Carbon credits & offsets are becoming more and more important as we strive to achieve net-zero emissions. Carbon credits are quickly becoming an important part of the global economy. So what are they, and why are they so important?
This guide will introduce you to carbon credits and outline the current state of the market. It will also explain how credits and offsets work in currently existing frameworks and highlight the potential for growth.
A quick history of Carbon Credits, Offsets and Markets
The Kyoto Protocol of 1997 and the Paris Agreement of 2015 were international accords that laid out international CO2 emissions goals. With the Paris Agreement being endorsed by all but six countries, they have given rise to national emissions targets and the regulations to back them.
The pressure on businesses to reduce their carbon footprint is increasing with these new regulations in place. A majority of today’s interim solutions involve the use of the carbon markets.
What the carbon markets do is transform CO2 emissions into a commodity by assigning them a value.
These gases can be divided into two groups: Carbon credits or carbon offsets, and they can both be bought and sold on a carbon market. It’s a simple concept with a market-based answer to a growing problem.
What are carbon credits and carbon offsets?
The terms are frequently used interchangeably, but carbon credits and carbon offsets operate on different principles.
Carbon credits, also known as carbon allowances, work like permission slips for emissions. When a company buys a carbon credit, usually from the government, they gain permission to generate one ton of CO2 emissions. With carbon credits, carbon revenue flows vertically from companies to regulators, though companies who end up with excess credits can sell them to other companies.
Carbon offsets flow horizontally, trading carbon revenue between companies. When one company removes or sequesters a unit of carbon from the atmosphere as part of their normal business activity, they can generate a carbon offset. Other companies can then purchase that carbon offset to reduce their own carbon footprint.
Note that the two terms are sometimes used interchangeably, and carbon offsets are often referred to as “offset credits”. Still, this distinction between regulatory compliance credits and voluntary offsets should be kept in mind.
A carbon credit is a tradable permit or certificate that provides the holder of the credit the right to emit one ton of carbon dioxide or an equivalent of another greenhouse gas – it’s essentially an offset for producers of such gases.
The main goal for the creation of carbon credits is the reduction of emissions of carbon dioxide and other greenhouse gases from industrial activities to reduce the effects of global warming.
Carbon credits are a market mechanism used to reduce greenhouse gas emissions. Governments or regulatory authorities set the caps on greenhouse gas emissions. For some companies, the immediate reduction of the emission is not economically viable. Therefore, they can purchase carbon credits to comply with the emission cap.
Companies that achieve the carbon offsets (reducing the emissions of greenhouse gases) are usually rewarded with additional carbon credits. The sale of credit surpluses may be used to subsidise future projects for the reduction of emissions.
Types of Carbon Credits
There are two types of credits:
- Voluntary emissions reduction (VER): A carbon offset that is exchanged in the over-the-counter or voluntary market for credits.
- Certified emissions reduction (CER): Emission units (or credits) created through a regulatory framework with the purpose of offsetting a project’s emissions. The main difference between the two is that there is a third-party certifying body that regulates the CER as opposed to the VER.
Carbon credits are tradeable on both private and public markets. Trading instruments currently in use allow for the global exchange of carbon credits.
The prices of credits are primarily driven by the levels of supply and demand in the markets. The prices of the credits vary depending on country-specific variations in supply and demand.
A carbon market allows investors and corporations to trade both carbon credits and carbon offsets simultaneously. This mitigates the environmental crisis, while also creating new market opportunities.
Almost every time a new issue arises, it creates a fresh market, and the continuing climate crisis and increasing global emissions are no exception.
Companies have increasingly turned to the voluntary market for carbon offsets as a result of new legal requirements and growing consumer pressure. Changing public attitudes on climate change and carbon emissions has added a public policy incentive.
Although carbon credits are beneficial to society, it is not easy for an average investor to start using them as investment vehicles. The certified emissions reductions (CERs) are the only product that can be used as investments in the credits.
However, CERs are sold by special carbon funds established by large financial institutions. The carbon funds provide small investors with the opportunity to enter the market.
How are carbon credits and offsets created?
Credits and offsets form two slightly different markets, although the basic unit traded is the same – the equivalent of one ton of carbon emissions, also known as CO2e.
Carbon credits are issued by national or international governmental organisations. We’ve already mentioned the Kyoto and Paris agreements which created the first international carbon markets.
In the U.S., California operates its own carbon market and issues credits to residents for gas and electricity consumption.
The number of credits issued each year is typically based on emissions targets. Credits are frequently issued under what’s known as a “cap-and-trade” program. Regulators set a limit on carbon emissions – the cap. That cap slowly decreases over time, making it harder and harder for businesses to stay within that cap.
Around the world, cap-and-trade programs exist in some form in Canada, the EU, the UK, China, New Zealand, Japan, and South Korea, with many more countries and states considering implementation.
As a result, companies are incentivised to reduce the emissions their business operations produce to stay under their caps.
In essence, a cap-and-trade system relieves businesses of the obligation to meet emissions targets in the near future while also providing market incentives to speed up carbon reductions.
Carbon offsets work a little differently…
Organisations with operations that reduce the amount of carbon already in the atmosphere say by planting more trees or investing in renewable energy have the ability to issue carbon offsets. The purchase of these offsets is voluntary, which is why carbon offsets form what’s known as the “Voluntary Carbon Market”. Companies may, nevertheless, reduce the rate at which CO2e is emitted even more by purchasing carbon offsets.
What is the carbon marketplace?
When it comes to the sale of carbon credits within the carbon marketplace, there are two significant, separate markets to choose from.
- One is a regulated market, set by “cap-and-trade” regulations at the regional and state levels.
- The other is a voluntary market where businesses and individuals buy credits (of their own accord) to offset their carbon emissions.
Think of it this way: the regulatory market is mandated, while the voluntary market is optional.
When it comes to the regulatory market, each company operating under a cap-and-trade program is issued a certain number of carbon credits each year. Some of these companies produce fewer emissions than the number of credits they’re allotted, giving them a surplus of carbon credits.
On the flip side, some companies (particularly those with older and less efficient operations) produce more emissions than the number of credits they receive each year can cover. These businesses are looking to purchase carbon credits to offset their emissions because they must.
How to produce carbon credits
Many different types of businesses can create and sell carbon credits by reducing, capturing, and storing emissions through different processes.
Some of the most popular types of carbon offsetting projects include:
- Renewable energy projects
- Improving energy efficiency
- Carbon and methane capture and sequestration
- Land use and reforestation
Renewable energy projects have already existed long before carbon credit markets came into vogue. Many countries in the world are blessed with a natural wealth of renewable energy resources. Countries such as Brazil or Canada that have many lakes and rivers, or nations like Denmark and Germany with lots of windy regions. For countries like these, renewable energy was already an attractive and low-cost source of power generation, and they now provide the added benefit of carbon offset creation.
Energy efficiency improvements complement renewable energy projects by reducing the energy demands of current buildings and infrastructure. Even simple everyday changes like swapping your household lights from incandescent bulbs to LED ones can benefit the environment by reducing power consumption. On a larger scale, this can involve things like renovating buildings or optimizing industrial processes to make them more efficient or distributing more efficient appliances to the needy.
Carbon and methane capture involves implementing practices that remove CO2 and methane (which is over 20 times more harmful to the environment than CO2) from the atmosphere.
Methane is simpler to deal with, as it can simply be burned off to create CO2. While this sounds counterproductive at first, since methane is over 20 times more harmful to the atmosphere than CO2, converting one molecule of methane to one molecule of CO2 through combustion still reduces net emissions by more than 95%.
For carbon, capture often happens directly at the source, such as from chemical plants or power plants. While the injection of this captured carbon underground has been used for various purposes like enhanced oil recovery for decades already, the idea of storing this carbon long-term, treating it much like nuclear waste, is a newer concept.
Land use and reforestation projects use Mother Nature’s carbon sinks, the trees and soil, to absorb carbon from the atmosphere. This includes protecting and restoring old forests, creating new forests, and soil management.
Plants convert CO2 from the atmosphere into organic matter through photosynthesis, which eventually ends up in the ground as dead plant matter. Once absorbed, the CO2-enriched soil helps restore the soil’s natural qualities – enhancing crop production while reducing pollution.