Carbon Markets & Sustainable Finance

A carbon market allows countries or companies to trade emission allowances or credits, putting a price on greenhouse gas emissions. It uses market incentives to reduce emissions where it is cheapest. The two main instruments are:

• Emission Trading Systems (ETS) (cap-and-trade)
• Carbon credits / offsets

Cap-and-Trade (ETS)

A regulator sets a cap on total emissions for covered sectors. Emission allowances equal to the cap are allocated or auctioned.

• Firms emitting less can sell surplus allowances.
• Firms exceeding limits must buy allowances or pay penalties.
• This creates a market price for emissions.
• Caps usually decline over time, raising prices and encouraging cleaner technologies.

Examples:

• EU Emissions Trading System (EU ETS): Launched in 2005; covers power plants, factories, and airlines in Europe. Each allowance equals 1 ton of CO₂. Prices have often ranged €50–€100/ton, driving emission cuts and green investment.
• Other ETS: California (USA), China (national ETS launched 2021, power sector), South Korea, New Zealand, UK, and several pilots.
• Banks participate by trading allowances, financing emission-reduction projects, and treating allowances as an asset class.

Carbon Credits (Offsets)

Carbon credits represent verified emission reductions from specific projects and are used to offset emissions.

• Kyoto Protocol mechanisms: Under the Kyoto Protocol, the Clean Development Mechanism (CDM) issued Certified Emission Reductions (CERs). India was a major participant, especially in renewable and industrial projects.
• Voluntary Carbon Market (VCM): Companies or individuals buy offsets voluntarily to meet carbon-neutral or net-zero goals. Projects include reforestation, renewables, and methane capture, certified by standards such as Verra or Gold Standard.
• Each credit usually equals 1 metric ton of CO₂e reduced or removed. Credits must be additional and not double-counted.

Compliance vs Voluntary Markets:

• Compliance markets (ETS, regulated credits): stricter rules, generally higher prices.
• Voluntary markets: prices vary widely by project type and quality, with nature-based credits priced differently from industrial projects.

Carbon Markets in India

India historically did not have a national CO₂ cap-and-trade system, but it has used market-based mechanisms for energy efficiency and emissions reduction.

Perform, Achieve and Trade (PAT) Scheme

Launched in 2012 by the Bureau of Energy Efficiency, PAT sets energy efficiency targets for large energy-intensive industries (steel, cement, fertilizers, power plants). Entities that exceed targets earn Energy Saving Certificates (ESCerts), which can be sold to underperforming entities for compliance. PAT has run in multiple cycles and delivered significant energy savings, though ESCert prices have remained modest.

Renewable Energy Certificates (RECs)

Under Renewable Purchase Obligations (RPOs), utilities and certain entities must source a share of electricity from renewables. If unable to do so, they can buy RECs, where one REC equals 1 MWh of renewable power. This creates a market for renewable attributes, though REC prices and volumes have fluctuated due to policy and demand–supply changes.

Carbon Credit Trading Scheme (CCTS) – New Initiative

In August 2022, amendments to the Energy Conservation Act created a framework for carbon credit trading. The government plans to integrate existing certificate markets (ESCerts, RECs) and expand toward a broader Indian Carbon Market. Initially voluntary, it may later include mandatory sectoral targets. Full operation is expected around 2025–26. A new Carbon Credit Certificate (CCC) may be issued to entities achieving verified emission reductions.

Use and Export of Carbon Credits

India has indicated that domestic carbon credits may not be freely exported for foreign compliance to avoid double counting against its Nationally Determined Contributions (NDCs). Priority may be domestic compliance and voluntary use, though Indian projects continue to supply international voluntary carbon markets, especially from renewable energy projects.

State-Level Initiatives

Some states and cities are exploring localized carbon trading schemes (e.g., Gujarat or sector-specific hubs), but these remain at an early stage.

Carbon Tax vs Carbon Market

Some countries use carbon taxes instead of markets. A carbon tax sets a fixed price per ton of CO₂ (price certainty but uncertain emission outcomes), while cap-and-trade fixes total emissions and lets prices fluctuate (quantity certainty). India does not have an explicit economy-wide carbon tax, though high fuel taxes on petrol and diesel act as an implicit carbon price.

Role of Banks in Carbon Markets

Banks and financial institutions act as intermediaries in carbon markets by:

• Facilitating carbon credit trades for clients through trading desks.
• Creating funds or investment products linked to carbon credits or green projects.
• Advising companies on carbon finance, credit generation, and compliance strategies.
• Proprietary trading of carbon allowances as commodities (mainly by large global banks).
• In India, supporting clients in regulated sectors as domestic carbon markets develop.

Sustainable Finance

Sustainable finance integrates environmental, social, and governance (ESG) factors into financial decisions to deliver long-term economic and societal benefits. It focuses on mobilizing capital for sustainable projects and embedding ESG risks and impacts into the financial system.

Key Components and Instruments

Green Finance

Financing for environmental and climate-related projects such as renewable energy, energy efficiency, pollution control, sustainable agriculture, and biodiversity. Instruments include green bonds, green loans, and green credit lines. Banks use these to support the low-carbon transition.

Social Finance

Targets positive social outcomes like affordable housing, education, healthcare, poverty reduction, and financial inclusion. Instruments include social bonds, microfinance, and SME financing in underserved areas.

Sustainability Bonds

Bonds whose proceeds finance a mix of green and social projects. Suitable for projects with combined environmental and social benefits, such as mass transit systems.

Sustainability-Linked Bonds (SLBs) and Loans (SLLs)

Not project-specific; linked to the issuer’s overall sustainability performance. Financial terms change if ESG targets (KPIs) are missed or achieved (e.g., higher coupon if emission targets are not met). In India, SEBI issued guidelines for SLBs in 2025.

ESG Investing and Funds

Includes ESG mutual funds, green funds, and impact funds investing in companies or projects meeting ESG criteria. India has seen a gradual rise in ESG-themed mutual funds.

Climate Finance

Focuses on climate mitigation and adaptation, including resilience projects like flood control and climate-smart agriculture. Globally, it also refers to financial flows from developed to developing countries, such as funding through the Green Climate Fund. A UN goal targets USD 100 billion annually, often discussed at Conference of the Parties (COP) meetings.

Transition Finance

Supports high-emitting sectors in reducing emissions through cleaner technologies (e.g., green hydrogen in steel). Instruments may be labeled transition bonds. SEBI recognized transition bonds in 2023.

Blended Finance

A structuring approach combining public or philanthropic funds with private capital to reduce risk and attract investment. Commonly used to scale sustainable projects in developing economies.

Sustainable Finance – Global Trends

Rapid growth

Global green bond issuance has risen sharply over the last decade. Cumulative green bond issuance since 2007 runs into hundreds of billions of dollars, and combined green, social, and sustainability bonds crossed USD 1 trillion by the mid-2020s. Major financial centres now embed sustainability in core investment mandates. The European Union introduced a Sustainable Finance Taxonomy to define sustainable activities and curb greenwashing.

Regulatory push

The EU mandates ESG disclosures through SFDR (Sustainable Finance Disclosure Regulation). Many countries require TCFD-aligned climate disclosures from large companies and financial institutions, increasing transparency and investor demand for sustainable assets.

Private sector commitments

Many global banks have pledged net-zero financed emissions by 2050. Large asset managers and pension funds have joined the Glasgow Financial Alliance for Net Zero (GFANZ), signalling potential reallocation of trillions of dollars toward low-carbon sectors.

G20 cooperation

The G20 revived the Sustainable Finance Working Group, which (2021–23) developed a Sustainable Finance Roadmap on disclosures, taxonomies, and portfolio alignment. During its 2023 presidency, India emphasized climate finance, SDGs, blended finance, affordability of green finance, and transition finance.

Social and sustainability bonds

Issuance surged around 2020 as institutions raised social bonds for COVID-19 relief, funding healthcare and MSMEs, showing flexibility of sustainable finance tools beyond climate.

India-Specific Trends

Sovereign green bonds

The Government of India began issuing Sovereign Green Bonds in 2023. In FY 2022–23, ₹16,000 crore (~USD 2 billion) was raised to fund renewables, clean transport, and water management. ₹20,000 crore was planned for FY 2023–24, creating a domestic green benchmark.

Corporate issuance

Indian corporates and financial institutions have increasingly issued green bonds domestically and overseas. Issuers include NTPC, Adani, Greenko, and IRFC. India’s cumulative sustainable bond issuance exceeds USD 50 billion, among the highest in emerging markets.

Regulatory framework

SEBI issued green debt guidelines in 2017, strengthened them in 2022–23 (including blue, yellow, and transition bonds), and launched a comprehensive ESG bond framework in 2025 covering social, sustainability, and sustainability-linked bonds with disclosure and verification norms.

Bank lending

Renewable energy is now a mainstream sector for Indian banks. Institutions such as IREDA, REC, and PFC play a major role. Banks also offer loans for rooftop solar and electric vehicles, often linked to subsidies.

ESG integration

ESG mutual fund schemes are expanding. Regulators are working on ESG ratings standards. Large investors like pension funds and insurers are gradually integrating ESG due to global investor pressure and recognition of climate risk.

Challenges
Key constraints include limited expertise in smaller banks, poor ESG data availability (especially for unlisted firms), and balancing development needs (e.g., short-term coal dependence) with sustainability. Discussions are ongoing on creating an Indian sustainable finance taxonomy to guide investors and lenders.