How Carbon Credits Exchange Works

The voluntary carbon credit market is a growing ecosystem of participants, projects, and institutions that support the financing and implementation of greenhouse gas emissions reductions. It has been growing rapidly in recent years, fueled by corporate net-zero goals and interest in reaching international climate goals.

When a company emits carbon credit exchange dioxide, it is awarded a permit that limits its emission to a certain amount of carbon dioxide equivalent over a set period. It may then sell any credits it does not need to another company that is in need of them. This is called a cap-and-trade program, which has been used to curb emissions from industries such as coal, oil, and transportation.

There are two types of cap-and-trade systems: compliance markets and emissions trading markets (ETSs). In a compliance market, governments establish a limit on the amount of greenhouse gases a sector can emit, and sources can reduce their pollution below that limit. If they fall short of the limit, they can buy additional allowances from the market.

A cap-and-trade system also allows companies to bank excess allowances for use later. Sources can use these to offset their own emissions, which is a powerful incentive for companies to cut their own pollution and to invest in newer, cleaner technologies.

Offsets are a key component of the global climate agenda. They are one way to meet the greenhouse gas reduction goals set out in the Paris Agreement and the California Cap-and-Trade law.

But offsets are not without their problems. First, they are not a substitute for action to reduce emissions. Second, they are not as robust and reliable as a fully regulated market such as the Clean Development Mechanism.

Third, they are often not fully transparent. And fourth, they lack pricing transparency, which creates an opportunity for money laundering and fraud.

To address these challenges, standards organizations, financial institutions, and other stakeholders should work to develop a robust carbon-credit system that has a number of key attributes. This includes addressing the following issues:

For a market to function well, it must have a robust set of participant eligibility requirements. To qualify, a project must demonstrate that it is reducing, removing, or avoiding emissions, and must be certified by a respected standard-setting organization. This should be done on a regular basis and not just at the end of the project.

Creating a tradable carbon credit market requires strict rules and limited availability of credits to ensure that they are scarce. This is especially true for the large, established cap-and-trade programs such as the EU ETS and California Cap-and-Trade.

The problem of excess permits is exacerbated by political interference in these schemes, which has created gluts of free allowances that are not traded and which have had a negative impact on the price. Moreover, the value of offset permits, which are gained from pollution reductions in poorer countries, is uncertain and has little real effect on emissions.