A carbon credit is a tradable unit representing one metric ton of carbon dioxide (CO2), or an equivalent amount of another greenhouse gas (GHG), avoided or removed from Earth's atmosphere.
It is not necessarily a carbon offset. A carbon credit only becomes a carbon offset when used for carbon offsetting, in other words, compensating for one’s GHG emissions. But carbon credits have uses other than carbon offsetting.
Let’s unpack what a carbon credit is and how it works.
What is the purpose of carbon credits?
GHGs are gasses that trap heat in the atmosphere, causing climate change. CO2 is the most common GHG emitted due to human activity, such as deforestation and burning fossil fuels, but it is not the only one. To avert the climate crisis, we must quickly and significantly reduce GHG emissions.
Throughout this article, we will refer to CO2 as this is the GHG usually most relevant to carbon credits. A small number of carbon crediting projects focus on other GHGs, and are then calculated in terms of CO2-equivalent (CO2e) metric tons.
The pricing of carbon credits creates two main financial rewards for reducing emissions.
- Projects that reduce emissions, such as protecting or planting forests, or switching to cleaner forms of energy, need funding. This funding can be provided by the sale of carbon credits. As credit prices rise, project activities that reduce emissions become more economically viable. However, it must be proven that the emissions reductions created by the carbon crediting project would not have taken place without the revenue from selling credits. If it would have happened anyway, then it is not considered additional and the crediting project would not be approved.
- As carbon credit prices increase, it will be more expensive for a person or business to purchase enough credits to compensate for their emissions. Therefore, the person or business will be more incentivized to reduce their own emissions, because this will be the more affordable choice.
The advantage of carbon credits being a tradeable unit is that this allows carbon project activities that are most effective at reducing emissions, anywhere in the world, to be financially rewarded.
How do carbon credits work?
Carbon credits are sold in carbon markets. These are divided into compliance (mandatory and regulated) markets and voluntary carbon markets (VCMs). The term “credit” is usually used in reference to VCMs, so that’s what we’ll focus on here.
A carbon credit is created through a carbon project, that is set up, implemented and run by a carbon project owner. This carbon project owner will conduct an activity that avoids CO2 emissions, or removes CO2 from the atmosphere. An example of an avoidance project is replacing a fossil fuel power plant with renewables. An example of a removals project is replanting a forest that will absorb CO2 as it grows.
Many carbon projects also contribute to other social and environmental objectives, providing income to local communities or protecting biodiversity. These are referred to as co-benefits.
To issue carbon credits, a carbon project owner must submit their project to a third party for verification. They work with consultants known as carbon project developers, who write the project’s documentation allowing it to become verified to issue carbon credits, but have no presence on the ground. The largest of these is Verra and the second largest is Gold Standard. These organizations then permit the project developer to issue a certain number of credits based on an analysis of how much CO2 the project is estimated to have avoided or removed.
How does carbon trading and pricing work?
Owners of voluntary carbon credits can decide what they would like to do with them. They might retire these credits, meaning they can never be sold on. The buyer then has a sole claim to the CO2 avoided or removed, so they can claim to have offset, or compensated, the CO2 they have emitted.
Alternatively, owners might trade the carbon credits through a carbon exchange platform. When a buyer purchases a carbon credit directly from a carbon project developer they are engaging in the primary market. When a buyer purchases a carbon credit from a carbon credit exchange platform, such as Xpansiv CBL or Climate Impact X, they are engaging in the secondary market.
Credits from different types of projects vary in price. For example, credits from nature-based solution (NBS) projects, such as forest conservation, usually have a higher price than other credits, such as renewables credits. This is often because buyers value the co-benefits of nature conservation and restoration. Besides the credit type, another variable that often affects price is the credit’s vintage, meaning the year that it was issued. Newer vintages generally command higher prices.
Credits also vary in their environmental performance, or quality — meaning the true amount of CO2 they represent. Sometimes this variation in quality is reflected in price variation, but often it is not, because the market does not currently have full information on each credit. This need for transparency has prompted the emergence of a new type of data provider: carbon intelligence and ratings platforms like Sylvera. There are many factors that affect the quality of carbon credits, and how they might be valued by the market in future. Read more about how Sylvera rates carbon credits here.
Carbon prices are also influenced by a range of economic factors such as demand or the level of speculative trade. Recently carbon credit prices have been increasing. To learn more, download our Carbon Credit Crunch Report here.