What is 'Carbon Credit'

A carbon credit is a permit or certificate allowing the holder to emit carbon dioxide or other greenhouse gases. The credit limits the emission to a mass equal to one ton of carbon dioxide. The issuance of carbon credits aims to reduce the emission of greenhouse gases into the atmosphere.

BREAKING DOWN 'Carbon Credit'

Near the end of the 20th century, concerns about global warming and environmental degradation grew. The aim of the carbon credit system is the reduction of the release of harmful gases from industrial activity. Industrial production is deemed a significant contributor to increased greenhouse gases.

The backbone of the carbon credit system is a government or other regulating bodies that can attempt to limit the total tons of carbon dioxide emitted through the issuance and regulation of carbon credit. Carbon credit policies place a cost on carbon emissions by creating credits valued against one ton of hydrocarbon fuel. A carbon credit is fundamentally a permit that allows the receiver to burn a specified amount of hydrocarbon fuel over a specified period. The ceding of carbon credits are to companies or groups that act to reduce carbon emissions measurably. Companies or nations may trade carbon certificates to help balance total worldwide emissions.

An Example of Carbon Credits

Under the cap-and-trade or emissions program, a company emitting less than its capped limit may sell unused credits to a company exceeding its limit.  For example, 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 the purchased carbon credits, Company A would face penalties. When the fines exceed the cost to buy, the company will favor purchasing the credits.  However, sometimes the price to acquire the credits exceeds the fines.  As a result, some companies accept the penalties and continue operations and the emissions of hydrocarbons.

The Kyoto Protocol

The Intergovernmental Panel on Climate Change (IPCC) presented its carbon credit proposal as a market-oriented mechanism to slow worldwide carbon emissions. The ratification of the international carbon credit system is in agreement with the Kyoto Protocol with clarification of its market mechanisms at the subsequent conference in Marrakesh. In addition to the legally binding goals of the Kyoto Protocol, there are also voluntary carbon credit markets.

The Kyoto Protocol divides countries into industrialized and developing economies. Industrialized, or Annex 1 countries, operate in an emissions trading market giving each nation its own emissions standards to meet. If a country emits less than its target amount of hydrocarbons, it may sell its surplus credits to countries that do not achieve their Kyoto level goals through the Emission Reduction Purchase Agreement (ERPA). 

The separate Clean Development Mechanism for developing countries issues carbon credits called Certified Emission Reduction (CER). A developing nation may receive these credits for supporting sustainable development initiatives. The trading of CERs is on a separate marketplace.

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