Carbon Credit

What Is a Carbon Credit?

A carbon credit is a permit that allows the company that holds it to emit a certain amount of carbon dioxide or other greenhouse gases. One credit permits the emission of a mass equal to one ton of carbon dioxide.

Key Takeaways

  • Carbon credits were devised as a market-oriented mechanism to reduce greenhouse gas emissions.
  • Companies get a set number of credits, which decline over time. They can sell any excess to another company.
  • Thus, "cap-and-trade" is an incentive to reduce emissions.
  • Negotiators at the Glasgow COP26 climate change summit in November 2021 agreed to a global carbon credit offset trading market.

The carbon credit is one half of a so-called "cap-and-trade" program. Companies that pollute are awarded credits that allow them to continue to pollute up to a certain limit. That limit is reduced periodically. Meanwhile, the company may sell any unneeded credits to another company that needs them.

Private companies are thus doubly incentivized to reduce greenhouse emissions. First, they will be fined if they exceed the cap. Second, they can make money by saving and reselling some of their emissions allowances.

Understanding a Carbon Credit

The ultimate goal of carbon credits is to reduce the emission of greenhouse gases into the atmosphere. As noted, a carbon credit is equal to one ton of carbon dioxide. According to the Environmental Defense Fund, that is the equivalent of a 2,400-mile drive in terms of carbon dioxide emissions.

Companies or nations are allotted a certain number of credits and may trade them to help balance total worldwide emissions. "Since carbon dioxide is the principal greenhouse gas," the United Nations notes, "people speak simply of trading in carbon."

The intention is to reduce the number of credits over time, thus incentivizing companies to find innovative ways to reduce greenhouse gas emissions.

Cap-and-Trade Programs Today

Cap-and-trade programs remain controversial in the U.S. However, 11 states have adopted such market-based approaches to the reduction of greenhouse gases, according to the Center for Climate and Energy Solutions. Of these, 10 are Northeast states that banded together to jointly attack the problem through a program known as the Regional Greenhouse Gas Initiative (RGGI).

California's Cap-and-Trade Program

The state of California initiated its own cap-and-trade program in 2013. The rules apply to the state's large electric power plants, industrial plants, and fuel distributors.

The state claims that its program is the fourth largest in the world after those of the European Union, South Korea, and the Chinese province of Guangdong.

The cap-and-trade system is sometimes described as a market system. That is, it creates an exchange value for emissions. Its proponents argue that a cap-and-trade program offers an incentive for companies to invest in cleaner technologies in order to avoid buying permits that will increase in cost every year.

The U.S. Clean Air Act

The United States has been regulating energy emissions since the passage of the U.S. Clean Air Act of 1990, which is credited as the world's first cap-and-trade program (although it called the caps "allowances").

The program is credited by the Environmental Defense Fund for substantially reducing emissions of sulfur dioxide from coal-fired power plants, the cause of the notorious "acid rain" of the 1980s.

The United Nations' Kyoto Protocol

The United Nations' Intergovernmental Panel on Climate Change (IPCC) developed a carbon credit proposal to reduce worldwide carbon emissions in a 1997 agreement known as the Kyoto Protocol. The agreement set binding emission reduction targets for the countries that signed it. Another agreement, known as the Marrakesh Accords, spelled out the rules for how the system would work.

California has its own carbon credit program, which is reputed to be the world's fourth-largest.

The Kyoto Protocol divided countries into industrialized and developing economies. Industrialized countries, collectively called Annex 1, operated in their own emissions trading market. If a country emitted less than its target amount of hydrocarbons, it could sell its surplus credits to countries that did not achieve its Kyoto level goals, through an Emission Reduction Purchase Agreement (ERPA). 

The separate Clean Development Mechanism for developing countries issued carbon credits called a Certified Emission Reduction (CER). A developing nation could receive these credits for supporting sustainable development initiatives. The trading of CERs took place in a separate market.

The first commitment period of the Kyoto Protocol ended in 2012. (The U.S. dropped out in 2001.)

The Paris Climate Agreement

The Kyoto protocol was revised in 2012 in an agreement known as the Doha Amendment, which was ratified as of October 2020, with 147 member nations having "deposited their instrument of acceptance."

More than 190 nations signed on to the Paris Agreement of 2015, which also sets emission standards and allows for emissions trading. The U.S. dropped out in 2017 but subsequently rejoined the agreement in January 2020 under President Joe Biden.

The Paris Agreement, also known as the Paris Climate Accord, is an agreement among the leaders of over 180 countries to reduce greenhouse gas emissions and limit the global temperature increase to below 2 degrees Celsius (3.6 F) above preindustrial levels by the year 2100.

The Glasgow COP26 Climate Change Summit

Negotiators at the summit in November 2021 inked a deal that saw nearly 200 countries implement Article 6 of the 2015 Paris Agreement, allowing nations to work toward their climate targets by buying offset credits that represent emission reductions by other countries. The hope is that the agreement encourages governments to invest in initiatives and technology that protects forests and build renewable energy technology infrastructure to combat climate change.

For instance, Brazil's chief negotiator at the summit, Leonardo Cleaver de Athayde, flagged that the forest-rich South American country planned to be a major trader of carbon credits. "It should spur investment and the development of projects that could deliver significant emissions reductions," he told Reuters.

Several other provisions in the accord include zero tax on bilateral trades of offsets between countries and canceling 2% of total credits, aimed at reducing overall global emissions. Additionally, 5% of revenues generated from offsets will be placed in an adaptation fund for developing countries to help fight climate change. Negotiators also agreed to carry over offsets registered since 2013, allowing 320 million credits to enter the new market.

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