What Is Carbon Credit?

Last Updated May 1, 2008 5:31 PM EDT

In step with the dramatic rise in C02 emissions and
other pollutants in recent years, a variety of new financial markets have
emerged, offering businesses key incentives — aside from taxes and
other punitive measures — to slow down overall emissions growth and,
ideally, global warming itself.

A key feature of these markets is emissions trading, or
cap-and-trade schemes, which allow companies to buy or sell "credits"
that collectively bind all participating companies to an overall emissions limit.
While markets operate for specific pollutants such as greenhouse gases and acid
rain, by far the biggest emissions market is for carbon. In 2007, the trade
market for C02 credits hit $60 billion worldwide — almost
double the amount from 2006.

How It Works

Emissions limits and trading rules vary country by
country, so each emissions-trading market operates differently. For nations
that have signed the Kyoto Protocol, which holds each country to its own C02 limit, greenhouse gas-emissions trading is mandatory. In the United States,
which did not sign the environmental agreement, corporate participation is
voluntary for emissions schemes such as the Chicago Climate Exchange. Yet a few
general principles apply to each type of market.

Under a basic cap-and-trade scheme, if a company’s
carbon emissions fall below a set allowance, that company can sell the
difference — in the form of credits — to other companies
that exceed their limits. Another fast-growing voluntary model is carbon
offsets. In this global market, a set of middlemen companies, called offset
firms, estimate a company’s emissions and then act as brokers by
offering opportunities to invest in carbon-reducing projects around the world.
Unlike carbon trading, offsetting isn’t yet government regulated in most
countries; it’s up to buyers to verify a project’s
environmental worth. In theory, for every ton of C02 emitted, a
company can buy certificates attesting that the same amount of greenhouse gas
was removed from the atmosphere through renewable energy projects such as tree

Why It Matters Now

Industry watchers say carbon markets will continue to grow
at a fast clip — especially in the United States, where Fortune 500
powerhouses such as DuPont, Ford, and IBM are voluntarily capping and trading
their emissions. Even though a national cap on carbon emissions doesn’t
yet exist in the United States, most consider it inevitable, and legislators
are already pushing the issue in Congress.

It’s not just governments who are demanding
emissions compliance — consumers want it, too. The commitment a
company makes to curb its pollutant output is an increasingly public aspect of
strategy. More and more employees are taking these factors into account when
deciding where to work. A recent study from MonsterTRAK found that 80 percent
of young professionals want their work to impact the environment in a positive
way, and 92 percent prefer to work for an environmentally friendly company.

Why It Matters to You

Let’s say a company can’t afford to
modify its operations to reduce C02. Purchasing carbon credits or
offsets buys it time to figure out how to operate within C02 limits.
For others, it can be a cost-effective tool to help lower emissions while
earning public praise for the effort. Each credit a company buys on the Chicago
Climate Exchange — usually for about $2 — means another
company will remove the equivalent of one metric ton of carbon.

The Advantages

Companies in different industries face dramatically
different costs to lower their emissions. A market-based approach allows
companies to take carbon-reducing measures that everyone can afford. “The
private sector is better at developing diversified approaches to manage the costs
and risks [of reducing emissions],” says Jesse Fahnestock, spokesman
at Swedish power company Vattenfall, which is a member of a global Combat
Climate Change coalition.

Reducing emissions and lowering energy consumption is
usually good for the core business. For example, in 1997 British energy company
BP committed to bring its emissions down to 10
percent below 1990 levels. After taking simple steps like tightening valves, changing light bulbs, and improving
operations efficiency, BP implemented an internal cap-and-trade scheme and met
its emissions goal by the end of 2001 — nine years ahead of
schedule. Using the combined C02 reduction
strategy, BP reported saving about $650 million.

Then there’s the long-term investment angle:
Buying into the carbon market boom now suggests significant dividends later on.
Carbon credits are relatively cheap now, but their value will likely rise,
giving companies another reason to participate.

The Disadvantages

As with any financial market, emissions traders are
vulnerable to significant risk and volatility. The EU’s trading
scheme (EU-ETS), for instance, issued so many permits between 2005 and 2007
that it flooded the market. Supply soared and carbon prices bottomed out,
removing incentives for companies to trade. Enforcement of trading rules can be
just as unpredictable, though Fahnestock says the EU is working to correct the

Carbon offsets have their own drawbacks, which reflect a
fast-growing and unregulated market. Some offset firms in the United States and
abroad have been caught selling offsets for normal operations that do not
actually take any additional C02 out of the atmosphere, such as
pumping C02 into oil wells to force out the remaining crude. In 2008
the Climate Group, the International Emissions Trading Association, and the
World Economic Forum will work to develop a Voluntary Carbon Standard to verify
that offsetting projects are beyond business-as-usual and have lasting
environmental value.

The lack of offset regulations has also made marketing
problematic. Recently, companies have taken to declaring themselves “carbon
neutral.” But until the Federal Trade Commission determines the
guidelines for such terms, it’s unclear which companies actually
merit the distinction. Already Vail Resorts, the organizers of the Academy
Awards, and other organizations have taken heat for touting their investments
in carbon offset projects that were not entirely environmentally sound.

Key Players

Bank of America is a leader in carbon-reduction
strategies. The bank recently launched a $20 billion, 10-year initiative to
finance emission-reduction projects, invest in green technology, and facilitate
carbon-credit trading.

BP is among the most well-known companies to
implement an internal cap-and-trade system. The company assigned its 150 units
an emissions quota and allowed them to buy and sell carbon credits among

The European Union Emission Trading Scheme (EU ETS)
is the mandatory cap-and-trade program for the EU.

The Chicago Climate Exchange (CCX) is a U.S.
carbon-trading scheme in which companies make a voluntary but legally binding
commitment to meet emissions targets.

How to Talk About It

Cap-and-trade scheme: A market approach to reducing
greenhouse gases that works by setting emissions targets. Governments or
businesses that reduce their carbon outputs in excess of the target can sell
the difference to those who produce more than the limit. This is the favored
solution of many business groups.

MACs: Marginal abatement costs refer to the cost of
cutting C02 emission, which varies from country to country and
industry to industry.

Free-market environmentalism: This theory holds
that the free market, which offers economic incentives, is the best tool to
address global warming. This view goes against the traditional approach to
environmentalism, which looks to government regulation to prevent environmental

Further Reading

Combat Climate Change Roadmap,” the 3C Initiative’s recommendations
to political leaders

Ahead of the Curve: Corporate Strategies That Address Climate Change,”
a report of the Pew Center on Global Climate Change

Caught in Carbon ‘Smokescreen,’” Financial
, April 25, 2007, on the problems with carbon offsetting

href="http://www.wri.org/publication/green-employment-tax-swap">A Green
Employment Tax Swap: Using a Carbon Tax to Finance Payroll Tax Relief,”
by Gilbert Metcalf, discusses the advantages of a revenue-neutral carbon tax

Inconvenient Truth,” BusinessWeek, March 26, 2007, on
carbon-offset deals that don’t deliver what they promise

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    Jessica lives in London where she works as a freelance writer with interests in green business and tech, management, and marketing.