In order to tackle climate change and boost the transition towards a more sustainable future, new mechanisms have been recently put into place to incentivize and promote decarbonization. Among them, carbon credits may be extraordinarily powerful if used and deployed adequately, but there is a growing controversy about their use.

Something that carbon credits may prevent is deforestation, however, recent news show that forest carbon offsets may not be fulfilling their purpose. Instead of planting new seeds, some carbon offsets are being used to avoid chopping existing trees, but it does not fix the problem of deforestation. As a result, some forest protection programmes are being more and more criticized, and thus the pressure to buy quality carbon credits is increasing proportionally. 

What are carbon credits?

Carbon credits, or carbon offsets, are permits that allow companies to emit a limited amount of carbon dioxide or other greenhouse gasses. Each credit allows a company to emit one ton of CO2 or equivalents. 

There are two types of markets for carbon credits: the compulsory and the voluntary market. The compulsory (also called mandatory) markets are used by governments or companies that are legally obliged to offset their emissions. EU ETS, California Compliance Carbon Offset Program, the Australian carbon market, among many others, follow a cap-and-trade program. Cap-and-trade systems are developing in most parts of the world. In the case of the EU, it has adopted the so-called EU ETS (EU Emissions Trading System) and has become a key element to reduce greenhouse gas emissions cost-effectively. 

The voluntary markets, however, are not regulated by governments but are driven by voluntary private initiatives and individuals. Contrary to compliance markets, voluntary markets are more fluid as they are open to a larger number of industries. Therefore, private investors, governments, non-governmental organizations, and businesses are allowed to voluntarily purchase carbon offsets to reduce their emissions. 

How do carbon credits work?

According to the carbon credit system, polluting companies are awarded credits that give them permission to pollute to a certain extent, and that limit is reduced periodically. If they exceed the cap of emissions, they must pay to get more credits, so they are incentivized to reduce their emissions. 

Following this line, companies are encouraged to invest in new and renewable energies, such as solar or wind power, to reduce their emissions and save their carbon credits. Carbon credits are normally issued by national or international governmental organizations, and the first international carbon markets were created as a result of the Kyoto and Paris agreements.

History and significance of carbon credits

In 1992, The United Nations Framework Convention on Climate Change (UNFCCC) established an international treaty to combat climate change, and gave birth to the concept of carbon credits. 

In 1997, The United Nations’ Intergovernmental Panel on Climate Change (IPCC) developed a carbon credit proposal aimed at reducing worldwide carbon emissions. This international agreement is known as the Kyoto Protocol, and it is binding to all the countries that signed it (84 countries in total). Another agreement, the Marrakesh Accords, set up the rules about how the system would work.

Market figures

From 2019 to 2020, companies with the net-zero commitment have doubled: from 500 corporates in 2019 to 1,000 in 2020. Carbon credits have been used for many decades now, which has meant an increase in the voluntary market for carbon credits. According to McKinsey, in 2020 buyers retired carbon credits for 95 million tons of carbon-dioxide equivalent (MtCO2e), more than twice than in 2017.

In 2022, investments in the voluntary carbon market (VCM) have grown to $10 billion, up from $7 billion in 2021. In 2021, the VCM suffered a slight decrease in the purchase of carbon credits, when companies only bought 155 million credits, down 4% from 2021. However, carbon credits supply has raised by 2%, with a total of 255 million carbon offsets generated globally. 

Following the stated demand for carbon credits and the demand projections from the TSVCM, the annual global demand for carbon credits may increase from 1.5 to 2.0 gigatons of carbon dioxide (GtCO2) by 2030 and up to 7 to 13 GtCO2 by 2050.

According to the Taskforce on Scaling Voluntary Carbon Markets (TSVCM), sponsored by the Institute of International Finance (IIF), the demand for carbon credits may increase by a factor of 15 by 2030, and by a factor of 100 by 2050. This would mean an increase in the value of the market for carbon credits, worth $50 billion in 2030. 

Based on a recent report published by BloombergNEF, it is estimated that the total value of carbon credits could be worth $1 trillion in 2037. 

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