What Are Carbon Credits? 16 Things (2021) You Need To Know

Carbon is necessary for life, but carbon emissions have been impacting the planet significantly for the past several decades – which is where carbon credits come in.

Carbon dioxide is the greenhouse gas with the highest levels of emissions into the atmosphere.

In turn, this causes global warming, and ultimately, climate change.

As a result, recent international treaties on climate change like the Paris Agreement have sought to reduce carbon dioxide in our atmosphere.

One proposed solution is carbon credits.

What are carbon credits?

Keep reading.

Here’s everything you need to know.

1. What is a carbon credit?

A carbon credit is a kind of permit that represents 1 ton of carbon dioxide removed from the atmosphere.

Carbon credits can be purchased by an individual or a company to make up for carbon dioxide emissions that come from industrial production, delivery vehicles, or travel.

Currently, it is more common for companies to purchase carbon credits than for individuals.

2. How are carbon credits created?

Carbon credits are often created through agricultural or forestry practices.

That said, they can also be made by nearly any project that reduces, avoids, destroys, or captures emissions.

Individuals or companies looking to offset their own greenhouse gas emissions can buy these credits through a middleman or directly from those capturing carbon.

3. What is the “compliance market” for carbon credits?

In the compliance market, also called the involuntary market, governments will set a cap on how many tons of emissions certain sectors (i.e., oil, transportation, energy, or waste management) can release.

So, say an oil company goes over the prescribed emissions limit.

The company must buy or use saved credits to stay under the emissions cap.

If a company stays under the cap, then it can save or sell those credits.

This practice is known as a cap-and-trade market.

The cap is the amount of a greenhouse gas a government is willing to release into the atmosphere and emitters must trade to stay within that limit.

The Paris Agreement tasked leaders with figuring out compliance markets on a global scale.

So far, about 64 carbon compliance markets are in operation around the world.

The largest are in the European Union, China, Australia, and Canada.

4. Does the U.S. have a carbon market?

The U.S. currently doesn’t have a federal, wide-ranging cap-and-trade market for greenhouse gases.

Regulators, businesses, and environmentalists have debated globalizing a cap-and-trade market for carbon.

That said, it’s challenging to agree on a common time frame, price, and measurement for carbon.

5. What is the voluntary carbon market?

The voluntary carbon marketplace encompasses all transactions of carbon offsets that are not purchased through an active regulated carbon market.

It includes offsets that are purchased with the intent to resell or meet a company’s carbon natural or other environmental claims.

Voluntary carbon markets allow businesses, governments, non-profit organizations, universities, municipalities, and individuals to offset their emissions beyond a regulatory structure.

6. What is a carbon offset?

The terms carbon offset and carbon offset credit (or “offset credit”) are often used interchangeably.

That said, they can mean slightly different things.

A carbon offset refers to a reduction in GHG emissions or an increase in carbon storage that is used to compensate for emissions that occur elsewhere.

A carbon offset credit is a transferrable instrument certified by governments or independent certification bodies to represent an emission reduction of one metric ton of CO2 (or an equivalent amount of other GHGs).

If they wish, the purchaser of an offset credit can “retire” it to claim the underlying reduction towards their own GHG reduction goals.

Offset credits are used to convey a net climate benefit from one entity to another.

As GHGs mix globally in the atmosphere, it doesn’t matter where they’re reduced.

In other words, the effects are the same if an organization…

bulletStops an emission-causing activity

bulletEnables an equivalent emission-reducing activity somewhere in the world

That said, carbon offsets are intended to make it easier and more cost-effective for organizations to pursue the second option.

7. How are carbon offsets generated?

Emissions reduction projects reduce the amount of greenhouse gases in the atmosphere in one of the following three ways:

bulletBy capturing and destroying a greenhouse gas that would otherwise be emitted into the atmosphere (Ex: methane gas capture project at a landfill).

bulletBy producing clean, renewable energy that eliminates the need for fossil fuels (Ex: wind power).

bulletBy capturing and storing greenhouse gases to prevent their release into the atmosphere (Ex: a project that promotes the healthy growth and maintenance of forests).

8. What are the different types of carbon credits?

There are two primary types of carbon credits:

bulletVoluntary emissions reduction (VER): This credit is a carbon offset that is exchanged in the over-the-counter or voluntary markets for credits.

bulletCertified emissions reduction (CER): This credit is an emission unit created through a regulatory framework with the purpose of offsetting a project’s emissions.

The primary difference between these two credits is whether there is a third-party certifying body.

9. How do you price carbon?

The World Bank says there are two main ways to price carbon: emissions trading systems (ETS) and carbon taxes.

The first caps the total levels of carbon and other GHG emissions.

This is known as a cap-and-trade system because it works as a system where caps are increasingly reduced every year.

Businesses with low emissions are then able to sell the allowances that they didn’t spend to others who spent more than their permitted allotment.

This helps create supply and demand within the carbon market.

Carbon taxes can also set a direct price on carbon as they establish a tax rate on GHG emissions.

Unlike the cap-and-trade system described above, the emissions reduction outcome isn’t predefined with carbon taxes.

Additionally, there are also other indirect ways to price carbon, such as taxing fossil fuels or removing fossil fuel subsidies.

10. Can carbon credits be traded?

Yes, carbon credits can be traded on both private and public markets.

Current rules of trading allow for the international transfer of credits.

The price of credits is primarily driven by the levels of supply and demand in the markets.

However, both supply and demand fluctuate quite a bit from country to country.

Keep in mind that it is hard for individuals to purchase carbon credits.

That said, Certified Emissions Reductions Credits can be sold by special carbon funds established by large financial institutions.

Alternatively, if your business is looking to trade your carbon credits, you should keep an eye out for one of the exchanges that specialize in trading these credits.

These special exchanges include the European Climate Exchange, the NASDAQ OMX Commodities Europe exchange, and the European Energy Exchange.

11. How big is the carbon credit market?

The voluntary market is on track to reach a record of $6.7 billion at the end of 2021.

Traders in the European compliance market project carbon prices to increase 88 percent by 2030 (roughly $67 per metric ton).

The voluntary market has had rapid acceleration over the course of the year, and this is largely due to recent corporate net-zero goals and interest in meeting international climate goals outlined in the Paris Agreement.

12. What is the U.S. Clean Air Act?

The U.S. Clean Air Act was the world’s first cap-and-trade program.

It was pioneered in 1990 and, at that point in time, it called the caps “allowances.”

The Environmental Defense Fund credits the program for substantially reducing emissions of sulfur dioxide from coal-fired power plants, which caused “acid rain” in the 1980s.

13. What is the United Nations’ Kyoto Protocol?

In 1997, the UN developed a carbon credit proposal to reduce worldwide carbon emissions, and it became known as the Kyoto Protocol.

The agreement set binding emission reduction targets for the countries that signed it.

Another agreement, the Marrakesh Accords, explained the rules for how the system would work.

If a country emitted less than its target number of hydrocarbons, then it could sell its surplus credits to countries that didn’t achieve its Kyoto level goals through an ERPA (Emissions Reduction Purchase Agreement).

The initial commitment period of the Kyoto Protocol ended in 2012, but the U.S. didn’t complete the term, dropping out in 2001.

The Kyoto Protocol was then revised in 2012 in an agreement known as the Doha Amendment, which was ratified as of October 2020.

In this ratification, 147 member nations deposited their instrument of acceptance.

14. What are Kyoto’s “flexible mechanisms”?

The Kyoto Protocol provides for three mechanisms that allow countries or operators in developed countries to acquire greenhouse gas reduction credits.

In most cases, transactions aren’t performed by national governments directly but rather by operators that have set quotas by their countries.

bulletUnder Joint Implementation (JI), a developed country with relatively high costs of domestic greenhouse reduction would set up a project in another developed country.

bulletUnder the Clean Development Mechanism (CDM), a developed country can “sponsor” a greenhouse gas reduction project in a developing country where the cost of greenhouse gas reduction project activities is typically lower but the atmospheric effect is globally equal.

The developed country would be given credits for meeting its emission reduction targets.

The developing country would receive the capital investment and clean technology or beneficial change in land use.

bulletUnder Emissions Trading (IET), countries can trade in the international carbon credit to cover their shortfall in assigned amount units.

Countries with surplus units can sell them to countries that are exceeding emissions targets.

15. What is the Paris Climate Agreement?

Also known as the Paris Climate Accord, this agreement was among the leaders of over 180 countries to reduce greenhouse gas emissions and limit the global temperature increase to below 2 degrees Celsius (3.6 F) above preindustrial levels by the year 2100.

More than 190 nations, including the U.S., signed onto the Paris Agreement in 2015.

The agreement set emissions standards and allowances for emissions trading.

The U.S. dropped out in 2017 under President Donald Trump but then subsequently rejoined in January 2020 under President Joe Biden.

16. What are the differences between a carbon credit and a carbon tax?

Both carbon credits and carbon taxes have their own advantages and disadvantages.

The Kyoto Protocol specifically selected credits as an alternative to carbon taxes.

Some argue that treating emissions as a market commodity makes it easier for businesses to understand and manage their activities.

However, the truth is that both have their benefits.

We’ll list some below as a way to distinguish between them.

Tradeable carbon credit advantages:

bulletThe price is more likely to be perceived as fair by those paying it.

bulletInvestors in carbon credits may have more control over their own costs.

bulletThe flexible mechanisms of the Kyoto Protocol help to ensure that all investments go into real sustainable carbon reduction schemes thanks to an internationally agreed-upon validation process.

bulletIf correctly implemented, some believe that a target level of emission reductions may be achieved with more certainty.

bulletCarbon credits may provide a framework for rewarding people or companies who plant trees or otherwise meet standards exclusively recognized as “green”.

Carbon tax advantages:

bulletMay be less expensive, complex, and time-consuming to implement (a great advantage when applied to markets like home heating or gasoline).

bulletReduced risk of certain types of cheating (both credits and tasks must be verified).

bulletReduced incentives for companies to delay efficiency improvements prior to the establishment of the baseline (if credits are distributed in proportion to past emissions).

bulletNew or growing companies are put at a disadvantage to established companies when credits are grandfathered.

bulletAllows for more centralized handing of acquired gains.

bulletPoor market conditions and weak investor interest have a smaller impact on taxation than trading due to government regulation.

Final Thoughts

So, what do you think about carbon credits?

Do you plan to use carbon offsetting in your own life?

While this practice is largely used by companies right now, individuals could engage in trading carbon credits by investing in carbon credit ETFs or offsetting their own carbon usage.

Right now, carbon credits introduce a key way to fight for climate change, increase profits, save money, and foster innovation.

The discussion about carbon isn’t over!

Additional Resources

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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.

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