What is a Carbon Credit?

A carbon credit is a permit or certificate allowing the holder, such as a company, to emit carbon dioxide or other greenhouse gases. The credit limits the emission to a mass equal to one ton of carbon dioxide. The ultimate goal of carbon credits is to reduce the emission of greenhouse gases into the atmosphere.

Carbon credits created a market in which companies or countries can trade for the right to emit greenhouse gases.

How a Carbon Credit Works

A carbon credit is fundamentally a permit—issued by a government or other regulatory body—that allows its holder to burn a specified amount of hydrocarbon fuel over a specified period. Each carbon credit is valued against one ton of hydrocarbon fuel. 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 United Nations' Intergovernmental Panel on Climate Change (IPCC) developed a carbon credit proposal as a market-oriented mechanism to slow worldwide carbon emissions. A 1997 agreement known as the Kyoto Protocol set binding emission reduction targets for the countries that signed it, set to go into force in 2005. Another agreement, known as the Marrakesh Accords, spelled out the rules for how the system was to be implemented. One mechanism through which countries were encouraged to meet their targets was emissions trading.

The Kyoto Protocol divided countries into industrialized and developing economies. Industrialized—or Annex 1—countries 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 their 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.

Key Takeaways

  • Carbon credits were devised as a market-oriented mechanism to slow worldwide carbon emissions.
  • Countries or companies with surplus carbon credits can trade them with others who need more to meet their targets and avoid fines.
  • Emissions trading is based on international agreements, most recently the Paris Agreement of 2015.

The first commitment period of the Kyoto Protocol ended in 2012, and the protocol was revised that year in an agreement known as the Doha Amendment, which has yet to be ratified. In the meantime, more than 170 nations signed on to the Paris Agreement of 2015, which also sets emission standards and allows for emissions trading.

Carbon Credit Example

Under the cap-and-trade or emissions program, a company that is emitting less than its capped limit may sell its unused credits to another company that is exceeding its limit. For example, say Company A has a cap of 10 tons but produces 12 tons of emissions. Company B also has an emission cap of 10 tons but emits only eight, resulting in a surplus of two credits. Company A may purchase the additional credits from Company B to remain in compliance. 

Without buying those carbon credits, Company A would face penalties. However, if the price of the credits exceeds the government fines, some companies may just accept the penalties and continue operations. By raising the fines, regulators can make the buying of credits more attractive, They can also lower the number of credits they issue each year, making credits more valuable in the cap-and-trade market and creating an incentive for companies to invest in clean technology once it becomes cheaper than buying credits or paying fines.