What are Carbon Credits?
A carbon credit is a tradable certificate that allows a company that holds it to emit a certain amount of carbon dioxide or other greenhouse gases. One carbon credit is equivalent to the reduction or offset of 1 tonne of CO2-equivalents.
Two other important definitions are:
Offsetting (GHG emissions): the process of reducing CO2 and other GHG emissions in order to compensate for emissions produced elsewhere
Carbon offset: the GHG reduction that is generated by a project that is designed specifically for this purpose (i.e. it has to go further than BAU – the offset would not be created otherwise)
Why and how does it help address climate change?
The greenhouse gas (GHG) effect is a global atmospheric mechanism. And since emissions are distributed throughout the atmosphere it doesn’t really matter where they occurred, or where they are mitigated. So it is not important how or where the reduction of CO2 takes place, the climate benefits are the same. This also means that a (global) carbon market is a cost effective way of reducing carbon emissions. I.e. through projects in places where the costs are low (lower state of technology advancement and lower costs of living ) and the benefits (CO2 reduction) are high. Which is why many carbon offset projects are located in developing countries.
Carbon Credit Markets
There are both regulated and voluntary carbon credit markets. The most important difference is that in most regulated markets a carbon credit represents a reduction in GHG emissions compared to a certain reference, whereas in voluntary markets a carbon credit can represent both a reduction/avoidance or sequestration of carbon by a carbon offset project (for example renewable energy projects and afforestation/reforestation projects). Afforestation and reforestation carbon offsetting is explicitly excluded from for example the EU-ETS.
The voluntary carbon market is a marketplace where any company or individual can purchase carbon offsets or carbon compensation voluntarily. Furthermore, there is no direct regulation from governments, and standards are defined by independent certification bodies. Companies buy carbon credits as a way to act on self-imposed emissions reduction goals.
One carbon credit is generated for one tonne of CO2 reduction from a validated and verified carbon offset project. By definition the project has to go further than business as usual, i.e. the offset would not be created otherwise. Projects get validated by an independent third party certifying body according to an accepted standard. The three largest standards for validation and verification – also called ‘offset standards’ are:
Verra (Verified carbon standard)
Only projects that are verified and validated according to an accepted standard, by an accredited certifying body, are eligible for tradable carbon credits. In most cases it is the project operator that takes ownership of the carbon credits after the project has gone through the registration process.
The project operator (potentially through a project developer) is able to market the carbon credits either directly to an end user/buyer or go through a broker, exchange or other aggregator (also potentially retail buyers or investors).
A registry – often related to the applicable ‘offset standard’ – is used to avoid double counting, by tracking ownership and compliance. Additionally, it is possible to make a certain quality diversification (and thus price diversification) between carbon credits from different projects. This is another important difference compared to the regulated markets, where this quality diversification does not exist.
The best known and largest regulated carbon market is the EU Emission Trading Scheme (EU ETS). It regulates the distribution and trading of emission allowances of greenhouse gases in the EU.
The focus is on large emitters of greenhouse gases (power sector, manufacturing industry and aviation). Households, agriculture, waste, and transport are currently excluded.
The EU ETS works on the 'cap and trade' principle (as does the California regulated carbon market). A cap is set on the total amount of certain greenhouse gases that can be emitted by the installations covered by the system. The cap is reduced over time so that total emissions fall.
Within the cap, installations buy or receive emissions allowances, which they can trade with one another as needed. The limit on the total number of allowances available ensures that they have a value.
After each year, an installation must surrender enough allowances to cover fully its emissions, otherwise heavy fines are imposed. If an installation reduces its emissions, it can keep the spare allowances to cover its future needs or else sell them to another installation that is short of allowances.
Trading brings flexibility that ensures emissions are cut where it costs least to do so. A robust carbon price also promotes investment in innovative, low-carbon technologies.
Under the 'Fit for 55' package the European Comission propose some important changes to the EU-ETS regulation. This includes the extension to the maritime, road transport and buildings sectors; a one-off withdrawal of 120 million emission allowances; the progressive scrapping of 'free' emission rights; and the increase of the rate of emission reductions from 2,2% tot 4,2%. These changes are currently under revision.