With global temperatures continuing to rise, governments and corporations are looking for ways to reduce greenhouse gas emissions. One method that’s gaining popularity is the use of Carbon Credits to incentivize emissions reductions and support renewable energy development. This article is the 3rd in a series we’re doing based on our widely respected Climate Change and Carbon Markets 2023 Report. Previous posts in the series are:
In this article we examine what carbon credits are, and how they work as part of a broader emissions reduction strategy.
What Are Carbon Credits?
A carbon credit represents one ton of carbon dioxide or other greenhouse gas that is prevented from entering the atmosphere. Each credit is assigned a unique identification number that allows it to be tracked and traded.
How Are Carbon Credits Created?
Carbon credits are generated through activities like renewable energy generation, reforestation projects, or installing technology to reduce industrial emissions. Organizations can then purchase these credits to offset their own emissions and essentially pay someone else to reduce greenhouse gases on their behalf. This gives companies an economic incentive to finance projects that take carbon out of the atmosphere.
How big is the Carbon Credit market?
Globally, the voluntary carbon credit market was estimated at $1 billion in 2021. Meanwhile the compliance carbon credit market, which consists of credits generated under cap-and-trade systems and carbon taxes, was valued around $272 billion. As more jurisdictions enact climate policies, demand for carbon credits is expected to grow.
Cap-and-Trade Systems
One of the most common uses of carbon credits is in emissions trading systems, also known as cap-and-trade. This revolutionary approach to controlling carbon emissions sets caps on the amount of carbon that can be released into the atmosphere, and creates a market where companies can trade carbon allowances. Those who wish to emit more can purchase additional allowances, while others might sell their unused ones.
How Does Cap-and-Trade work?
Under a cap-and-trade system, the government sets an overall legal limit on greenhouse gas emissions from major sources like power plants and heavy industry. Companies receive or buy emission allowances up to their allotted share of the cap. If they reduce emissions below their cap, they can sell spare allowances to other companies as carbon credits.
Using Carbon Credits in Cap-and-Trade Systems
This creates a financial incentive for organizations to cut their carbon footprints, as they can profit from selling excess carbon credit allowances while still meeting their own targets. Meanwhile companies that would struggle to reduce emissions can purchase carbon credits as a flexible, cost-effective way to comply with regulations. The overall emissions cap guarantees the desired environmental outcome is still achieved.
Using Carbon Credits in Carbon Tax Systems
In a carbon tax system, governments directly tax emissions from sources like electricity generation and transportation fuels. This gives companies a standing financial reason to look for ways of reducing their tax burden by cutting carbon output.
Carbon credits can provide tax relief in two main ways:
- Credits can be surrendered to offset tax obligations directly. Each credit represents one tonne of emissions that a company doesn’t have to pay tax on.
- Revenue from credit sales can help finance emission reduction projects, lowering a company’s overall taxable emissions.
Voluntary Carbon Credit Purchases
Beyond regulatory requirements, some organizations and individuals buy carbon credits on a voluntary basis. Reasons for voluntary credit purchases include:
- Corporate social responsibility – Companies offset their emissions to demonstrate a commitment to sustainability to customers and shareholders.
- Carbon neutral products – Retailers and manufacturers invest in credits to compensate for emissions associated with making and transporting products, allowing them to sell carbon neutral or “net zero” goods.
- Voluntary reductions – People offset things like air travel through credits to reduce their personal carbon footprint.
- Pre-compliance buying – Companies purchase credits speculatively in anticipation of future climate regulations.
Carbon Credit Project Categories
There are many types of activities that can generate saleable carbon credits, provided they satisfy the key requirement of demonstrably reducing or removing emissions. Some major project categories include:
- Renewable energy – Building wind, solar or hydropower instead of fossil fuel generation.
- Energy efficiency – Upgrading equipment, appliances and processes to reduce energy usage and associated emissions.
- Fuel switching – Transitioning from higher emission fuels like coal to lower carbon alternatives like natural gas or bioenergy.
- Industrial gas destruction – Destroying potent greenhouse gases like nitrous oxide or hydrofluorocarbons.
- Waste management – Installing gas capture systems at landfills and livestock operations to prevent methane release.
- Forestry – Planting trees or avoiding deforestation through forest conservation programs. Trees naturally absorb CO2 as they grow.
- Carbon capture and storage – Technologically capturing emissions at source and permanently sequestering them underground.
- Agricultural practices – Adopting techniques like low/no-till cultivation, crop rotation and organic soil management to boost carbon storage in farmland.
Voluntary demand makes up a relatively small segment of the global carbon credit market, but this segment has seen significant growth over the past decade – According to data from Forest Trends’ Ecosystem Marketplace, voluntary carbon credit retirements have increased over 20-fold from 10 million tons CO2e in 2010 to 220 million tons CO2e in 2020. The value of the voluntary carbon market more than tripled between 2017 and 2021, reaching an estimated $1 billion in transactions last year, and this segment is expected to play an increasing role as sustainability awareness grows among businesses and consumers.
Are Carbon Credits Effective?
Carbon credits are sometimes criticized as an excuse for companies to keep polluting while paying others to enact change. However, when paired with sound climate policies, credits can provide an efficient market mechanism to drive meaningful emissions reductions.
Conclusion – Carbon Credits for a Net-Zero Future
With rising worldwide emissions, new strategies are essential for achieving global climate targets. Carbon pricing policies like emissions trading and carbon taxes create regulatory and economic incentives to tackle greenhouse gas output. Within this context, carbon credits offer a market mechanism for driving cost-effective emissions reductions while supporting renewable energy and climate-smart development.
To learn more about the role carbon credits play in fighting climate change contact us for the full report.
Additional sources and suggested reading
- World Bank. (2019). State and Trends of Carbon Pricing 2019. Link
- Stavins, R. N. (2008). A meaningful U.S. cap‐and‐trade system to address climate change. Harvard Environmental Law Review, 32, 293.
- Carbon Pricing Leadership Coalition. (2021). Carbon Pricing Dashboard. Link
- Ellerman, A. D., & Buchner, B. K. (2008). Over-allocation or abatement? A preliminary analysis of the EU ETS based on the 2005–06 emissions data. Environmental and Resource Economics, 41(2), 267-287.
- European Commission. (2021). EU Emissions Trading System (EU ETS). Link
- Metcalf, G. E. (2009). Designing a carbon tax to reduce U.S. greenhouse gas emissions. Review of Environmental Economics and Policy, 3(1), 63-83.
- Forest Trends’ Ecosystem Marketplace. (2021). Voluntary Carbon Markets Insights. Link
- Wara, M. W. (2007). Is the global carbon market working? Nature, 445(7128), 595-596.
- Aldy, J. E., & Stavins, R. N. (2012). The promise and problems of pricing carbon: Theory and experience. The Journal of Environment & Development, 21(2), 152-180.
- Intergovernmental Panel on Climate Change (IPCC). (2018). Global Warming of 1.5°C. Link
