Derivatives play an essential role in carbon markets. Companies subject to carbon compliance programs use carbon derivatives to meet their obligations and manage risk in the most cost-effective way. Derivatives can also be used by a variety of businesses that have financial positions indirectly tied to carbon prices. Investors can use the price signals from carbon derivatives to assess climate transition risk in their portfolios and can then access liquidity pools to manage risk and allocate capital to benefit from energy transition opportunities.
Derivatives markets also play a major role in enhancing transparency by providing forward information on carbon, which contributes to long-term sustainability objectives and provides helpful signals to policy-makers on the regulation of carbon prices.
This paper describes the role of derivatives in carbon markets and reviews exchange-traded and over-the-counter carbon derivatives. It also provides some insights on compliance and voluntary carbon markets and explains how firms use these markets and carbon derivatives to meet their compliance obligations, achieve corporate social responsibility goals and manage risks. In addition, the paper summarizes global climate change mitigation efforts and international carbon markets.