Clean Energy

Beyond Cap and Trade: What’s Next for Carbon Markets?

04.16.26 | 9 min read | Text by Sara Meyers & Hannah Safford & Craig Segall

It’s a fascinating time to be thinking about carbon markets. In one corner, California just reauthorized its carbon market program, the EU’s Emissions Trading System continues to evolve as the world’s largest compliance market, and a growing number of countries — from Brazil and Indonesia to Singapore and Kenya — are standing up or expanding their own systems, with the architecture for international carbon trading under Article 6 of the Paris Agreement beginning to take shape. In the other, markets are facing headwinds. Pennsylvania just dropped out of a regional carbon market, and while about a quarter of global emissions are now covered by trading systems, steep emissions cuts haven’t followed.

More broadly, profound legal and political changes in the larger economy and in global climate policy are pushing forward a wide-ranging conversation on next steps in climate policy. In this transitional moment, carbon markets clearly have a role to play in economic and industrial policy, but that role, and the policy environment in which markets function, merits examination.What would it take for carbon markets to actually deliver at the scale and pace the climate problem demands?

The standard story on the role of pollution markets goes like this: emissions trading worked brilliantly for acid rain in the 1990s, so let’s do it for carbon. Effectively pricing and trading carbon emissions is key to driving a clean-technology transition.

But that story glosses over something important. The acid rain program was operating in specific conditions, with a small universe of highly regulated power plants, shared grids, clear cost information, and a relatively straightforward, easy-to-deploy fix (smokestack scrubbers) for the problematic emissions in question. Carbon emissions trading is orders of magnitude harder – it spans every sector of the economy, involves far more actors, and requires infrastructural changes that don’t come cheap.

That doesn’t mean carbon markets are futile. It means they need to be fit for purpose and embedded in a broader policy strategy. We call this regulatory ingenuity: fitting tools to tasks, rather than hoping one tool does everything.

Three Tools, Three Roles

Climate policy has historically relied on three approaches, each with real strengths and real limits.

Regulatory mandates have been effective at cutting smog and cleaning up fuels. But motivating a wholesale shift in energy sources – where the required infrastructure investment runs into trillions and the economic and societal implications are complex and multifaceted – has proven far harder to accomplish through existing regulatory tools, and far harder to sustain politically.
Fiscal and industrial policy, exemplified by the Inflation Reduction Act, has helped drive down clean energy costs, build domestic supply chains, and deploy major industrial and regional strategies that regulation alone couldn’t deliver. Though IRA implementation faced deployment challenges, and a partial partisan repeal under Trump limited its reach, its core policy design moved markets. The replacement bill retains many of the IRA’s programs.
Carbon markets have generated billions in revenues for reinvestment and, in principle, long-term emissions accountability. In practice, both governmental and voluntary markets have struggled to track and deliver emissions reductions reliably across the economy.

These tools work best together. Markets in particular have seen the most success as part of a “portfolio” of programs – including regulation and fiscal policy – where the carbon market functions as a backstop, setting direction and generating funds but not carrying the full weight of an economy-wide transition.

Zooming In On Markets

Positioning markets for continued success requires being clear-eyed about what they can and can’t do. Several structural limits are worth naming.

First, markets optimize for cost per ton, a powerful but incomplete signal. Capital flows to the cheapest reductions first, and that is how markets should work. But cheap reductions are not necessarily the ones critical to fully developed industrial strategies. For example, the marginal cost of generation is not the full cost of reliable, delivered, politically durable clean power. Integration, transmission, siting, and community acceptance all carry real costs that today’s price signals don’t reflect. Until those full system costs are reflected and competitive, markets alone will not scale clean energy at the pace or scale needed. This disjunct between cheap reductions and strategic reductions recurs across the economy. Bridging that gap requires R&D and early deployment to drive costs of needed solutions down to the point where markets take over.

Second, carbon prices can’t drive decarbonization without affordable alternatives. A carbon price passed along to gas-pump drivers doesn’t transform transportation unless there is something cheaper to switch to. Where affordable alternatives exist, as in markets with cheap electricity and accessible EVs, adoption follows. Where they don’t, carbon pricing cannot close the gap, and the political backlash against visible consumer costs has been swift.

Finally, market revenues may not cover the real costs of transition. Refinery closures, shifting energy economies, and job losses in fossil-dependent regions have major consequences for workers and communities, as California is now grappling with. Carbon revenues alone won’t fill that gap.

Beyond these structural realities, there’s a second, more fixable problem: carbon markets haven’t yet been built to function like mature markets.

The first problem is an infrastructure problem. Today’s carbon markets lack the infrastructure, breadth, and sophistication of mature financial markets. Registries are fragmented, data fields are inconsistent, chain-of-title is unclear, and there is no unified ledger capable of ensuring finality of settlement. A functional carbon market requires the same institutional foundations that other markets rely upon: transparent interoperable ledgers, consistent data schemas, reliable transfer and custody, and audit trails that regulators and institutions can trust. Only with this plumbing does a market become truly “investable.” Without it, liquidity cannot form and institutional capital remains on the sidelines.

The second problem is a comparability problem. In markets where a “ton” of carbon credit does not represent a consistent underlying asset, credits can vary dramatically in durability, additionality, leakage, and earth-system risk. These differences are economically meaningful because they characterize the credit, duration, and performance risks of this asset class, and current markets do not sufficiently account for them.

Financial markets long ago learned how to handle heterogeneous assets. Commodities are graded, mortgages are underwritten, bonds are rated, structured products are tranched in a standardized form that, when paired with transparency, enables informed decision-making. Carbon markets similarly need a standardized, quantitatively grounded way to express expected atmospheric impact. Infrastructure and comparability are mutually dependent. Without infrastructure, standardized units can’t be recorded, verified, or enforced. Without comparability, infrastructure has nothing meaningful to track.

These problems are solvable; indeed, efforts are underway to solve both the infrastructure and comparability gaps. But even a technically mature carbon market will still bump against the structural limits above. The market needs to be embedded in a broader strategy.

What Well-Designed Markets Can Do

There is broad agreement that big industrial emitters — power plants, large manufacturers, heavy industry — are natural candidates for direct market participation, and especially so in the context of well-developed economic strategies that can attend to a range of transition equities. In compliance markets, where regulation creates scarcity, well-designed trading systems can accelerate their decarbonization while generating substantial revenues that can be directed toward harder-to-reach parts of the economy.

The harder question is what role markets should play beyond these large point sources — particularly in voluntary and offset markets, where demand is discretionary, the underlying units are heterogeneous, and market infrastructure is less mature.

One view is that most other sectors are poor fits for direct market participation and that the primary value of carbon markets lies in generating revenues and behavioral shifts from the parts of the economy that respond well to price signals, and directing those resources toward the parts that don’t. Natural and working lands, for instance, urgently need funding to manage climate risk — wildfires are erasing climate gains in California, and carbon sinks are deteriorating under pressure from fire, drought, and deforestation. Diffuse emitters — small freight operators, aging refrigeration systems, millions of buildings that need electrification — lack the capital or capacity to participate in complex trading systems. In this framing, carbon markets function less as direct decarbonization tools and more as engines of transition finance: pricing what can be priced, and channeling the proceeds toward what cannot.

Adherents to this view would also emphasize that there are broad categories of public transition cost, like addressing major regional shifts in public budgets and private incomes as entire industries transition, that at minimum require additional funds and policy to manage. California’s closing refineries (and the attendant political debate over the fundamental structure of its fuels system and the fiscal stability of affected counties) are an example of revenue and policy challenges that a market alone cannot close.

A different view holds that the problem isn’t that many sectors are inherently unsuited to markets, or that markets can’t contribute to larger public finance challenges, but that the markets themselves are unfinished. Today’s markets lack sufficient demand signals that arise when governments impose some form of compliance obligation, whether through a tax, procurement standards, or other policy mechanisms. Carbon credits from forestry projects, land management, methane abatement, and engineered removal all represent real atmospheric interventions — but the current market has no rigorous way to compare what they actually deliver. Without standardized infrastructure and a common unit of impact, a forestry credit and an engineered removal trade as if they are equivalent when they are not, or one is excluded entirely when it could be valued proportionally.

In this framing, the fix is not to route around the market but to build the market properly — with the comparability tools and settlement infrastructure that would let heterogeneous credits be priced accurately and traded with confidence. A market built this way could reach diffuse actors through intermediation, aggregation, and structured products, much as mortgage markets reach individual homeowners without requiring each one to trade directly. A framework for carbon markets, which proposes standardized assessment of atmospheric impact per dollar, offers a concrete path toward this kind of market maturation. It could also more efficiently channel funds to public needs by helping direct scarce capital to whatever delivers the most verified atmospheric benefit per dollar.

Though we (the authors) differ about which view we believe to be most true, we also realize that these two views are not necessarily in conflict. Revenue transfer and market maturation can work in parallel. A strategy oriented around revenue transfer focuses on regulation, fiscal policy, and public investment to do the heavy lifting, with markets in a supporting role. A strategy oriented around market maturation invests in the infrastructure and standards that would allow markets to bear more of the weight directly. The right path almost certainly involves both, and getting the sequencing and emphasis right could be one of the most consequential design choices in climate policy today.

Where Do We Go From Here?

The above analysis lets us take a more sophisticated look back at the acid rain program. The lesson this program teaches isn’t “markets work, full stop.” It’s that markets can accelerate a transition whose economics are favorable, such as the transition to widespread use of smokestack scrubbers: straightforward, cost-effective technology. But markets cannot create that favorability, nor are they always designed to anticipate and manage second-order effects.

A second lesson is that well-designed tools, matched to the right problem and the right timescale, can deliver real results. That applies to carbon markets themselves — which today have design flaws that can be corrected — and to the broader policy architecture in which they sit. A powerful path emerges when well-designed markets are embedded in a broader strategy: enforceable regulatory limits that create real scarcity and price signals; industrial policy that is not only well-designed but well-executed; and a clear theory of how the costs and benefits of transition are distributed.

But it also applies within the market. If carbon markets are going to play a meaningful role — whether as engines of transition finance, as instruments of accurate pricing across heterogeneous climate interventions, or both — they need the infrastructure and standards that any serious market requires. That work is underway, and it deserves at least as much attention as the policy debates that surround it.

So what’s going on with carbon markets? We’ve asked one incomplete tool to do the work of three. And we’ve debated what role markets should play without finishing the market itself. It’s time to do both: modernize market structure, and stop asking markets to work alone.