities for project developers to partner with governments to deliver Article 6.2 deals;
- Enabling the use of carbon credits for international mitigation schemes, such as CORSIA for international aviation, if countries so authorize;[1] and
- Creating added certainty for carbon credit buyers in the Article 6.4 carbon market (because the restriction on revocations in Article 6.2 applies to the PACM as well).
Potential private-sector partners are also likely to welcome the greater transparency that the rules could deliver. Because the procedures for oversight of bilateral trading are less binding than some observers had hoped for, however, there remains a significant role for third-party organizations in ensuring integrity. Both the initiatives that have defined integrity standards for carbon markets, such as the Integrity Council for the Voluntary Carbon Market (ICVCM) or the CORSIA scheme, as well as independent ratings providers such as MSCI Carbon Markets, can contribute to tracking the integrity of projects traded under bilateral agreements. In short, it will be up to independent parties to assess these projects and put pressure on governments to do the right thing.
Agreement on Article 6.4 and implications for investors
The agreement brings a U.N.-backed international carbon market a step closer to operation. There are now indications that projects could be registered and start issuing carbon credits as early as next year. The agreement:
- Sets the high-level standards for carbon credit methodologies and projects;
- Adds further requirements for carbon-removal projects;
- Finalizes Article 6.4’s sustainable development tool, which addresses the environmental and social impacts of projects; and
- Provides processes for lodging grievances against projects or appealing decisions made by the PACM authority.
The emergence of a credible, U.N.-backed carbon credit mechanism presents opportunity for private investment that advances national climate targets and global goals. It provides an additional platform for companies to purchase credits that advance their climate strategies. The decisions reached at COP29 mean that investors can have greater confidence that the PACM is likely to be operational in the near future.
Many details remain to be finalized. Absent the more specific standards that must be developed or methodologies to be approved, project developers cannot submit projects just yet. The lead negotiators on Article 6.4 expressed hope, however, that the first credits could be available by the end of 2025.
Nothing agreed to at COP29 changes voluntary corporate carbon trading, which we anticipate will continue apace, with standard-setting bodies continuing to improve the quality of their methodologies and accelerate convergence with the U.N. processes. During the first week of COP29, three new methodologies for carbon projects that reduce emissions from deforestation and forest degradation (REDD+) received approval from the ICVCM for meeting their Core Carbon Principles integrity standards, marking a key milestone in building a high-integrity REDD+ market.
MSCI Carbon Markets will host a conversation on Dec. 5 to brief clients in more detail on the developments in Baku and the consequences for carbon markets. Register here (clients only).
Mixed signals on the energy transition
Countries could not agree at COP29 on how to take the energy transition forward. Nor could they affirm their pledge to transition away from fossil fuels in energy systems by midcentury as agreed to last year at COP28 in Dubai.
Several countries put forward revised national climate plans at COP29, the first in a series of such blueprints due by February:
- The U.K. unveiled a pledge to reduce greenhouse gas (GHG) emissions by 81% from 1990 levels by 2035.[2]
- Mexico said it aims to increase its share of electricity generated from clean sources to more than 40% by 2035, while reallocating 1% of military spending to reforestation.[3]
- Brazil has pledged to reduce net GHG emissions between 59% and 67% by 2035, compared with 2005 levels.[4]
Countries in Baku also announced new commitments to phase out subsidies for fossil fuels and to halt the building of new coal plants.[5] Much will depend on whether these and other commitments can be realized with concrete domestic policies. Taken together, however, the lack of consensus on fossil fuels alongside the advancements toward a clean-energy economy suggested by some updated climate plans align with both our own analysis and the market’s outlook.
Investors already anticipate a world in which the energy transition unfolds with significant disparities across regions and sectors, according to a study conducted by the MSCI Sustainability Institute and our firm’s Climate Risk Center on the eve of COP29. Dislocation between political cycles and climate action raises the risk that climate ambitions could be scaled back or delayed in some regions, while accelerating in others.
The outcomes in Baku are unlikely to change the market’s view. We anticipate that investors will continue to allocate capital by regions and sectors based on the presence of enabling policies, and that disparities in policy across regions will continue to create both risks and opportunities for capital allocators.
Climate-related physical risk moves to the forefront
It was clear from our conversations in Baku that severe-weather events and climate-driven hazards have risen significantly on the agenda of private-sector finance. A majority of investors in every region say that worsening climate impacts are creating economic fallout sooner than current scenarios anticipate, our study cited above finds. As a result, investments to reinforce resilience to climate-related physical risk are likely to ramp up regardless of decisions reached (or not reached) by countries at climate negotiations.
Adaptation is likely to continue to demand funding from governments for investments in climate-resilient infrastructure that serves the public good and protects vulnerable regions. In the meantime, as we heard at a conversation we co-hosted with BCG in Baku, the private sector increasingly sees investment in adaptation and resilience as a necessity for reducing risk. Banks and insurance companies, for example, are accessing location-specific data to sharpen their view of climate-related physical risk. They know that as the climate changes, the hazards change, as do forecasts for economic growth.
At the same time, adaptation and resilience is emerging as an investment thesis for investors who seek to capitalize on the demand for products and services that reduce vulnerability to the effects of a warming world. Researchers from the MSCI Sustainability Institute and investor-led Global Adaptation and Resilience Investor working group, for example, are using artificial intelligence to identify companies in every region that offer technologies or equipment that can help governments, businesses or households prepare for and adapt to the realities of a changing climate.
Compared with the political uncertainty that surrounds climate mitigation, the impacts of a changing climate leave little ambiguity — and they’re only likely to intensify based on society’s current emissions trajectory. Global emissions reached a record 57.1 billion tons last year and are unlikely to fall much between now and 2030, according to the latest U.N. Emissions Gap Report, which finds that current policies would translate to global warming of 3.1°C (5.6°F) above preindustrial levels this century.[6]
The landscape for climate finance looks unlikely to change
Developed countries agreed at COP29 to scale-up climate aid for their developing counterparts to at least USD 300 billion annually by 2035. Developed-country governments agreed to take the lead in tapping funds from a wide variety of both public and private sources, including multilateral development banks and private investors.
While the agreement calls on governments to send clear signals that incentivize private climate capital for emerging markets, we anticipate that the bulk of such investment will continue to come from government-to-government transfers. Though there is, as the agreement at COP29 notes, sufficient global capital to close the investment gap, the challenges in attracting private-sector finance in developing countries, including the cost of capital and the opportunity for private investors, particularly fiduciaries, to achieve the same reward for less risk in developed markets, remain.
That’s not to suggest that there isn’t room for innovation or market-based mechanisms designed to help private capital flow more freely for the energy transition in emerging economies. The enablers envisioned in the agreement on climate finance, including guarantees and support for local-currency funding, might narrow the gap between actual and perceived risks, according to global investors, development finance experts, policymakers and civil-society leaders at a forum convened by the MSCI Sustainability Institute at COP29.
A move toward standardization could help as well, stressed financial institutions in the room. Despite successes with blended finance and other mechanisms designed to enhance the bankability of projects, such mechanisms demand a degree of tailoring that prevents the scaling required to achieve climate goals.
The advent of a global carbon market may, in the end, prove to be the biggest enabler of climate action in emerging markets, by adding to the number of developing countries that are already attracting capital for clean-energy projects. Carbon trading at scale can also help to establish a uniform price for carbon that can speed decarbonization while strengthening the ability of low-income countries to benefit from debt-free investment.