What are Carbon Credits and How Do They Work?

What are Carbon Credits and How Do They Work?

Understanding the basic currency of cap-and-trade regimes

The scientific community has reached a consensus: the climate is warming and human activities are contributing to the change. The next question for policy makers and economists is: What do we do about it? What is the most effective way to curtail the output of carbon dioxide and other greenhouse gases (GHG), like methane, nitrous oxide, and fluorinated gases, while recognizing the economic activity can’t be brought to a halt? 

There, too, a consensus is emerging among policy leaders. Cap-and-trade systems built around carbon pricing have become the most popular tool for encouraging reductions in pollution and innovation on the part of companies, nations, and other organizations. Carbon credits and carbon offsets are integral parts of these systems, and may be our best hope for slowing—and even reversing—climate change. 

What is carbon pricing?

Fundamental to many current programs to reduce greenhouse gas emissions is the idea of carbon pricing. In economies without regulations against pollution, companies and countries are free to emit carbon dioxide and other GHGs without facing any consequences, even while the health of the community and the environment suffer. 

Carbon pricing attempts to regulate pollution, but in a way that gives companies the flexibility to devise their own approaches to reach a set goal. Carbon pricing systems assign a dollar amount to carbon emissions, and assigns companies a budget to work within. Exceeding their carbon budget comes with financial consequences, whether in the form of a tax or penalty paid to a regulatory agency or, as with cap-and-trade systems, through the mandatory purchase of carbon credits or offsets. A company may, in the end, choose to continue to pollute, but with a carbon pricing plan that choice comes with consequences and tangible costs. 


What carbon marketplace programs currently exist?

Carbon marketplaces can be divided into two main types: voluntary programs and legally mandated ones. The latter are much larger than the former. 

Mandatory Markets

While regulatory plans often intervene in markets and prohibit or penalize certain activities—like polluting the environment—mandatory cap-and-trade programs (often also called “emissions trading” regimes) use the mechanisms of the market to shape behaviors. Countries and corporations are allotted a certain level of acceptable pollution—the “cap” in “cap-and-trade.” If they control their carbon output so that they fall below their cap, they can sell the difference between the actual and capped carbon levels to other companies that have exceeded their quotas. Companies that are unable to reduce their carbon production sufficiently have to turn to the market to buy carbon credits—this is the “trade” in “cap-and-trade.” Each year the caps are adjusted, ideally downwards, bringing the total level of pollution down as well.

The goal is to use market forces to encourage reductions in pollution: Companies are incentivized to decrease their carbon output by the prospect of earning credits that can then be sold to other companies, giving their bottom line a boost. At the same time, companies are penalized if they fail to reduce carbon production beneath their cap as they must then pay for carbon credits to cover their excess emissions.

Voluntary Markets

Unlike mandatory markets, companies that participate in voluntary markets don’t face legal penalties if they fail to reduce their carbon output or purchase offsets. Even if they are not required by regulators to curtail their carbon output—either because there is not a carbon reduction regime at all or the company is exempt from its mandates—companies that participate in voluntary markets enjoy the benefits of being socially responsible industry leaders. 

As with mandatory markets, companies participating in voluntary ones can purchase offsets through marketplaces. While voluntary carbon marketplaces are smaller than compliance offset markets, they have a similar effect of providing funding for green efforts and encouraging innovation. They have also helped guide mandatory marketplaces. With their greater flexibility, they have shaped, for example, regulatory standards and registries. While voluntary markets may lack the “stick” of mandatory ones, they still offer a “carrot”—allowing companies to contribute to the health of the planet in a measurable, verifiable way. 


Existing cap-and-trade programs

Arguments have been made by economists for cap-and-trade regimens since at least the 1960s, though it was not until 1990 that they were incorporated in US legislation, in amendments to the Clean Air Act. At that time, a marketplace of pollution credits was created around the area of sulfur dioxide output (the cause of acid rain). 

In this century, the cap-and-trade model has expanded into the area of greenhouse gas emissions. An attempt to create a national cap-and-trade scheme for GHGs in the US as another amendment to the Clean Air Act passed the House in 2009 but failed in the Senate. While there is, at least for now, no national cap-and-trade program covering greenhouse gases in the US or Canada, there are state and regional programs. There are also international treaties in place, which can have implications for US-based companies operating internationally even when the US has not ratified them. 

Regional cap-and-trade programs in the US

RGGI. The Regional Greenhouse Gas Initiative (RGGI) became the US’s first market-based initiative intended to reduce GHGs when it was established in 2009. It currently includes nine states in the mid-Atlantic and Northeast, which will increase to ten with the addition of Pennsylvania in 2022. It has generally been viewed as a success, reducing emissions across these states while the regional GDP has continued to rise.

California Cap and Trade. The state of California launched its own cap-and-trade initiative in 2013, which covers about 85 percent of emissions in the state. The program met its 2020 target to reduce emissions to 1990 levels four years ahead of schedule, in 2016. It has generated roughly $5 billion to support green initiatives.

International governance of carbon marketplaces

Kyoto Protocol. This international treaty covering emissions of six GHGs came into effect in 2005 and assigns caps to signatory countries. While it has met targets, the failure of the United States to ratify the treaty is a significant obstacle towards its meeting its larger goals. The Marrakesh Accords, adopted in 2001, outlined in extensive detail the rules for the global carbon marketplace under the Kyoto Protocol.

Paris Agreement. Intended to supplant the Kyoto Protocol, every country in the world has agreed, at least to some degree, to support the GHG reduction plans of this agreement reached in 2015. One of its most discussed measures is the clean development mechanism which allows wealthier and more developed countries to, in effect, purchase offsets by funding green projects in developing nations. That said, the US’s participation is uncertain and many of the rules of how carbon markets will operate remain unresolved—and they will be until at least 2021, when negotiators are next scheduled to meet in Glasgow.


What are carbon credits?

Carbon credits in cap-and-trade systems are typically calculated in terms of one metric ton, or more commonly one tonne, of carbon emissions or their equivalent in other greenhouse gases. (A tonne, or metric ton, is 1,000 kilograms—that converts to roughly 1.1 US tons, which weigh 2,000 pounds.) To put that number in some context, a single roundtrip transatlantic flight produces 1.6 tonnes of CO2 per passenger while a typical driver produces 2.4 tonnes of CO2 over the course of a year.

CO2 is not the only gas that contributes to global warming. Among the other culprits are methane, nitrous oxide, and fluorinated gases. These other gases are much more damaging to the environment than carbon dioxide—1 tonne of methane is equivalent to 25 tonnes of carbon dioxide. In other words, if a dairy farm were to reduce its output of methane emissions by 40 kilograms that would be treated the equivalent of one carbon credit. (Livestock is a common source of methane.) 

Fluorinated gases range broadly in terms of their global warming potential but they can be up to 23,000 times as damaging as carbon dioxide. Just 40 grams of one especially potent fluorinated gas, sulfur hexafluoride, is equivalent to one tonne of CO2—eliminating that amount in output would equal one carbon credit. 

The process by which carbon credits work under cap-and-trade systems is that they are accumulated, and then can be sold, after companies reduce the amount of carbon produced by their operations. By limiting electricity usage, curtailing travel by employees, or replacing old equipment with more energy-efficient alternatives, a company can reduce their output to a level below their cap, resulting in credits that they can sell. 

One type of carbon credit, however, is obtained by supporting initiatives outside the company itself: the carbon offset.


What are carbon offsets?

Companies that have exceeded their carbon cap can purchase credits from companies that have managed to reduce output below their allotted level, or they can also choose to purchase carbon offsets which support green initiatives. These generally fall into three areas: energy efficiency, renewable energy, and carbon removal.

  • Energy efficiency. Examples include  programs to provide people with more energy efficient stoves or LED lighting, steps that would reduce fuel consumption and, potentially, pollution as well. 
  • Renewable energy. Offsets might use funds to provide farmers with biodigesters that transform animal and plant waste into cooking gas or support the installation of wind turbines or solar panels, measures that would reduce a community’s dependence on fossil fuels. 
  • Carbon removal. As opposed to energy efficiency and renewable resources offsets, both of which aim to reduce the production of carbon dioxide, carbon capture or sequestration initiatives attempt to reduce the amount of carbon dioxide in the environment. These can range from reforestation and afforestation initiatives—which build upon the rather old-fashioned sustainability strategy of planting trees—to programs on technology’s cutting edge using direct air capture to target carbon dioxide and remove it from the atmosphere.

These carbon offsets are priced in terms of how many dollars it costs to reduce the amount of carbon in the environment by one tonne. Their availability is not limited to companies or countries endeavoring to become more carbon neutral or comply with cap-and-trade regulations; a number of secondary marketplaces offer carbon offsets to individual consumers looking to mitigate the environmental damage caused by their travel or home electricity consumption.

A key measure in determining the quality of a carbon offset project is known as “additionality.” In short, this describes measures that would not have been taken but for a carbon offset requirement. If, for example, manufacturers would have adopted voluntary carbon reduction processes even without a third party purchasing offsets (perhaps because they were incentivized to do so under other regulations), then offsets that support a transition that was inevitable are pointless. They don’t result in credits to the purchaser under many cap-and-trade programs.


Do carbon credit systems effectively lower emissions?

The reception of cap-and-trade regimes, along with their carbon credit currency, has generally been favorable, from stakeholders across the spectrum including both business organizations and environmental advocacy groups. By allowing companies to make their own decisions about efficiency, they encourage sustainable development and innovation. While it can be difficult to trace a drop in emissions to any single cause, most cap-and-trade systems are successfully meeting their long-term targets.

Voluntary markets are small compared to mandatory or compliance offset markets, but their growth in recent years has been remarkable. In 2018, the volume of voluntary offsets equaled 98.4 tonnes of CO2 (or equivalents)—an increase of 52.6% over just two years earlier, in 2016. Cumulatively, voluntary offsets now total 1.2 billion tonnes of CO2, the equivalent of Japan’s total annual emissions. Growth in the sale of carbon offsets on voluntary markets may slow in the short term because of COVID-19, though the long term forecast remains optimistic—one estimate is that they  will grow to $463.7 million in 2026 (up from $247.9 million in 2020). That figure represents resources for many green initiatives around the world. 

The certification of emissions and setting the prices of carbon offsets remains one of the problematic areas of cap-and-trade systems, especially in an international context. The process of setting carbon prices and assessing the value of energy efficiency measures, for example, falls to different state, national, and independent authorities often using different guidelines and often reaching different conclusions.

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