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Forest Carbon Market Structures and Mechanisms

This article provides an introduction to differences across carbon market structures. Content provided by the Forest Owner Carbon and Climate Education (FOCCE) program.

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Updated:

October 12, 2023

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Introduction

Credits generated from forest carbon projects can be sold to either compliance or voluntary carbon markets, depending on the methodology and standard used for the project. Key aspects of each of these carbon market structures are discussed in this paper, including the motivation for credit transactions, dynamics of supply and demand, and differences across the market schemes in terms of commitments, requirements, development, verification, and market size.

Compliance Markets

Compliance markets are created and regulated by mandatory national, regional, or international carbon reduction programs. Generally referred to as cap-and-trade markets or emission trading systems (ETS), these are markets in which actors, generally businesses within capped sectors, are required to emit no more than their set greenhouse gas (GHG) emissions cap. Any emissions above that cap must be offset by a reduction in emissions elsewhere, with such transactions occurring within the compliance market. Emissions allowances are typically lowered over time such that, in theory, this mechanism will reduce overall emissions from a given sector over a set timeframe. Individual businesses make decisions about when and how to invest in new technology or participate in other advancements to reduce emissions, recognizing that the costs of continuing to emit will increase over time as the cap lowers.

Illustration of a cap and trade market. Image by the Forest Carbon and Climate Program.

The illustration above shows a depiction of a compliance, or cap-and-trade, market. In this example, Business A has produced emissions that exceed its emissions cap. In contrast, Business B has emitted fewer GHGs than its set cap and, as such, is in possession of excess allowances. Business A has two choices: either buy the excess allowances from Business B or offset their excess emissions by purchasing credits generated by projects storing or sequestering additional carbon, such as an approved forest carbon project.

For example, if a power plant is required to keep emissions below 2 million metric tons of CO₂e annually but emits 2.5 million metric tons each year, the plant will need to purchase 0.5 million credits to offset the excess emissions. The terms "credit" and "offset" are often used interchangeably because they refer to the same unit. One metric ton of CO₂e stored or avoided for 100 years is equivalent to one carbon credit and can be used to offset one metric ton of CO₂e. Note that most compliance markets limit the percentage of allowable emissions that may be offset with carbon projects in addition to having rules limiting the types and locations of allowable projects. As an example, under the California Cap-and-Trade Program, regulated entities are currently permitted to offset only 4% of their emissions in order to meet overall compliance, and 50% of those offset credits must come from projects that directly benefit California.

Voluntary Markets

Like compliance markets, the voluntary carbon market (VCM) aims to facilitate overall emissions reductions. Here, too, actors seek to keep emissions at or below a specific target level, though it is not regulated that they do so. Often these are sustainability targets agreed upon by companies or groups of companies representing specific industries. Because participation is voluntary and unregulated, voluntary markets do not have viable enforcement mechanisms to ensure that actors comply with their expressed targets. An entity that emits more than their target has two choices: it can either offset emissions elsewhere and remain in compliance with their self-enforced target, or it can become non-compliant. In the absence of enforceable penalties, VCMs are driven by a variety of factors such as considerations around corporate social responsibility, ethics, and reputational or supply chain risk.

Illustration of voluntary carbon emission reduction targets and offsetting. Image by the Forest Carbon and Climate Program.

Supply and Demand of Forest Carbon Credits

Key actors involved in the supply and demand of forest carbon credits in compliance and voluntary carbon markets are shown in the table below. Forest landowners and managers who voluntarily engage in forest management activities (as part of a forest carbon project) are the primary suppliers of carbon credits in both voluntary and compliance markets, alongside project developers and credit brokers, who are involved in the issuance and transfer of credits.

However, the demand side of the two market types is fueled by different actors and actor motivations. Under a compliance market, demand for carbon credits comes directly from businesses in emissions-capped sectors that have emitted more than their determined allowance. Government action can impact the strength of that demand by adjusting the terms of the compliance regime through actions such as manipulating or mandating carbon credit prices, increasing or decreasing corporate emissions allowances, and determining which industries are required to cap emissions.

In the voluntary market, demand can come from a variety of actor types including businesses, nonprofits, governments, and individuals. Demand may shift in response to market prices and motivational changes such as organizational climate commitments and personal interest.

Table 1. Actors impacting the supply and demand of forest carbon credits in compliance and voluntary markets.
Market	Demand	Supply
Compliance	Direct demand comes from businesses in emissions-capped sectors that have emitted more than their allowed amount. Demand is impacted by government actions affecting carbon credit price, emissions targets (how difficult they are to achieve), and which industries are included in the scheme.	Forest landowners and managers engaging in voluntary forest management activities Project developers Credit brokers and exchanges
Voluntary	Demand comes from businesses, nonprofits, and voluntarily looking to curb net emissions, motivated by ethical, reputational, or supply chain considerations.	Forest landowners and managers engaging in voluntary forest management activities Project developers Credit brokers and exchanges

Although voluntary markets are growing rapidly (nearly quadrupling between 2020 and 2021), the demand from voluntary markets is still dwarfed by that of compliance markets. In 2020, demand from across the thirty compliance markets operating around the world represented US$851 billion (15,811 mtCO₂e), while demand from voluntary markets in 2021 was US$1.985 billion (493 mtCO₂e). Notably, the European Union’s Emissions Trading System (EU ETS), which does not allow forest carbon offset projects, accounted for 90% of the global value of compliance credits in 2021. In voluntary markets, 46% of credits supplied in 2021 came from forestry and land use projects, with 65% of those credits coming from REDD+ projects. 'REDD' stands for "Reducing emissions from deforestation and forest degradation in developing countries." The '+' stands for "additional forest-related activities that protect the climate, namely sustainable management of forests and the conservation and enhancement of forest carbon stocks" (United Nations Climate Change).

Comparing Attributes of Compliance and Voluntary Markets

Beyond the supply-demand divide, other differences exist between compliance and voluntary markets. These differences are associated with external standards set by certifying bodies—standards that project developers must comply with to generate credits appropriate to the type of market they are supplying. However, many attributes are shared between compliance and voluntary markets. Table 2 lists a series of market attributes for easy comparison.

Beyond the fundamental difference of mandatory versus voluntary enrollment, the biggest differences between the two markets are found in the project commitment parameters. For credits traded in compliance markets, projects must commit to a 100-year or longer contract with varied acreage requirements, whereas in voluntary markets projects can span a much shorter time period of contracts ranging from one to forty years and project acreage is generally small, under forty acres.

Many attributes are shared across compliance and voluntary markets, such as project requirements concerning additionality, permanence, and leakage; the basic developmental stages projects must go through (feasibility analysis, carbon inventorying, verification, registration, and monitoring); and the need for third-party verification processes.

Forest landowners with smaller parcel sizes may find voluntary carbon markets more accessible, especially if they are able to enroll in programs that reduce the burden of up-front costs associated with determining feasibility and other developmental stages of a carbon project such as inventorying, verification, registration, and monitoring.

Table 2. Attributes of compliance and voluntary markets.
Attribute	Compliance	Voluntary
Enrollment	Mandatory according to regulations	Voluntary by interested parties
Commitments	Initial ~100+ year contract (generally can renew for shorter period); acreage requirement varies by project developer	1–40+ year contracts; 1–40+ acres, depending on approved project methodology
Requirements	Real, additionality, permanence, non-leakage	Real, additionality, permanence, non-leakage
Development stages	Feasibility analysis, carbon inventorying, verification, registration, monitoring	Feasibility analysis, carbon inventorying, verification, registration, monitoring
Verification process	Third-party audit, periodic ground-truthing	Third-party audit, verification process varies
Market size (2021)	US$851 billion (15,811 mtCO₂e)	US$1.985 billion (493 mtCO₂e)