Carbon Credit

Carbon credits are a way of assigning value to emissions reduction that is central to the economics of carbon trading. Under the Kyoto Protocol , carbon credits may be emissions allowances originally allocated or auctioned as part of a national cap-and-trade program or an emissions offset. In a cap-and-trade scheme, policymakers set a cap on total emissions and the market sets a price for emissions through trading. Carbon credits are permits that represent emissions reductions. These credits are awarded to countries or firms that emit at or have reduced their GHG emissions to a level below the quota or cap assigned to them by an emissions regulatory regime. Emitters above the cap purchase carbon credits in the carbon market. Credits are bought and sold in international markets and can be exchanged between businesses. The marketplace establishes the monetary value of greenhouse gas emissions.

It is also possible for individuals and companies who would like to reduce their carbon footprint to purchase carbon credits in voluntary markets .  Sellers in the voluntary market aggregate carbon credits from individual carbon projects .  These units tend to face a less rigorous validation process than carbon credits sold through the Clean Development Mechanism and therefore have less value because of their lower quality.

Credits under Kyoto

The Kyoto Protocol established caps on the maximum quantity of greenhouse gas emissions permitted for Annex I developed and developing countries. These countries set internal quotas on emissions and oversee this responsibility through their own national 'registries', which are required to be validated and monitored for compliance by the UNFCCC. Each operator of a polluting installation is allocated an allowance of carbon credits.  Generally, each unit gives the owner the right to emit one metric ton of CO2e. Operators that have not met their quotas can sell their unused allowances as carbon credits, while businesses that are about to exceed their quotas can buy the extra allowances as credits, privately or on the open market.  Businesses alter their decision-making to find the most cost-effective way of operating under these regulations, either by investing in cleaner business practices or by purchasing carbon credits from another operator with excess capacity.

The European Union Emission Trading Scheme and its member states follow the Kyoto template.  The "Linking Directive" permits the use of Kyoto flexible mechanisms within the EU ETS.  Similar schemes are under consideration in the United States, which has not ratified Kyoto, and in Australia, whose ratification came into force in March 2008.

The Kyoto Protocol includes three flexible mechanisms which offer countries or operators in developed countries means of acquiring carbon credits.

• Under Joint Implementation (JI), a developed country with relatively high costs of domestic emission reduction can fund carbon projects in another developed country.

• Under the Clean Development Mechanism (CDM), a developed country can sponsor a greenhouse gas reduction project in a developing country where the cost of greenhouse gas reduction project activities is usually much lower, but the atmospheric effect is globally equivalent. The developed country is given carbon credits towards meeting its emission reduction targets, while the developing country receives the benefits of sustainable development and investment.

• Under International Emissions Trading (IET), countries can trade in the international carbon credit market to cover their shortfall in allowances. Countries with surplus carbon credits can sell them to countries with capped emission commitments.

These carbon projects can be created by a national government or by an operator within the country. In practice, most transactions of this type are not performed by national governments directly, but by operators who have been given set quotas by their country.

Emission markets

For trading purposes, one carbon credit or CER is considered equivalent to one metric tonne of CO₂ emissions. These allowances can be sold privately or in the international market at the prevailing market price. These trade and settle internationally and hence allow carbon credits to be transferred between countries. Each international transfer is validated by the UNFCCC. Each transfer of ownership within the European Union is additionally validated by the European Commission.

Climate exchanges have been established to provide a spot market in allowances, as well as futures and options market to help discover a market price and maintain liquidity. Carbon credit prices are normally quoted in Euros per tonne of carbon dioxide or its equivalent (CO₂e). Other greenhouse gases can also be traded, but are quoted as standard multiples of carbon dioxide with respect to their global warming potential (GWP ). These features reduce the quota's financial impact on business, while ensuring that the quotas are met at a national and international level.

Currently there are at least six exchanges trading in carbon credits: the Chicago Climate Exchange , European Climate Exchange , Nord Pool, PowerNext, Multi Commodity Exchange and National Commodity and Derivatives Exchange. Recently, NordPool listed a contract to trade offsets generated by CDM carbon projects called Certified Emission Reductions (CERs). Many companies now engage in emissions abatement, offsetting, and sequestration programs to generate carbon credits that can be sold on one of the exchanges.

Unchecked, energy use and hence emission levels are predicted to keep rising over time. Thus the number of companies needing to buy carbon credits will increase, and the rules of supply and demand will push up the market price, encouraging more groups to undertake environmentally friendly activities that create carbon credits to sell.

An individual allowance, such as a Kyoto Assigned Amount Unit (AAU) or its near-equivalent European Union Allowance (EUA), may have a different market value to an offset such as a CER. This is due to the lack of a developed secondary market for CERs, a lack of homogeneity between projects which causes difficulty in pricing, as well as questions due to the principle of supplementarity and its lifetime. Additionally, offsets generated by a carbon project under the Clean Development Mechanism are potentially limited in value because operators in the EU ETS are restricted as to what percentage of their allowance can be met through these flexible mechanisms.