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Carbon Credit

Updated on January 24, 2024
Article byPeter Johnson
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Carbon Credit?

Carbon credits are exchangeable certificates issued by a government or regulating authority, requiring companies or organizations to emit carbon dioxide or other greenhouse gases over a specific period. The companies that surpass the cap may have to pay penalties, while carbon credit buyers that can reduce pollution will receive credit rewards.

Carbon Credit

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The goals of carbon credits are to reduce the 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.

Key Takeaways

  • 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 who remain 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 impose the carbon credits price, the Kyoto Protocol defines greenhouse gas emission quotas.

Carbon Credit Explained

Carbon credit refers to the permission granted by regulatory authorities or the government to corporation to emit greenhouse gases such as carbon di oxide, methane etc., to manufacture or produce their goods.

The carbon credit price can fluctuate as they are issued as a certificate that can be traded or exchanged with other corporations. Companies that underutilize the certificate or emit lesser gases than permitted, receive rewards

According to the Global Climate Report – Annual 2019 from the National Oceanic and Atmospheric Administration (NOAA), since 1880, the average global temperature constantly rises at a rate of 0.13 degrees F (0.07 C) on average each decade. Although it may not seem significant at first, even a bit of temperature change can profoundly affect the environment and weather patterns. As a result, the research and other insights have changed how 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 strive toward selling carbon offset credits. Due to this, many companies are turning to carbon offset projects, creating the demand for carbon credits and growth opportunities for such development projects.

Carbon-dioxide

They created these credits to reduce greenhouse gas emissions into the atmosphere and limit environmental harm. There are a few primary types of them, including: –

  1. Certified Emissions Reduction (CER)
  2. Voluntary (Verified) Emissions Reduction (VER)
  3. European Union Allowances (EUA)

Certified Emissions Reductions (CER) are distributed by the United Nations’ Clean Development Mechanism to a country or company to remain within its emission targets. Voluntary or Verified Emissions Reductions (VER) are certified through voluntary processes and created through projects 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.

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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 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)

The countries in the Annex 1 group are industrialized nations but not completely 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 individual 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.

Types

There are two major types of credits issued to carbon credit companies- compliance and Voluntary. Let us understand them in detail through the discussion below.

Compliance Credits:

Regulatory credits are issued with regard to regional, national, or international regulatory requirements. These credits help governments and regulatory authorities to put a cap on the level of emissions from corporations and to promote a marketplace where every player is conscious of the effect on the environment.

Voluntary Credit:

  • Voluntary credits refer to the issuance, trading through buying, and selling of these certificates through voluntary means. The majority of demand for voluntary credits comes from private entities who want to compensate for their personal carbon footprints or with sustainability targets.

Trading

Global warming and excessive carbon footprint on a macro level has portrayed significant effects on the environment in the recent past. Therefore, these measures to let corporations trade carbon credit price certificates have been a pivotal move to reduce carbon footprint globally. Let us understand how this form of trading takes place through the discussion below.

The countries can sell the carbon credits to nations or organizations that cannot limit greenhouse emissions. The credits are tradable in a scheme referred to as a “cap and trade” system, which has two components: –

  1. To put a cap on the amount of greenhouse gas emissions.
  2. Organizations can trade credits.

The carbon credit price works by incentivizing organizations to reduce their emissions and save money. Either that or they may have to buy credits to create the difference. Each credit is typically worth 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.read more will determine the price of carbon credits. As more organizations need the credits, the higher price will have to pay. The costs may fluctuate from country to country as different nations have individual requirements.

The countries and organizations that meet their credit requirements and have a surplus can sell them to those who cannot meet their set targets. It can give them another incentive to cut back on emissions. If they can remain under the cap, they can sell their credits.

The cap will decrease in most cases over time. That is because 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 cannot remain under the cap. If they do not develop a solution, they may be paying more.

Markets

Carbon credits trading on an exchange allows for spot trading and keeps the carbon credits market in line with the supply and demand of carbon credit companies. 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

The credit 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.read more and futures marketsFutures MarketsA futures market is a financial marketplace where participants trade futures contracts for commodities, stock indices, currency pairs, and interest rates at a pre-determined rate and agreed-upon future date. It, thus, protects investors and traders from losing money on a transaction even if the price of the commodity or financial instrument rises or falls later.read more to provide liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more.

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 economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more.

As time goes on, the cap on emissions for companies may continue to decline, putting pressure on these organizations to reduce the amount of carbon dioxide they release. If they do not decrease it, they may pay more for credits in the future as demand is also expected to increase continuously.

Tax

The taxation structure depends on the jurisdiction and government policies. For example, USA levies $49 per metric ton of emissions. Whereas, countries like Canada have specifically mentioned carbon credit in their federal budget.

The tax rate for investment in equipment for capturing CO2 and direct air capture projects was set at 60%, while 50% tax was allotted for other CCUS projects.

In India, a flat tax rate of 10% is levied for income from the transfer of such a certificate.

Frequently Asked Questions (FAQs)

What is Gold Standard carbon credit?

The Gold Standard (GS) or the Gold Standards for the Global Goals is published and administered by the Gold Standard Foundation, a non-profit foundation headquartered in Geneva, Switzerland. This carbon credit is a standard and logo certification mark program for non-governmental discharge reduction projects in the Clean Development Mechanism(CDM), the Voluntary Carbon Market, and other climate and development interventions.

What is blue carbon credit?

Blue carbon credit refers to projects that require preserving and restoring natural blue carbon sinks. The prime objective of blue carbon credit is removing atmospheric carbon dioxide or preventing the carbon release preserved in the sea floor. It represents the primary tool for climate change mitigation in the future.

What are the types of carbon credit?

Carbon credits are of two types: Voluntary Emissions Reduction(VER), a carbon offset exchanged in the voluntary market, or over-the-market for credits. And, Certified Emissions Reduction(CER) relies on emission units made through a managerial structure to offset a project’s emissions.

How much is a carbon credit worth?

The carbon credit value is derived from supply and demand. It varies as per the market conditions. Most carbon credit prices are below the $40-$80 per carbon dioxide metric ton released needed to retain global warming within 2-point degrees as per the Paris agreement.

This article has been a guide to what is Carbon Credit. Here, we explain its trading, markets, taxation structure, types, and amendments in its law. You may learn more about financing from the following articles: –