What Are Carbon Credits?
Carbon credits are exchangeable certificates issued by a government or regulating authority, requiring companies or organizations to emit a certain amount of carbon dioxide or other greenhouse gases over a specific period. Companies that surpass the cap will have to pay fines, while those that can reduce pollution will receive credit rewards.
The goals of carbon credits are to reduce carbon footprint and global warming caused by industrial activities. Usually, one credit permits an organization to release one ton of greenhouse gases, including carbon dioxide, nitrous oxide, methane, and hydrofluorocarbons. These are also known as carbon allowances or emissions permits in some instances.
- Carbon credits are exchangeable certificates given out to companies and organizations to reduce greenhouse gas emissions into the atmosphere.
- Governments or regulating bodies put the cap on greenhouse gas emissions to one ton and issue credits to be bought voluntarily by local businesses. Companies exceeding emissions caps will have to purchase extra credits. And those staying within limits can sell their balance credits to other organizations in need.
- These credits are available for trading through dedicated international brokers and exchanges, such as the European Climate Exchange.
- While supply and demand dictate the carbon credits price, the Kyoto Protocol defines greenhouse gas emission quotas.
According to the Global Climate Report – Annual 2019 from the National Oceanic and Atmospheric Administration (NOAA), the average global temperature keeps rising at a rate of 0.13 degrees F (0.07 C) on average each decade since 1880. Although it may not seem a significant number at first glance, even the slightest change in temperatures can profoundly affect the environment and weather patterns. The research, along with other insights, has changed the way to look at climate change.
Cement, steel, fertilizer, power and textile industries, and many others, involved in fossil fuel production, such as coal, natural gas, and oil, are emitters of greenhouse gases. However, industries like biomass, solar, wind, and geothermal work toward selling carbon offset credits. Because of this, many companies are turning to carbon offset projects, creating the demand for carbon credits and growth opportunities for such development projects.
These credits were created to reduce greenhouse gas emissions into the atmosphere and limit the environmental harm they cause. There are a few primary types of them, including:
- Certified Emissions Reduction (CER)
- Voluntary (Verified) Emissions Reduction (VER)
- European Union Allowances (EUA)
The first type of credit, Certified Emissions Reductions (CER), is distributed by the United Nations’ Clean Development Mechanism to a country or company to stay within its emission targets. Voluntary or Verified Emissions Reductions (VER) are certified through voluntary processes and created through projects that are not associated with the Kyoto Protocol. On the other hand, the European Union distributes European Union Allowances (EUA) tradable through the “cap and trade” system.
1997 Kyoto Protocol
The Kyoto Protocol is a universal agreement proposed by the Intergovernmental Panel on Climate Change (IPCC) of the United Nations in 1997. The agreement outlines how countries will use carbon credits to reduce greenhouse gas emissions, particularly carbon dioxide. The protocol sets emissions targets for more than 170 countries separated into two groups:
- Annex 1 (Industrialized)
- Annex 2 (Developed)
Countries in the Annex 1 group are nations that are industrialized but not yet fully developed. The countries included in Annex 2 are fully developed and can help pay for some of the costs of developing nations. Those in Annex 2 can also sell their credits to countries unable to meet their targets to help fund development and new technology advancement.
The New Treaty
Many countries disagreed on the terms and conditions of the Kyoto Protocol at the time of its extension. After a few separate meetings in 2015, over 190 nations signed a global agreement on climate change known as The Paris Agreement. Its goal is to limit global warming to 1.5 degrees Celsius.
Trading Of Carbon Credit
Carbon credits can be sold to nations or organizations that cannot meet their obligations with limiting greenhouse emissions. The credits are tradable in a scheme referred to as a “cap and trade” system, which has two components:
- To put a cap on the amount of greenhouse gas emissions
- Organizations to have the ability to trade credits
The system works by incentivizing organizations to reduce their emissions and save money. Either that or they will have to buy credits to make up the difference. Each credit is typically worth the equivalent of one ton of greenhouse gas emissions.
The market supply and demandSupply And DemandSupply has a direct relationship with the price. Thus, if the price rises, the product's supply will also increase, and if the price falls, then supply will also decrease. In contrast, demand has an indirect relationship with price. Thus, if the price drops, demand will rise and vice-versa. will determine the price of carbon credits. As more organizations need the credits, usually the higher price they will have to pay. Prices can fluctuate from country to country as different nations have individual requirements.
Countries and organizations that meet their credit requirements and have a surplus can sell them to those who cannot meet their set targets. It gives them another incentive to cut back on emissions. If they can stay under the cap, they can sell their credits.
The cap will decrease in most cases over time. It gives organizations the ability to slowly implement new processes and technology that can help them save on emissions. However, this can also work against companies that are unable to stay under the cap. If they do not come up with a solution, they will be paying more over time.
Markets of Carbon Credit
Carbon credits trading on an exchange allows for spot trading and keeps the carbon credits market in line with supply and demand. There are a few different exchanges where one can buy and sell these credits, including:
- European Climate Exchange
- NASDAQ OMX Commodities Europe
- Commodity Exchange Bratislava
- European Energy Exchange
Credits prices on these exchanges reflect the current supply and demand. Some of them have also initiated optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date. and futures markets to provide liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses..
The carbon credit price fluctuates over time, but since July 2017, the price has steadily risen and has hit an all-time high price in 2021. The trend is expected to continue, with many governments opting for green recovery packages in the wake of the COVID-19-hit economy.
As time goes on, the cap on emissions for companies will continue to decline, putting pressure on these organizations to reduce the amount of carbon dioxide they release. If they do not cut back on it, they will end up paying more for credits in the future as demand is also expected to increase continuously.
This has been a guide to what are Carbon Credit and its meaning. Here we discuss how Carbon Credits works, the Kyoto protocol, trading, and its markets. You may learn more about financing from the following articles –