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Carbon Credits Explained

Article Overview

Carbon credits are a type of traded credit intended to offset a given amount of Greenhouse Gas (GHG) emissions, and often come in the form of permits and certificates. The carbon credit market has expanded significantly in recent years, having quadrupled since 2020, and is expected to explode to a value reaching $2.4 trillion by 2027.

Carbon credit markets, both mandatory and voluntary, are controversial, to say the least, and as the amount of companies using them increases, the debate on the efficacy of their use is heating up. Aviation, oil and gas, and other emissions-intense industries have seen regulators in the EU, China, California, and others mandate them to buy and sell carbon credits, while others do so voluntarily. Critics claim carbon credits enable companies to continue business as usual and avoid ownership of action towards true decarbonization.

Despite the controversy, carbon credits can play a key role in global decarbonization plans, especially for those industries dependent on fossil fuels. But what are they, why are they so controversial, and are they effective?

What are Carbon Credits?

Carbon credits, also sometimes called carbon allowances, act as a permit for organizations to emit one tonne of CO2e, which has been removed or prevented from entering the atmosphere. Carbon credits can be seen as a climate currency, which is bought and sold in carbon markets. Carbon credits can be bought directly from the company removing, avoiding, or capturing the CO2e as the buyer sees fit for their own goals in a “voluntary” carbon credit market. However, in an involuntary or “mandatory” carbon credits market, companies are required to limit the amount of emissions they are producing according to a sector-specific limit set by their local regulators and use carbon credits to offset any emissions that exceed that limit. If a facility or company stays within the emissions limit for their sector, those emissions can be saved for subsequent years or sold as carbon credits in that market.  

Types of Carbon Credits

Carbon credits can be created and sold by any company that is reducing, capturing, or storing GHG emissions. The mechanisms for creating carbon credits fall into four primary categories:

  • Forestry and Land Use - Reforestation, deforestation protections, land use changes, and natural resource conservation can all be turned into carbon credits. Farmers and landowners can sell a carbon credit for every tonne of CO2e their land sequesters.  
  • Renewables - Companies that create wind, solar, and hydroelectric power can sell the emissions they avoid as carbon credits. Companies can also buy Renewable Energy Credits (REC), which allows companies to claim their energy comes from a renewable source, regardless of where their actual used energy is sourced from.
  • Carbon Capture and Storage - Carbon can be sucked directly out of the air through direct air capture or captured at the source of emissions and sequestered geologically for long-term storage. Companies that capture carbon can sell their captured carbon as credits.
  • Energy Efficiencies - For each tonne of CO2e energy savings prevented from being emitted, the entity can sell as a carbon credit. Energy Efficiency Credits (EEC), also known as “white tags,” are another way for companies to sell a type of carbon credit. However, EECs are sold by the energy measurement MWh, which has to be converted into a CO2e saving.

What Carbon Credits are Not

Carbon credits are seen by some companies as permission to resume business as usual, but they are not; they also are not:

  • The ‘holy grail’ in solving climate change, although some companies see them as a means to reach their net zero or carbon neutral goals. They should be used only as a last resort when decarbonizing operations is not possible.
  • A substitute for emission reduction efforts. Carbon credits should be used in conjunction with a comprehensive decarbonization plan. Net zero standard setting frameworks like the SBTi’s “Net-Zero Standard,” require companies to first reduce emissions by 90-95% before they use carbon credits to achieve net zero.

Carbon Credits vs. Carbon Offsets

Carbon credits and carbon offsets are terms that are often used interchangeably, but they are slightly different mechanisms for reducing an organization's carbon footprint. Carbon credits represent an allowance for companies to emit one tonne of CO2e. Carbon offsets represent emissions that have been removed from the atmosphere, which can be bought as a way to reduce emissions beyond what an organization can achieve through its own decarbonization efforts.

The main difference between offsets and credits is how they are traded. Offsets are bought and sold voluntarily through brokers and trading platforms such as Patch, whereas carbon credits are bought and sold both on voluntary markets and mandatory cap-and-trade markets. Cap-and-trade markets are policy-driven mechanisms that cap the number of emissions a company from a certain sector can emit and allow companies to trade permits (carbon credits) for the emissions they save.  

Two Types of Global Carbon Markets: Voluntary and Compliance

Carbon credits are traded through carbon markets; the two types of carbon markets are voluntary and compliance (a.k.a. mandatory) markets. As their names suggest, the main differences in these markets are that one is based on emissions compliance requirements in a cap-and-trade system, and the other is voluntary and based on the decarbonization ambitions of each company.

Compliance Carbon Credit Markets

Compliance carbon credit markets, also known as mandatory carbon credit markets, are those that have been mandated by legislation. In these compliance markets, emissions are traded through a cap-and-trade system, where emissions are capped at a certain amount for specific sectors, which typically declines annually to incentivize decarbonization. For example, if a coal company produces fewer emissions than its allotted amount, the difference is translated into carbon credits, which the company can then sell or save for future use. On the other hand, if it produces excess emissions, it must purchase new or use previously saved carbon credits.

There are now over 30 compliance carbon credit markets operating globally, covering almost a fifth of all emissions. The EU’s Emissions Trading Scheme was the first in 2005. Now, China, Australia, and Canada all have mandatory carbon credit markets.

Voluntary Carbon Credit Markets

A voluntary carbon credit market is where organizations can freely purchase and sell carbon credits that represent an expected emissions reduction equivalent to one tonne of CO2e. To match increasingly ambitious corporate climate commitments to reach decarbonization goals like net zero emissions, the voluntary carbon credit market has grown substantially in recent years. However, purchasing carbon credits through voluntary carbon markets has been controversial. Carbon credits are extremely difficult to validate and demonstrate that they are sequestering, reducing, or mitigating the amount of carbon they claim to be.  Some of the primary challenges in the voluntary carbon credit markets include:

Quality: Ensuring that carbon credits are what they say they are is difficult. Determining whether the carbon credit project actually has reduced emissions vs. a baseline, if the reductions are permanent and not at risk of fire or disease and if there is a risk of GHG leakage with the displacement of emissions to other regions. However, multiple companies, such as Patch, are working to verify the quality of their carbon credits before putting them on the market.

Double counting: Because all carbon credits do not exist on a central registry, the same credits can be sold twice. In some cases, countries include credits in their national decarbonization plans, and companies sell the same credits to companies.

Transparency: Different methodologies to count avoided or reduced carbon exists, which makes it difficult for companies to assess what they are buying and puts them at risk of greenwashing. Transparent methodologies would go some way to mitigating these risks. There is also a lack of transparency in how much of the money raised in selling credits goes to the offsetting and how much goes to the reduction project, and how much goes to the company.

How do Carbon Credits Work?

Both mandatory and voluntary carbon credits work the same way in that they permit an entity to emit one tonne of CO2e; the only difference is mandatory credits are sold and purchased retroactively for emissions that went under or over an emissions cap, whereas voluntary carbon credits are sold and purchased for carbon reductions that are expected to be removed and emitted.

How to Buy Carbon Credits?

How carbon credits are purchased depends on whether the carbon credit market is voluntary or compliance-based:

  • Voluntary Markets - Companies buy credits from brokers or project developers who work with farmers and landowners to develop carbon credit projects, or they can buy them on a carbon credit marketplace.
  • Compliance Markets - Companies buy credits from other companies that have extra allowances as they fall below the cap, or they can buy them from the local government.

How to Sell Carbon Credits?

How carbon credits are sold depends on whether the carbon credit market is voluntary or compliance-based:

  • Voluntary Markets - Any individuals who avoid, reduce, or remove carbon can have their carbon credits minted by a third party, such as Verra, gold standard, or ISO. Once verified, they can sell their credits to a broker or a marketplace.
  • Compliance Markets - Companies that have low emissions under the emissions cap can sell or trade emissions to other companies within the same carbon credit market.

US Mandatory Carbon Credits Market

Although the US does not have a national mandatory carbon credit market, state and regional governments have created cap-and-trade programs.

California’s Cap and Trade Program

California’s compulsory carbon credit market was launched in 2013 and is now the fourth largest globally. It sets emissions allowances across multiple sectors, including any sources that emit at least 25,000 tonnes of CO2e/year. Companies that exceed their allowance must buy carbon credits at auction at a minimum and maximum price, which rises annually. The proceeds of the California cap-and-trade program have put $5 billion toward California’s Greenhouse Gas Reduction Fund.  

Regional Greenhouse Gas Initiative

Twelve North East states, including Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, and Virginia, have created a cap-and-trade conglomerate. The Regional Greenhouse Gas Initiative sets an annually reducing regional cap on emissions for any fossil fuel power plants that produce over 25 MW of energy. Since its implementation, the initiative has reduced emissions at power plants by more than 50%, double the national average, and has raised over $4 billion to invest in the region’s communities.

Global Carbon Credits Market​

In 2021, the global carbon credit market sat at $851 billion. The EU’s ETS makes up the majority of that, at 90%. Others in the US and Asia make up the majority of the other 10%. The voluntary carbon credit market, on the other hand, made up only $1 billion of the $851 billion overall.

EU’s Emissions Trading Scheme (ETS)

The EU’s ETS is the oldest in the world and remains the largest by market cap. It started in 2005 and has been one of the main tools for emissions reductions in the EU. Covering aviation, fossil fuel combustion plants, and emission-heavy industries, the plan used to cover 50% of the total emissions of the EU. In 2020 that number dropped to 36%, as the sectors are reducing emissions faster than others not covered by the ETS. Emissions for each sector under the trading scheme are capped, and those that need to buy credits can do so through an auction.

UK’s Emissions Trading Scheme (ETS)

The UK’s ETS replaced the EU’s ETS on 1 January 2021. It replicates many of the aspects of the EU’s ETS, covering the same sectors (aviation and fossil fuel combustion), and companies that need to buy credits purchase them at auctions.

Australia’s Emissions Reductions Fund

Australia’s carbon credit market is a voluntary scheme that incentivizes businesses, farmers, and landowners to reduce their emissions and sell those abatements to the Australian government to be put into an auction. By 2020, Australia’s Emissions Reduction Fund had reduced 80 million tonnes of CO2e.

China’s Emissions Trading System (ETS)

China’s compulsory ETS started in 2020. Initially, the ETS set emissions allowances covering just coal- and gas-fired power plants but is expected to expand to seven other sectors. China’s carbon market is already the largest in amount of emissions traded at three times the EU’s ETS, but when it adds additional sectors in 2024, it is set to become bigger than all other carbon markets combined. The ETS will permit coal- and gas-fired plants to emit allocations based on benchmarks for that certain fuel source and plant type. Plants that go over their allocations purchase credits, and the proceeds go to GHG reduction projects.

Canada’s Greenhouse Gas Offset Credit System

In June 2022, Canada released guidelines to support a domestic voluntary carbon market, the Greenhouse Gas Offset Credit System. The credit system aims to create economic opportunities for companies and regions that are reducing emissions. By following federal offset protocols, companies can sell credits to other Canadian companies wanting to voluntarily buy credits. The price of each tonne bought is initially C$50 but will increase to C$170 by 2030.

Frequently Asked Questions

How Much is a Carbon Credit Worth?

A carbon credit is almost always the price of a tonne of CO2e. The cost can have huge differences depending on the jurisdiction of the mandatory carbon credit market and the type of carbon credit in voluntary markets.

In the EU’s ETS, the cost of one tonne of CO2e in Q4 2022 was close to €90 (USD$94), but in China’s Emissions Trading System in 2022, the price was USD$9.29 for one tonne of CO2e. In voluntary markets, the prices can fluctuate based on the type of carbon removal or avoidance. Prices can range from USD$15-20 for one tonne of CO2e for reforestation projects, whereas technological carbon credits from carbon capture and storage can range from USD$100-1,000 for one tonne of CO2e.

Where can you Trade Carbon Credits?

In a mandatory carbon credit market, the government or regulating body acts as the middleman to buy and sell carbon credits. In a voluntary market, carbon credits can be traded by individuals who get their emissions avoidance, reductions, or removals accredited by a third party or from a carbon credit marketplace.

Are Carbon Credits Effective?

Carbon credits in compulsory emissions trading schemes have been effective in reducing GHG emissions in the jurisdictions and sectors they are regulated in. The EU’s ETS, for example, reduced the emissions of the facilities it covered by 35% between 2005 and 2019. Voluntary carbon credit markets have been less effective but have reduced some emissions and created funds for decarbonization projects. Critics would say that other decarbonization efforts, such as reducing energy consumption or switching to renewable energy, would be much more effective.

Are Carbon Credits Considered Greenwashing?

Critics say carbon credits allow big polluters like oil and gas companies to greenwash by continuing to produce the same level of emissions instead of cutting them through decarbonization. Concerns over low-quality carbon credits failing on both counts of channeling funds to the carbon reduction efforts that produce the carbon credits and reducing emissions have tarnished the reputation of credits. However, steps are being taken by brokers and markets to improve carbon credits through rigorous quality assurance and vetting. Additionally, mandatory carbon markets have shown to be effective in reducing emissions in some of the most emissions-intensive industries. Ideally, companies take the approach of using carbon credits as supplemental action after considering actions to reduce emissions from their operations and supply chains.

Carbon credits are a controversial but necessary part of decarbonization plans, especially for emissions-intensive industries like aviation and oil and gas. Mandatory carbon credit markets like the EU’s ETS have been proven to be an effective way to reduce emissions in some of the most difficult to decarbonize sectors.

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