What Are Carbon Credits?

July 27, 2023
Carbon credits are permits issued by the government which allow a company to generate one ton of C02 (carbon dioxide) into the air. Also called carbon allowances, they enable the government to restrict how much greenhouse gas an industry can generate by limiting the number of credits issued. Because not every company creates the same amount of pollution, carbon credits can be bought and sold in what’s known as the carbon market. This essentially turns each carbon unit into an asset whose price will be based on the current supply and demand.

Carbon Emissions Background

In the 1980s, pollution from large companies was escalating into a major environmental problem. The sulfur dioxide (S02) they’d release into the atmosphere resulted in acid rain which was harming wildlife and crops.

In the 1990s, the U.S. government began charging companies that released too much S02 into the air as a way to financially motivate them to cut back or find alternative means of production. This had a positive effect in reducing sulfur emissions, and the international community began to take notice.

In 1997, several countries from around the world came together in an effort to combat climate change by signing a treaty that became known as the Kyoto Protocol. They decided to adopt the system that the U.S. was using to cut back on sulfur and apply it to other gases such as carbon. This initiative was again revisited in 2015 with the creation of the Paris Agreement and has since led to the framework used today for what’s known as the carbon market.

How Does the Carbon Market Work?

The carbon market starts with the basis of the government putting a limit or “cap” on how much carbon an industry can release into the air. These caps are split up into permits representing one ton of carbon dioxide with each essentially acting as a sort of permission slip for the holder to use.

These permits (or credits) are then given or sold to firms by the government. Companies must keep track of how many carbon emissions they had and pay for them with credits.

Since these credits are transferable, naturally:

●       Some companies will use less than the credits they have and decide to sell their surplus

●       Some companies will use more than the credits they have and need to acquire more

Hence, a market for these credits exists similar to securities.

This process of restricting carbon pollution and selling credits is what’s known as cap-and-trade. The government dictates the cap on how much carbon can be used, and the businesses will trade amongst themselves to appease the system.

As part of reducing greenhouse gas emissions, governments will generally lower the number of permits they allow each year. Hence, the laws of supply and demand should make carbon credits more valuable over time and serve as an incentive to use clean and renewable energy.

What Are Carbon Offsets?

A carbon offset is when a company or project removes one unit of carbon from the atmosphere. Though the term often gets confused with carbon credits, they refer to different purposes - offsets essentially remove carbon from the air while credits allow its creation.

Unlike credits, businesses that engage in carbon removal have the ability to issue carbon credits. An example of carbon offset activities may include:

●       Agriculture

●       Reforestation

●       Renewable energy (such as a wind farm)

Carbon offsets can be used alongside credits to satisfy the government allowance for producing emissions. Therefore, these businesses will also participate in the carbon market by voluntarily selling their offsets to businesses in demand.

Does the U.S. Use Carbon Credits?

The United States participated in the 2015 Paris Agreement with intentions to do its part to reduce greenhouse gas. However, they formally withdrew from the agreement under then-president Trump only to later rejoin after President Biden succeed him in office.

According to the USDA, the U.S. has several voluntary and regulatory markets that have emerged, allowing carbon offset purchases. In many of these markets, agricultural conservation can be a source of offsets.

Despite this, the U.S. still needs to officially set up a national carbon market. Only one state, California, has a formal cap-and-trade program for businesses and residents.

Do Carbon Credits Reduce Greenhouse Emissions?

In theory, the concept of cap-and-trade within the carbon market should motivate companies to reduce their emissions. Those who take steps to lower their carbon footprint will have a surplus of credits to sell making it a lucrative opportunity.

However, in practice, this has not always been the case. If the majority of companies were to reduce their carbon output, then this would create an industry surplus of credits. More supply and lower demand would result in a decreased value. If the price of a credit becomes too low, then there would be no financial incentive for a company to reduce its emissions.

Another problem is with the legitimacy of the practice itself. Because the carbon market is worldwide, it's up to each country to regulate and enforce how credits are being bought and sold. This can naturally lead to corruption if it's not properly monitored.

At the same time, companies may also try to mislead regulators about how much carbon they’ve produced in a given year. A famous example of this was a scandal in 2015 when it was discovered that German automaker Volkswagen had altered its software to report a lower emissions value.

Companies may further abuse the system through something called carbon leakage. Carbon leakage is when a business intentionally relocates from one country to another where the carbon rules are more relaxed. Though this has the effect of decreasing emissions for the former country, the problem simply moves to the latter country where it could potentially produce even greater pollution than before.

Despite the abuse of the system, many countries remain committed to the goal of reducing carbon emissions. For instance, the U.S. signed the Inflation Reduction Act into law on Aug. 16, 2022. Among its many objectives, one of them includes generous tax credits for carbon capture projects in hopes that more companies will be motivated to pursue them.

The Bottom Line

Carbon credits are permits where each unit allows a company to release one ton of carbon dioxide per year. They are part of the larger international carbon market which was created to regulate how much greenhouse gas companies produce.