The international community agrees that we must reduce greenhouse gas emissions to combat climate change. Many countries have accepted that trading carbon credits is one of the effective ways to reduce emissions in the long term. But what are carbon credits and how do they work? This article will take you through the basic concepts of carbon credits and carbon trading.
What are carbon credits?
A carbon credit, also known as a carbon offset, is a permit that allows the holder to emit a certain amount of greenhouse gases. The main greenhouse gas is carbon dioxide, which is simply called “carbon”, but carbon credits cover all types of greenhouse gas emissions. One credit usually allows for the emission of one ton of carbon.
There are two types of carbon emitters. A coal-fired power plant is a specific example of a direct emitter—and every business that uses that electricity is an indirect emitter. Even service businesses that may not appear to be direct emitters still contribute to carbon emissions, such as flying to a client meeting.
Historically, carbon emissions were not measured and there was no cost to the emitter. However, by actively measuring carbon emissions, a cap-and-trade system can be used to effectively put a price on carbon. This system was successful in controlling sulfur dioxide pollution in the United States in the 1990s. By placing a cost on sulfur pollution, the system gave emitters a financial incentive to reduce sulfur production levels. The same model is now being applied to carbon emissions. In this structure, the total amount of carbon emissions is capped and can be gradually reduced over time.
Companies and countries then trade carbon credits with the exchange based on whether they need or have excess carbon credits. High emitters will buy credits from low or negative-emitting companies, which provides an economic benefit for reducing carbon emissions because the cost of carbon is now measurable.
There are two main types of emissions trading – mandatory and voluntary. Mandatory markets are formal emission reduction schemes where companies and governments use credits to meet agreed obligations, such as the Kyoto Protocol. Voluntary carbon credits are used by companies that want to reduce or eliminate their carbon footprint for ESG reasons. These credits can be traded between companies, but cannot be used to pay international debts.
How are carbon credits priced?
There is no global market for carbon trading yet. The largest is the EU Emissions Trading System1, which is considered the world benchmark. China has set up a trading scheme for about 40% of its electricity sector2, and other sectors are expected to be included. This may develop into the largest in the world. There are also some markets in the United States that adopt a state-led rather than national carbon trading approach.
The price of carbon credits varies, but is usually quoted as a cost per ton of carbon dioxide emissions or equivalent gas. According to the World Bank3, the price of carbon credits in the UK Emissions Trading System (ETS) is about $99. In the Canadian carbon market, the latest price is about $40. In California, the price is $31. In addition, the price in China and Tokyo is lower, about $9 and $4 respectively. Different carbon credit schemes use different frameworks and rules, resulting in huge differences in prices.
How to invest in carbon credits?
Individual investors can choose to invest in the price of carbon credits through futures. For example, futures are traded on the International Commodity Exchange, which tracks the cost of EU carbon credits. But this type of investment is short-term, risky, and more suitable for institutional players. A more common approach for investors seeking to address climate change is to focus on companies that are actively reducing or compensating for emissions.
Various mutual funds and exchange-traded funds hold companies that are linked to carbon credits or have low exposure to carbon-emitting industries. They may filter and exclude “dirty” industries, such as coal and steel production, while actively looking for sustainable investment opportunities involving renewable energy technologies or technologies that can directly reduce carbon emissions.
Investors can also focus on companies that buy and sell carbon credits or have carbon offset projects. However, these investments are less diversified and riskier than low-carbon or zero-carbon exchange-traded funds or mutual funds5.
What are the advantages and disadvantages of investing in carbon credits?
One major advantage is that investors can have a positive impact on climate change by allocating funds to companies or industries that are working to reduce greenhouse gas emissions. At the same time, by excluding specific “dirty” industries, companies are encouraged to take steps to reduce their carbon intensity.
“Greenwashing” refers to some companies claiming that they are reducing carbon emissions by purchasing carbon credits, but in fact they fail to take tangible measures to address the carbon intensity of their business. Although “greenwashing” does occur and is seen as a negative development, it at least reflects some positive ideology that its customers and investors are paying attention to the problem of climate change.
Another potential disadvantage of higher carbon credit prices is that companies can only pass on the increased costs to their customers. This may lead to higher prices for certain products without achieving any actual carbon reductions.
Carbon Awareness and Carbon Credits
For most investors, investing directly in carbon credits may not be a realistic or sensible option. However, increasing awareness of the carbon intensity of investments is a more achievable and realistic goal. Investors who explicitly exclude companies or funds that are not “clean” and focus on sustainable development will send a strong signal that carbon emissions are not cost-free and reducing carbon emissions has significant financial and environmental implications.
