What is Carbon Credit?

A carbon credit is a permit that allows the company that holds it to emit a certain amount of carbon dioxide or other greenhouse gases. One credit permits the emission of a mass equal to one ton of carbon dioxide.

The carbon credit is one half of a so-called “cap-and-trade” program. Companies that pollute are awarded credits that allow them to continue to pollute up to a certain limit. That limit is reduced periodically. Meanwhile, the company may sell any unneeded credits to another company that needs them.

Private companies are thus doubly incentivized to reduce greenhouse emissions. First, they will be fined if they exceed the cap. Second, they can make money by saving and reselling some of their emissions allowances.

The ultimate goal of carbon credits is to reduce the emission of greenhouse gases into the atmosphere. As noted, a carbon credit is equal to one ton of carbon dioxide. According to the Environmental Defense Fund, that is the equivalent of a 2,400-mile drive in terms of carbon dioxide emissions. Companies or nations are allotted a certain number of credits and may trade them to help balance total worldwide emissions. “Since carbon dioxide is the principal greenhouse gas,” the United Nations notes, “people speak simply of trading in carbon.”

Cap-and-trade programs remain controversial in the US However, 11 states have adopted such market-based approaches to the reduction of greenhouse gases, according to the Center for Climate and Energy Solutions. Of these, 10 are Northeast states that banded together to jointly attack the problem through a program known as the Regional Greenhouse Gas Initiative (RGGI).

The United Nations’ Intergovernmental Panel on Climate Change (IPCC) developed a carbon credit proposal to reduce worldwide carbon emissions in a 1997 agreement known as the Kyoto Protocol. The agreement set binding emission reduction targets for the countries that signed it. Another agreement, known as the Marrakesh Accords, spelled out the rules for how the system would work. The Kyoto Protocol divided countries into industrialized and developing economies. Industrialized countries, collectively called Annex 1, operated in their own emissions trading market. If a country emitted less than its target amount of hydrocarbons, it could sell its surplus credits to countries that did not achieve its Kyoto level goals, through an Emission Reduction Purchase Agreement (ERPA). 

The separate Clean Development Mechanism for developing countries issued carbon credits called a Certified Emission Reduction (CER). A developing nation could receive these credits for supporting sustainable development initiatives. The trading of CERs took place in a separate market.

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