Carbon credits, also known as carbon offsets, are permits that allow the owner to emit a certain amount of carbon dioxide or other greenhouse gases. One credit permits the emission of one ton of carbon dioxide or the equivalent in other greenhouse gases.
The carbon credit is half of a so-called cap-and-trade program. Companies that pollute are awarded credits that allow them to continue to pollute up to a certain limit, which is reduced periodically. Meanwhile, the company may sell any unneeded credits to another company that needs them. Private companies are thus doubly incentivized to reduce greenhouse emissions. First, they must spend money on extra credits if their emissions exceed the cap. Second, they can make money by reducing their emissions and selling their excess allowances.
Proponents of the carbon credit system say that it leads to measurable, verifiable emission reductions from certified climate action projects, and that these projects reduce, remove, or avoid greenhouse gas (GHG) emissions.
Key Takeaways
- Carbon credits were devised as a mechanism to reduce greenhouse gas emissions.
- Companies get a set number of credits, which decline over time, and they can sell any excess to another company.
- Carbon credits create a monetary incentive for companies to reduce their carbon emissions. Those that cannot easily reduce emissions can still operate, at a higher financial cost.
- Carbon credits are based on the cap-and-trade model that was used to reduce sulfur pollution in the 1990s.
- Negotiators at the Glasgow COP26 climate change summit in November 2021 agreed to create a global carbon credit offset trading market.
How Do Carbon Credits Work?
The ultimate goal of carbon credits is to reduce the emission of greenhouse gases into the atmosphere. As noted, a carbon credit represents the right to emit greenhouse gases equivalent to one ton of carbon dioxide. According to the Environmental Defense Fund, that is the equivalent of a 2,400-mile drive in terms of carbon dioxide emissions.
Companies or nations are allotted a certain number of credits and may trade them to help balance total worldwide emissions. “Since carbon dioxide is the principal greenhouse gas,” the United Nations notes, “people speak simply of trading in carbon.”
The intention is to reduce the number of credits over time, thus incentivizing companies to find innovative ways to reduce greenhouse gas emissions.
U.S. Carbon Credits Today
Cap-and-trade programs remain controversial in the United States. However, 11 states have adopted such market-based approaches to the reduction of greenhouse gases, according to the Center for Climate and Energy Solutions. Of these, 10 are Northeast states that banded together to jointly attack the problem through a program known as the Regional Greenhouse Gas Initiative (RGGI).
California’s Cap-and-Trade Program
The state of California initiated its own cap-and-trade program in 2013. The rules apply to the state’s large electric power plants, industrial plants, and fuel distributors. The state claims that its program is the fourth largest in the world after those of the European Union, South Korea, and the Chinese province of Guangdong.
The cap-and-trade system is sometimes described as a market system. That is, it creates an exchange value for emissions. Its proponents argue that a cap-and-trade program offers an incentive for companies to invest in cleaner technologies to avoid buying permits that will increase in cost every year.
The U.S. Clean Air Act
The United States has been regulating airborne emissions since the passage of the U.S. Clean Air Act of 1990, which is credited as the world’s first cap-and-trade program (although it called the caps “allowances”).
The program is credited by the Environmental Defense Fund for substantially reducing emissions of sulfur dioxide from coal-fired power plants, the cause of the notorious acid rain of the 1980s.
The Inflation Reduction Act
The most recent development expected to affect the carbon credit market is the Inflation Reduction Act, a landmark bill signed into law on Aug. 16, 2022, that aims to reduce the deficit, fight inflation, and reduce carbon emissions.
The legislation is very focused on cleaning up the environment and includes a provision to reward high-emitting companies that store their greenhouse gases underground or use them to build other products. The rewards come in the form of significantly expanded tax credits, which have increased to $85 from $50 for each metric ton of captured carbon stored underground and to $60 from $35 for each ton of captured carbon that is used in other manufacturing processes or for oil recovery.
It is hoped that these more generous credits will convince investors to make a bigger effort at capturing carbon. Previously, the tax incentive, known as 45Q, was accused of only paying enough to make easy carbon capture projects worth pursuing.
Worldwide Carbon Credit Initiatives
The United Nations’ Intergovernmental Panel on Climate Change (IPCC) developed a carbon credit proposal to reduce worldwide carbon emissions in a 1997 agreement known as the Kyoto Protocol. The agreement set binding emission reduction targets for the countries that signed it. Another agreement, known as the Marrakesh Accords, spelled out the rules for how the system would work.
The Kyoto Protocol divided countries into industrialized and developing economies. Industrialized countries, collectively called Annex 1, operated in their own emissions trading market. If a country emitted less than its target amount of hydrocarbons, it could sell its surplus credits to countries that did not achieve its Kyoto level goals, through an Emissions Reduction Purchase Agreement (ERPA).
The separate Clean Development Mechanism for developing countries issued carbon credits called a Certified Emission Reduction (CER). A developing nation could receive these credits for supporting sustainable development initiatives. The trading of CERs took place in a separate market.
The first commitment period of the Kyoto Protocol ended in 2012. The U.S. Had already dropped out in 2001.
The Paris Climate Agreement
The Kyoto Protocol was revised in 2012 in an agreement known as the Doha Amendment, which was ratified as of October 2020, with 147 member nations having “deposited their instrument of acceptance.”
More than 190 nations signed on to the Paris Agreement of 2015, which also sets emission standards and allows for emissions trading. The U.S. Dropped out in 2017 under then-President Donald Trump, but subsequently rejoined the agreement in January 2021 under President Biden.
The Paris Agreement, also known as the Paris Climate Accord, is an agreement among the leaders of more than 180 countries to reduce greenhouse gas emissions and limit the global temperature increase to below 2 degrees Celsius (36 degrees Fahrenheit) above preindustrial levels by the year 2100.
The Glasgow COP26 Climate Change Summit
Negotiators at the summit in November 2021 inked a deal that saw nearly 200 countries implement Article 6 of the 2015 Paris Agreement, allowing nations to work toward their climate targets by buying offset credits that represent emission reductions by other countries. The hope is that the agreement encourages governments to invest in initiatives and technology that protect forests and build renewable energy technology infrastructure to combat climate change.
For instance, Brazil’s chief negotiator at the summit, Leonardo Cleaver de Athayde, flagged that the forest-rich South American country planned to be a major trader of carbon credits. “It should spur investment and the development of projects that could deliver significant emissions reductions,” he told Reuters.
Several other provisions in the accord include zero tax on bilateral trades of offsets between countries and canceling 2% of total credits, aimed at reducing overall global emissions. Additionally, 5% of revenues generated from offsets will be placed in an adaptation fund for developing countries to help fight climate change. Negotiators also agreed to carry over offsets registered since 2013, allowing 320 million credits to enter the new market.
Why should levels of carbon and greenhouse gases in the atmosphere be reduced?
Scientists at the United Nations’ Intergovernmental Panel on Climate Change (IPCC) have shown that increased levels of greenhouse gases (GHG) in the atmosphere are warming the planet. This creates extreme weather changes around the world. Currently, carbon dioxide is the main GHG and is created by burning fossil fuels—coal, oil and gas. By reducing the amount of carbon dioxide we emit, we may avoid doing further damage to our climate.
How much does a carbon credit cost?
Carbon credits have different prices, depending on the location and market where they are traded. In 2019, the average price for carbon credits was $4.33 per ton. This figure spiked to as much as $5.60 per ton in 2020 before settling to an average of $4.73 in the first eight months of the following year.
Where can you buy carbon credits?
Several private companies offer carbon offsets to companies or individuals seeking to reduce their net carbon footprint. These offsets represent investments or contributions to forestry or other projects with a negative carbon footprint. Buyers can also purchase tradable credits on a carbon exchange such as New York-based Xpansive CBL or Singapore’s AirCarbon Exchange.
How large is the carbon credit market?
Estimates of the size of the carbon credit market vary wildly, due to the different regulations in each market and other geographical distinctions. The voluntary carbon market, consisting largely of companies that buy carbon offsets for corporate social responsibility (CSR) reasons, had an estimated value of $1 billion in 2021, according to some figures. The market for compliance credits, related to regulatory carbon caps, is substantially larger, with estimates ranging as high as $272 billion for 2020.
The Bottom Line
Carbon credits were devised as a mechanism to reduce greenhouse gas emissions by creating a market in which companies can trade in emissions permits. Under the system, companies get a set number of carbon credits, which decline over time. They can sell any excess to another company.
Carbon credits create a monetary incentive for companies to reduce their carbon emissions. Those that cannot easily reduce emissions can still operate, but at a higher financial cost. Proponents of the carbon credit system say that it leads to measurable, verifiable emission reductions.
How Carbon Markets Work
Understanding how markets work, the value of carbon to your business and what to look for in a scheme.
The market for carbon credits is expanding at pace as governments move towards net zero and more companies are required to prove their ‘green’ credentials to auditors. Purchasing carbon credits from brokers is one way of achieving this.
However, there is an imbalance in available information on carbon markets – both in how they work and the value of carbon. Carbon credit buyers know a great deal more about the market and the value of that credit to their businesses than the sellers (farmers and land owners). There is real need to provide clear and unbiased information to allow our farmers and land owners to make informed business decisions on whether to enter into carbon markets.
Here, we aim to help our levy payers navigate the plethora of emerging schemes, assess whether a particular one is a good fit for their business, know if or when to enter a scheme, and decide whether to sell the carbon credits generated.
The latest information and guidance will be made available as it develops in order to support informed, evidence-based decision making.