Carbon credits explained

In the race toward a low-carbon economy, carbon credits have become a key tool for companies to manage their greenhouse gas (GHG) emissions and meet corporate sustainability and net-zero commitments. For those in high-carbon industries like manufacturing and commodity trading, understanding how carbon credits and carbon allowances work within carbon markets is critical for regulatory compliance.

While the terminology in this sector has not always been consistent, in this article we will use the most widely understood definitions for carbon credits, carbon allowances, and carbon offsets.

What are carbon credits?

At their core, carbon credits represent ownership of one metric ton of CO₂ or its equivalent in other greenhouse gasses (CO₂e). These credits are generated by projects that have avoided or removed GHG emissions from the atmosphere.

Carbon credits can be held, sold, or retired, whether to meet a voluntary emissions reduction target or to meet a mandatory emissions cap. For those industries subject to mandatory emissions trading systems, carbon credits function as a permit that allows a company to emit a specific amount of carbon dioxide or other greenhouse gas. Carbon credits are typically issued through two main avenues: 

• Compliance carbon markets, where companies must adhere to legal emission limits
• Voluntary carbon markets, where companies purchase credits to offset their carbon footprint, even if they aren't subject to strict emissions regulations

Carbon credits originated and are primarily used in the voluntary carbon market. However, the term is sometimes used interchangeably with carbon allowances, which are permits granted within compliance markets.

Similar to carbon credits, a carbon allowance typically represents one metric ton of CO₂e. These allowances are part of a cap-and-trade system, where a regulatory body sets a cap on total emissions for participating entities. Companies must hold enough allowances to cover their emissions; if they exceed their limits, they must purchase additional allowances, or credits, from others in the market.

The purpose of carbon credits is to put a price on carbon emissions and incentivize companies to reduce polluting impact on the environment. By creating a monetary value for carbon emissions, businesses are encouraged to innovate, invest in cleaner technologies, and adopt sustainable practices.

How do carbon credits work?

Carbon credits are part of a broader system designed to reduce global greenhouse gas emissions. Here's a breakdown of how they work in practice:

1. Emission caps: In a compliance market, governments set an overall cap on the amount of greenhouse gasses that can be emitted by businesses within their jurisdiction. This is known as a cap-and-trade system. Companies are allocated a certain number of credits (or allowances), each representing one ton of CO₂e that they are allowed to emit.
2. Trading credits: If a company emits fewer greenhouse gasses than the amount they’ve been allocated, they can sell their surplus credits to other companies that have exceeded their limits. This creates a financial incentive for businesses to reduce their emissions, as selling unused credits can generate revenue. Conversely, companies that struggle to meet emission limits must purchase credits to cover their excess emissions.
3. Voluntary markets: In voluntary carbon markets, companies that wish to offset their emissions to meet their sustainability goals or public commitments can purchase carbon credits from projects that reduce or remove CO₂e. In this market, there is no regulatory requirement to buy credits.
4. Retiring credits: Once a carbon credit’s benefit has taken place, it is retired, meaning it can no longer be traded or sold. This ensures that the emission reduction it represents has been accounted for and cannot be used by multiple companies to claim the same offset.
   
   There are two different timelines for carbon credit retirement, depending on the type of carbon credit purchased:
   
   1. For ex-post credits (for which a carbon reduction has already occurred), retirement takes place immediately after purchase.
   2. For ex-ante credits (credits for future emission reductions) and pre-purchase credits (which represent a commitment to buy credits not yet issued), retirement doesn’t happen until the carbon benefit takes place.

Whether carbon credits are purchased voluntarily or as a means of compliance, the overall goal is the same: to create a market-based mechanism for emissions reduction.

How much do carbon credits cost?

The price of carbon credits varies widely depending on several factors, including the type of market, geographic region, and the type of project generating the credit. Here’s a breakdown of key factors that influence carbon credit pricing.

Compliance markets vs. voluntary markets:
In compliance markets like the EU Emissions Trading System (EU ETS) or in the United States, California’s Cap-and-Trade Program, carbon credit prices are typically higher because these markets are regulated and companies are required by law to purchase credits if they exceed their emission caps. In contrast, voluntary markets often see more variability in pricing since companies buy credits at their own discretion to meet sustainability or corporate responsibility goals.

Geographic region:
Prices can fluctuate significantly by region. For instance, in 2024, carbon prices in California averaged around $42 per ton, while prices in Europe are forecasted to average €71 per ton ($76 per ton). This disparity is often due to different regulatory frameworks and demand levels in various regions.

Type and quality of the project:
Credits generated by high-impact projects, such as carbon removal initiatives (e.g., direct air capture or reforestation), typically command higher prices due to their greater environmental benefits. Similarly, projects certified by trusted organizations like Verra’s Verified Carbon Standard (VCS) or Gold Standard may fetch higher prices because of the credibility and transparency associated with these certifications.

Market conditions and demand:
Like any commodity, the price of carbon credits can be influenced by supply and demand dynamics. As more businesses commit to net-zero goals or face regulatory pressure, demand for carbon credits increases, driving up prices. Additionally, changes in government policies, such as stricter emission reduction targets, can also cause prices to rise.

Over time, as regulatory frameworks tighten and global decarbonization efforts accelerate, carbon credit prices are expected to increase. Companies that reduce their emissions early may avoid higher costs in the future.

What is a carbon market?

A carbon market is a system in which carbon allowances and/or carbon credits are traded, allowing participants to buy and sell instruments related to GHG emissions. 

In compliance markets, participants trade allowances and credits which represent the right to emit greenhouse gasses. In voluntary markets, participants trade carbon credits which represent verified reductions or removals of GHG emissions.

The primary objectives of carbon markets are to:

• Generate funding for climate solutions, including carbon removal projects
• Create a financial incentive for businesses to reduce their emissions

Compliance carbon markets

Compliance carbon markets, also known as regulated markets, are mandatory and governed by regional or national laws. Companies within these markets must adhere to a cap-and-trade system, where a regulatory body sets a cap on the total emissions allowed. 

Businesses are allocated a set number of carbon allowances. If they exceed their emissions limits, they may purchase additional allowances or credits from other companies that have reduced their emissions below their allocated amount, or face fines.

Voluntary carbon markets

Voluntary carbon markets operate outside of regulatory requirements. Companies and individuals participate in these markets to offset their emissions as part of sustainability goals or corporate social responsibility initiatives. While participation is optional, many businesses opt in to meet growing expectations for environmental responsibility.

Carbon credits versus offsets — what’s the difference?

The terms "carbon credits" and "carbon offsets" are often used interchangeably. In practice, each term might refer to different concepts within carbon markets. Let’s break down their differences:

Carbon credits

A carbon credit is an electronic certificate that acts as a tradable unit representing one metric ton of CO₂e reduced or removed from the atmosphere. Carbon credits are generated through initiatives such as reforestation, direct air capture, or renewable energy projects that sequester carbon. They originate in the voluntary carbon market, but can be used in compliance markets too. 

“Carbon credit” is sometimes used interchangeably with “carbon allowance,” which is a permit granted within compliance carbon markets that allows a company to emit a certain amount of greenhouse gasses, typically one metric ton of CO₂e.

Carbon offsets

A carbon offset, on the other hand, is the actual reduction or removal that takes place to generate a carbon credit. When a company purchases a carbon credit, they are funding a carbon offset to balance out their own emissions that cannot be eliminated directly. Each offset is equivalent to one ton of CO₂e reduced or removed from the atmosphere.

“Carbon offset” is sometimes used interchangeably with “carbon credit,” though it should be noted that carbon offsets are relevant primarily to voluntary markets, while carbon credits are used in both compliance and voluntary markets.

Take control of your carbon footprint with CarbonChain

Carbon credits are just one piece of the decarbonization puzzle. Companies must take steps to measure, report, and set targets to reduce their emissions. It’s wise to act now and avoid paying a higher cost for your emissions in the future.

CarbonChain is purpose-built to help manufacturers, commodity traders and their banks access the data they need to take control of their carbon footprint and meet demand for low-carbon or carbon-transparent products.