An investigation by The Guardian in 2023 revealed that over 90% of forest-based carbon offsets certified by Verra, a leading carbon credit certifier, were likely worthless. This raised serious concerns about the integrity of the carbon offset market and the reliability of carbon credits as a tool for climate action.

Meanwhile the Australian Institute has criticised the Australian Carbon Credit Unit (ACCU)for issuing credits for projects that did not deliver genuine emission reductions. This has led to concerns about the environmental effectiveness of the scheme and its ability to achieve climate targets.

The Global Forest Coalition has shown that The Ecotrust Uganda Project,which aimed to generate carbon credits by planting trees in Uganda, was found to have significant flaws in its implementation. The project failed to deliver on its promises of carbon sequestration and sustainable development, and instead led to land grabbing and displacement of local communities.

Is this an unintended effect of global carbon trading or the inevitable result of a system designed to give polluters access to the cheapest carbon offset programmes regardless of its consequences?

The Economic Foundations of Carbon Trading

At its core, carbon trading is built on a simple but powerful economic principle: when something becomes more expensive, people use less of it. This fundamental relationship between price and consumption forms the backbone of how carbon markets should work.

Carbon emissions have long been what economists call a “negative externality” – a cost imposed on society that isn’t reflected in the price of goods and services. Carbon trading attempts to correct this market failure by putting a price on emissions, effectively internalizing this external cost. When companies have to pay for their emissions, they have a direct financial incentive to reduce them.

The price mechanism works through multiple channels. In the short term, companies will reduce emissions when the cost of doing so is less than the cost of buying carbon credits. More importantly, over the longer term, higher carbon prices drive innovation by making low-carbon technologies and processes more commercially attractive. This is where the true transformative potential of carbon markets lies.

Market boundaries play a crucial and often overlooked role in this process. When carbon trading is global, companies naturally seek the cheapest possible credits, often from projects in developing countries. While this might seem efficient, it can actually undermine the market’s fundamental purpose. Very low prices fail to create meaningful pressure for technological change or operational improvements. It’s like trying to solve a local traffic problem by paying people in another city to take the bus – it might look good on paper, but it doesn’t address the root issue.

Local carbon markets, in contrast, create stronger and more focused price signals. When companies can only trade credits within their jurisdiction, the price better reflects the true cost and difficulty of reducing emissions in that economic context. This leads to more accurate price discovery – the process by which markets determine the real value of goods or services.

The basic economic logic here is straightforward: local markets create local solutions. If reducing emissions in a particular region is genuinely difficult and expensive, carbon credit prices will rise accordingly. These higher prices then incentivize local entrepreneurs and innovators to develop new solutions, creating a virtuous cycle of innovation and adaptation.

How Global Markets Diverged from Economic Principles

The current global carbon trading system offers a masterclass in how good economic theory can be undermined by poor implementation. The fundamental disconnect emerges from a misguided focus on making carbon credits as cheap as possible, rather than as effective as possible.

Consider the case of forest preservation credits in the Amazon. In theory, paying to preserve forests that would otherwise be cut down is a valid way to reduce emissions. However, in practice, investigations have found numerous projects claiming credits for protecting forests that were never at risk of being cut down. This isn’t just a verification problem – it’s a direct result of market incentives. When companies can buy credits from anywhere in the world, they naturally gravitate toward the cheapest options, creating a race to the bottom in quality.

This race to the bottom manifests in several ways:

First, there’s the “leakage” problem. A project might protect one forest area, only to have deforestation shift to an adjacent region. The emissions aren’t reduced – they’re just moved. In a local market, such displacement would be obvious and would affect credit validity. In the global market, it’s easily obscured.

Second, we see the “additionality” challenge. Many projects claim credits for actions that would have happened anyway. Chinese hydroelectric projects, for instance, have claimed millions of credits for dams that were already economically viable and would have been built regardless. This problem persists because the global system’s complexity makes it nearly impossible to verify true additionality.

Third, there’s the price signal failure. When credits trade for a few dollars per ton because companies can access ultra-cheap international options, it creates the illusion of climate action without driving real change. A steel manufacturer in Germany buying $3 credits from questionable projects abroad has no incentive to invest in expensive but necessary technological improvements.

The verification challenges compound these issues. Distance doesn’t just make verification harder – it makes it qualitatively different. Local regulators can physically inspect projects, understand local context, and maintain ongoing oversight. Global verification often relies on paper trails and satellite imagery, missing crucial local nuances.

Perhaps most perniciously, the current system has created a moral hazard. The easier it is to buy cheap credits; the less pressure companies feel to make fundamental operational changes. This directly contradicts the market’s theoretical purpose of driving innovation and transformation.

The Local Solution: Restoring Market Fundamentals

Localizing carbon markets does more than just simplify oversight – it realigns market incentives with environmental goals. Let’s examine how this addresses each of the major failures we’ve identified.

First, consider the price signal. When a steel manufacturer can only buy credits generated within their own jurisdiction, the price naturally reflects the real cost of reducing emissions in that economic context. If local reduction opportunities are limited, prices rise. While this might seem like a problem, it’s actually the market working as intended. Higher prices drive investment in new technologies and processes. A steel company facing $100/ton local carbon prices has a genuine incentive to invest in hydrogen reduction or carbon capture technologies.

The leakage problem becomes largely self-correcting in a local system. When all credits must be generated within the same jurisdiction, displacement of emissions becomes visible and measurable. If protecting one forest just shifts logging to another local forest, this becomes immediately apparent to regulators and market participants. The confined geographic scope makes it much harder to hide environmental shell games.

Additionality verification improves dramatically. Local regulators and market participants have deep understanding of their industrial base, economic conditions, and development patterns. They can make informed judgments about whether a project truly represents additional emission reductions. A local environmental agency can readily determine if a new solar farm would have been built anyway, something that’s much harder to assess across international borders.

The moral hazard of cheap credits disappears. When companies can’t shop globally for the cheapest possible credits, they must confront the real cost of their emissions. This drives precisely the kind of innovation and operational changes that carbon markets were meant to encourage. A cement manufacturer can’t avoid investing in cleaner technology by buying questionable credits from halfway around the world.

The limited international trading window (5-10%) we discussed maintains some flexibility without undermining these benefits. This allows access to some high-quality international projects while ensuring the bulk of reductions happen locally.

Crucially, local markets also create positive feedback loops. As local carbon prices rise, they attract entrepreneurs and innovators focused on solving local emission challenges. This builds local expertise and capacity, leading to more reduction opportunities and more efficient markets over time.

Addressing Concerns: The Case Against Localization

Critics of market localization raise several significant concerns that deserve careful examination. Let’s address each one:

Local Markets Will Be Too Expensive – This is perhaps the most common objection. Critics argue that forcing companies to buy local credits will dramatically increase compliance costs. However, this argument misunderstands the purpose of carbon pricing. Higher prices aren’t a bug – they’re a feature. If reducing emissions in a particular region is expensive, the price should reflect that reality. This is what drives innovation and structural change. Moreover, experience with regional carbon markets, like California’s cap-and-trade system, shows that local economies adapt when given clear price signals.

Small Markets Won’t Be Liquid Enough – Another frequent concern is that local markets won’t have enough buyers and sellers to function efficiently. While market size does affect liquidity, modern financial markets can operate effectively at various scales. Consider that many commodity markets function well within regional boundaries. The key is proper market design – ensuring regular trading, transparent price discovery, and appropriate participation rules. A well-designed local market with clear rules can be more efficient than a larger, poorly regulated global one.

We’ll Lose the Benefits of International Investment – Some argue that localizing carbon markets will deprive developing nations of valuable climate finance. This is a serious concern, but it assumes that current international carbon trading is effectively delivering this investment. Evidence suggests otherwise – many international credits fund projects of questionable value while allowing continued emissions in developed nations. Better mechanisms for international climate finance could include direct investment, technology transfer, and targeted aid – separate from carbon markets.

It’s Less Efficient Than Global Trading – Economic theory suggests that global markets should find the lowest-cost emission reductions. However, this theoretical efficiency depends on perfect information and verification – conditions that clearly don’t exist in current markets. Local markets trade some theoretical efficiency for practical effectiveness. The “inefficiency” of higher local prices is actually the market correctly pricing the real cost of emission reductions.

Implementation Would Be Too Complex – Transitioning from global to local markets would indeed be challenging. Companies have built business models around current systems, and changing them would require careful planning. However, the complexity of implementation shouldn’t be confused with complexity of operation. Local markets would actually be simpler to run and regulate once established.

Where to go from here?

The global carbon credit system is at a critical juncture, facing significant challenges that undermine its effectiveness in combating climate change. Integrity concerns, lack of standardization, and reputational risks have led to a decline in confidence among stakeholders. However, a clear path forward exists that involves actionable strategies for policymakers and proactive engagement from businesses.

Policymakers must establish robust regulatory frameworks that ensure the integrity of carbon credits while promoting localized markets. By encouraging communities to participate directly in carbon credit projects, they can foster solutions tailored to specific regional needs. Additionally, integrating carbon taxes with carbon credit systems can create comprehensive financial incentives for businesses to reduce emissions genuinely.

Businesses, in turn, have a vital role to play by investing in sustainable practices and engaging with local initiatives. Transparency in emissions reporting and carbon credit transactions will build trust with stakeholders and demonstrate a commitment to meaningful climate action.

By implementing these strategies, we can enhance the integrity of the carbon credit system, drive real emissions reductions, and foster greater community engagement. Ultimately, these efforts will contribute to achieving global climate goals while supporting local economies and environmental sustainability.