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A carbon credit is the ownership of one metric ton of carbon dioxide. Companies, businesses, and individuals can trade, sell, or retire their carbon credits ownership.
An organization usually has a limit on how much carbon credits it is allowed to release. If the organization produces fewer carbon emissions than this limit, it can trade, sell, or keep the remaining carbon credits. When an organization sells its carbon credits, the buyer essentially purchases the seller’s allowance of carbon emissions. Companies can use carbon credits to make up for emissions from their industrial production, delivery vehicles, or employees’ travel to work.
A carbon credit is tradeable because it represents an actual reduction in emissions.
The UN’s 1997 Kyoto Protocol on climate change was the first to set up the carbon market scheme we are familiar with today.
Under the agreement, developed countries had greenhouse gas reduction targets, but developing countries did not. That means that if a developing country reduced its greenhouse gas emissions by installing solar or wind energy or pushing for the adoption of electric vehicles, it obtained a carbon credit for these reductions. The developing country could then sell this carbon credit to a developed country. The developed country would count the credit under its own emission reduction targets.
California’s ‘cap-and-trade’ system is another example of a carbon market. The Californian government created the program to lower the state’s greenhouse gas emissions. California has around 450 businesses responsible for 85% of the state’s greenhouse gas emissions. These businesses include industrial plants, electric power plants, and natural gas and petroleum distributors. California law requires that the companies comply with the cap-and-trade program. With this law, California expects around a 40% reduction in greenhouse gas emissions by 2030.
The government sets the upper limit of how greenhouse gases an organization can emit. This is called the ‘cap’. Businesses that emit less than the ‘cap’ can sell their remaining credits to businesses finding it difficult to reduce emissions. The government also set up an Offset Project Registries to issue carbon credits to companies. The registry also lists, reports, and verifies offset projects. Another positive outcome of the program has been the large-scale participation of tribal groups. The Yurok tribe, Round Valley Indian Tribes, the Confederated Tribes of Warm Springs, and the White Mountain Apache tribe participate in the cap-and-trade program. By protecting natural resources and ecosystems, these tribes obtain carbon credits. They then sell these carbon credits to businesses. The purchase of carbon credits becomes an essential source of revenue for the tribes and local community.
Carbon markets play critical roles in getting businesses to contribute to the fight against climate change. Companies that run emission reduction projects such as wind and solar farms, replanting forests, restoring ecosystems, and producing electric vehicles can sell their emission reductions to other countries and businesses.
Here, environmental laws mandate that companies offset their carbon footprint. In the compliance market, the government sets a cap on how many tons of carbon dioxide a sector can emit. Regions such as the European Union and California have cap-and-trade environmental laws. The ‘cap’ represents the upper limit on carbon emissions a company or business is allowed to produce. As the cap reduces in the future years, total pollution levels decline. Energy generation companies, large factories and industries, and refineries that emit large quantities of carbon dioxide must hold allowances. These allowances represent how much carbon dioxide they are permitted to release or how much of their emissions they need to offset. Businesses like these enter a compliance carbon market when they can buy and sell carbon credits.
For example, if an oil company goes beyond the emissions limit prescribed to it, it must buy carbon credits or use saved ones to stay under the emissions cap. If a company manages to stay under that cap, it can sell or save those credits.
The voluntary carbon market represents all credits bought and sold with the intention of surrendering them into an active carbon market. This carbon market is driven by companies that voluntarily take responsibility for offsetting their own emissions. Companies may also purchase offsets before regulation and law require emission reductions. The voluntary carbon market consists of companies and businesses driven by social responsibility, ethics, a desire to enhance their reputation, etc. Here, there are no laws driving businesses to reduce emissions.
Voluntary carbon markets are smaller than compliance carbon markets. However, voluntary markets have more flexible and innovative finances, methodologies, and monitoring processes.
1. Double counting.
In the new Paris Agreement, developed and developing countries alike have carbon reduction targets. This introduces the risk of double counting.
For example, imagine India reducing emissions by one metric ton through a solar power scheme. India will acquire one carbon credit because of its emission reductions. India then sells its carbon credit to Australia. But, India and Australia would both count the carbon credit under their own reduction target. This amounts to ‘cheating’ because countries would not be reducing as much carbon emissions as they claim. In fact, the countries would reduce only half as much carbon emissions as they claim.
2. The new Paris Agreement
The carbon market that came into existence following the Kyoto Protocol collapsed due to corruption by nations. The U.S left the Protocol in 2001. In 2012, the EU stopped allowing member states to buy carbon credits. The EU feared that many projects were not as successful in reducing emissions as they claimed to be. The stoppage of carbon trading in the EU provided very few potential buyers in the carbon market. In countries like Russia and Ukraine, companies abused the credit system to enrich themselves at the environment’s expense. A study in 2015 found that around 80% of projects under the Kyoto Protocol actually increased emissions rather than decreasing them.
The Paris Agreement resulted in the creation of a new international carbon market. But, some countries, like Australia, want to carry over their old credits from the Kyoto Protocol to the Paris Agreement. Many countries have opposed this, claiming that this carrying forward of credits will water down climate ambitions. Emissions reduction targets could be cut by an amount more than the total carbon dioxide emissions.