As climate change continues to be a pressing global concern, climate finance remains a central focus of sustainable development. In this context, carbon markets have emerged as one avenue for companies and countries to mitigate their current emissions and meet climate targets. By pricing carbon through carbon credits, these markets are designed to encourage carbon emitters to internalize the negative externalities associated with emissions. While carbon credits have been met with criticism regarding the transparency of markets, the legitimacy of credit-verification methodologies, and the markets’ greenwashing practices, they have the potential to be a useful solution for climate change mitigation and adaptation. Climate Policy Initiative (CPI), reports $6.2 trillion of climate finance is required between now and 2030 to meet companies’ Net Zero requirements. As the carbon markets gain credibility through improved industry guidelines, blended finance can be a valuable tool in de-risking these investments and increasing private sector participation.
Carbon credits
Formally introduced to the global market in 2005, carbon credits became a central component of the Kyoto Protocol and later, the Paris Agreement under Article 6. Commonly referred to as emission trading schemes (ETS), carbon credits were created to help countries meet their emission reduction targets. A carbon credit represents one metric tonne of greenhouse gas (GHG) emissions reduced, avoided, or removed in the atmosphere because of an emissions-focused project or activity. Carbon credits can be generated through nature-based solutions (NbS) such as afforestation, reforestation, and reduced deforestation efforts, or technology-based solutions such as renewable energy projects, carbon capture practices, or clean-cooking technology. Accreditation agencies verify carbon credits sold to buyers, aiming to offset the GHG emissions that cannot be reduced through internal, operational changes.
Carbon markets
The carbon market is a specialized financial system where credits are traded by various actors, including companies, banks and project developers, amongst others. There are two main types of carbon markets where credits can be produced, bought and sold: the compliance and voluntary markets.
The compliance carbon market (CCM) is established by regional, national, and international regulatory bodies to reduce GHG emissions. CCM actors– typically companies operating in participating regions–must adhere to mandated emission limits. The voluntary carbon market (VCM) is a decentralized market where actors, including individuals, project developers, companies, banks, or even regions, voluntarily participate in producing, purchasing, and selling carbon credits. In the VCM, buyers and sellers of carbon credits are not obligated to meet certain emissions targets, but participate in reducing or offsetting their carbon emissions individually or as part of an industry. Due to the market's decentralized nature, various standards and certification programs exist to verify emission reductions and facilitate the distribution of carbon credits. Despite structural differences, the two markets share a similar goal of achieving global climate targets by cost-effectively reducing carbon emissions. In 2023, the CCM was valued at over $900 billion, while the VCM was valued at $2 billion.
Considerations and challenges
Despite the potential for carbon markets, it is important to recognize that the VCM is still in its early stages, facing growing pains that investors should consider before providing financing. A primary barrier influencing the integrity of VCMs is the lack of established regulations and standards. As a decentralized market, the VCM lacks a unified credit verification mechanism. Verification depends on certification agencies' self-determined methodologies, resulting in a wide array of what constitutes a "credit." This self-reliant verification system makes distinguishing authentic programs from greenwashing (where firms exaggerate their environmental efforts to appear more sustainable to the public) carbon credit activities and sales difficult. Moreover, certification agencies' prescriptive calculations for determining avoided emissions raise concerns that such calculations may not accurately account for the unique geographic landscapes and conditions where these emission avoidance projects occur.
Lastly, the carbon market allows companies to commit to net-zero targets by relying primarily on purchasing carbon credits rather than adapting internal practices and technology to reduce emissions. For effective climate action, carbon credits should complement decarbonization efforts within businesses rather than serve as the sole strategy to meet net-zero goals.
There are, however, ongoing efforts to strengthen the credibility of the VCM through guidelines and best-practice documents. Namely, Article 6 of the Paris Agreement facilitates voluntary international cooperation among countries to meet their Nationally Determined Contributions (NDCs). Specifically, Article 6.4 establishes a framework for a centralized, global carbon market. In addition, in June 2022, the World Resources Institute (WRI) released Guidance on Voluntary Use of Nature-based Solution Carbon Credits Through 2040, and in 2024, the U.S. Government issued a Voluntary Carbon Markets Joint Policy Statement and Principles document advocating for increased transparency of credited projects, robust third-party verification of credits, reduction of leakage and double counting, and adoption of practices that respect human rights. Organizations such as the Voluntary Carbon Markets Integrity Initiative (VCMI) and the Integrity Council for the Voluntary Carbon Market (ICVCM) have also emerged to contribute to the VCM regulation conversation. The discussion of regulating the VCM was also an agenda item at COP28, and the discussion is anticipated to continue at COP29.
Opportunities for Blended Finance
Blended finance is uniquely positioned to support VCM alignment with regulatory initiatives by building the capacity of project developers to meet standards set forth by policy bodies and by promoting market transparency, through for example technical assistance (TA). Blended finance can also be leveraged to increase private sector confidence in carbon credit-linked projects. Some private investors remain hesitant about funding carbon credit vehicles, given concerns about the project’s ability to deliver credits at the needed volume or quality, and the volatility of carbon prices in recent years. Blended finance tools, such as concessional risk insurance can help boost investor confidence and reduce perceived risks.
Similarly, a catalytic party taking a first-loss position in the transaction, and thus taking on disproportionate exposure to the risk that the carbon revenue will not materialize, can protect senior, commercial investors in the capital stack. Private commercial capital refers to institutional and individual investors, including commercial banks, investment management firms, family offices, pension funds, etc. These investors operate under strict mandates, focused on protecting clients’ capital and generating secure returns. The presence of a junior, first-loss tier in a transaction brings the risk-return profile of their senior investment into alignment with their needs.
However, there are limitations to blended finance in the VCM. While in the short term, it can attract private investment by reducing the risk profile and demonstrating the viability of initiatives, the ultimate goal of blended finance is to help develop mature markets where investments become commercially sustainable and no longer rely on concessional funding. Blended finance is not designed to be a permanent solution, but to build investor confidence and market readiness. For long-term commercial success in the VCM, stricter regulations, compliance mechanisms by policymakers, and improved market transparency by industry actors are essential.
Examples of Blended Finance in the VCM
Convergence has tracked various blended finance deals that leverage carbon credits to generate climate and social benefits. These deals demonstrate how blended finance can support pioneering transactions in the VCM and create important knowledge spillovers. For example, the Livelihoods Carbon Funds (LCF), which has launched three sub-funds thus far. The latest installment of the fund, LCF III, launched in 2021 and focuses on providing financing to project developers for ecosystem restoration, agroforestry, and rural energy projects. The fund seeks to improve food security for rural communities and income for smallholder farmers. Fund investors then receive carbon credits generated from these projects in return for their financial contributions. LCF III, received a grant from Global Environment Facility (GEF), through Conservation International to help seed the fund, as well as a partial credit-default guarantee from U.S International Development Finance Corporation (DFC), to provide risk protection against the uncertainties of the investment, making it more attractive to commercial investors. The fund aims to sequester nearly 30 million tons of carbon dioxide (CO2) in the next 20 years and to benefit two million people.
Blended finance can also aid the evolution of the VCM through TA, which can help establish a project’s credibility by improving the investment-readiness of carbon-linked transactions, providing capacity building, subsidizing operational costs, and supporting the accurate measurement, monitoring, and reporting of emissions. An example of a blended transaction using TA is Café Selva Norte, which aids smallholder farmers in Peru's transition to sustainable land practices. The project provides access to financing for smallholder coffee farmers to improve degraded coffee plantation infrastructure and operations, thereby improving product quality and generating land restoration and forestry co-benefits. The rehabilitated coffee plants and other agroforestry initiatives are expected to sequester 3.8 million tonnes of CO2, which will be converted into verified credits. The initiative received a TA grant from the Land Degradation Neutrality Fund to assist community co-operatives in establishing accurate baseline monitoring mechanisms for environmental returns.
Finally, Terra Global Capital, a leading NbS investment firm, has managed and contributed to funds focused on reducing carbon emissions through NbS. In 2011, the firm launched the Terra Global Fund to finance agroforestry small and medium sized enterprises (SMEs), integrating emission reduction strategies into their operations and generating verified carbon credits. The fund received political risk insurance from the Overseas Private Investment Corporation (OPIC) due to the limited carbon market sector knowledge at the time. Recently, Terra Global began fundraising for the Terra Bella NbS Carbon Pool Fund to support rural income growth in emerging markets through projects that generate nature-based credits by reducing deforestation and reforestation initiatives. The fund will use blended finance to create a TA facility. The facility will provide support to community-level projects to improve their bankability and provide training on sustainable land practices and carbon emission recording. Given the lack of regulation and market volatility in the VCM, blended finance can improve these projects' risk/return profile to investors and stimulate economic growth for agri-dependent communities.
Conclusion
Despite challenges, carbon markets have the potential to boost financial flows toward climate efforts. The markets’ success and integrity, however, hinge on establishing industry-wide best practices, increasing transparency in carbon-linked initiatives and implementing robust credit verification protocols. Carbon credit-linked projects are increasingly integrated into blended finance transactions, with blended finance proving out and demonstrating to commercial investors their viability. As the VCM evolves, blended finance can support bringing carbon-linked initiatives to market and providing the necessary transaction and impact data investors need to assess the risks and returns.
