Last Updated on October 1, 2023
Carbon credit trading is a mechanism, part of the measures to accelerate climate change action and promote cleaner practices.
After scientists made it clear that humans are the main reason for climate change, companies started facing questions about the sustainability of their operations.
The case is similar on a national level. Since many governments worldwide didn’t want to embark on the journey to emission reduction, they started looking for ways to offset their emissions while continuing to do business as usual.
A popular tool for this is the free distribution and trade of emission quotas.
This article will delve into the evolution of carbon credit and how nations and corporations have collaborated to embrace cleaner practices for a more sustainable planet.
The History of Carbon Credits
Carbon credit trading was first championed in the 1960s by Ronald Coase – an economist who won the Nobel Prize in 1991.
His most famous contribution is the Coase theorem, which focused on trading externalities. Externalities are benefits or costs to one economic party that aren’t suffered or enjoyed by the same party. As a result, those benefits or costs are enjoyed or suffered by a third party that usually hadn’t agreed to the arrangement.
For example, the byproduct of a factory’s operation is air pollution. However, the ones paying for the effects of this pollution usually are municipalities and residents near it, which have to cover healthcare costs.
In fact, pollution is among the externalities people tend to see most often.
This idea is the backbone of the Kyoto Protocol and, more recently, the Paris Agreement of 2015.
Carbon credit trading aims to cap how much companies can pollute by giving them credits (quotas). The companies that don’t reach that limit can also choose to trade their available credits.
The objective of the market is to prevent over-pollution while also fostering efficient carbon pricing.
The system aims to incentivize industries and companies to reduce their emissions and promote a more sustainable strategy to manage their environmental impact.
How Do Carbon Credits Work?
Carbon credits are distributed to various countries by the United Nations Carbon Offset Platform based on estimates of the likely emissions for each respective country.
Once the quotas are set, each country can further distribute them domestically.
Companies receive a certain amount of credits (emission cap). If they pollute less than the allowed limit, they will have credits left. They are then allowed to sell unneeded credits to another company that needs them.
This idea grants companies a double incentive to reduce emissions. First, over-polluters have to spend money on extra credits. Next, companies that slash their emissions can make money by selling their excess credits.
Proponents of the carbon credit system say that it leads to measurable, verifiable emission reductions from certified climate action projects and that these projects reduce, remove, or avoid greenhouse gas (GHG) emissions.
In a nutshell, the idea intends to punish companies that produce high pollution by increasing their operating costs and putting them at a competitive disadvantage while also bringing financial gains to eco-friendly companies.
Each carbon credit represents a metric tonne of CO2 or equivalent gas emissions.
The price of carbon credits is continuously increasing, so it can make pollution more expensive. For example, the carbon pricing per the European Union Emission Allowance (EUA) ranged from approximately EUR 3 to 7 right after the launch, while it is now topping EUR 100.
Europe is pioneering carbon credit trading, having the most developed framework.
Where Can You Cap and Trade Carbon Credits?
Carbon credits come in different forms based on the climate agreement they are aligned with, the issuer, the project type, and more.
Initially, these quotas were traded Over The Counter (OTC) outside the regulated markets. However, today, they were already available on various quasi-exchanges.
The Intercontinental Exchange (ICE) also released its own official carbon credit futures contract.
You can trade carbon credits in numerous cap-and-trade systems implemented at the regional, national, or international levels. Some of them include:
Regional/National Emissions Trading Schemes
Several countries and regions have established their own system to regulate emissions in their territories, such as the EU Allowances (EUA) for the European Union Emissions Trading Scheme.
International Agreements and Protocols
Some global initiatives, such as the Certified Emissions Reduction (CER) credits for the Kyoto Protocol and the Paris Agreement, have facilitated the trading of international carbon credits between participating nations.
Voluntary Carbon Markets
Aside from regulated schemes, voluntary carbon markets, and P2P exchanges allow individuals and organizations to offset their emissions by purchasing carbon credits.
Carbon Offset Projects
Organizations can take part in different sustainable projects that can help offset emissions, including planting trees, funding clean energy projects, and more.
Practical Issues with Emissions Trading
Although it seems plausible in theory, in practice, these quota estimates end up being overly generous. This allows most companies to meet their emission targets with relative ease.
As countries started publicly coming out with the numbers on how much they had saved and how many credits they had left, it became evident that the market was skewed and that there would be a massive seller surplus.
As a result, the market had practically no liquidity.
The lack of buyers also made the quota price unstable, completely undermining the tradeable asset.
Another major flaw comes from the fact that when emissions trading is cheap, companies are willing to spend a little extra to keep up or even increase their emissions.
You may also like: Environmentally Friendly Trading
The Future of Carbon Credits
In theory, carbon credits can play a crucial role in achieving the global emission reduction target.
According to a report by Morgan Stanley, the voluntary carbon credit market is booming, with 3,800 projects listed, pre-registered, or registered and awaiting credit issuance. It is anticipated to grow from about $2 billion in 2022 to about $100 billion in 2030 and about $250 billion by 2050.
As of 2023, the price of EUA traded on the European Union’s Emissions Trading Scheme (ETS) soared to 100.34 euros.
As the price continues to rise, it shows the need for businesses and industries to transition towards more sustainable environmental practices to reduce their carbon emissions.
To Conclude
The evolution of carbon credit trading, from its inception in the Kyoto Protocol to its progress under the Paris Agreement, marks an important step in combatting climate change.
While the various flaws in the current design and implementation of carbon credit trading have attracted significant criticism over the years, they can be adequately addressed with the right measures. Once that happens, the mechanism can play a major role in the goal of slashing emissions.
