Carbon credits, carbon offset, carbon allowance—you can be forgiven for finding the terminology used to describe carbon markets and the strategies employed to reduce carbon emissions confusing.
In the pursuit of clarity, let’s cut through the ambiguity and explore each concept.
What is a carbon credit?
A carbon credit is a method of exchange—a permit or certificate used to offset a company or country’s greenhouse gas (GHG) emissions. One carbon credit represents one metric ton of carbon dioxide emissions or its equivalent (tCO2e) in another greenhouse gas, including methane (CH4), nitrous oxide (N2O), and fluorinated gases like the ozone layer harming hydrofluorocarbons.
Ultimately, carbon credits incentivize carbon removal from the atmosphere to combat anthropogenically-driven climate change (climate change caused by human activity) that directly interferes with the Earth’s climate system.
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Carbon Credits vs. Carbon Offsets: What is the difference between carbon credit and carbon offset?
Carbon credits and carbon offsets are often used interchangeably, but there are critical distinctions between the two. While carbon credits are a market-based instrument used to price and trade carbon, a carbon offset is a method of offsetting emissions through investments in GHG reduction projects that compensate for or cancel out an organization’s carbon footprint.
Here’s the process behind carbon offset projects:
- Calculate and measure carbon emissions. An organization’s carbon footprint is calculated by a third party, like VERRA, Gold Standard, or the International Carbon Reduction & Offset Alliance (ICROA). The calculation is based on industrial practices, including emissions from importing raw materials, manufacturing products, and transporting goods.
- Reduce emissions. Once an organization’s carbon footprint is known, the organization can take measures to reduce emissions, such as investing in energy efficiency or renewable energy initiatives.
- Offset unavoidable emissions. Even with the best efforts to reduce emissions, there may remain an amount of unavoidable emissions. In these cases, carbon offset companies and the offset projects they fund and support make the difference and achieve a net-zero carbon footprint.
- Receive a carbon credit. Any surplus of carbon capture achieved by carbon offset projects is rewarded with a carbon credit representing every metric ton of GHG offset. These carbon credits are used to offset future emissions, or they can be sold on the carbon market.
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How Do Carbon Credits Work?
The process of generating and using carbon credits can be broken down into three steps:
- GHG emitting projects are registered and verified. Registering and verifying GHG emitting projects involves determining which carbon projects are eligible to generate carbon credits. An independent third-party organization, like the current undertaking in the agricultural industry by the USDA or other carbon offset projects monitored by verified carbon standard organizations, conducts this process to ensure that GHG reduction projects create measurable reductions in GHG emissions.
- GHG reduction projects receive carbon credits. Once a project is registered, carbon credits are generated. The number of credits generated is based on the size and scope of the GHG reduction project. For example, a tree planting project will generate one carbon credit for every metric ton of carbon dioxide it sequesters.
- Carbon credits are sold or used to offset emissions. When a company or country wants to emit GHGs, it can purchase carbon credits. The carbon credits purchased represent the amount of GHGs that can be emitted.
So how do carbon allowances fit into all of this?
Carbon allowances are distinct from carbon credits in that the carbon allowance is the amount of GHG a company has the legal right to emit. In contrast, a carbon credit is a unit of measurement for those emissions.
For example, if a company has been granted a carbon allowance of 1,000 tons of tCO2e, it can purchase 1,000 carbon credits to offset these projected emissions. While the company can purchase more credits than it needs, let’s say 1,200 carbon credits, the company is still restricted to emitting only its allowance, 1,000 metric tons of tCO2e.
Learn more: How to Invest in Carbon Credits.
How Much Does a Carbon Credit Cost?
Ideally, to meet the 2°C goals set by the Paris Agreement, carbon credits should be priced at $40-80 USD per metric ton. Although, the price of carbon credits varies depending on the market and the specific project the credit was generated from.
There are three key reasons:
- Carbon credits are priced on a cost-based model. For example, the cost of implementing regenerative agriculture is less expensive and energy-intensive than developing and manufacturing renewable energy technologies.
- The cost of a carbon credit reflects the value of emissions. In other words, the price of a carbon credit should be equal to the social and environmental cost of emitting one ton of carbon dioxide into the atmosphere, including effects of climate change, like more extreme weather events, increased costs of food and water, and damages to infrastructure.
- The price of carbon credits is subject to supply and demand fluctuations. As with any commodity, when demand is high and supply is low, the cost of carbon credits will increase. The opposite is also true; prices will drop when demand is low, and supply is high.
How Do Cap-And-Trade Systems Work?
Cap-and-trade systems are market-based mechanisms that set an overall cap on GHG emissions and allow businesses to trade (buy and sell) emission allowances within this system. In other words, the goal of cap-and-trade systems is to reduce emissions by creating a cost-effective carbon market.
What does this look like in practice?
Businesses are allocated a set number of emission allowances representing their GHG emissions limit. Companies that emit less than their allowance can “bank” their carbon credits for future use or sell them to other businesses that expect to emit more than their carbon allowances. The cost of buying allowances incentivizes companies to invest in cleaner technologies and employ low-emission operating processes to reduce their carbon production.
How big is the carbon credit market?
Pricing now applies to a fifth of the world’s global GHGs. Further, the carbon market is continuing to grow. Environmental and Energy Leader reports that the global carbon market was valued at USD 211.5B in 2019. This number is projected to hit USD 2.4T by 2027. That’s more than an 11x increase in just eight years.
Where do the largest carbon credit markets currently exist?
Europe’s carbon credit market, known as the European Union Emissions Trading Scheme (EU-ETS), has been, for a long time, the world’s largest. However, as reported, China has just relaunched its version of carbon credits, referred to as China Certified Emission Reductions (CCER). The reboot of China’s emissions trading system (ETS) makes it the largest in the world.
What is the “compliance market” for carbon credits?
The carbon “compliance market” facilitates the trading of carbon credits, allowing organizations to sell excess carbon credits or buy the carbon credits they need to meet mandated emissions reduction targets and remain carbon neutral. For example, members of the European Union have mandatory emissions reduction targets under the EU-ETS. To meet these targets, organizations within the EU can purchase carbon credits to offset their emissions. Currently, projections suggest the price of carbon within the European compliance market is set to hit around $67 per metric ton by 2030.
What regulations or oversight does this market have?
The compliance carbon market is regulated by international, regional, and sub-national carbon reduction overseers, including targets set by the Clean Development Mechanism under the Kyoto Protocol, the EU-ETS, and the California Carbon Market.
Comparatively, the voluntary carbon market is not subject to these regulations or oversight. Instead, primarily driven by consumer demand, good faith, or an expectation of future regulation, voluntary carbon markets are opted into by carbon-emitting organizations.
For those skeptical that this system can make a meaningful impact, don’t be fooled by the voluntary market’s, well, voluntary nature.
The voluntary carbon market hit a record $6.7B at the end of 2021, demonstrating just how seriously some organizations—even those that aren’t required by law—take reducing their carbon footprints.
You can learn more about how to offset your carbon footprint in our complete guide to carbon offsetting.
Carbon Offset Examples: What is the US doing about carbon credits?
In the US, the Regional Greenhouse Gas Initiative (RGGI) is a regional cap-and-trade program that requires electric power plants in California and twelve northeastern states to reduce their GHG emissions. The RGGI is the first mandatory cap-and-trade program established in the US. As part of this program, each state has a GHG emissions budget that requires fossil fuel power plants to purchase carbon credits at auction to cover their GHG emissions.
As proof of its effectiveness, since the establishment of the RGGI, power plants within these states have reduced their carbon emissions by a massive 50 percent.
Learn more: Carbon Offset Shopify App.
California’s Cap-and-Trade Program
California’s Cap-and-Trade Program is a market-based approach to reducing GHG emissions. The program requires companies that emit greenhouse gases to purchase allowances at quarterly auctions—these credits are set to increase 66 percent to an average of $41 each by 2030. These allowances can then be used to offset their emissions or be traded in the secondary market.
The California Air Resources Board oversees the program, with all proceeds from the auction being reinvested into offset projects that reduce greenhouse gas emissions. And the aim of the program? To lower emissions by 40 percent or below 1990 levels.
The US Clean Air Act
The US Clean Air Act, passed in 1963, is the primary federal law for air pollution control in the US. The act requires the Environmental Protection Agency (EPA) to set National Ambient Air Quality Standards (NAAQS) for six “criteria” pollutants, including carbon monoxide, lead, nitrogen oxides, ozone, particulate matter, and sulfur dioxide.
In its enactment, several amendments have been made to the Clean Air Act to address concerns about climate change. These amendments give the EPA the authority to regulate GHG emissions under the Act.
The Inflation Reduction Act
The Inflation Reduction Act, enacted this year (2022), includes a provision for the 45Q tax credit. The updates made to the 45Q tax credit incentivize the use of carbon capture and storage, both strategies the Intergovernmental Panel on Climate Change (IPCC) and the International Energy Agency (IEA) have highlighted as key strategies to combat anthropogenically-drive climate change.
Some Worldwide Carbon Credit Initiatives:
Looking beyond the US, numerous carbon credit initiatives have been established worldwide. These include:
The Paris Climate Agreement
The Paris Agreement is a legally binding international treaty. The treaty’s primary goal is to keep the global temperature increase this century below 2°C above pre-industrial levels.
To achieve this, the Paris Agreement sets out a global framework of action by all countries to curb emissions and adapt to the adverse effects of climate change. The agreement came into force on November 4, 2016, and has been ratified by 194 parties.
The Glasgow COP26 Climate Change Summit
The Glasgow COP26 Climate Change Summit was an international conference on climate change held in Glasgow, Scotland, from October 31 to November 13, 2021. The conference brought together world leaders, businesses, NGOs, and other organizations to discuss how global action on climate change can be accelerated.
One of the key outcomes of the conference was the Glasgow Climate Pact, which committed almost 200 countries to more ambitious climate action, and included a future commitment to keeping average global temperature increases to no more than 1.5°C.
The Sharm el-Sheikh COP27 Climate Change Summit
The Sharm el-Sheikh COP27 Climate Change Summit was an international climate change conference held in Sharm el-Sheikh, Egypt, from the 7th to the 8th of November, 2022. The conference brought together Heads of State and Governments to discuss how to accelerate global action on climate change.
Where Can Businesses Buy Carbon Credits?
Companies can purchase carbon credits on either the compliance or voluntary market. The most common way for companies to buy carbon credits is through a broker. Carbon brokers are intermediaries that connect buyers and sellers of carbon credits.
Businesses can also purchase carbon credits on the open market directly from carbon market exchanges. See a comprehensive list of both carbon trading brokers and exchanges here.
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