How carbon markets can deliver climate investment for developing nations

With conventional development assistance in decline, innovative sources of finance are urgently needed to keep climate goals on track. Meanwhile, tariffs and cuts in development assistance are inflicting severe harm on poor and extremely climate vulnerable economies. Within this context, this article explores how sovereign carbon markets (carbon traded between countries) could become more development friendly and provide new innovative sources of finance. This includes between likeminded countries and through new linkages to different types of carbon border, taxation, and emissions trading schemes (ETSs).

Carbon markets go mainstream

Most national carbon action plans under the Paris Agreement that have been submitted to date – the nationally determined contributions (NDCs) – now integrate carbon markets. This signifies widespread recognition of carbon markets’ instrumental role to advance domestic climate change ambitions and international commitments. Since the international framework to support international carbon markets – Article 6 of the Paris Agreement – was finalized at COP29 in Baku in November 2024, there have been new moves to utilize the new agreement to secure international climate change goals through leveraging high-integrity carbon markets.

For example, discussions within the European Union have recently signaled an intention to consider the role of the carbon credits obtained through Article 6 provisions to support the EU’s ambitious climate change targets. New flexibilities could include:

• a possible limited role for high-quality international carbon credits in the second half of the 2030 to 2040 decade
• the use of domestic permanent removals (for example, carbon captured and stored within the EU permanently) in the EU Emissions Trading System (EU ETS)
• enhanced flexibilities across sectors

Re-establishing green leadership

These flexibilities come at a time of continued controversy regarding the EU’s application of carbon border adjustments (CBAs). Due to be imposed by 2026, CBAs impose costs on selected imports according to their embedded carbon intensity and are intended to level the playing field between EU firms and importers. CBAs are expected to raise more than USD 80 billion per year in potential revenue by 2039, depending on price and emission intensity. However, at the time of writing, there is no provision for revenue recycling, where revenues are recycled into green investments in adversely affected countries, particularly those making only minimal contributions to global greenhouse gas emissions.

This inequity continues to fuel controversy regarding the application of CBAs, especially given the UN Framework Convention on Climate Change (UNFCCC) principle of Common But Differentiated Responsibility (which states that while all countries must act on climate change, wealthier and historically higher-emitting nations are expected to do more). Given this, the new moves to include Article 6 credits, whether internationally transferred mitigation outcomes (ITMOs), government to government credits under the Paris Agreement, or emission reductions (credits traded under a centralized body, in the context of CBAs could provide much needed green leadership, as well as channel new sources of finance to the most climate vulnerable economies.

New finance through Article 6

Under Article 6 of the Paris Agreement, carbon credits allow countries to trade emission reductions with one another. Singapore’s carbon tax, for example, permits firms to use ITMOs to offset up to 5% of their taxable emissions. Switzerland employs a similar approach, requiring motor oil importers to retire ITMOs to fulfil domestic carbon tax obligations, effectively treating them as a form of carbon tax payment (see Article 6 piloting: state of play and stakeholder experiences).

Many developing countries have expressed their intentions to develop carbon markets to achieve the ambitions specified within their NDCs submitted as part of UNFCCC processes. India, for example, will implement its own ETS in 2026, known as the carbon credit trading scheme, to support its climate change goals. Developing carbon markets, including through ETSs, may therefore not only be a route to adjusting to CBAs but also to incentivize broader green transition and sustainable development aspirations enshrined within countries’ NDCs.

Who bears the burden?

In principle, ETSs can produce the same carbon price effect as carbon taxes. However, carbon taxes can be politically more challenging to implement. ETSs can be more politically palatable because the burden is perceived to fall less on voters. Equity and fairness are important considerations, both within and between countries, as carbon pricing schemes expand and CBAs become more widespread. Within this context, the international trade dimension of sovereign carbon markets plays a vital role in cost-effectively reducing emissions and supporting cap-and-trade systems.

Without access to climate finance at scale, developing countries cannot afford to decarbonize. Carbon trading not only generates economic benefits, but if the resulting savings are re-invested, climate ambition can be further enhanced.There are now several proposals to ensure Article 6 channels and supports green investment and global decarbonization efforts (such as a proposal for border carbon adjustments to increase global climate finance).

For example, Mozambique – consistently highlighted as one of the most exposed countries to the EU’s CBA based on its current scope – has a strong interest in carbon markets but does not yet have a carbon price. Mozambique is also seeking to increase the share of renewables in energy consumption (driven by hydropower); this could boost its future green competitiveness in the future, assuming indirect emissions will be under the CBA’s scope at a later date. This is because, currently, the energy supply for aluminum production comes from the South African grid. To overcome the challenges of CBAs, one obvious route is to ensure production is powered by Mozambique’s own grid, reducing embedded carbon and enhancing green competitiveness – which provides an obvious entry point for new resources channeled via Article 6.

A race against time

International carbon markets aim to cut emissions where costs are lowest. But more than this, carbon markets as conceived within Article 6 of the Paris Agreement are intended to incentivize nature-based solutions, as well as carbon capture and storage. There is an urgency in not only putting a price on carbon and supporting its removal from the atmosphere, but also profoundly shifting how we perceive and value nature-based ecosystem support services. Last year was the hottest on record, with average global temperatures exceeding those of any previous year.

A larger share of resources raised through Article 6 will be channeled into an adaptation fund compared with the previous international carbon trading mechanism – the Clean Development Mechanism (CDM). Indeed, many of the lessons learned from the CDM have been encompassed within the design of Article 6. Moving to operationalize Article 6 within the current global context now assumes a particular urgency, given the need to keep climate change goals on track and to secure green investment within a challenging geopolitical landscape.