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What are Carbon Credits and How Do They Work?

CRISIS - Atmospheric CO2 Levels by Shachi Wadhawan Global Commons Jan 22nd 20227 mins
What are Carbon Credits and How Do They Work?

Carbon credits may offer just the incentives we want emitters to seek. We explore what are carbon credits and whether carbon credit offsets work. 

With COP27 ending in November 2022, if there was much of a display of intent to act, it was in the many net-zero declarations made by nation-states and corporations. For us to have a real chance at avoiding the much-feared inevitability of irreversible climate change, sweeping changes to the global economy are needed. As per a McKinsey estimate, it would require US$9.2 trillion in annual average spending on physical assets for net-zero results globally by 2050.

Despite energy prices continuing their rise, fossil fuels remain an important source of energy the world over. In its 2021 report on World Energy Outlook, the International Energy Agency (IEA) says that more than USD$1 trillion of capital has yet to be recovered in younger plants in the existing coal fleet, and further investments in coal continue to be backed by large investors. In a scenario where alternatives such as renewable energy are viewed as not being cheaper than fossil-based power due to the price of investment and storage, the only way therein to incentivise the world to shift to this more expensive yet low-carbon future is to make fossil fuels costlier. 

Similar is the case with the cement industry, which is responsible for about a quarter of all industry CO2 emissions. With much of the world on the path towards economic development, cement will continue to play a key role in the growth story, particularly in the Global South. Major technological changes and innovation are required to shift to a “sustainable” form of cement.

Across industries, it is a question of hastening technological progress, investments, and reducing the lead time to shift away from carbon-intensive processes and practices while at the same time managing transitions for workforces, communities, assets, and the environment, all in tandem.

While large-scale transformation is planned and executed across industries around the globe, in the more immediate term, carbon pricing as an economic instrument forces nation states and enterprises to tread within certain guardrails. Cap-and-trade and levying carbon taxes on emitters are two such well-known and widely adopted mechanisms. A cap-and-trade market mechanism enforces a ceiling on allowed emissions beyond which the emitters would need to purchase the right to pollute further. On the other hand, carbon taxes fix a price on the emitted carbon and allows investors and businesses to invest without the fear of price fluctuations, thus incentivising reductions.

what are carbon credits, what is carbon pricing

The uptake of carbon pricing in G20 nations. Source: Our World in Data (Courtesy of MCC Berlin, see also Edenhofer et al. 2017).

Taxes may be easier to implement administratively but they can fail to guarantee reduction in emissions. Moreover, as taxes are required to capture negative externalities, determining the appropriate price of carbon is a tricky and convoluted exercise, one rife with assumptions on future pathways and the associated social cost. A group of policy researchers propose an alternative design framework for a carbon tax that keeps in focus clearer short-term goals against nebulous and difficult to predict long-term outcomes. Frequent changes in taxation could also pose political difficulties.

Some domestic decisions may spawn far-reaching international repercussions. Take the case of the European border tax – a levy to ensure imported industrial products face the same carbon price as those covered by the domestic systems. As free emissions allowances are phased out, the purported intent of such a tax is to create a level playing field for domestic industry within the European Union (EU). Though the driver of this move may be internal to the EU, its effect is bound to reverberate globally. The border tax may possibly trigger a string of protectionist measures and countermeasures, and certainly further strain the already disrupted global supply chains. With all the attendant problems of a carbon tax, do carbon credits offer any real hope towards achieving net-zero?

You might also like: What Countries Have A Carbon Tax?

How do Carbon Credits Work?

As heavy emitters plan for a transition to alternative technologies and resources, they may use carbon credits generated by other entities to compensate for their own emissions. Carbon credits can be generated from either reducing emissions, removing pre-existing greenhouse gases in the atmosphere, or avoiding the release of emissions altogether. Projects undertaken to achieve any of these account for the purpose of offsetting.

To put things into perspective, offsets issued in 2020 were equivalent to 210 million metric tons of carbon dioxide emissions, which is 0.4% of total global emissions. This needs to go up to 2 billion tonnes of CO2 to get to the 2030 target and approximately 7.6 gigatons of carbon dioxide offsets or removal to achieve net-zero energy emissions by 2050. Which by any measure,  is a long road ahead.

Many countries across the world have their own national carbon trading systems and depend on carbon credits generated in other countries (typically developing countries). The European Union (EU) was the pioneer in carbon trading through the EU Emissions Trading System (ETS), established back in 2005. Today, the UK has its own scheme, while there are two regional carbon markets in operation in North America. The Chinese national emissions trading scheme is the largest in the world and is based on intensity of emissions (the amount of emissions per unit of energy generated) rather than absolute emissions to help reduce its impact on climate. However, the existence of these schemes may still not be enough to meet the 2030 targets of peak emissions and net zero by 2060.

Implementation of cap-and-trade itself has been fraught with inefficiencies, making them untenable without significant amendments. The EU ETS has been much criticised for its structural faults and lack of results. Initial allowances were too generous, creating a surplus leading to low prices of allowances. Nation states and industries are alleged to have gamed the system raking in windfall profits for the energy sector. Moreover, the penalties for failing to comply have not been severe enough. Effectiveness of the ETS in California has also been under question.

In That Case, What Needs to Change?

The experience thus far underscores the role of political will to set emissions more stringently, to lay price floors and ceilings to avoid volatility, and for emissions allowances to be auctioned instead of being given away. Integrity of reporting and monitoring of emissions is a key success factor, with independent agencies required to verify the data reported. At the same time, reducing caps and tightening allocations may push out small and weak actors without the capital and the clout, leaving the scene dominated by large emitters; it is a precariously fine balance to achieve.

The need of the hour is to strengthen the ETS as an investment driver and to reinforce market stability, while maintaining a decrease in carbon emission in total. Setting an emissions cap that declines over time could increase certainty that emissions will fall below the predetermined emissions targets. Some of the rules were adequately set during the COP26 held last November, including those around avoiding double counting of carbon credits. Some others need further attention. In an ideal world, cap-and-trade as a measure would have worked well if kicked-in only after other policy interventions were made to address the fundamental flaws in today’s production and consumption patterns. Policies still need framing and implementation, for instance, around clean energy, green vehicles/transportation, and those encompassing other polluting sectors and industries, without exception.

Carbon Credits Are Here to Stay and Grow

Be that as it may, the demand for carbon credits today is at an all-time high. Refinitiv reported that the value of traded global markets for carbon permits grew by 164% to a record USD$851 billion in 2021, with 90% attributable to the EU ETS. Prices in the EU ETS ended 2021 at more than 80 euros a tonne, more than double the price at the end of 2020. With the ongoing conflict in Europe, soaring natural gas prices will lead to more coal power generation, spurring demand for permits and making them more expensive. As per a study, European businesses should prepare for CO2 prices of nearly $200 a tonne by 2030 if the EU is serious about its climate-change targets while McKinsey & Co. estimates that the demand for carbon credit could increase by 15 times by 2030 and by 100 times by 2050. Market by 2050 could reach US$50 billion. Another research draws scenarios at differing future carbon offset prices.

Amidst the anticipated increase in future demand, Voluntary Emissions Reductions (VER) are garnering much attention. Voluntary carbon market (VCM) is where companies, organisations or individuals purchase carbon credits generated from projects to reduce emissions. However, for VCM to flourish as an additional source of credits, it needs clear definitions, contracting standards, trading infrastructure, and the right set of measures to provide liquidity and to preserve integrity of the market. VCM is already attracting some big names, which should push the case for required changes.

Does that mean carbon credits offer the panacea we need? Armed with the collective experience of the past few decades of experimentation, there never was to be a silver bullet to saving the planet. Looking however ahead from 2022, the real solution is in exercising all tools available in the policy toolbox in a concerted manner. If there is any one area in the utmost need for green innovation – beyond technology – it is in the fields of economics and finance. Fortunately, there is no tax or  a cap on creativity with regards to solving the ever-convoluted problem we find ourselves in. Therefore, hope sustains.

You might also like: Nature Credits Can Succeed Where Carbon Capture Technologies Failed: An Interview with Walid Al Saqqaf and Amit Ghosh

Tagged: carbon credits

About the Author

Shachi Wadhawan

Shachi is a general management and strategy professional currently employed with a global MNC. At the moment, she in the process of discovering how climate change would impact our lives and the potential mechanisms for businesses to play a central role in mitigation and adaptation.

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