Market fragmentation describes when a market is divided into numerous segments, each served by different companies, with no single entity dominating the market. This leads to intense competition, an often confusing variety of choices for consumers, poor transparency due to the numerous players competing for market share.
The voluntary carbon markets (VCM), suffers from such fragmentation due to the dozens of issuing bodies, hundreds of methodologies and use of low-tech infrastructure to manage the complexities. This is largely a consequence of the lack of regulation, diverse approaches to carbon offsetting and decentralised, broker-mediated, OTC trading.
Fragmentation impedes the establishment of a coherent and scalable VCM by complicating the comparability and aggregation of carbon credits. This, combined with disparate pricing mechanisms, and no common benchmarks, further contribute to market inefficiencies, potentially discouraging investments in carbon reduction projects and increased inefficiencies and transaction costs.
Efforts to address market fragmentation typically involve the development of common standards and practices, ratings agencies, data homogeneity and robust methods to track the ownership and retirement of carbon credits. Getting these elements right is crucial for enhancing market transparency, integrity, and accessibility. This will ultimately make voluntary carbon markets a more effective tool for global climate change mitigation.
Right now, carbon markets are too fragmented. The key to scaling investment is harmonising markets so that they can link across borders.
Dirk Forrister, IETA (Reuters, 2023)
Causes of Fragmentation in VCMs
Diverse Standards and Methodologies: There are numerous standards for verifying and validating carbon offset projects, such as the Verified Carbon Standard (VCS), Gold Standard, and Puro. Across the 5 main standards alone there are over 200 differing methodologies, which adds complexity to the market.
Geographical Differences: Carbon offset projects are globally dispersed, and regional differences in carbon taxation, regional registries and market access can stunt the scale of certain projects and methodology types.
Clarity on what constitutes an ‘impactful’ project: Lack of clarity stems from varied standards and methodologies, leading to inconsistent benchmarks for quality and effectiveness. Diverse project types, ranging from forestry to renewable energy, further complicate the establishment of a universal quality measure.
Implications of Fragmentation
Price discovery: Fragmentation leads to inefficiencies in the market, making it harder for buyers to compare and value carbon credits accurately. This can relate to quality, but also to price-discovery and therefore hamper both the supply and demand side of any transaction.
Reduced Transparency: With so many standards and project types, it becomes challenging for investors and buyers to make informed decisions and contributes to the perceived risk of greenwashing. Businesses rarely get a full market picture, and are typically limited to what their intermediary has available to show them.
High barriers to Entry: The complexity of navigating through various standards can be a deterrent for new entrants, both on the supply and demand side of the market. Businesses can choose the less risky option to not engage at all.
Reduced fungibility/aggregation: All carbon credit projects are defined using certain attributes. These include Sustainable Development Goals (SDGs), the type of project, the location, the vintage year etc. The credits from one project and vintage will not share the same attribute values as other credits from a different project and vintage. This is known as semi-fungibility and results in numerous low volume pockets of fungibility. The semi-fungible nature of carbon credits means that financial instruments that could dramatically scale the market are hard to implement.
Data management: Purchasing credits from across different registries and being able to easily track and report against offsetting is extremely challenging for businesses in its current format.
Towards a More Unified Market
Fragmentation presents considerable challenges that can hinder the efficiency and efficacy of carbon markets. In order to move towards an effective market we should move towards a more unified market. Below lists some of the potential areas of improvement and some of the actions already taking place.
Harmonisation of Standards: Efforts to harmonise standards across different certification bodies could reduce inconsistencies in how carbon credits are valued and traded. Efforts like the World Bank’s Climate Action Data Trust to develop standardised meta-registries are a step in the right direction.
Improved Transparency and Reporting: Efforts from the now combined forces of Integrity Council for the Voluntary Carbon Market (ICVCM) and Voluntary Carbon Markets Integrity Initiative (VCMI) with their CCP’s will dramatically support businesses designing and implementing their carbon strategies. Clear and consistent reporting guidelines across different market segments can enhance transparency, making it easier for buyers to make informed decisions.
Building Market Infrastructure: Developing a more unified market infrastructure, including centralised markets, data repositories and registries, can help streamline transactions and improve market efficiency.
Standardised units: Standardised carbon units being developed off the back of some of the aforementioned efforts are being created around the market. These units aim to provide a uniform measure for quantifying and comparing carbon credits across projects. The simplification of the buying process is intended to reduce demand friction and support dramatic scaling of the market.
Ratings agencies: BeZero and Sylvera are leading the charge with rating and reporting against individual projects. Harmonised ratings will allow for businesses to be more discerning about the credits they’re purchasing and allow for increased fungibility between different project types.
Conclusion
Market fragmentation in voluntary carbon markets causes significant friction that must be resolved to unlock the scalability required for major climate action.
Solving data management, price opacity and fungibility issues are serious challenges, but also offer opportunities for improvement and innovation. Harmonising standards, improving transparency, developing market infrastructure, and enhancing stakeholder collaboration are critical steps towards a more efficient and effective market.
As the world increasingly looks towards market-based solutions to combat climate change, addressing the issue of market fragmentation in the VCM will be critical for its success and credibility.
