Understanding Carbon Credits

Carbon Markets 101

A carbon market allows investors and corporations to trade both carbon credits and carbon offsets simultaneously. This mitigates the environmental crisis, while also creating new market opportunities.

New challenges nearly always produce new markets, and the ongoing climate crisis and rising global emissions are no exception.

The renewed interest in carbon markets is relatively new. International carbon trading markets have been around since the 1997 Kyoto Protocols, but the emergence of new regional markets have prompted a surge of investment.

The advent of new mandatory emissions trading programs and growing consumer pressure have driven companies to turn to the voluntary market for carbon offsets. Changing public attitudes on climate change and carbon emissions have added a public policy incentive. Despite an ever-shifting background of state, federal, and international regulations, there’s more need than ever for companies and investors to understand carbon credits.

Carbon Credits, Offsets and Markets – An Introduction

The Kyoto Protocol of 1997 and the Paris Agreement of 2015 were international accords that laid out international CO₂ emissions goals. With the latter ratified by all but six countries, they have given rise to national emissions targets and the regulations to back them.

With these new regulations in force, the pressure on businesses to find ways to reduce their carbon footprint is growing. Most of today’s interim solutions involve the use of the carbon markets.

What the carbon markets do is turn CO₂ emissions into a commodity by giving it a price.

These emissions fall into one of two categories: Carbon credits or carbon offsets, and they can both be bought and sold on a carbon market. It’s a simple idea that provides a market-based solution to a thorny problem.

What are carbon credits and carbon offsets?

The terms are frequently used interchangeably, but carbon credits and carbon offsets operate on different mechanisms.

Carbon credits, also known as carbon allowances, work like permission slips for emissions. When a company buys a carbon credit, usually from the government, they gain permission to generate one ton of CO₂ emissions. With carbon credits, carbon revenue flows vertically from companies to regulators, though companies who end up with excess credits can sell them to other companies.

Offsets flow horizontally, trading carbon revenue between companies. When one company removes a unit of carbon from the atmosphere as part of their normal business activity, they can generate a carbon offset. Other companies can then purchase that carbon offset to reduce their own carbon footprint.

Note that the two terms are sometimes used interchangeably, and carbon offsets are often referred to as “offset credits”. Still, this distinction between regulatory compliance credits and voluntary offsets should be kept in mind.

How are carbon credits and offsets created?

Credits and offsets form two slightly different markets, although the basic unit traded is the same – the equivalent of one ton of carbon emissions, also known as CO₂e.

It’s worth noting that a ton of CO₂ does refer to a literal measurement of weight. Just how much CO₂ is in a ton?

The average American generates 16 tons of CO₂e a year through driving, shopping, using electricity and gas at home, and generally going through the motions of everyday life.

To further put that emission in perspective, you would generate one ton of CO₂e by driving your average 22 mpg car from New York to Las Vegas.

Carbon credits are issued by national or international governmental organizations. We’ve already mentioned the Kyoto and Paris agreements which created the first international carbon markets.

The number of credits issued each year is typically based on emissions targets. Credits are frequently issued under what’s known as a “cap-and-trade” program. Regulators set a limit on carbon emissions – the cap. That cap slowly decreases over time, making it harder and harder for businesses to stay within that cap.

Organizations with operations that reduce the amount of carbon already in the atmosphere, say by planting more trees or investing in renewable energy, have the ability to issue carbon offsets. The purchase of these offsets is voluntary, which is why carbon offsets form what’s known as the “Voluntary Carbon Market”. However, by buying these carbon offsets, companies can measurably decrease the amount of CO₂e they emit even further.

What is the carbon marketplace?

When it comes to the sale of carbon credits within the carbon marketplace, there are two significant, separate markets to choose from.

One is a regulated market, set by “cap-and-trade” regulations at the regional and state levels.
The other is a voluntary market where businesses and individuals buy credits (of their own accord) to offset their carbon emissions.

Think of it this way: the regulatory market is mandated, while the voluntary market is optional.

When it comes to the regulatory market, each company operating under a cap-and-trade program is issued a certain number of carbon credits each year. Some of these companies produce less emissions than the number of credits they’re allotted, giving them a surplus of carbon credits.

On the flip side, some companies (particularly those with older and less efficient operations) produce more emissions than the number of credits they receive each year can cover. These businesses are looking to purchase carbon credits to offset their emissions because they must.

Most major companies are doing their part and will or have announced a blueprint to minimize their carbon footprint. However, the amount of carbon credits allocated to them each year (which is based on each business’s size and the efficiency of their operations relative to industry benchmarks)., may not be enough to cover their needs.

Regardless of technological advances, some companies are years away from reducing their emissions substantially. Yet, they still have to keep providing goods and services in order to generate the cash they need to improve the carbon footprint of their operations.

As such, they need to find a way to offset the amount of carbon they’re already emitting.

Here’s an example:

Let’s say two companies, Company 1 and Company 2, are only allowed to emit 300 tons of carbon.

However, Company 1 is on track to emit 400 tons of carbon this year, while Company 2 will only be emitting 200 tons.

To avoid a penalty comprised of fines and extra taxes, Company 1 can make up for emitting 100 extra tons of CO₂e by purchasing credits from Company 2, who has extra emissions room to spare due to producing 100 tons less carbon this year than they were allowed to.

The Difference between the Voluntary and Compliance Markets

The voluntary market works a bit differently. Companies in this marketplace have the opportunity to work with businesses and individuals who are environmentally conscious and are choosing to offset their carbon emissions because they want to. There is nothing mandated here.

It might be an environmentally conscious company that wants to demonstrate that they’re doing their part to protect the environment. Or it can be an environmentally conscious person who wants to offset the amount of carbon they’re putting into the air when they travel.

For example: in 2021, the oil giant Shell announced the company aims to offset 120 million tonnes of emissions by 2030

Regardless of their reasoning, companies are looking for ways to participate – and the voluntary carbon market is a way for them to do just that.

Both the regulatory and voluntary marketplaces complement one another in the professional (and the personal) world. They also make the pool of buyers more accessible to farmers, ranchers, and landowners – those whose operations can often generate carbon offsets for sale.

How to produce carbon credits

Many different types of businesses can create and sell carbon credits by reducing, capturing, and storing emissions through different processes.

Some of the most popular types of carbon offsetting projects include:

Renewable energy projects,
Improving energy efficiency,
Carbon and methane capture and sequestration
Land use and reforestation.

Renewable energy projects have already existed long before carbon credit markets came into vogue. Many countries in the world are blessed with a natural wealth of renewable energy resources. Countries such as Brazil or Canada that have many lakes and rivers, or nations like Denmark and Germany with lots of windy regions. For countries like these, renewable energy was already an attractive and low-cost source of power generation, and they now provide the added benefit of carbon offset creation.

Energy efficiency improvements complement renewable energy projects by reducing the energy demands of current buildings and infrastructure. Even simple everyday changes like swapping your household lights from incandescent bulbs to LED ones can benefit the environment by reducing power consumption. On a larger scale, this can involve things like renovating buildings or optimizing industrial processes to make them more efficient, or distributing more efficient appliances to the needy.

Carbon and methane capture involves implementing practices that remove CO₂ and methane (which is over 20 times more harmful to the environment than CO₂) from the atmosphere.

Methane is simpler to deal with, as it can simply be burned off to create CO₂. While this sounds counterproductive at first, since methane is over 20 times more harmful to the atmosphere than CO₂, converting one molecule of methane to one molecule of CO₂ through combustion still reduces net emissions by more than 95%.

For carbon, capture often happens directly at the source, such as from chemical plants or power plants. While the injection of this captured carbon underground has been used for various purposes like enhanced oil recovery for decades already, the idea of storing this carbon long-term, treating it much like nuclear waste, is a newer concept.

Land use and reforestation projects use Mother Nature’s carbon sinks, the trees and soil, to absorb carbon from the atmosphere. This includes protecting and restoring old forests, creating new forests, and soil management.

Plants convert CO₂ from the atmosphere into organic matter through photosynthesis, which eventually ends up in the ground as dead plant matter. Once absorbed, the CO₂ enriched soil helps restore the soil’s natural qualities – enhancing crop production while reducing pollution.

How companies can offset carbon emissions

There are countless ways for companies to offset carbon emissions.

Though not a comprehensive list, here are some popular practices that typically qualify as offset projects:

Investing in renewable energy by funding wind, hydro, geothermal, and solar power generation projects, or switching to such power sources wherever possible.
Improving energy efficiency across the world, for instance by providing more efficient cookstoves to those living in rural or more impoverished regions.
Capturing carbon from the atmosphere and using it to create biofuel, which makes it a carbon-neutral fuel source.
Returning biomass to the soil as mulch after harvest instead of removing or burning. This practice reduces evaporation from the soil surface, which helps to preserve water. The biomass also helps feed soil microbes and earthworms, allowing nutrients to cycle and strengthen soil structure.
Promoting forest regrowth through tree-planting and reforestation projects.
Switching to alternate fuel types, such as lower-carbon biofuels like corn and biomass-derived ethanol and biodiesel.

Voluntary vs Compulsory: The biggest difference between credits and offsets

Participation in a cap-and-trade scheme typically isn’t voluntary. Your company either needs to abide by carbon credit limits set by regulators, or no such limits exist. As more and more countries adopt cap-and-trade programs, companies increasingly need to participate in carbon credit programs.

Carbon credits intentionally add an extra onus to businesses. In return, the best cap-and-trade programs provide a clear framework for reducing carbon emissions. Not all programs are created equal, of course, but at their best, carbon credits have a clear impact on total carbon emissions.

The Two Types of Global Carbon Markets: Voluntary and Compliance

There’s one more important distinction between carbon credits and carbon offsets:

Carbon credits are generally transacted in the carbon compliance market.
Carbon offsets are generally transacted in the voluntary carbon market.

References:

Understanding Carbon Credits