Carbon Credits: What Are They, How Do They Work, and What Are the Verification Standards?

The climate crisis has been deemed a “code red for humanity” as scientists warn of increasingly extreme heatwaves, droughts and flooding, and breaking the 1.5°C temperature limit set out by the Paris Agreement in just over a decade

Carbon offset and credits

The climate crisis has been deemed a “code red for humanity”[i] as scientists warn of increasingly extreme heatwaves, droughts and flooding, and breaking the 1.5°C temperature limit set out by the Paris Agreement in just over a decade.  The main driver of climate change is humans or more specifically, the greenhouse gas (GHG) emissions that we generate. GHG plays an important role in keeping the planet warm enough to inhabit. But the amount of these gases in our atmosphere have skyrocketed in recent decades disrupting the earth’s fragile ecosystems and the processes that are essential for keeping us alive.

By 2020, the concentration of CO2 in the atmosphere had risen to 48% above its pre-industrial level (before 1750)[ii] and natural causes, such as changes in solar radiation or volcanic activity are estimated to have contributed less than ~0.1°C to this.[iii]

To help fight climate change, individuals and companies are investing in environmentally friendly projects to cancel or neutralize their carbon footprint. This process is called carbon offsetting. Carbon offsetting compensates for unavoidable emissions (the ones we can’t currently reduce due to a lack of technology, alternatives, or prohibitive costs).

What Are Carbon Credits?

A carbon credit also called a carbon offset is a certified transferrable instrument that represents an emissions reduction of one metric tonne of CO2. There are two types of carbon credits: Voluntary Credits and Compliance Credits.

Voluntary credits allow carbon emitters to voluntary offset unavoidable emissions by purchasing carbon credits from companies that claim the action of avoiding or removing one tonne of CO2.

What are carbon credits and how they work

Governments or regulatory authorities set caps on greenhouse emissions as outlined in the Kyoto Agreement and the Paris Agreement. For some companies the immediate reduction of emissions is not economically viable, therefore they can purchase carbon credits to abide by the emission cap. These compliance credits can be accumulated, traded, and sold through regulated systems.

How carbon or compliance credits work for companies

Both types of carbon credits are used to facilitate a net climate benefit or carbon neutrality from one entity to another.

For example, an individual can offset a flight that emits 1.2 tonnes of CO2 by purchasing a carbon credit that promises to reduce 1.2 tonnes of CO2 via a reforestation project in Alaska. While this scenario would only require the flyer to purchase a few offsets, carbon offsets can range in size from a couple tonnes that individuals can purchase to kilotonnes that large organizations buy to meet assigned targets. Since climate change is a global problem, so is the approach to carbon offsetting: where a tonne of carbon dioxide is emitted or reduced is irrelevant for the atmosphere in scientific terms.

How Do Carbon Credits Work?

Humankind must slash GHG emissions by 50% by 2030 and reduce them to net zero by 2050 to meet the Paris Agreement’s 1.5°C target[iv]. Carbon credits can help meet this target by financing technologies and practices that deliver the most significant and cost-effective draw downs in a timely manner. There are two types of markets where carbon credits can be bought and sold.

1)  Compliance Markets (CER) – Market value: $40-$120 billion

In several parts of the world such as the EU and California, companies and governments buy carbon credits through a cap-and-trade system in order to comply with mandatory and legally binding caps on the amount of CO2 they are allowed to emit per year. Failure to comply with these caps results in fines or legal penalty. Countries all over the world have compliance markets, but the largest one is The European Emissions Trading System which represents nearly 90% of the global value of carbon credits and accounts for most of the record high global traded volume of 10.3 Gt. Over 8 billion emission allowances traded hands in the European carbon market in 2020, nearly 20% more than in 2019.[v]

In compliance markets cap-and-trade programs are used to control the distribution and management of carbon credits. In cap-and-trade systems countries and corporations are allotted a certain level of acceptable emissions —the “cap” in “cap-and-trade.” These caps were initially introduced by the Kyoto Protocol which assigned signatory countries a base national emissions amount and in turn, these countries set quotas on the emissions of local organizations. If a business controls their carbon output so that it falls below their cap, they can sell the difference between the actual and capped carbon levels to other companies that have exceeded their quotas (companies profit from selling these credits). Companies that are unable to reduce their carbon production must buy carbon credits from the market —this is the “trade” in “cap-and-trade.” Each year the caps are adjusted, ideally downwards, bringing the total level of pollution down as well.

World carbon markets total value by segment
Source: https://www.refinitiv.com/content/dam/marketing/en_us/documents/reports/carbon-market-year-in-review-2020.pdf

2)  Voluntary Markets (VER) – Market value: $283 million

The voluntary carbon offset market is different from the compliance market because as the name suggests it’s completely voluntary and up to the company or individual to engage in purchasing offsets. There also is no cap-and-trade mechanism. Instead, voluntary credits can be sold and purchased through carbon credit brokers, retailers, or exchange trade platforms. It’s important to note that the voluntary market is comprised of both verified and unverified carbon credits.

A wide range of participants are involved in the voluntary carbon offset market, including providers of different types of offset projects, brokers, retailers, standards boards, and consumers who purchase offsets.

Verification Standards

In compliance markets, the UN’s Clean Development Mechanism (CDM) is involved in setting standards and verifying projects and carbon credits are verified and certified by authorized third parties called Designated Operational Entities (DOE). In voluntary markets, there are a handful of independent organizations, such as the American Carbon Registry, Verra, Gold Standard, and Climate Action Reserve, that serve this purpose.

What exactly do DOE’s and standards boards look at when evaluating the legitimacy of carbon credits and offset projects?

1. Additionality – The emissions reduction achieved by the offsetting project must be “above business as usual," meaning they would not have happened unless the credit was bought, and the project was implemented. It usually requires rigorous analysis and investigation to ensure the project is additional.

2. Permanence – To limit climate change, greenhouse gas emissions must be kept out of the atmosphere pretty much forever – e.g., the effects of offset projects that develop new ways of storing carbon will likely last longer than the effects of tree planting projects.

3. Double Counting – Once someone purchases an offset, the underlying emissions reduction shouldn’t be sold again or be available for someone else to take credit for. This principle is especially important for international offsets.

4. Leakage – Not all individuals and organizations respect or abide by mandatory environmental initiatives. For example, if a country implements a cap-and-trade scheme, it’s possible that the sources of emissions — factories, power plants, farms — may relocate to a place without a cap. As with additionality, controlling leakage demands rigorous accounting and good governance, which in the international arena, requires cooperation between countries.

Moving Forward

Climate change is at the forefront of governmental and corporate agendas. The climate crisis has also been in focus for individuals as we are seeing more extreme heatwaves, droughts, wildfires and abnormalities in our weather.

July 2021 has been earth's hottest month on record, and around the globe the combined land and ocean-surface temperature was 0.93°C above the 20th-century average of 15.8°C.

Carbon offsetting programs are becoming more than just a trending topic among environmental activists and investors as they aren't only a responsible way of reducing the impact of individual’s, businesses’, governments, and nation’s unavoidable carbon emissions, but they are a key to getting need negative emissions we need in order to limit global warming to 1.5°C as per the Paris Agreement.


Sources:

[i] McGrath, M. (2021). Climate change: IPCC report is 'code red for humanity'. Retrieved from https://www.bbc.com/news/science-environment-58130705

[ii] Causes of climate change. Retrieved from https://ec.europa.eu/clima/climate-change/causes-climate-change_en

[iii] Ibid.

[iv] Intergovernmental Panel on Climate Change. (2021). Climate Change 2021 The Physical Science Basis. Cambridge University Press. Retrieved from https://www.ipcc.ch/report/ar6/wg1/downloads/report/IPCC_AR6_WGI_Full_Report.pdf

[v] Carbon Market Year in Review 2020. (2021). Retrieved from https://www.refinitiv.com/content/dam/marketing/en_us/documents/reports/carbon-market-year-in-review-2020.pdf.

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