Carbon Pricing And Carbon Credits – Definition, Examples And History

What is carbon pricing? What are carbon credits and how do they work? Are carbon credits a good method to fight pollution and climate change? Is the system of carbon credits already running? Are carbon credits only for businesses or can individuals participate tool? Let’s find out all about carbon credits.

What Is Carbon Pricing? Carbon Price Definition

To meet the objective of the Paris Agreement, we need to get to … scale. None of the critical investments will be possible unless we get the policies right. That means creating incentives for change— removing fossil fuels subsidies, introducing carbon pricing, increasing energy efficiency standards, and implementing auctions for lowest cost renewable energy.

As mentioned by Jim Yong Kim, the World Bank President back in 2017, carbon pricing is one of the policies that will play an important role in contributing to fulfilling the Paris Agreement. A carbon price gives an economic signal to polluting businesses to reduce and eventually discontinue their harmful activities emitting CO2 and other GHG. In this way, carbon pricing aims to stimulate the development of new, greener, more efficient, low-carbon technologies.

Check the video below for a visual understanding of the importance of carbon pricing:

Kyoto And The Origin Of Carbon Pricing – Where Did This Idea Come From?

It’s 1997 and we’re in Kyoto, Japan, in the United Nations Framework Convention on Climate Change (UNFCCC). Here, the world’s nations agreed carbon credits were a good way of reducing the emission of CO2 and other greenhouse gases. Later, in 2001 in Germany, 191 countries ratified the protocol, including Japan, Australia, Canada or France. The United States didn’t. Among other issues, the protocol mandated that 37 industrialized nations plus the UE cut down their emissions. For the first time, the idea of a cap-and-trade system and a carbon credits market were brought to the table.

Furthermore, according to the Kyoto Protocol Reference Manual, parties can add or deduct from their initial assigned amount, thus raising or lowering the level of their allowed emissions over the commitment period, by trading Kyoto unis with other parties. These additions and subtractions took under the Kyoto mechanisms of emissions trading, joint implementation or the clean development mechanism. These mechanisms allowed the parties flexibility to meet their commitments by allowing them to take advantage of lower-cost emission reductions outside their territories – the carbon offsets we’ll further discuss.

Later, in 2015 at the Paris Agreement, a new set of policies to be implemented from 2020 onwards started being discussed. One of the differences is that developing countries are also setting reduction targets, and not only developed nations. One of the goals is to extend the reach and deepen the integration of carbon markets. Because by linking various trading schemes to a global carbon market will likely stabilize prices and, as a consequence, create more options to reduce carbon emissions.

The 2 Main Ways Of Pricing Carbon

According to the World Bank, there are 2 main cornerstones of carbon pricing: emissions trading systems (ETS) and carbon taxes. The first, also known as a cap-and-trade system, caps the total levels of carbon and other GHG emissions. It works as a system where caps are increasingly reduced every year and where businesses with low emissions can sell the allowances they didn’t spend to others who spend more than they were allowed to. This creates the supply and demand of the carbon market.

On the other hand, carbon taxes set a direct price on carbon as they establish a tax rate on GHG emissions. Contrary to the cap and trade system, with carbon taxes, the emission reduction outcome is not pre-defined. Furthermore, there are also other indirect ways to price carbon such as taxing fossil fuels or removing fossil fuel subsidies. Trade policies where tariffs on solar or wind-generated electricity are reduced, or renewable portfolio standards where the electric grid has to be a mix with a minimum share of clean energy, are also alternative ways of pushing carbon emissions out. But let’s focus on carbon credits again.

What Are Carbon Credits? Definition Of Carbon Credits

A carbon credit represents the right to emit a measured amount of GHG. It is carbon credit is a recognized certification where the business or individual who owns it is counterbalancing the emission of greenhouse gases (GHG). In this way, the system of carbon credits works as a compensation method assuring balance between GHG emissions and the respective amounts of certified mitigations. The ultimate purpose of carbon credits is, therefore, to reduce the emission of GHG into the atmosphere.

In other words, carbon credits are exchanged in a carbon market, commonly referred to as the cap-and-trade market, where businesses can sell each other’s rights to pollute.

Carbon Credit Official Definition

According to the Corporate Credit Institute, a carbon credit is a tradable permit or certificate that provides the holder of the credit the right to emit one ton of carbon dioxide or an equivalent of another greenhouse gas. The main goal for the creation of carbon credits is the reduction of emissions of carbon dioxide and other greenhouse gases from industrial activities to reduce the effects of global warming.

The Merriam Webster also defines it as a tradable credit granted to a country, company, etc., for reducing emissions of carbon dioxide or other greenhouse gases by one metric ton below a specified quota

How Much Is A Carbon Credit Worth?

According to the Carbon Fund, a carbon credit is an instrument that represents ownership of one metric tonne of carbon dioxide equivalent (using co2 as a unit to measure different greenhouse gases)  that can be traded, sold or retired.

In this way, if a business is regulated by a cap-and-trade system, it will have the benefit of allocating, trading, selling or holding a carbon credit if it managed to keep its emissions below the top limit. On the opposite way, if a business has used more than what it has been allocated with, it will need to purchase a credit to be in compliance or to pay heavy fines instead. Therefore, a carbon credit turns into a tradable asset that allows measuring a reduction in polluting greenhouse gas emissions.

The Carbon Cap-And-Trade Market – How Does It Work?

carbon credit harmful

Carbon trades are regulated by governments or international organizations responsible for setting a limit/cap on the amount of GHG (in a CO2 unit) that can be released. Businesses are therefore alotted with a specific amount of carbon they can emit annually. If they exceed this limit, they need to purchase carbon credits or carbon offsets. If they don’t exceed the cap, they can sell the unused carbon credits or business that need them.

According to the World Economic Forum, the number of permits in the market is limited, since the total amount is an attempt to match the reduction target. At the start of a trading phase, emission licenses can either be bought at auction or allocated to businesses for free. As time goes by, the number of available licenses diminishes which contributes to putting pressure on the participating businesses to reduce their emissions and to invest in cleaner production alternatives. The goal is that in the long term the price of new and cleaner technologies decreases while innovation increases.

 What’s The Difference Between Carbon Credit And Carbon Offset?

As we’ve been discussing, carbon credits are assets obtained when a company doesn’t waste all its carbon credit. This extra amount of carbon emissions isn’t, however, achieved via projects specifically designed to cut down GHG emissions. Instead, they’re the consequence of a company’s efforts to reduce its emissions via actions like making operations more efficient and spending less energy, using wood from sustainably managed forests… At the same time, carbon credits are only traded in a private cap-and-trade market.

On the other hand, while a carbon offset embodies one tonne of greenhouse gases too, it is specifically and directly created with the purpose of reducing emissions. Examples of carbon offsetting initiatives are planting trees and reforestation, projects supporting methane reduction, building solar or wind energy farms… These initiatives and projects are validated by third-parties regarding their potential to avoid co2 emissions and once they’re certified, these offsets can be traded in an open stock market where individuals can also participate. In this way, if someone flies or drives very often, these people can offset their carbon footprint by buying carbon offset credits is a good way of negating these emissions.

In this way, carbon credits can be combined with offset credits as a way to pay for emission reductions elsewhere rather than investing in the country of operation. In this way, for instance, an American aluminum producer that already has the most efficient technology can choose to invest in a clean development project in Africa instead. This means the same funds will probably help avoid a larger amount of carbon to emerge in developing countries.

Carbon Pricing Worldwide

According to the World Bank, in 2018, 45 national and 25 subnational jurisdictions had put or were about to put a price on carbon, in what would reach 11 gigatons of CO2, the equivalent to ~20% percent of global GHG emissions. This is a significant increase compared to the 8 GtCO2 (15%) emissions covered in 2017. And what explains his increase? Well, the expected added coverage from China’s national cap-and-trade system.

As for the global price of carbon, it goes from US$1/tCO2 to a maximum of US$139/tCO2. And again, in 2018 they increased compared to 2017, especially due to the growth of the European Union Allowance (EUA) prices from €5/tCO2 to €13/tCO2, in line with the EU’s strategy for the 4th stage of its ETS program starting in 2020.

Which Countries Are Developing Carbon Credit Initiatives?

According to the International Carbon Action Partnership, China started its national emissions trading scheme (ETS) in 2017. The goal of this scheme is to gradually reduce carbon emissions in China while achieving green and low carbon developments. This program is expected to regulate around 1700 businesses from the power sector which have overall total emissions over 26,000 tonnes of greenhouse gases. The forecasts are that the Chinese system would cover more than 3 billion tonnes of CO2e in its initial phase, accounting for about 30% of national emissions.

The UE Emissions Trading System is referred to as EU ETS was first launched in 2005. According to the European Commission, this system is the foundation of the EU’s policy to fight climate change and it’s a cornerstone to reduce GHG emissions in a cost-effective way. It is present in 31 nations (all 28 EU countries plus Iceland, Liechtenstein, and Norway) and it limits emissions from more than 11,000 heavy energy-using installations (power stations & industrial plants) and airlines operating between these countries. Furthermore, it also covers ~45% of EU’s GHG emissions. The expectations are that in 2020 and 2030, emissions from sectors covered by the system will be 21% and 43% lower, respectively, compared to the emission levels of 2005.

According to the Center For Climate And Energy Solutions, a third of the United States GDP comes from 10 states that are being successful at reducing GHG emissions. These states are California and the nine Northeast states from Connecticut to Vermont. Together, they make up the Regional Greenhouse Gas Initiative, which was the first mandatory cap-and-trade program in the US. Its goal is clear: to limit carbon dioxide emissions from the power sector. Jersey and Virginia are also expected to join the program, while Washington is expecting the Clean Air Rule program to be approved on the courts. This latter program, aiming to reduce GHG by 2,5% year until it reaches 1.8MtCI2 in 2050 has already been approved back in 2018. However, the Department of Ecology didn’t have the power to cover suppliers of natural gas and petroleum products under its ETS as they’re not direct emitters of GHGs. So today the program is on hold, waiting for a legal court resolution.

Criticisms To The Cap-And-Trade Carbon Credit System

Depending on the actors, the opinion about the value added by carbon credits is variable. Some environmental activists argue schemes based on cap and trade are a way to extend the lifecycle of powerplants. They assume that instead of acting with urgency, these facilities will operate and delay action taking for as long as they can until it is no longer economically feasible.

Economists, on the other hand, see carbon credits and cap-and-trade programs as a cost-effective tool to reduce GHG. However, many argue the problem lies in governments, responsible for creating the carbon markets, who haven’t been imposing costs to industries in a way that makes businesses consider the transition more seriously. In other words, this means the caps on carbon have overall been weak, which keeps the price of carbon low and doesn’t generate a market response where it would be financially more attractive to, for instance, bet in clean, renewable energies. According to the WEF, in most places, in 2017, the price of carbon was under $10 a tonne.

There are also other criticisms based on the challenge of truly guaranteeing carbon offset projects are fulfilling their promises of absorbing or avoiding emissions. They take place far away in developing countries in Africa or Asia, and the offsets they bring along aren’t always crystal clear and can be based on too optimist projections. It’s up to the transparency of third-party entities responsible for the certifications and to follow them closely. Furthermore, contestation also cames from the free allocations of carbon permits which may lead of oversupply in the market – something that more strict caps in line with the climate targets may help solve, as well as auctioning all available permits.

However, defining caps is no easy task. If governments impose too high caps they may lead to higher emissions, while a cap that is too low would be a huge weight on industries and consumers would likely have a price to pay too. Nonetheless, prices need to come up. The Carbon Pricing Leadership Coalition also states, in their report, that if the Paris temperature target is to be achieved, the carbon prices need to be around US$40–80/tCO2 by 2020 and US$50–100/tCO2 by 2030.

The Benefits Of Carbon Pricing

A well-designed carbon price is an indispensable part of a strategy for reducing emissions in an effective and cost-efficient way. Carbon prices incentivize low-cost abatement options and can equalize marginal abatement costs3 across the sources and sectors to which the carbon price applies. They do so by creating incentives for markets to use all levers available to reduce emissions: the type of activity pursued, the structure and energy intensity of a particular industry or of the economy as a whole, and the type of fuel chosen.

The quote above, from the Carbon Pricing Leadership Coalition, shows the importance carbon pricing might play in the fight for climate change and balancing GHG emissions. Pricing these emissions encourages producers to decrease the carbon intensity of the energy sector and other manufactured products. At the same time, these reductions bring along opportunities to increase profit (e.g. entering new markets) or save money (e.g. improving efficiency) and to foster innovation as well.