How do carbon credits work ? 

How do carbon credits work ? 

20 July 2022

Carbon Credits

A carbon credit is a permit that allows an individual or a company to emit a certain amount of carbon dioxide or the equivalent greenhouse gas. Companies that pollute are awarded a certain number of credits given the size of their firm which allows them to continue polluting up to a certain limit that is in line with their amount of credits. In addition to this companies may sell any unneeded credits to other firms that require them.

Why were Carbon Credits introduced?

The United Nations’ Intergovernmental Panel on Climate Change (IPCC) developed a carbon credit proposal to reduce worldwide carbon emissions in a 1997 agreement known as the Kyoto Protocol. The agreement set binding emission reduction targets for the countries that signed it with carbon credits being introduced as the main vehicle to be used to achieve this goal. Nations and in turn companies are allotted a certain number of credits and may trade them to help balance total worldwide emissions.

Cap and Trade Program

As mentioned above the main program that is enforced by the governments of these nations that have agreed to be more carbon friendly is a Cap and Trade program. The government sets the limit, or “cap” on emissions permitted across a given industry. It issues a limited number of annual permits that allow companies to emit a certain amount of carbon dioxide and related pollutants. Companies are taxed if they produce a higher level of emissions than their permits allow. They may even be penalized for a violation. On the other hand, companies that reduce their emissions can sell allowances (“trade” them) to other companies that pollute more. They can also bank them for future use.

Carbon Credit Creation

Carbon credits are most often created through agricultural or forestry practices, although a credit can be made by nearly any project that reduces, avoids, destroys, or captures emissions. These firms that are in these carbon destroying industries submit their practices to government registries which deem them acceptable as offsetting projects and in turn quantify the amount of carbon that is offset and issue the necessary and equivalent credits. A carbon credit represents the right to emit greenhouse gases equivalent to one ton of carbon dioxide. According to the Environmental Defense Fund, that is the equivalent of a 2,400-mile drive in terms of carbon dioxide emissions. Therefore, if an offsetting product is able to reduce 10 tons of carbon from the atmosphere it is granted 10 credits.

Registries have enforcement systems which assure that contracts clearly identify ownership of offset credit and define who bears the risk in case of project failure. Registries consequently track offset projects and issue offset credits for each unit of emission reduction or removal that is verified and certified as a result they are vital in creating a credible, fungible offset commodity. They additionally record the ownership of credits by assigning a serial number to each verified offset credit. When a credit is sold, the serial number for the reduction is transferred from the account of the seller to an account for the buyer. If the buyer “uses” the credit by claiming it as an offset against their own emissions, the registry retires the serial number so that the credit cannot be resold. In this manner, registries reduce the risk of double counting.

Carbon Credit Auctions

Carbon credit auctions are onetime events that governments use to sell carbon credits into the market and that corporate buyers use to make large purchases, often in the voluntary market.  Voluntary markets function outside of compliance markets and enable companies and individuals to purchase carbon offsets on a voluntary basis with no intended use for compliance purposes. Compliance markets are created and regulated by mandatory national, regional, or international carbon reduction regimes. Therefore, voluntary markets are unregulated. Additionally, project developers can also use auctions to launch voluntary offsets, but that’s less common.  Generally, in the voluntary market, it’s the buyers who list their criteria such as the number of credits they require and at what price and the sellers who responds in what is known as a “reverse auction”.

Secondary market

Once auctioned, the allowances can be bought and sold in the secondary “spot” market before being retired. To link supply and demand, there are also brokers and retail traders, just as in other commodity markets. Retail traders purchase large amounts of credits directly from the supplier, bundle those credits into portfolios, ranging from hundreds to thousands of equivalent tons of CO2, and sell those bundles to the end buyers, typically with some commission. While most of the transactions are currently happening in private conversations and over-the-counter deals, some exchanges are also emerging. Spot platforms let buyers and sellers trade continuously during market hours and is best at handling large numbers of identical products. They also trade at different prices, depending on the location and market where they are traded.

Pros of the carbon credit program

Due to the cap and trade system creating an exchange value for emissions, firms with carbon credits that are not used can be sold thus creating a new economic resource for some industries. Cap and trade systems incentivises firms to invest in cleaner technologies to avoid buying more permits, thus motivating companies to fund research into alternative energy resources. Additionally, this process may lead to faster cuts in pollution, since companies that cut their emission levels faster are somehow rewarded as they can then sell their allowance to other companies. Due to the government being able to auction emissions credits to the highest bidder, cap and trade is also a revenue source for the government that can be used to cover infrastructure needs, social programs, or help solve budget deficits

Cons of the carbon credit program

Caps given to companies by the government might be too generous leading to an overproduction of pollutants and thus slowing the move to cleaner energy. The penalties given to firms for surpassing their cap limit are relatively cheap when compared to the costs needed to convert to cleaner technology. This is especially evident for industries that use fossil fuels therefore, the cap and trade program is not a real incentive for these companies. Furthermore, most industries do not have the necessary devices to help monitor and determine their number of emissions. Thus, it makes it relatively easy for firms to be dishonest on their emission reports. For the cap and trade system to be effective standards for monitoring must be in place in order for better enforcement to take place

Please note that any information in our posts, documents, infographics, emails etc is general information and should not be considered as providing financial advice. We therefore disclaim all liability and responsibility arising from any reliance placed on such information by any reader, client or visitor to our website. Though we make every effort to ensure the accuracy of the information provided we accept no liability for any inaccuracies.

latest Articles