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Carbon credit trading is a market-based system. Its design reduces greenhouse gas emissions by creating financial incentives to do so.
There are primarily two types of carbon credits:
1. Voluntary Emission Reductions (VERs)
A VER refers to a carbon offset exchanged in the voluntary carbon market for credits.
2. Certified Emission Reductions (CERs)
A regulatory framework creates a CER with the purpose of offsetting a project’s emissions. A certified third body regulates the CER as opposed to the VER.
Both private and public markets carry out the trading of carbon credits. Current trading rules even allow the international transfer of credits. The demand for credits in the market determines the prices of carbon credits. The prices of credits fluctuate due to the differences in supply and demand in different countries.
Though we describe it as ‘a market’, it is not just a single market. There are multiple markets for carbon credit trading. Carbon credits bought and purchased in one market might not be valid in another.
The mandatory carbon schemes require businesses and companies whose emissions exceed a specified limit to obtain a permit or allowance for each ton of carbon emissions. The compulsory scheme might also apply only to businesses in a specific industry, such as the fossil fuel energy sector.
The businesses may receive an initial allocation of credits free of charge or enter into an auction to buy the credits. Firms that manage to reduce their emissions can sell their credits to businesses whose emissions increased. Therefore, this creates a trade and a market for the credits.
Regulatory carbon markets generally allow trade only within their carbon allowances. However, some schemes might permit the use of carbon offsets in place of a proportion of credits.
All current carbon trading schemes use a model called a ‘cap-and-trade’. In this type of scheme, a governmental body sets the cap – the upper legal limit on emissions over a fixed period of time. The governmental body will grant a fixed number of permits to those businesses releasing emissions. A company must hold enough permits, or credits, to cover its emissions.
If a business does not use all its permits, it can trade them with another company that has already used up all its permits and needs more to continue releasing emissions.
The two major carbon trading schemes in operation are the Kyoto Protocol and the European Union Emission Trading Scheme (EU ETS). The Kyoto Protocol sets the cap for emissions for each industrialized nation. It does not set limits for developing countries, arguing that the historically large polluters – the industrialized nations – must take responsibility for initial emission reductions.
In the EU ETS, each EU member state passes on a portion of the permits received under the Kyoto Protocol to its major polluting industries.
The ‘cap-and-trade’ theory assumes the auctioning of permits and that the price of credits will therefore be set by demand. However, in reality, all cap-and-trade programs initially distribute permits free of charge on a company-by-company basis.
Every cap-and-trade scheme involves offset credits in one form or another. Offset credits are a supplementary source of permits. They represent permissions to pollute that businesses can buy, usually from the developing world. Purchasing an offset credit allows the company to exceed its emissions cap by paying another entity to reduce its emissions instead. Offsets do not reduce emissions; they only replace them.
Offset credits are based on the assumption that it does not matter where or how we reduce emissions. Offset projects develop in regions it is cheap to reduce emissions, while the release of emissions can continue in the capped country.
In short, governments, companies, and businesses pay someone else to reduce emissions somewhere else. They do so because it is cheaper for them in the short term than reducing emissions themselves.
Before a carbon project can sell its offsets, its owner will document how the project will reduce emissions and by how much. The document then goes through a lengthy process of consultation, validation, approval, registration, and verification with several consultancies and auditing firms. The project will then start generating credit offsets and sell them into the carbon market.
Many people still think of carbon credit trading as a simple process. But, the carbon market has deepened and matured over the years. Carbon markets now involve a variety of buyers and sellers that introduce a broad range of complex financial products. The amount of carbon trading largely determines the size of carbon markets. Financial speculation drives carbon markets worldwide rather than the simple need to comply with emission reduction targets.
Carbon credit trading has come under increasing criticism. Industrialized countries are not reducing their carbon emissions at the rate necessary to avoid catastrophic climate damage.
Many scientists believe that carbon trading is a dangerous distraction. It is diverting our attention away from the need to end fossil fuel use and move to a low-carbon economy. Trading essentially does nothing to reduce emissions. Carbon trading only gives us the impression of action against climate change. In reality, the cap remains too large to actually do anything to stop climate change.
Carbon trading delays structurally reforming polluting industries to transition to a low-carbon economy. Carbon credit trading only enables capped enterprises to meet short-term reduction goals without making fundamental changes in their operations. Even after decades of carbon trading, the level of carbon dioxide in our atmosphere has risen and continues to increase.
However, cap-and-trade schemes have been somewhat effective in tackling environmental problems. In the US, for instance, trading sulfur dioxide permits helped to limit acid rain. For governments, too, carbon trading is much easier to implement than direct regulations and unpopular carbon taxes.
National governments and international organizations could even work together and join up cap-and-trade schemes globally. It would result in a strong carbon price and also a speedy way to help global decarbonization.