Innovative financing series: Leveraging the untapped potential of carbon markets

Introduction

Amid cascading global crises, the development finance landscape is under extraordinary pressure. The Donor Tracker Budget Cuts Tracker reveals a stark reality: many donor countries are tightening ODA budgets, with some enacting outright cuts to key development sectors. This trend risks undermining years of progress just when low- and middle-income countries are confronting the most severe challenges to date, including the increasing frequency and severity of extreme weather events and other effects of climate change.

At the same time, the investment gap for achieving the SDGs in low- and middle-income countries stood at US$3.9 trillion per year as of 2020, and will amount to US$4.2 trillion annually until 2030. In 2022, global climate adaptation finance reached US$76 billion. Yet the estimated need for emerging markets and developing economies for adaptation alone is US$212 billion per year by 2030. Traditional sources of development finance, especially public sector grants and concessional loans, remain essential. But they are clearly insufficient to meet the scale and urgency of today’s needs.

This growing gap underscores the imperative for innovative development finance—financial instruments and mechanisms that mobilize new capital, blend public and private resources, and unlock climate and development co-benefits. Crucially, these approaches do not replace ODA but can enhance its efficiency and leverage additional funds.

This Insight is part of the Donor Tracker's series on innovative financing and will take an in-depth look at a prominent example of innovative financing in action: carbon markets.

What are carbon markets?

A carbon market is a system where carbon credits are bought and sold, allowing organizations or individuals to balance out their greenhouse gas emissions. Each credit typically represents the reduction or removal of one metric ton of carbon dioxide, or an equivalent amount of other greenhouse gases. By purchasing credits from groups involved in emission-reducing activities—such as reforestation, renewable energy projects, or other climate-focused initiatives—participants can offset their own emissions while contributing to broader environmental goals.

Once a credit is used to cut or prevent emissions, it becomes an offset and cannot be traded.

There are two primary types of carbon markets:

• Compliance Carbon Markets (for example, EU ETS): Regulated systems in which industries with higher emissions are required to meet set emission reduction targets. Participants in these markets, such as those in the EU Emissions Trading System must buy allowances to cover their emissions and face penalties for non-compliance. These markets are strictly regulated, with uniform standards, central registries, and rigorous verification processes to ensure environmental integrity; and
• Voluntary Carbon Markets: Platforms where organizations and individuals may offset their emissions by supporting certified projects. Companies and individuals buy carbon credits, called VERs, to support sustainability or corporate responsibility, not due to regulations. VERs can come from projects, like reforestation or renewable energy.

Voluntary carbon markets as a climate finance tool

Among innovative finance tools, the VCM stands out as a rapidly evolving platform that can both mobilize significant private capital and channel it toward climate-resilient development. In the VCM, individuals and organizations can issue, buy, and sell carbon credits, with one credit representing the reduction or removal of one ton of carbon dioxide from the atmosphere. While carbon credits have long played a role in offsetting emissions, their structure and potential are changing fast. The 2025 State of the Voluntary Carbon Market report from EM sheds light on how carbon markets—despite recent setbacks—are increasingly well-positioned to contribute meaningfully to SDG #13: Climate Action.

Carbon removals: a high-value segment

Carbon removal credits are distinct from emissions avoidance credits in that they directly remove carbon from the atmosphere. The growing price premium on carbon removal credits, which are on average 381% more expensive than reduction credits according to the report, represents a noteworthy shift in demand. These credits, often from nature-based solutions like ARR, Agroforestry, and Blue Carbon restoration, now represent the largest cluster of removal credits traded.

• ARR credit prices rose by 19% in 2024, reaching US$20.44 per ton;
• Blue Carbon credits saw an astonishing 257% price increase, driven by their co-benefits to coastal protection and biodiversity (SDG #14 and SDG #15); and
• IFM—another project type which can involve both carbon removal and avoidance—tripled in volume, with prices averaging nearly US$15 per ton.

These trends signal that buyers, including businesses and governments seeking to offset carbon emissions, increasingly value long-term, durable climate impact and are willing to pay for it—especially when these projects contribute to broader development goals.

Beyond climate: co-benefits across the SDG framework

While SDG #13 is the SDG stands to make the most direct gains from carbon markets, a broader set of SDGs can see co-benefits:

• Forestry and Land Use projects - still the most traded category - support biodiversity (SDG #15), water regulation (SDG #6), and indigenous livelihoods (SDG #1, SDG #2, SDG #8);
• Household/Community Devices (e.g. clean cookstoves, water filters) provide health benefits (SDG #3), empower women (SDG #5), and improve local energy access (SDG #7). Though transaction volume in this category halved in 2024 due to project consolidation, demand for high-quality credits from this segment remains strong; and
• Agriculture projects, while small in volume, saw an 18% increase in average price - driven by growing interest in soil carbon and sustainable land management solutions that directly impact food security (SDG #2) and climate resilience.

Furthermore, Waste Disposal credits - especially those from Landfill Gas Destruction and Biochar Production - benefited from CCP approval under the ICVCM. Landfill Gas credits drove a 3X increase in transaction volume for Waste Disposal, while Biochar credits traded at over US$160 per ton, the highest among all project types.

Despite overall market contraction, the pace of carbon credit retirements has held steady—with 182 million tons retired in 2024—indicating consistent demand for climate impact even in volatile financial conditions. Buyers are also showing stronger preferences for recent vintages (i.e., newly issued credits), with a 217% price premium over older vintages.

From a geographic perspective, the highest growth in value came from North American and European credits, often linked to high-quality Forestry and Waste Disposal projects. Yet, credits originating in Latin America continue to play a central role in supply and have growing potential to attract finance; the Latin America region led globally in VCM transaction volume in 2023 and 2024.

Challenges facing carbon markets

Why is the potential still untapped?

Despite growing interest and investment, the potential of carbon markets remain significantly underutilized.

Many high-potential countries have begun to issue large volumes of credits, but demand has not kept pace: A prominent example is Gabon, which in 2022 offered 90 million REDD+ credits to the market but struggled to generate sufficient buyer interest, especially as the verifiability of the credits was called into question. Issues around credit vintage, measurement methodologies, and trust in the permanence of emissions reductions limited uptake.

There is significant pricing disparity across regions: Countries like China are able to produce carbon credits at lower costs due to more mature infrastructure and economies of scale, making it difficult for low- and middle-income countries with smaller or more complex projects—often involving nature-based solutions—to compete. High-quality credits that deliver co-benefits may also be more expensive to generate, pricing them out of a market still dominated by cost-sensitive buyers.

The legacy of low-integrity credits continues to haunt the voluntary market: Skepticism around verification systems and inconsistent quality standards has led to a credibility gap, which recent reforms—such as the creation of the ICVCM—aim to address, but progress remains uneven.

These systemic barriers highlight why carbon markets should be seen not as a silver bullet, but as one piece of a broader climate finance puzzle—one that requires global coordination, strong governance, and intentional efforts to center the voices and needs of low- and middle-income countries.

How can donor governments strengthen and promote carbon markets?

To fully realize the potential of carbon credits, donor governments and development institutions must act. Donors can:

• Develop coalitions to strengthen regulation on verification and pricing;
• Fund the measurement, reporting, and verification systems required for high-integrity credits; and
• Support the institutional capacity needed to engage with mechanisms like Article 6.2, which allows countries to count carbon credits, known as ITMOs, towards their NDCs.

As carbon markets mature and the focus shifts from offsets to outcomes, donors, and investors have a unique opportunity to use carbon finance as a bridge between climate ambition and development impact.

Conclusion

A climate finance mechanism that pulls double duty—but needs structural backing

In a world where public climate finance is stretched thin, carbon markets offer a practical and scalable mechanism to unlock private capital for mitigation and adaptation—particularly in low- and middle-income countries. However, unlocking this potential fully requires addressing systemic barriers that limit participation and benefit-sharing.

First, carbon markets must not be seen in isolation: Structural reforms to MDBs, debt relief mechanisms, and climate finance governance would have positive ripple effects, helping low- and middle-income countries access technical and financial resources needed to generate high-integrity credits and benefit from global market demand.

Second, low- and middle-income country voices are essential to shaping the future of carbon markets: Many governments, CSOs, and Indigenous groups express cautious optimism, noting that carbon finance could provide vital resources—but only if safeguards are in place to ensure equitable benefit-sharing, land rights protection, and fair pricing. Countries like Ghana, Kenya, and Papua New Guinea are already piloting Article 6.2 frameworks, while regional platforms such as the ACMI are pushing for scaled and equitable participation.

Third, carbon markets are increasingly on the agenda at global climate forums: At COP28, carbon markets were the focus of intense negotiations under Article 6, with further technical work expected ahead of COP29. The UNFCCC and the ICVCM continue shaping standards for market credibility. Stakeholders should watch closely how voluntary and compliance markets interact going forward, and how low- and middle-income country concerns are reflected in rule-setting.

Finally, climate leaders are sending mixed but evolving signals: While some criticize carbon markets for historical integrity issues, others—including UN Special Envoys and multilateral climate funds—highlight their role as one of the few tools available to channel private finance to low- and middle-income countries at scale. The emphasis is increasingly on carbon removal, co-benefits, and alignment with long-term development goals.

Advocacy efforts can play a critical role in ensuring donor governments prioritize equity and integrity in their support for carbon markets. This means pushing for clear safeguards, funding for low- and middle-income country capacity-building, and support for participation in global governance processes. Carbon markets are not a silver bullet—but if embedded in a fairer global system and informed by local realities, they can become a key lever to drive both climate and development impact.