06 Feb 2025

8 MIN READ

Everything You Need to Know About Carbon Credits Market

What are carbon credits?

Carbon markets emerged as a revolutionary tool to reduce emissions by assigning a price to pollution. By making polluters pay for their emissions, these markets found a way to curb greenhouse gases while incentivizing sustainable practices.

The idea of monetizing pollution has roots in a bold experiment from the late 1980s. At the time, America faced a significant environmental crisis: its power plants were emitting large amounts of sulfur dioxide, causing acid rain that damaged ecosystems and infrastructure. Despite the environmental destruction, industries had no motive to reduce these harmful emissions.

Front page of The Japan Times on December 12, 1997, the day after the signing of The Kyoto Protocol. Source: https://www.climateforesight.eu/articles/success-or-failure-the-kyoto-protocols-troubled-legacy/

In 1990, the US government introduced an innovative solution: a cap-and-trade system. This system required polluters to purchase permits for their emissions. This market-based approach led to a 20% reduction in acid rain levels across eastern America within eight years. At last, there was a possible solution to tackle the issue. Leveraging economic incentives could drive environmental progress.

Inspired by this success, the 1997 Kyoto Protocol introduced the concept of carbon markets on a global scale. Carbon markets are centred on the commodity of carbon credits. But what exactly are carbon credits? Each carbon credit represents one ton of CO2 either removed from the atmosphere or avoided through sustainable practices.

For example, planting trees absorbs carbon dioxide (removed), while transitioning from fossil fuels to renewable energy prevents emissions from occurring (avoided). Both actions are measured, certified, and translated into tradable credits, forming the backbone of the carbon credit system.

What is a carbon credit market?

Carbon markets are trading systems where entities buy carbon credits or offsets. When a company buys a carbon credit, it essentially purchases the right to emit one ton of CO2. If a company emits less than its allowance, it can sell its surplus credits to others. This gives large corporations a financial incentive to innovate and reduce emissions.

A depiction of credit to offset journey. Source: https://www.thallo.io/the-price-of-carbon-credits-an-overview/

On the other hand, carbon offsets occur when an organization funds projects like reforestation or clean energy initiatives to balance out its unavoidable emissions. The two allow displacement and replacement of CO2 from the environment. Though often used interchangeably, carbon credits and offsets are distinct mechanisms operating within the carbon market.

Carbon markets have two primary forms: compliance and voluntary, each serving distinct purposes. Compliance markets are regulated by governments and international bodies, compelling industries to adhere to emission caps. Voluntary markets, however, allow cities, businesses, organizations, and individuals to offset emissions at their discretion, often as part of their corporate social responsibility goals or net-zero ambitions.

Compliance or regulated market

To grasp the mechanics of the carbon market, imagine a government setting a strict cap on CO2 emissions for an industry. This cap is divided into permits, which companies can buy, sell, or trade. Over time, the cap tightens, reducing the total emissions allowed and increasing the value of permits. The shrinking pool drives industries to adopt cleaner technologies, while the trading of permits fosters innovation and collaboration. This is the most common type of carbon market regulatory system, it is called the cap-and-trade system.

A graphic representation of compliance market emissions trading system via cap-and-trade. Source: https://carboncredits.com/who-certifies-carbon-credits/

To illustrate, imagine that country X sets an annual CO2 emission limit, let’s say 100 tons, for companies in the energy sector. Now consider two companies, Company A produces electricity by burning coal and emits 150 tons of CO2 annually. Company B produces electricity using wind turbines and emits only 50 tons of CO2 annually.

Since Company B emits less than its limit, it holds 50 surplus carbon credits. These credits can be sold to companies like Company A, which exceeds its cap or can be stored for future use.

Meanwhile, Company A faces a challenge, it has exceeded its limit and has two options. It can buy carbon credits from Company B, or offset its emissions through climate-friendly projects or switch to cleaner technologies. This is the essence of cap-and-trade.

Voluntary market

The voluntary market on the other hand is a completely different ballgame. The goals remains the same; to reduce or eliminate carbon emissions to fight climate change. However, the voluntary market operates without regulatory mandates. Compliance markets are regulated by governments. In these markets, carbon credits are issued by governments and bought and sold only among organizations.

In contrast, instead of government-issued carbon credits, voluntary markets trade carbon offsets, which represent emissions reductions achieved by independent projects. These offsets are purchased by businesses and individuals who voluntarily seek to neutralize their carbon footprint.

Who are the buyers and sellers of the voluntary market?

In Voluntary carbon markets, the buyers are companies, non-profit organizations, and individuals who purchase carbon credits voluntarily. It could be as a part of corporate social responsibility (CSR) or sustainability initiatives. Unlike compliance markets, VCMs function as an open marketplace where participants voluntarily offset their emissions.

Ecosystem of the voluntary carbon market. Source: https://greenblogs.crown-monkey.com/challenges-of-voluntary-carbon-market-and-how-to-overcome-them/

On the other end, the sellers of the voluntary carbon market are project developers with independent projects that generate tradable carbon offsets certificates. A fundamental feature of VCMs is that they provide a platform for environmental projects aimed at either reducing or preventing emissions from the atmosphere. These projects span across various sectors, including energy, forestry, agriculture, and wetlands, where initiatives such as reforestation, renewable energy development, and carbon sequestration take place.

What is the process of generating carbon offsets for the voluntary market?

A crucial aspect of voluntary carbon markets is ensuring the credibility of offset projects. To maintain high standards, organizations such as Gold Standard and Verra set rigorous criteria that projects must meet to qualify as high-quality offsets. These standard setters develop methodologies, oversee implementation, and ensure that carbon reductions are accurately quantified and monitored.

The process typically follows these steps:

Project Development – A developer creates an initiative aimed at carbon reduction or removal.
Validation and Verification – Third-party auditors assess whether the project meets established criteria and ensure compliance with standards.
Registration – Once approved, the project is officially registered in the voluntary carbon market.
Implementation and Monitoring – The project begins operations, with continuous monitoring to verify carbon reductions.
Issuance – After a set period, the project generates carbon offsets that can be sold in the market.
Transfer – After they’re issued, carbon credits can be transferred through trade. As a buyer, your company can use those credits to offset your business’ footprint.
Retirement – Carbon credit holders must retire the offsets after they’ve used them and claim their reductions. After retirement, the offsets cannot be transferred or used. In other words, the credits must be removed from circulation.

One of the most critical principles in VCMs isadditionality, which ensures that a project would not have been financially viable without funding from carbon markets. This is particularly significant because many projects in the voluntary market rely entirely on revenue from carbon offset sales to exist.

What determines carbon credit prices?

The heart of the carbon market lies in rigorous verification and transparency. For a carbon credit to hold value, it must meet stringent international standards. Projects that generate these credits undergo meticulous validation and monitoring to ensure genuine environmental impact. Once verified, credits are entered into registries. Registries are secure databases that track the origin, methodology, and status of each credit.

After issuance, credits are bought and sold, often by specialist retailers who assess project quality and create portfolios for end buyers. When a company uses a carbon credit to offset its emissions, the credit is “retired” on the registry, ensuring it cannot be reused or resold.

The price of carbon credits is influenced by their quality, which depends on internationally or domestically recognized standards. These standards establish rigorous methodologies for calculating emissions reductions or removals, setting the benchmark for high-quality carbon credits.

Factors affecting the price of carbon credits. Source: https://www.thallo.io/the-price-of-carbon-credits-an-overview/

While market conditions and the traditional supply-demand dynamic are the primary drivers of carbon credit prices, other factors influence carbon pricing as well. This is particularly true in the case of voluntary carbon markets. The price of a carbon credit is a reflection of its quality, co-benefits, and market forces.

High-quality carbon credits are valuable because they help mitigate climate change and support a sustainable future for communities worldwide.

Six key attributes define carbon credit quality.

Additionality

Does the project rely on carbon credit revenue to exist?

Additionality ensures that a project wouldn’t happen without the financial support from carbon credit sales. The funding from credits must be the cornerstone of the project, making or breaking its feasibility.

Quantification

How accurate are the emissions reductions or removals being claimed?

Quantification ensures that one carbon credit equals exactly one metric ton of CO2 equivalent (CO2e). Standardized methodologies are used to calculate both the baseline (emissions without the project) and the reductions achieved.

However, some degree of estimation is often involved. High-quality projects document any deviations from standard approaches and include buffer pools to account for potential inaccuracies.

Leakage

Are the project’s benefits unintentionally offset elsewhere?

Leakage occurs when emissions reductions within a project lead to increased emissions outside its boundaries. For example, protecting a forest from deforestation might shift logging pressure to nearby areas.

High-quality projects proactively identify and address leakage risks, incorporating them into their calculations.

Permeance risk

Will the project’s climate benefits last?

Permanence refers to the durability of a project’s emissions reductions. For instance, if a forest protected by carbon credits is later destroyed by logging or fire, the climate benefits are reversed.

To mitigate this risk, some projects set aside a portion of their credits as insurance. Buyers can also self-insure by purchasing surplus credits.

Vintage

How recent are the carbon credits?

The vintage of a carbon credit refers to the year it was issued. Recent credits are more likely to meet updated standards and support innovative, active projects. For example, programs like CORSIA only allow credits from projects starting after 2016.

Co-benefits

Does the project deliver benefits beyond reducing emissions?

Many high-quality projects offer additional social or environmental benefits, such as improving public health, creating jobs, or enhancing biodiversity. This improves credit quality and drives up their prices.

In addition to quality, other factors affecting credit prices include:

Project Type: Tech-based solutions (e.g., direct air capture) are often more expensive than nature-based solutions (e.g., reforestation).
Geographic Location: Projects in remote or vulnerable regions may incur higher costs.
Scale and Complexity: Larger, more complex projects often require higher investments.

Do carbon markets effectively reduce emissions?

If implemented correctly, carbon markets can be a valuable tool in combating climate change. However, their effectiveness depends on robust implementation, regulation and oversight. Both carbon credits and offsets do not always function as intended, and several challenges hinder their success.

One major issue is the lack of a unified global carbon market, leading to variations in regulation and the exploitation of loopholes. Without standardized rules, inconsistencies arise, weakening the system’s integrity. Corruption and weak enforcement enable companies to bypass regulations. This fragmented enforcement contributes to carbon leakage, where businesses relocate to countries with weaker environmental regulations to avoid carbon pricing or compliance costs.

Graphic representation of the process and barriers of carbon credit cycle. Source: https://rmi.org/our-work/climate-intelligence/carbon-markets-initiative/

Measurement challenges persist, particularly in distinguishing between direct and indirect emissions. The complexity of tracking emissions across supply chains makes accurate accounting difficult, increasing the risk of misreporting. Additionally, issues such as double counting the same emission and greenwashing, where companies falsely market themselves as environmentally or falsify evidence without adhering to rigorous carbon reduction or offsetting practices, raise concerns about accountability.

Carbon pricing is another critical factor. Many carbon prices remain too low to drive substantial emission reductions. Even when carbon pricing is set appropriately, fines for exceeding permitted levels can be minimal, failing to incentivize meaningful change. This is especially the case in cap-an-trade systems.

Who can buy?

Large corporations, organizations, and investors can participate in carbon markets, while individual consumers typically cannot purchase carbon credits directly. However, individuals can still support climate action by buying carbon offsets through retailers or online platforms.

As a large corporation, one way to acquire carbon offsets is by purchasing directly from project developers. For individuals or small businesses, buying from retailers is the simplest option. Retailers provide access to small quantities of carbon offsets and usually retire the credits on behalf of the buyer. Another option is purchasing credits through carbon exchanges. Platforms like Xpansiv CBL, AirCarbon Exchange, and Carbon Trade Exchange facilitate the buying and selling of carbon offsets. This method often results in lower costs compared to brokers.

Trading carbon credits functions similarly to stock trading, buyers aim to purchase credits at a low price and sell them at a higher price.

What is the scope?

The future of carbon trading is promising but complex. As global efforts to reduce emissions intensify, carbon markets will play an increasingly critical role. In 2023, the price of carbon in the European trading system reached 100 euros per tonne for the first time, reflecting heightened activity and investment in the sector. Achieving net zero by 2050 will require an estimated $4.6 trillion annually by 2030, yet fewer than 40% of companies are currently on track to meet their sustainability commitments.

Despite recent economic uncertainties and climate-related disruptions, net-zero and decarbonization strategies are expected to accelerate in 2025.