What are carbon credits and why do we need them to combat climate change?

What are carbon credits and why do we need them to combat climate change?

A guide to emission trading and carbon prices

Sabrina Haumann

Aug 26, 2021

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15

min read

How much does the Earth cost?

Seriously - if we would need to attach a monetary value to the Earth, its land and its use of resources, how would you actually price this? Can you think of any way to price the only known planet capable of sustaining and supporting life?

The astrophysicist Greg Laughlin actually created a formula for this and estimated our planetary home to be worth a bank-breaking 5 quadrillion dollars (that’s a number with 15 (!) zeros). This hefty price tag is quite reasonable considering that our Earth is still the nicest on the block - despite being a little crowded and a tiny bit too hot.

Those of us working in economics or financial markets have long accepted that basically everything comes with a price (and so do the planets of our solar system). Yet, when it comes to climate change and greenhouse gas emissions, we feel like not enough people know and are discussing ways to charge industries, companies or consumers for the use of our most precious resource - our home.

Carbon emissions mark a prime example for a so-called “negative externality”: a cost incurred by a third party who did not agree to it. In simpler terms, firms that emit greenhouse gases (GHGs) place a burden on the environment which is borne by everyone in the form of a changing climate, yet they don’t incur a cost for doing so.

Carbon pricing is an attempt to put a price on the emission of carbon into the atmosphere and to balance supply and demand by introducing a cost for this important externality.

Carbon credits - a tradable certificate representing the right to emit one tonne of carbon or the equivalent of different GHGs (known as CO2e). But how are carbon credits priced and how exactly does this whole thing work?

Read on to find out...

The Speed Read:

1. By putting a price on carbon emissions, society can hold big emitters responsible for the GHGs they add to the atmosphere. Carbon price varies per country: for example, at the time of writing this article, the carbon price in the EU is €56.2.

2. A carbon credit is essentially an allowance or permit, received from the government or an authority body, to emit a certain amount of CO2 for a specific price. One carbon credit = one tonne of CO2. The government may choose to give the permits away for free or to auction them.

3. If a company doesn’t need all its credits, it can sell any unneeded creditsto another company that needs them. This is known as the economics of cap and trade (CAT) or an emissions trading scheme (ETS).

4. In short, think of it all as a market of its own: a market where you can trade, buy, get allowances and permissions; a market with its own tax principle; a market that can rise and fall. For many businesses out there, carbon means business too.

What are carbon credits?  

A key aspect of carbon pricing is the “polluter pays” principle. By putting a price on carbon emissions, society can hold emitters responsible for the serious costs of adding GHG emissions to the atmosphere. These costs are not directly monetary but rather include polluted air, warming temperatures, and various attendant ills (i.e. threats to public health and to food and water supplies, as well as increased risk of certain dangerous weather events).

In general, there are two main methods of carbon pricing: trading carbon credits in the form of an emission trading system or controlling them with a carbon tax.

Let’s look at them one by one.

Emission trading is a market-based approach to control pollution by providing economic incentives to reduce emissions. Here, a central authority or governmental body sets a cap on the maximum level of emissions and creates carbon credits (or: allowances) for each unit of emissions allowed under the cap. One credit permits the emission of GHGs equal to one tonne of carbon dioxide. This concept is widely known as a cap and trade (CAT) or an emissions trading scheme (ETS). Emitting firms must obtain and surrender a permit for each unit of their emissions. They can obtain permits from the government or through trading with other firms. The government may choose to give the permits away for free or to auction them. Meanwhile, if a company doesn’t need all their credits because they switched to green energy or simply decreased their energy consumption, the company can 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. If you find this particularly interesting, we will dive into the economics behind emission trading later on.

A brief history of emission trading  

The history of emission trading reaches a few decades back when President George H.W. Bush proved that cap and trade works. Back in the 1980s, he used it to curb pollutants causing acid rain. This marked the first such program in the world!

Following from there, the application of flexible, market-based mechanisms for reducing greenhouse gas emissions has achieved widespread political support. The acceptance of emissions trading was reflected in the Kyoto Protocol, which established several emissions trading mechanisms. Signatory countries to this treaty did adopt legally binding commitments to reduce emissions to levels below those experienced in 1990.

Related read:

28 essential climate change terms you should know

Mandatory (compliant) vs voluntary carbon market

Have you ever seen (or even made use of) the option to tick a so-called “carbon offset” when you were booking a flight? In case you didn’t, here’s an example:

A carbon offset example
SOURCE: RYANAIR

We all know that short hops on flights are very costly for the planet - despite becoming more affordable and attractive for all of us. With many low-cost flight offers and the prospect of being able to travel more again in the near future, carbon offsets seem to be a convenient solution — passengers can voluntarily pay to, for example, help finance clean energy and forestry projects in developing countries. One carbon offset represents the absorption of one tonne of CO2 or the equivalent amount of any other GHG (CO2e), and offsets are offered in units to compensate for the emissions arising from a trip.

Now that we have understood what mandatory carbon markets, such as the ETS, are, it is interesting to know that carbon markets also exist under these voluntary programs, such as carbon offsetting programs. Voluntary carbon markets enable businesses, governments, nonprofit organizations, universities, municipalities, and individuals to purchase carbon offsets outside a regulatory regime.

In fact, you can find a lot of reputable offsetting platforms online, on which you can either offset your flights or any other CO2 amount you wish to offset.

The principle behind offsetting is really simple. The objective is to make up for carbon dioxide (CO2) emissions that cannot be avoided at one place either by reducing emission elsewhere or by increasing the absorption of CO2 by carbon sinks elsewhere. Here’s a breakdown of Atmosfair, Southpole, Project Wren and the United Nations offsetting platform, four of the most popular options.

An overview of voluntary offsetting platforms
AN OVERVIEW OF THE MOST POPULAR OFFSETTING PLATFORMS


Emission trading vs Carbon Tax  

In comparison to a cap-and-trade program where a set number of emissions “allowances” is issued and distributed each year, a carbon tax directly establishes a price on greenhouse gas emissions — so companies are charged a dollar amount for every tonne of emissions they produce.

On the downside, under a carbon tax, there is no cap on emissions. This means that people are free to emit as much or as little as they like, but if they do emit, they must pay the tax.

Nevertheless, carbon taxes and cap-and-trade programs share several major advantages. Both reduce emissions by encouraging the lowest-cost emissions reductions, and they do so without anyone needing to know beforehand when and where these emissions reductions will occur. Furthermore, both policies encourage investors and entrepreneurs to develop and implement new low-carbon technologies.

Also, the revenue that a carbon tax generates can be used to encourage investment in more renewable energy projects by offering subsidies to companies that build low or no-carbon plants. The revenue could be used to remediate environmental damage caused by carbon emissions and pollution.

In the end, both options offer advantages as well as disadvantages and countries and politicians themselves have to decide what way is best for them.

Trading carbon credits: How do carbon credits work?  

The economics of cap and trade

As said before, each large-scale emitter (like big companies) needs to adhere to a limit on the amount of GHG it can emit. In essence, governments distribute a finite number of CO2 “credits” to companies on every tonne of carbon dioxide released into the atmosphere. That’s the “cap” part. Over time, the limits become stricter, allowing less and less pollution, until the ultimate reduction goal is met. The companies can only emit as much CO2 as they have credits for. Those companies below their CO2 limit can sell surplus credits to companies that exceed their limits. Simply said, if firm A implemented some new technologies and made their production more efficient and more sustainable, they have a good chance to emit less than they are technically allowed to. Now, firm A can sell their unused credits to firm B, which wants to pollute more than their initial credits allow them to and is therefore willing to buy additional allowances. That’s the “trade” part.

How a cap and trade system works
SOURCE: CANADIAN CANOLA GROWERS ASSOCIATION

The market emerging from this gives companies flexibility and financial incentives to make reductions and hence rewards innovation. In addition, the government lowers the number of permits each year, thereby lowering the total emissions cap. That makes the permits more expensive. Over time, companies are incentivized to invest in clean technology as it eventually becomes cheaper than buying permits. (In case you are following the carbon price, you are already aware of its skyrocketing behaviour - in case you don’t, just stay with us and we’ll cover this later on.)

The big goal here is to slow down global warming by limiting big emitters - this also explains why some industries, like Utilities, are the biggest traders: They burn coal and other fossil fuels that emit too much carbon dioxide into the air which then they have to make up for. Additionally to their production costs, they therefore have to pay for their needed permits. This gives renewable energy companies a big advantage: Instead of paying extra for their emissions, they can sell their carbon credits which lowers their production costs.  

OK, but what does this have to do with carbon prices?  

So, we have already learned that carbon credits can be traded, and the sales and purchases (supply and demand) of credits yield a market price for allowances — essentially the price of one tonne of CO2 emissions. But how exactly does this work? Or, in other words: What are the economics of pollution? To understand the concept behind this, you need to understand externalities, market failure, and social costs.

Let’s start at the bottom: Industrial processes and production cause environmental damages, that is crystal clear. And this is where the so-called negative externality we mentioned before comes into play: Firms that emit GHGs place a burden on the environment which is borne by everyone in the form of a changing climate, yet they don’t incur a cost for doing so. Therefore, we speak of a market failure when talking about pollution as a negative externality, since the environmental damage is not taken into account as firms make pricing decisions (as opposed to e.g. labor costs or cost of production).

When there is market failure, the private market fails to achieve efficient output because either firms do not account for all costs incurred in the production of output. And this is the exact reason why we need a price for carbon. Without a price for carbon emission, we would essentially face an oversupply of goods, producing too much and therefore facing detrimental environmental damages.

Explained: How neglecting environmental costs lead to oversupply

In case you ever took a lecture or a course in economics or business, you know the ground rule: Supply equals demand. This is the point where there is no surplus or shortage of goods and the market is in equilibrium - or so to say, at its optimum. How do we make this decision though, you may ask? Well, if you put aside all the math behind this, you essentially look at the costs a company is facing in their production. As explained above, here is where the market failure happens! Since the original supply-demand model doesn’t take into account any environmental damage (here: MEC) occurred by a company, the costs are underestimated. In fact, a company is facing social costs (here: MSC),the sum of economic costs and environmental costs. Looking at the graph below, you can see that higher costs shift the supply curve upwards (blue) to a point where the optimal quantity supplied is less than before, having prevented an oversupply of goods.

Supply and Demand diagram on Carbon Credits

MSC: MARGINAL SOCIAL COST, MPC: MARGINAL PRIVATE COST, MEC: MARGINAL ENVIRONMENTAL COST, D = MPB = MSB: DEMAND = MARGINAL PRIVATE BENEFIT = MARGINAL SOCIAL BENEFIT.  

Carbon prices have already been implemented in more than 40 countries.

In 2010, about 5% of the world’s emissions were covered by a carbon price. In 2020, that figure was already over 15% and with the roll-out of the Chinese emission scheme in 2021, this share is projected to grow.

GHG coverage by carbon allowances

SOURCE: WORLD BANK, BASED ON THE ECONOMIST

According to a 2019 World Bank report on trends in carbon pricing, a carbon price range of US$ 40-80 was necessary by 2020 to reach the goals set by the 2015 Paris Agreement. As countries try to limit the average global temperature increase to 2°C, average carbon prices could increase more than sevenfold to US$120 per metric tonne by 2030.

Yet, despite these projections, carbon pricing varies enormously. In most cases, it is far below $75 for a tonne of carbon.

With this in mind, let’s now have a look at the European carbon market.

Carbon markets around the globe:

The European Emission Trading Scheme (EU ETS)

In January 2005, the EU ETS commenced operation as the largest multi-country, multi-sector GHG ETS worldwide. The roll-out of the ETS was organised to take place in several phases. In the first phase of the scheme (2005 -2007), a limited number and type of installations were involved covering energy activities, production and processing of ferrous metals, the mineral industry and pulp, paper and board activities.

In theory, it was clear that, in order to ensure that real reductions in CO2 emissions really occurred, EU governments were required to guarantee that the total amount of allowances issued to installations was less than the amount of CO2 that would have been emitted under a predicted scenario of normal business operations. However, the first few years have shown that most member states granted their industries carbon emission allowances which were far too generous, and that this resulted in the virtual collapse of the carbon market in 2007. Looking at the graph below, we can see that in practice.

During the first year, the price of emissions increased steadily to reach a peak of almost €30 per tonne in April 2006, but the price began to fall rapidly soon after as it became clear that many countries had given their industries such generous emission caps that industries did not need to reduce emissions. This created a crisis of confidence in the scheme, with CO2 prices falling rapidly over the next year to a trading price of €1.2per tonne in March 2007. The price eventually declined to €0.10 per tonne by September 2007, which discredited the market and caused calls from many NGOs for more stringent restrictions on CO2 and tighter allocations of emission credits in the next phase of the scheme.

The price of carbon allowances over the years
SOURCE: TRADING ECONOMICS

On the bright side, this gave an important takeaway for the following phases: The cap must be low enough to actually reduce the greenhouse gases that cause global warming! If the cap is too low, then it will make the cost of doing business too high and slow economic growth. If the cap is too high, then it won't impact the pace of global warming.

As of November 2017, the EU reduced the carbon cap by 2.2% each year through 2030. Alongside this, many countries implement stricter climate policies, and, this way, the carbon market has found more momentum.

And ta-da! - what did we see over the past year? The carbon price increased enormously. In fact, the EU’s carbon price surpassed €50 for the first time ever in early May 2021, having stood at around €20 before the coronavirus pandemic. And that’s not it - predictions go as far as projecting a price of around €100 per tonne of carbon by 2030.

And all this is bearing fruit. Since the EU ETS was introduced in 2005, emissions have been cut by 42.8% in the main sectors covered: Power and Heat generation and energy-intensive Industrial Installations.

So far so good. But now that we’ve looked at the EU ETS, what’s the case in other countries?

Looking at the map below, we can see that, all around the world, there are regional, national and subnational carbon pricing initiatives implemented, scheduled for implementation and under consideration, whether it’s an ETS and/or a carbon tax. This is really important, because, as we know, climate change is a global, not a national, problem.

Map on ETS and/or carbon tax implementation
SOURCE: CENTRE FOR CLIMATE AND ENERGY SOLUTIONS

One last side note: Latest on the news was the Chinese emission trading system (ETS) which has recently been launched. China is known as being the world’s largest emitter of greenhouse gases, so researchers now argue that this system might not be ambitious enough to enable China to meet its emissions-reduction goals, including a 2030 deadline for peak emissions and a 2060 goal of net-zero emissions. China’s carbon price is predicted to be traded at around 40 yuan ($6.18) per tonne. That sounds really low compared to the EU ETS. Also, the allocation of permits is based on carbon intensity instead of absolute levels, which might make it less effective and falsify it a bit.

However, we should also keep in mind that the carbon emissions per capita in China are actually lower than in Germany, the United States and other developed countries, so who are we to judge?

Conclusion

Reducing GHG in our atmosphere is a not-so-soon ending process for each and everyone of us, so much is clear. Part of the responsibility lies in our hands, but much is also up to governments and corporations to keep track, manage and reduce their emissions.

By putting a price on carbon emissions, society found a way to hold big emitters responsible for the GHGs they add into the atmosphere. With a market-based mechanism, emitting firms are incentivized to boost investments in low-carbon technologies, such as carbon capture, hydrogen, and offshore wind.

Questions remain on how efficient this market is going to be once the carbon price hits even higher levels. Will firms demonstrate the efforts to reduce their carbon footprint and eventually hit net zero, or will they pass on increasing costs and make us consumers pay the price of climate change?

In the end, what matters in combating climate change is one thing: combined efforts. So what’s on us is tracking emissions, reducing them as much as possible, offsetting what we cannot eliminate, and investing our money in companies that drive positive change.

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