Carbon Credits

What Are Carbon Credits?

Carbon credits are permits representing the reduction or removal of one ton of CO2 emissions from the atmosphere.

While international carbon trading markets have existed since the 1997 Kyoto Protocols, recent developments in regional markets have led to renewed interest in carbon markets.

Individuals or businesses can acquire these credits to offset CO2 emissions resulting from various sources, including daily activities, industrial operations, delivery trucks, or travel.

Carbon markets enable investors and businesses to trade carbon allowances and offsets concurrently, contributing to environmental protection. Companies purchase carbon credits to offset their greenhouse gas emissions.

Companies can establish a blueprint outlining globally equivalent criteria for carbon savings, laying the groundwork for transparent carbon credit trading.

History Of Carbon Credit

The Kyoto Protocol, signed in 1997, and the Paris Agreement, signed in 2015, were the two core international agreements establishing global CO2 emission reduction targets. 

With the national emissions targets and policies established, businesses are under increasing pressure to find solutions to reduce their carbon footprint. Unfortunately, the majority of today's temporary solutions rely on carbon markets.

Carbon markets transform CO2 emissions into a tradable commodity by assigning them a monetary value. These emissions can be classified as the following:

• Carbon credits: Also known as carbon allowances, they serve as emission permits. Companies acquire these credits from the government, allowing them to emit one ton of CO2. Carbon income flows vertically from firms to regulators through carbon allowances, while surplus credits can be sold among companies.
• Carbon offsets: A carbon offset is created when a company removes a carbon unit from the atmosphere as part of its normal business operations. Other corporations can then purchase the carbon offset to lower their carbon footprint. Carbon revenue flows horizontally because carbon offsets can be traded among companies.

Both emissions credits can be traded on a carbon market.

How Do Carbon Credits Work?

Carbon allowances and offsets are measured in units equivalent to one ton of carbon emissions, commonly called CO2e. Understanding that a ton of CO2 represents a weight measurement is crucial.

To illustrate, driving an average 22 mpg automobile from New York to Las Vegas would generate approximately one ton of CO2 emissions. On average, daily activities result in around 16 tons of CO2e emissions per year for the average American.

Carbon allowances are typically issued by national or international governmental bodies based on emissions targets set each year. These credits are often distributed through a program called 'cap-and-trade.'

Cap-and-trade schemes alleviate the burden on businesses striving to meet short-term emissions goals while offering market incentives to expedite carbon emissions reduction.

Companies can issue carbon offsets by engaging in operations that decrease the quantity of carbon already present in the atmosphere, such as tree planting or investing in renewable energy.

Carbon offsets are part of the 'Voluntary Carbon Market' because their purchase is voluntary. Companies can mitigate their CO2 emissions by purchasing carbon offsets.

What is the carbon market?

The carbon market comprises two major segments for selling carbon allowances. These are:

• Regulated market governed by regional and state-level "cap-and-trade" rules
• A voluntary market in which firms and people acquire credits to offset their carbon emissions on their initiative

Companies participating in a cap-and-trade program in the regulatory market receive a predetermined number of carbon allowances annually based on their size and efficiency relative to industry benchmarks.

Some businesses emit fewer emissions than the allocated carbon allowances, leading to a surplus of carbon credits. Conversely, some businesses, particularly those with less efficient operations, emit more emissions than the allocated credits can cover each year.

Therefore, less efficient companies need to purchase carbon allowances from companies with a surplus to offset their emissions.

Despite technological advancements, some businesses are still far from significantly lowering their emissions. However, they must continue to provide goods and services to generate the funds necessary to reduce their carbon footprint.

As a result, they must find a way to compensate for the carbon they already emit.

Voluntary Vs. Compliant Markets

Companies increasingly need to engage in these credit programs as more countries implement cap-and-trade programs. 

Participation is not optional in most cap-and-trade schemes. Either your organization must adhere to regulatory carbon credit restrictions, or no such limits exist.

There is no legal requirement for businesses to purchase carbon offsets. This practice goes above and beyond regulatory obligations, especially for companies without cap-and-trade programs. Consequently, offsets offer several benefits that credits do not.

Carbon allowances place an additional burden on businesses. Cap-and-trade schemes that function best provide a framework for lowering carbon emissions in exchange. 

While not all programs are equal, when implemented correctly, carbon allowances effectively account for total carbon emissions.

How are carbon credits created?

Carbon credits are generated and sold by various businesses by implementing carbon offsetting methods to reduce, absorb, and store emissions. The following are some of the most popular carbon offset projects:

Projects involving renewable energy

Renewable energy initiatives existed long before the credit markets became popular. Countries with many lakes and rivers, like Brazil or Canada, or countries with many windy regions, like Denmark and Germany, are abundant with renewable energy supplies.

Renewable energy was already an appealing and low-cost source of electricity generation for countries, and it now comes with the extra bonus of creating carbon offsets.

Improving energy efficiency is becoming a priority

Improving energy efficiency in existing buildings and infrastructure complements renewable energy installations. Simple changes, like switching from incandescent to LED bulbs at home, contribute to environmental conservation by reducing electricity consumption.

On a larger scale, initiatives may include building renovations, enhancing industrial operations, or providing energy-efficient equipment to those in need.

Capture and storage of carbon and methane

Carbon and methane capture involves removing CO2 and methane from the atmosphere. Methane is about 20 times more harmful to the environment than CO2, but it is easier to deal with because it can be burned to produce CO2. 

While this may appear counterproductive because methane is over 20 times more destructive to the environment than CO2, converting methane to a molecule of CO2 through combustion reduces net emissions by over 95 percent.

Reforestation and land usage

Natural carbon sinks, such as trees and soil, are utilized in land use and reforestation initiatives to absorb carbon from the atmosphere. Natural carbon sinks include preserving and repairing historic forests, planting new woods, and managing soil.

Plants use photosynthesis to transform CO2 from the atmosphere into organic matter, ending up in the earth as dead plant matter. 

The CO2-enriched soil, once absorbed, aids in the restoration of the soil's natural properties, increasing agricultural yield while lowering pollution.

How big is the Carbon offset market?

According to analysts at Refinitiv, the value of traded global markets for carbon allowances reached 760 billion euros ($851 billion) in 2021. 

The voluntary carbon market is expected to reach between $10 and $25 billion by 2030, depending on how vigorously countries worldwide pursue climate change goals.

Credit prices vary based on the area and market where they are exchanged. The current weighted carbon price is $34.99 (as of June 2021), up from around $20 near the end of 2020.

Challenges of the carbon offsets market

It is not easy to assess the voluntary carbon market. The credits vary in price, especially for carbon offsets, because the value is tightly tied to the perceived quality of the issuing organization. 

Third-party validators provide the process with more control by ensuring that each carbon offset is based on real-world emissions reductions. However, there are still differences between different forms of carbon offsets.

Analysts agree that voluntary carbon market participation is fast increasing despite the challenges.

Even at the expansion rate mentioned above, the voluntary carbon market would fall short of the investment required for the world to meet the Paris Agreement's commitments.

U.S. Carbon Credits

There is no national carbon market in the United States, and only California has a formal cap-and-trade program. According to the Center for Climate and Energy Solutions, 11 states have adopted market-based approaches to greenhouse gas reduction. 

Ten Northeastern states have teamed together to combat the problem through the Regional Greenhouse Gas Initiative (RGGI). Apart from that, let's see some of the U.S. examples:

1. Clean Air Act of the United States: Since the United States Clean Air Act of 1990, considered the world's first cap-and-trade scheme, the U.S. has regulated airborne pollutants. The Environmental Defense Fund credits the initiative with significantly reducing sulfur dioxide emissions from coal-fired power stations, which were the source of the infamous "acid rain" of the 1980s.
2. Cap-and-Trade Program in California: In 2013, California launched its cap-and-trade program. The regulations apply to large electric power plants, industrial plants, and gasoline distributors throughout the state.

Reducing carbon emissions

Companies have various options to offset carbon emissions. Below are some common practices often considered as offset projects, although this list is not exhaustive:

• Companies can invest in renewable energy projects like wind power, hydropower, geothermal heat, and solar power generation or transition to such sources whenever feasible
• Another option is to enhance global energy efficiency, such as providing more efficient cookstoves to individuals in rural or underprivileged areas."
• Companies can invest in methods like capturing carbon from the atmosphere to manufacture biofuel, thereby creating a carbon-neutral fuel source
• Returning biomass to the soil is a practice aimed at conserving water by minimizing evaporation from the soil surface. It also nourishes soil bacteria and earthworms, facilitating nutrient cycling and enhancing soil structure. This involves mulching and returning biomass to the land
• Tree-planting and forestry operations are utilized to facilitate forest recovery
• Utilizing lower-carbon biofuels such as corn, biomass-derived ethanol, and biodiesel as alternatives

Investing In Carbon Credits

The voluntary carbon credits market has recently matured, offering retail investors additional investment opportunities. Here are several options for investing:

1. Carbon Mutual Funds and ETFs

Investing in carbon markets through mutual funds and ETFs is one of the simplest and lower-risk approaches.

These funds often have diversified holdings, reducing the risk associated with investing in a single entity, albeit with potentially lower returns.

2. Green Company

Investing in green enterprises presents another opportunity for knowledgeable investors to participate in the carbon credit market with a narrower focus.

Many green businesses, such as Tesla, are net carbon-negative. As a result, they're already producing carbon allowances that, if applicable, can be sold in their local compliance markets.

However, because there are many more jurisdictions without compliance markets than those, many green businesses have yet to fully benefit from the credit market.

3. Carbon Credits Futures

For retail investors, buying carbon credit futures, such as European Union Allowance futures on the ICE, offers the most direct exposure to the voluntary carbon markets. However, this strategy can be highly sophisticated and risky compared to other kinds of green investing.

Carbon offset projects potentially provide the best exposure to carbon allowances. However, it is currently challenging for retail investors to invest directly in these projects due to their preference for private cash acquisitions.

Alternatively, businesses investing in carbon offset projects, where credit generation and sales are their primary revenue streams, are well-placed to capitalize on the increasing demand for carbon allowances and voluntary carbon markets.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Climate Finance
• Climate Risk
• ESG
• Green Bond
• Greenwashing