What Are Carbon Credits And How To Trade Them

A short introduction to Carbon Credits. A carbon credit, in a broad sense, is a permit allowing a business holding the credit to emit (and offset) greenhouse gases or carbon dioxide. Whether this is a legal obligation for the relevant business or voluntary depends on the jurisdiction and legal carbon emission caps defined for businesses.

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Table of Contents

A short introduction to Carbon Credits.

A carbon credit, in a broad sense, is a permit allowing a business holding the credit to emit (and offset) greenhouse gases or carbon dioxide. Whether this is a legal obligation for the relevant business or voluntary depends on the jurisdiction and legal carbon emission caps defined for businesses. One credit is equivalent to one ton of carbon dioxide generated or a mass equivalent to the greenhouse effect of other greenhouse gases.

Companies can typically access as many credits as they need in order to offset their carbon emissions. While it is advised to do everything possible to reduce emissions intrinsically, many businesses still decide to reduce emissions and offset via credits in tandem, especially when there currently are no other options, such as in the aviation industry.

The history of carbon offsets and credits

The 1997 Kyoto Protocol and the 2015 Paris Agreement were international agreements that set global CO2 emission targets. While the Kyoto protocol has, over time, resulted in the creation of the first Carbon offset compliance in the European Union and California, voluntary carbon offset markets were yet on the horizon.

The Paris Agreement finally resulted in national emissions targets and the laws to support them, with all but six nations approving them. The Paris Agreement has also called for a voluntary carbon offset market.

blue and brown steel bridge

What exactly are carbon offsets and credits?

Even though the phrases are used interchangeable, there are specific nuances: carbon credits and offsets have slightly different designs and purposes.

Carbon credits function as emissions permit forms commonly referred to as carbon allowances or ‘mandatory’ carbon allowances. A corporation is authorised to emit one ton of CO2 emissions when they purchase a carbon credit, typically from a market operating under government rules.

Certain industries, such as steel and power generation, have a government-mandated cap on how much carbon they are permitted to emit yearly, declining over time to reach net-zero goals. Eventually, those businesses should become net zero.

If they surpass their annual allowance, they must purchase mandatory carbon allowances for excess emissions. In this way, there is an economic incentive to reduce emissions significantly than the government asks businesses to do. Otherwise, the firm faces substantial costs in purchasing carbon credits in the open market.

On the other hand, if they emit less than they are permitted to, corporations can sell any surplus credits to other businesses and thus earn an extra income.

Carbon offsets are not part of a mandatory compliance market. Instead, they are voluntary arrangements between businesses to cover their carbon emissions.

A company working on a project to remove 1 ton of CO2 from the atmosphere by doing a reforestation project and planting trees can get certified for their work using an accredited certification authority and Carbon Registries such as VERRA and Gold Standard.

On the other side, businesses that would like to offset emissions they can not eliminate, such as aviation companies, may purchase those credits.

It should be noted that the two terms are occasionally used synonymously and that “offset credits” are frequently used to refer to carbon offsets. Nevertheless, it’s important to remember the difference between voluntary offsets and regulatory compliance credits.

plant during sunset


How are carbon offsets and credits produced or originated?

Although the fundamental denomination unit is the same — one credit is equal to one ton of carbon emissions, commonly known as CO2e — credits and offsets represent two slightly different markets.

Origination of carbon credits

Carbon Credit markets are based on laws and regulations a country our federation establishes. Typically, the government would establish a so-called “cap-and-trade” program which stipulates emissions targets for industries covered by the program. The most widely adopted programs are the EU Emission Trading System (EU ETS) and the California Cap and Trade Program.

Emissions targets thus determine the annual carbon credit issuance.

Companies would receive an amount of ‘free’ credits, which they can sell on the market or keep to cover their emissions which improvements can’t reduce the business.

Regulators then established a cap on carbon emissions for each company or sector. If the company surpasses the cap, it would need to buy additional credits on the market. Otherwise, it may sell surplus credits it did receive to other companies that have not met their targets.

It gets more complex for firms to keep their emissions below the cap over time because the cap level gradually declines. In this way, a market mechanism is forcing businesses to cut their emissions according to or faster than scheduled by the government. Otherwise, they are penalised because they need to purchase additional credits on the open market.

As a result, businesses are encouraged to cut back on the emissions they emit to stay within their limits.

A cap-and-trade program adds economic incentives to cut carbon emissions more quickly while easing the burden on businesses striving to fulfil short-term emissions limits.

Carbon offsets are voluntarily created in the market

In the voluntary carbon market, a single Credit is produced whenever a project dedicated to carbon removal is judged to have reduced 1 ton of greenhouse gases. So, for example, the credit may be created by growing a forest, under a so-called ‘reforestation project’, which would remove 1 ton of carbon emissions.

Companies that engage in activities that actively reduce emissions already present in the environment, such as by increasing tree planting or utilising renewable energy sources, which would replace generation by fossil fuels, have the option to create carbon offsets.

Due to the voluntary nature of offset purchases, carbon offsets are a component of the so-called “Voluntary Carbon Market.”

The Voluntary Carbon Market is global and unregulated. Theoretically, anybody could create a project and originate carbon offsets. However, certification authorities were created to protect the market from bad actors. These non-governmental organisations set standards that projects need to meet to get certified.

Only certified projects have the credibility to originate carbon offsets that can be sold on the open market. Yet, because the market is unregulated, there is no mechanism preventing a company from marketing themselves as ‘carbon neutral’ and backing this claim by having purchased ‘some sort of carbon offset’.

Insofar, such claims should be backed up by inspecting if the relevant company has produced a thorough analysis and accounting of their carbon footprint and has offset residual emissions using certified carbon offsets. Furthermore, the certification authorities’ carbon registry should be inspected to see if the company is effectively holding said credits and has retired in the past to offset the emissions effectively.

Voluntary Carbon Credits are issued in vintages, where the vintage year refers to the year the emission occurred. Most projects issue credits every year, but it is also possible to have multi-year issuance.

As a result, carbon credits expire over time, so businesses have to develop new solutions to reduce emissions.

While this sounds straightforward, many intricacies are involved before a project can issue and sell Carbon Credits, such as going through verification of the project with an established and credible verification program such as VERRA or Gold Standard.

Selling an offset effectively requires time and dedication to planning a project which is sustainable, beneficial for the environment and would actively help to reduce emissions.

Sellers of carbon offsets typically have three ways to market their Credits to Buyers:

  • direct sales to clients, i.e. directly contacting an Airline
  • supplying brokers, meaning contacting a business which acts as an intermediary
  • listing the credits on exchanges

To sum up: by purchasing voluntary carbon offsets, businesses can measurably lessen the quantity of CO2e they cause. On the flip side, by purchasing these credits, companies proactively finance projects that remove CO2e from the atmosphere.

How are carbon credits traded?

In the voluntary carbon market, many credits are purchased and sold bilaterally, meaning a project originator would directly sell the credits to a business which wants to offset its emissions.

However, centralised trading platforms and brokers have become more prevalent recently. 

Such trading businesses and brokers would purchase credits directly from project originators in bulk and re-sell them to anyone who might require them. Those traders can also be active on wholesale exchanges. The Carbon Credit market has seen increasing institutional trading activity develop in 2021 and 2022. However, aggregate wholesale trading volumes are still relatively low compared with commodity and energy markets.

Once the Credits are sold to the final buyer, such as an offsetting business or individual, traders typically add a margin on top of their wholesale purchase price to compensate for their activity and risk.

Insofar, Carbon Credits are not considered an investment to buy and hold. Before actively trading Carbon Credits, one should be aware that wholesale markets are typically not accessible to everyday investors but only for specialised companies.

If an everyday investor wants to invest in Carbon Credits, they should look out for listed instruments such as ETFs and ETPs holding Carbon Credit Derivatives for investment purposes. 

What is the carbon marketplace?

As we elaborated, two main, distinct markets are available for purchasing carbon credits inside the carbon market.

One is a market governed by “cap-and-trade” laws at the state and government levels. The second is a voluntary market where companies and people can purchase credits to offset their non-reduceable emissions.

The open or voluntary market is optional, whereas the regulated market is required. Still, both markets operate and allow for the buying and selling of carbon credits.

Each business participating in a cap-and-trade program receives a specific quantity of carbon credits per year, according to the regulatory market. Some of these businesses generate fewer emissions than the allocated number of credits, leaving them with extra carbon credits.

On the other hand, some firms (especially those with older, less efficient operations) generate more emissions than they can offset with the credits they obtain annually.

As a result, these companies must look to buy carbon credits on the open market to compensate for their emissions. A good example of such companies is power generation companies using fossil fuels such as coal or oil.

Most noteworthy, nearly all businesses have started or will soon announce a plan to reduce their carbon impact. Their efforts can be tracked via the Netzero Tracker which covers the 2,000 largest publicly traded companies worldwide by revenue.

The number of carbon credits allotted to each firm each year depends on the size of each company and how effectively they operate compared to industry benchmarks.

Reasons for establishing the Carbon Market

Despite technological advancements, some businesses have a long way to go before significantly decreasing their emissions. However, they must continue to offer items and services to make the money required to reduce their operations’ carbon impact, as indicated in their respective jurisdiction’s net-zero targets. 

Interim targets for 2030 in the European Union and the United States are based on the Paris Agreement’s goal to keep global warming at a maximum of 1.5 degrees Celsius. They are calling for an emission reduction of at least 55% (EU) and more than 50-52% (US) of 2005 levels. 

As a result, they must figure out a means to cut the levels of carbon they already emit. Regulators and governments have set up Compliance Carbon Markets to create economic incentives for, particularly carbon emission incentive industries, to reach the goals set out.

Voluntary carbon markets have been set up to enable industries not covered by regulations to offset their emissions and thus funnel investments into the creation of carbon sinks, renewable energy projects and projects increasing energy efficiency. 

carbon emissions from a black ship

 Voluntary Carbon Markets

The voluntary carbon market operates differently from the mandatory market. As we already mentioned, businesses have the possibility to collaborate with organisations and people who value the environment and opt to neutralise their carbon emissions out of personal preference and/or increased public awareness and demand of their customers. 

However, since this market is voluntary, no emission reduction is required by the law of companies operating outside the scope of mandatory carbon markets.

Many businesses looking to convey their sustainability and net-zero ambitions to their customers thus choose to engage in the voluntary carbon market to offset non-reduceable emissions. 

Early market participants are businesses that care about the environment and want to show that they contribute to environmental protection. As for individuals, those are usually people who care about the environment and want to reduce the carbon they emit when they travel. 

If you ever noticed (and ticked!) the small tickboxes airlines offer to offset your carbon emissions when travelling for an extra fee – the offsets to do so are purchased in the voluntary carbon market. 

To sum up: the motivation why somebody engages in the voluntary carbon market can range from environmental consciousness to marketing and aligning with customers’ values: if businesses seek to become involved, the voluntary carbon market gives them that opportunity.

The voluntary and regulatory markets thus are supposed to supplement each other to accelerate the transition to net zero. 

Market size for carbon offsets

The measurement of the market size of the voluntary carbon market is challenging. This is because many offsets are traded bilaterally; for example, a reforestation project would directly sell the offsets produced to an airline. In addition, there currently is no worldwide central registry or database which records all credits nor an agreed terminology. 

All verified offsets are recorded in different verified carbon registries. These third-party validators add control to the process, ensuring that each carbon offset results from real-world emissions reductions.

According to Trove Research, the voluntary carbon market could reach a market size of $10 and $40 billion by 2030, depending on how strongly nations around the world pursue climate change commitments. In 2021, the market size surpassed $1bn for the first time.

Analysts concur that the voluntary carbon market’s involvement is expanding quickly despite recent prices setbacks in early 2022. However, the projected market size in 2030 would still fall well short of the amount of investment needed in carbon sinks for the world to ultimately reach the targets set by the Paris Agreement, even at the rate of growth shown above.

Carbon symbol CO2

 Methods for creating (voluntary) carbon credits

A wide range of business types can produce and market (voluntary) carbon credits by lowering, absorbing, and storing emissions via various procedures.

The following are some of the most well-liked forms of carbon offsetting projects:

  • projects utilising renewable energy,
  • increasing energy efficiency,
  • capturing and storing carbon and methane
  • Use of the land and reforestation

Voluntary carbon credits should incentivise the creation of new projects, which, without the receipt of cash flows from selling the offsets, would not happen. At any time, such projects can be set up without issuance of carbon offsets and certainly have been in the past. 

Examples of projects which are eligible to issue carbon offsets

Improving energy efficiency in buildings

Significant improvements support renewable energy initiatives by decreasing the energy demands of present buildings and infrastructure. Even simple everyday improvements like converting domestic lights from incandescent light bulbs to LED ones can help to protect the environment by minimising power use. On a broader scale, this can entail things like remodelling buildings, streamlining industrial operations to increase efficiency, or providing the less fortunate with more efficient equipment.

Carbon Capture and Storage

Implementing procedures to remove CO2 and methane from the atmosphere (which is over ten times more damaging to the environment than CO2) is known as carbon and methane capture.

Carbon capture frequently occurs at the origin, such as from chemical or power facilities. While injecting this collected carbon underground for various uses, such as increased oil recovery, has been done for decades, the idea of long-term storage of this carbon, treating it similarly to nuclear waste, is a more recent proposal.

Nature Based Projects

Trees and soil, Mother Nature’s carbon sinks, are used in land use and reforestation efforts to capture atmospheric carbon. This includes managing soil, growing new forests, and preserving and repairing old forests.

Through photosynthesis, plants transform Co2 from the air into organic matter, which eventually becomes dead plant matter and is buried in the earth. After being absorbed, the CO2-enhanced soil aids in restoring the soil’s original properties, increasing crop yield while lowering pollution.

grasses during golden hour

While this article has been created with diligence and care, we can not guarantee that all information is up-to-date, correct and exhaustive. Do you have additional information you believe we should include?  Please use the contact form to submit your information (including sources). We rely on notifications by our readers to keep articles up to date. 

Disclosures: Our publications provide information and education on the carbon and environmental markets. While some of the posts can reference investment products for information purposes, our authors are not investment advisers. Please be aware of our disclaimer.

led lights on the ceiling
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