The concept of carbon credits developed in the 90s when the climate change crisis began to loom large over the heads of various countries. The carbon credits system was officially set up in 1997 as part of the first international agreement to bring down emissions, i.e., the Kyoto Protocol and its mechanism were further established in the Marrakesh Accords.
A "carbon credit", also known as a carbon allowance, is a tradable permit that gives the holder the right to emit a certain amount of carbon dioxide (CO2) or other greenhouse gases (GHG). Each credit corresponds to one tonne of CO2 or equivalent GHG.
It is a voluntary offset scheme that uses both the ”carrot” and the “stick” approach to reduce GHG emissions.
It does so by penalising the polluters on one end and also providing economic benefits to entities that reduce their emission levels. The concept behind carbon credits is that as the price of credits rises, it puts increasing pressure on entities to make permanent reductions, so there is no longer a need to purchase them outside. The system converts CO2 or GHG emissions into a commodity by making it tradeable and giving it a price. Carbon credits, in this regard, help accelerate emission reductions and transition into a more sustainable future.
Carbon credits are traded within carbon markets. These markets enable the exchange of emissions or emission reductions. Currently, there are two types of carbon markets:
Compliance Carbon Market (CCM)
Voluntary Carbon Markets (VCM)
Compliance carbon markets are much bigger than VCMs; they had a market size of $261 billion in 2020, while the size of VCMs was around USD 1 billion in 2021.
The Compliance Carbon Market
The Compliance Carbon Market, or Mandatory Market, is a government-regulated market where the threshold of permitted emissions is prescribed for specific industries. These emission limits are known as allowances.
Carbon credits function in a trading approach, where credits are bought and sold. This concept is known as cap and trade (CAT) or emissions trading scheme (ETS). In this system, a cap or limit is set on the amount of GHG emissions an entity is allowed to emit. If the entity's emissions exceed the limit, it is penalized. However, to avoid the penalty, it can buy carbon credits from entities whose emissions fall below their limit. Accordingly, the system is designed to reduce emissions by incentivizing entities to earn profits by selling excess carbon credits on one end and by penalizing entities with excessive emissions.
To better understand this process, the following example may be considered: Companies Alpha Corporation and Summit Enterprise are allowed to emit up to 400 tons of carbon in a year. Alpha Corporation emits only 300 tons of carbon, making it have a surplus of carbon credits. Summit Enterprise, on the other hand, emits 500 tons of carbon. In this case, Summit Enterprise can purchase surplus credits from Alpha Corporation to avoid paying the penalty.
At present, there are three major Emissions Trading Systems in the world. These are:
Voluntary Carbon Market
The Voluntary Carbon Market (VCM) is the second type of carbon market. It is set up by private actors and is not regulated by government bodies, unlike the compliance markets.
The VCM enables private individuals, corporations, and other actors to issue, buy and sell carbon credits outside of regulated or mandatory carbon pricing instruments. VCM allows carbon-emitting companies to offset their emissions by purchasing carbon credits from project developers that remove or reduce GHG by means of their projects. Each credit here is equivalent to one metric ton of reduced, avoided or removed carbon dioxide or equivalent GHG. When a credit is used for this purpose, it becomes an offset.
Carbon allowances are generally transacted within the compliance market, whereas Carbon offsets are transacted in the voluntary carbon market.
For standardisation in accounting, GHG emission reductions/ removals are measured in terms of carbon dioxide equivalent (CO2e) units. They are primarily expressed in tons (t) or Metric tons (Mt) of CO2e emissions reductions/ removals with their abbreviations as tCO2e or MtCO2e.
Carbon offsets consist of two categories:
Avoidance or Reduction: This refers to preventing or reducing GHG emissions through sustainable practices. For example, a company can replace the burning of fossil fuels in a village and set up renewable power installations instead. The polluting energy production in this regard is compared to the production of clean energy, and the difference between the both is considered as the emissions avoided.
Removal or sequestration: This refers to removing greenhouse gases from the atmosphere or increasing carbon storage. For example, a company may plant trees to undertake afforestation. It also includes other methods such as carbon capture and storage (CCS) and Direct Air Capture (DAC).
Pricing of Carbon Credits
A myriad of factors drives the pricing of carbon credits. In this regard, the lack of transparency and unified standards in pricing is one of the biggest challenges facing the carbon credits system today. As of November 2021, the price per carbon credit varied from a few cents per MtCO2e to USD 20 per MtCO2e. Thus, a standard mechanism is needed to set prices and improve market transparency.
Some of the significant factors that influence the price of carbon credits are as follows:
Market Dynamics: The VCM today is driven by the market forces of supply and demand. The World Bank’s latest report on State and Trends of Carbon Pricing in this regard States that the significant increase in carbon prices in the past year can be primarily attributed to the increased demand for credits as decarbonization efforts accelerate globally.
Project Location: The location of the project is a vital factor influencing the price of carbon credits. This is because it is more challenging to implement a project in certain countries owing to the lack of infrastructure, resources, policy barriers, risks etc. Implementing a project in such places could be more expensive, thus leading to higher prices.
Vintage of Carbon Credits: The vintage refers to the year in which carbon credits are issued. Generally, buyers pay more for issuances that are more recent as they are issued under more updated methodologies and standardisation. However, it is important to note that older vintages do not expire and continue to neutralise emissions.
Economies of scale: The principle of economies of scale also tends to determine the prices of credits. Developers may give bigger discounts on the purchase of more credits. However, this tends to depend on the project developer.
Quality of credits: High-quality credits have relatively higher costs for designing and implementing activities and monitoring and verifying impacts. High-quality credits represent real, measurable, permanent and additional GHG emission reductions or removals. Verifying these impacts necessitates increased monitoring reliability, which comes with increased costs.
Additional certifications: Projects that have accomplished additional certifications with regard to broader sustainability benefits cost more. For example, Verra, a standard for certifying carbon emissions reductions, has the Sustainable Development Verified Impact Standard (SD VISta), where project developers can certify contributions to Sustainable Development Goals (SDGs). These certifications assure customers that such benefits will create environmental or social impact, in addition to GHG reductions.
Power Asymmetries and negotiation skills: Prices are also influenced by power asymmetries. For example, if a particular buyer or group of buyers dominate the shares of the voluntary carbon market, they often hold the ability to decide the price. For example, in the case of jurisdictional programs for Reduced Emissions from Deforestation and Degradation Plus (REDD+), coordinated bilateral and multilateral buyers have dominated the transactions.
Carbon credits hold tremendous potential in tackling the ongoing climate change crisis. While it is not the only answer to reducing emissions, it is one of the promising tools to facilitate it. Since there is no silver bullet to the problem, considering that each vertical has its shortcomings and trade-offs, an effective strategy to combat climate change would thus require every tool in the box, including carbon credits.
As various factors influence the price of carbon credits, there is a need for standardisation and enhanced transparency. As the market develops, standardised price-setting systems are also likely to develop. In this regard, exchanges, credit ratings, price indices, and initiatives such as Taskforce for Scaling Voluntary Carbon Markets might play an essential role in developing a more transparent carbon pricing system in the near future.