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Home » Blog » ESG Fundamentals » Carbon Credits: Unveiling the Secrets of a Sustainable Future

Carbon Credits: Unveiling the Secrets of a Sustainable Future

Carbon Credits

In the fight against climate change, businesses have a crucial role to play. Reducing greenhouse gas (GHG) emissions is a top priority, and carbon credits are emerging as a powerful tool in this effort. Let’s dive deep into carbon credits, explaining their function, how they work, and their role within a comprehensive ESG strategy. By understanding Carbon Credits, companies can leverage them to achieve their sustainability goals.

What are Carbon Credits?

A carbon credit represents one tone of carbon dioxide equivalent (CO2e) removed, avoided, or sequestered from the atmosphere. They function within cap-and-trade programs, a market-based approach to regulating GHG emissions. These programs set a limit on total emissions allowed within a specific sector or region. Companies receive a set number of carbon allowances, essentially permitting them to emit a certain amount of CO2e.

Carbon credits are not simply created out of thin air. They originate from carbon offset projects that demonstrably remove, avoid, or sequester greenhouse gases (GHG) from the atmosphere. These projects can encompass a wide range of initiatives, including:

· Renewable Energy Production: Solar, wind, geothermal, and hydropower projects that generate clean electricity and displace emissions from fossil fuel-based power plants.

· Forestry and Land-Use Change: Preserving existing forests, reforestation efforts, and improved forest management practices that increase carbon storage in biomass.

· Soil Carbon Sequestration: Agricultural practices that promote the storage of carbon in soil, such as cover cropping, no-till farming, and compost application.

· Waste Management: Projects that capture methane emissions from landfills or reduce methane released during organic waste decomposition.

Not all carbon offset projects are created equal. To ensure the legitimacy and impact of the carbon reductions achieved, projects undergo a rigorous verification process by independent third-party organizations. These verifiers assess the project design, methodology, and the permanence of the carbon reductions it generates. Common verification standards include the Verified Carbon Standard (VCS) and the Gold Standard.

Cap-and-Trade: Setting the Limits

Imagine a pie chart representing the total allowable greenhouse gas emissions for a specific industry or region. This “pie” is the cap, set by a regulatory body. The government then slices the pie into allowances, essentially tradable permits, and allocates them to companies within that sector. Each allowance represents a certain amount of CO2e a company can emit.

The Carbon Credit Market: A Balancing Act

Companies that operate efficiently and emit less than their allowances can:

· Sell their surplus allowances to companies that exceed their limits. This creates a financial incentive for companies to reduce emissions – reducing their need to purchase credit becomes a cost-saving measure.

On the other hand, companies that exceed their allowances have two options:

· Reduce their emissions through operational changes, cleaner technologies, or energy efficiency upgrades.

· Purchase carbon credits from the market to compensate for their excess emissions and remain compliant with regulations.

How Do Carbon Credits Work?

There are two main ways companies can interact with carbon credits:

1. Compliance:

  • Companies that exceed their allowances through their operations must either reduce their emissions or purchase additional carbon credits from the market.
  • Companies that operate efficiently and emit less than their allowances can sell their surplus allowances to companies that exceed their limits.
  • This creates a financial incentive for companies to reduce their environmental footprint.

2. Voluntary Market:

  • Companies committed to exceeding regulatory requirements or offsetting their unavoidable emissions can purchase carbon credits in the voluntary market.
  • These credits come from projects that remove carbon from the atmosphere, such as renewable energy projects, forestation efforts, or soil sequestration initiatives.

Carbon Offsets vs. Carbon Credits

The terms “carbon credits” and “carbon offsets” are often used interchangeably, but there’s a subtle difference. Carbon credits are typically created within a compliance market, whereas carbon offsets are generated from voluntary projects. Both achieve the same goal of reducing the overall amount of CO2e in the atmosphere, but compliance creates a mandatory market for credits.

Carbon Credit Price

The price of a carbon credit fluctuates based on factors like:

  • Supply and demand: The number of available credits and the demand from companies seeking to offset their emissions.
  • Project type: The type of project generating the credit (e.g., renewable energy vs. forestry) can influence the price.
  • Verification standard: Credits verified by reputable standards often command a higher price.

 

While the voluntary market offers flexibility, compliance markets set a mandatory price floor for carbon emissions. According to Statista, the average price of carbon emission allowances in the EU Emissions Trading System (EU ETS) hovered around €80 per tonne (roughly $88 USD) in early 2024. This price point is significantly higher than the voluntary market average, reflecting the stricter enforcement mechanisms within compliance programs.

The core principle behind carbon pricing is simple: polluters pay. Many of the costs associated with GHG emissions, like extreme weather events and rising sea levels, are

borne by society as a whole. Carbon pricing aims to internalize these external costs by attaching a monetary value to carbon emissions.

The Two Main Carbon Pricing Mechanisms:

There are two primary forms of carbon pricing:

1. Carbon Taxes: Under a carbon tax, the government sets a fixed price per tonne of CO2 (or equivalent) emitted. This essentially increases the cost of producing and consuming carbon-intensive goods and services, encouraging consumers to shift toward lower-emission alternatives. Carbon tax rates vary significantly across the globe, with some countries like Sweden implementing significantly higher rates to drive faster emission reductions.

2. Emissions Trading Systems (ETS): An ETS operates on a cap-and-trade principle. The government establishes a total limit on allowable emissions within a specific sector or region. They then distribute a fixed number of tradable permits, each representing the right to emit a certain amount of CO2. Companies can buy and sell these allowances on a dedicated market.

Over time, the total number of allowances is reduced, forcing emitters to become more efficient or purchase additional permits to maintain their emission levels. This system incentivizes companies to reduce their emissions to remain compliant and potentially profit from selling excess allowances.

Carbon pricing is rapidly gaining traction worldwide. As of today, over 70 carbon pricing mechanisms are in operation, covering nearly a quarter of global GHG emissions. Revenue generated from carbon taxes and ETS in 2022 surpassed $86 billion USD, demonstrating the significant financial potential of this approach.

The European Union’s Emissions Trading System (EU ETS), established in 2005, is the world’s first and currently the largest international ETS. China launched its national ETS in 2021, making it the world’s biggest carbon market in terms of coverage, targeting emissions from its power sector. These developments signal a growing global commitment to carbon pricing as a key strategy for achieving ambitious climate goals.

Why Consider Carbon Credits?

For companies committed to sustainability, carbon credits offer a valuable tool:

  • Reduce Environmental Impact: Offsetting emissions helps mitigate your company’s contribution to climate change.
  • Enhance Brand Reputation: Demonstrate your commitment to sustainability and attract environmentally conscious customers and investors.
  • Future-Proof Your Business: As regulations around emissions tighten, a proactive approach to carbon reduction positions your company for success.

Integration with a Comprehensive ESG Strategy

Carbon credits are a powerful tool, but they should not be viewed as a standalone solution. For maximum impact, they should be integrated into a broader Environmental, Social, and Governance (ESG) strategy. An effective ESG strategy encompasses a range of initiatives that promote environmental responsibility, social well-being, and ethical governance practices.

Here’s how carbon credits can complement a holistic ESG approach:

· Complementing Emission Reductions: Carbon credits are most effective when used alongside a strong focus on internal emission reductions. Companies should prioritize optimizing operations, investing in clean technologies, and implementing energy efficiency measures to minimize their environmental footprint. Carbon credits can then address unavoidable emissions and contribute to achieving ambitious sustainability goals.

· Transparency and Stakeholder Engagement: Transparency is paramount in any ESG strategy. Companies purchasing carbon credits should clearly communicate their approach to stakeholders, including the types of projects they support and the rationale behind their selections. Engaging with stakeholders in the carbon credit selection process can further enhance transparency and build trust.

· Supporting Sustainable Development Goals (SDGs): The UN’s Sustainable Development Goals (SDGs) provide a comprehensive framework for addressing global challenges like climate change and poverty. Many carbon offset projects contribute directly to achieving these goals. By supporting projects aligned with the SDGs, companies can maximize the positive social and environmental impact of their carbon offset investments.

The Future of Carbon Credits

The carbon credit market is still evolving, but the trend is clear; As businesses and governments become increasingly committed to achieving net-zero emissions, the role of carbon credits is likely to expand. Here are some key trends shaping the future of the carbon credit market:

· Stringent Verification Standards: The focus on environmental integrity will continue to intensify. Demand is growing for carbon credits verified by robust standards that ensure the permanence and measurability of the emission reductions generated.

· Technological Advancements: Technological innovation plays a crucial role in enhancing the transparency and efficiency of the carbon credit market.

· Integration with Carbon Capture, Utilization, and Storage (CCUS): As CCUS technologies mature, they are expected to generate new types of carbon credits representing the removal of CO2 from the atmosphere. These credits could become a valuable tool for companies seeking to achieve deep decarbonization.

Conclusion

Carbon credits are a powerful tool for businesses to address their environmental impact and contribute to a greener future. By understanding carbon credits, integrating them into a comprehensive ESG strategy, and carefully selecting high-quality projects, companies can leverage this market-based solution to become more sustainable and responsible actors in the global economy.

The future of the carbon credit market is bright, offering exciting opportunities for businesses to contribute to a more sustainable future while achieving their sustainability goals. Book a demo today!

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