Overview
Carbon credits are market-based instruments that allow companies, governments, and other organizations to address their greenhouse gas emissions by funding projects that reduce or remove CO2 from the atmosphere.
Carbon dioxide is one of the most common greenhouse gases contributing to global warming. Therefore, the CO2 equivalent has become the standard unit for describing different GHGs.
- Each carbon credit represents a reduction of one metric ton of carbon dioxide in the atmosphere.
The global carbon credit market is divided into two sub-markets based on the governing mechanism:
Compliance carbon markets are established by governments as a means of achieving their carbon reduction targets. They operate on a mandatory basis, meaning that certain organizations are required by law to participate and to meet certain carbon reduction targets. One example is the European Union’s Emissions Trading System (EU ETS).
Voluntary carbon markets (VCM) allow businesses and individuals to offset their carbon emissions on a voluntary basis, either to meet their own sustainability goals or to demonstrate their commitment to reducing their carbon footprint. The traded commodity represents the emissions reduced or eliminated by undertaking decarbonization projects.
While compliance markets are limited to specific regions, voluntary carbon credits are significantly more fluid, unrestrained by boundaries set by nation states. They can be accessed by every sector of the economy, and also make the pool of buyers more accessible to landowners and forestry companies – those whose operations can generate carbon offsets for sale.
The VCM is now smaller than the compliance market, but expected to increase by a factor of 15 by 2030, with the market value reaching upward of $50b.
The VCM offers a wide variety of projects to investors:
- technology-based, such as renewable energy projects, improving energy efficiency, methane collection;
- nature-based projects, such as land use and reforestation.
How forest carbon offsets work
A factory emits CO2, which rises into the atmosphere and helps seal it as if the planet were a greenhouse.
It thus contributes to global warming and changing the planet’s climate.
A forestry management company, with the help of local communities, takes care of the forest so the trees grow healthy.
Trees absorb CO2 over their entire lifetime and store it as carbon.
Regulatory incentives continue to stimulate carbon sequestration. A factory owner, in order to compensate the planet for the amount of CO2 emitted, buys a “carbon credit”.
An independent firm verifies the project and calculates how much CO2 is being sequestered. For every ton of carbon that will now remain in the forest, it issues a “carbon credit”.
After deducting commission for the verifying firm and managing partners, the plantation operator and the community receive most of the money from the credit’s sale to continue caring for the forest.
Thus, an efficient market system ensures that the atmosphere receives less carbon, that the factory pays for its pollution and that the communities have resources to live with dignity by taking care of the forest.
Carbon credits certification
As the size of the overall carbon market increases globally, there is a risk of organizations using it unethically, an action popularly known as “greenwashing.” Greenwashing occurs when a company markets its products and services as more sustainable or greener than they actually are.
To avoid this, carbon credit certification companies play a major role in ensuring that the carbon credit details are not misrepresented, particularly in the largely unstructured voluntary market. Governance is largely overseen by three independent agencies and one industry body:
• Verra: It offers the Verified Carbon Standard, the Sustainable Development Verified Impact Standard and the Climate, Community and Biodiversity Standard. It is one of the most widely used voluntary carbon credit certification programs.
• Gold Standard: It is an independent body with a framework to issue and retire high quality carbon credits. They have over 2,300 projects in 98 countries and have reduced 191 megatons of GHG emissions.
• American Carbon Registry (ACR): It is a carbon offset program and registry with its own standard for market participants. Founded in 1996, ACR was the first private GHG registry but has a more limited geographical scope than other agencies.
• ICROA (International Carbon Reduction and Offset Alliance): It is an industry body designed to uphold responsible corporate climate action through the integrity in the use of carbon credits and ensuring the quality of carbon credit supply.
Assessing a carbon credit’s quality
Carbon credits can be generated from a range of activities or projects and, thus, can have different attributes that determine their price. Six major parameters that can be used to assess eligibility and, subsequently, the quality of carbon credit are:
- Additionality
The project should not be legally required, or financially attractive in the absence of credit revenues. - Permanence
The impact of the GHG emission reduction should not be at risk of reversal and should result in a permanent drop in emissions. For example, if the trees comprising a forestry project are cut down or destroyed by fire, some or all of the carbon they removed from the atmosphere may get (re)emitted or “reversed.” - No overestimation
CO2 emissions reduction should match the number of offset credits issued for the project and should take account for any unintended GHG emissions caused by the project. - Exclusive claim
Each metric ton of CO2 can only be claimed once and must include proof of the credit retirement upon project maturation. A credit becomes an offset at retirement. - Monitoring, reporting and verification
Project performance must be monitored and verified by third parties. Performance measurement and data collection procedures must be scientifically sound, methodologically robust and rigorously verify performance data. - Avoiding social and environmental harms
Despite all the above conditions being met, a project can contribute to social and environmental damage, making the carbon credits generated unethical. Determining the impacts of a project depends on specific conditions like project type and jurisdiction and requires additional reviews and safeguards to avoid negative impacts.
Prominent certifying agencies like Verra and Gold Standard have their own standards for assessing carbon credits and engage qualified independent third parties to perform validation and verification of carbon credits based on these standards.
Investment Opportunities
The voluntary carbon market is expected to experience rapid growth due to several trends, including the increase in the number of VCM platforms, the growth of carbon as a new investment asset class, the need for high-quality offsets, and Article 6 of the Paris Agreement redefining global carbon markets, among others.
According to the report by United Nations Environment Programme, the price currently paid for forest carbon removal is not in line with the goal of the Paris Agreement to keep global temperature increase below 1.5°C. The report suggests that meeting this goal would require increasing the price of forest carbon to at least $40-50 /tCO2 by 2030 with a corresponding increase in volume.
FORECASTS
Estimates for demand in voluntary carbon credits are expected to grow by 40 to 100 times the current levels by 2050: Trove Research.
The demand for high-quality credits will naturally affect their price, rising from an average of $25/ton in 2022 to $80–$150/ton in 2035 and $150–$200/ton by 2050: Ernst & Young.
Voluntary markets are expected to increase by a factor of 15 by 2030, with the market value reaching upward of $50b by 2030: McKinsey.
The voluntary carbon offset market, which was worth about $2 billion in 2021, will grow to $10-40 billion in value by 2030, transacting 0.5-1.5 billion tonnes of CO2 equivalent: Shell and BCG.