Carbon credit


23 Mar 2015

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Carbon credits is a mechanism adopted by national and international governments to mitigate the effects of Green House Gases(GHGs). One Carbon Credit is equal to one ton of Carbon. Greenhouse Gases are capped and markets are used to regulate the emissions from the sources. The idea is to allow market mechanisms to drive industrial and commercial processes in the direction of low Greenhouse Gases(GHGs). These mitigation projects generate credits, which can be traded in the international markets for monetary benefits.

There are also many companies that sell carbon credits to commercial and individual customers who are interested in lowering their carbon footprint on a voluntary basis. These carbon offsetters purchase the credits from an investment fund or a carbon development company that has aggregated the credits from individual projects. The quality of the credits is based in part on the validation process and sophistication of the fund or development company that acted as the sponsor to the carbon project. This is reflected in their price; voluntary units typically have less value than the units sold through the rigorously-validated Clean Development Mechanism.


Fossil Fuels are the major source of Greehouse Gas Emissions. Industries such as Power, Textile, Fertilizer use fossil fuels for their high volumes of operations. The major greenhouse gases emitted by these industries are carbon dioxide, methane, nitrous oxide, hydrofluorocarbons (HFCs), etc, all of which increase the atmosphere's ability to trap infrared energy and thus affect the climate.

The increasing awareness about the environmental degradation gave rise to the concept called Carbon Credit. The IPCC (Intergovernmental Panel on Climate Change) has observed that:

Policies that provide a real or implicit price of carbon could create incentives for producers and consumers to significantly invest in low-GHG products, technologies and processes. Such policies could include economic instruments, government funding and regulation,

while noting that a tradable permit system is one of the policy instruments that has been shown to be environmentally effective in the industrial sector, as long as there are reasonable levels of predictability over the initial allocation mechanism and price.

The mechanism was formalized in the Kyoto Protocol, an international agreement between more than 170 countries, and the market mechanisms were agreed through the subsequent Accords.

Emission Allowances

The Protocol agreed 'caps' or quotas on the maximum amount of Greenhouse gases for developed and developing countries. In turn these countries set quotas on the emissions of installations run by local business and other organizations, generically termed 'operators'. Countries manage this through their own national 'registries', which are required to be validated and monitored for compliance by the UNFCCC. Each operator has an allowance of credits, where each unit gives the owner the right to emit one metric tonne of carbon dioxide or other equivalent greenhouse gas. Operators that have not used up their quotas can sell their unused allowances as carbon credits, while businesses that are about to exceed their quotas can buy the extra allowances as credits, privately or on the open market. As demand for energy grows over time, the total emissions must still stay within the cap, but it allows industry some flexibility and predictability in its planning to accommodate this.

By permitting allowances to be bought and sold, an operator can seek out the most cost-effective way of reducing its emissions, either by investing in 'cleaner' machinery and practices or by purchasing emissions from another operator who already has excess 'capacity'.

Since 2005, the Kyoto mechanism has been adopted for CO2 trading by all the countries within the European Union under its European Trading Scheme (EU ETS) with the European Commission as its validating authority. From 2008, EU participants must link with the other developed countries who ratified the protocol, and trade the six most significant anthropogenic greenhouse gases. In the United States, which has not ratified Kyoto, and Australia, whose ratification came into force in March 2008, similar schemes are being considered.

Kyoto's 'Flexible Mechanisms'

A credit can be an emissions allowance which was originally allocated or auctioned by the national administrators of a cap-and-trade program, or it can be an offset of emissions. Such offsetting and mitigating activities can occur in any developing country which has ratified the Kyoto Protocol, and has a national agreement in place to validate its carbon project through one of the UNFCCC's approved mechanisms. Once approved, these units are termed Certified Emission Reductions, or CERs. The Protocol allows these projects to be constructed and credited in advance of the Kyoto trading period.

The Kyoto Protocol provides for three mechanisms that enable countries or operators in developed countries to acquire greenhouse gas reduction credit.

  • Under Joint Implementation (JI) a developed country with relatively high costs of domestic greenhouse reduction would set up a project in another developed country.

  • Under the Clean Development Mechanism (CDM) a developed country can 'sponsor' a greenhouse gas reduction project in a developing country where the cost of greenhouse gas reduction project activities is usually much lower, but the atmospheric effect is globally equivalent. The developed country would be given credits for meeting its emission reduction targets, while the developing country would receive the capital investment and clean technology or beneficial change in land use.

  • Under International Emissions Trading (IET) countries can trade in the international carbon credit market to cover their shortfall in allowances. Countries with surplus credits can sell them to countries with capped emission commitments under the Kyoto Protocol.

These carbon projects can be created by a national government or by an operator within the country.

Emission Markets

One allowance or CER is considered equivalent to one metric tonne of CO2 emissions. These allowances can be sold privately or in the international market at the prevailing market price. Each international transfer is validated by the UNFCCC.

Climate exchanges have been established to provide a spot market in allowances, as well as futures and options market to help discover a market price and maintain liquidity. Carbon prices are normally quoted in Euros per tonne of carbon dioxide or its equivalent (CO2e). Other greenhouse gasses can also be traded, but are quoted as standard multiples of carbon dioxide with respect to their global warming potential. These features reduce the quota's financial impact on business, while ensuring that the quotas are met at a national and international level.

Many companies now engage in emissions abatement, offsetting, and sequestration programs to generate credits that can be sold on one of the exchanges.

Managing emissions is one of the fastest-growing segments in financial services in the City of London with a market now worth about €30 billion, but which could grow to €1 trillion within a decade. Louis Redshaw, head of environmental markets at Barclays Capital predicts that "Carbon will be the world's biggest commodity market, and it could become the world's biggest market overall."

Setting A Market Price For Carbon

Energy usage and emissions should be kept under constant check else they will only rise over time. Hence the number of companies needing to buy credits will increase over the period of time. This Supply-Demand for credits will determine the price of the Carbon which will in turn encourage companies to go cleaner.

An individual allowance, such as a Kyoto Assigned Amount Unit (AAU) or its near-equivalent European Union Allowance (EUA), may have a different market value to an offset such as a CER. This is due to the lack of a developed secondary market for CERs, a lack of homogeneity between projects which causes difficulty in pricing. Additionally, offsets generated by a carbon project under the Clean Development Mechanism are potentially limited in value because operators in the EU ETS are restricted as to what percentage of their allowance can be met through these flexible mechanisms.

Raising the price of carbon will achieve four goals. First, it will provide signals to consumers about what goods and services are high-carbon ones and should therefore be used more sparingly. Second, it will provide signals to producers about which inputs use more carbon (such as coal and oil) and which use less or none (such as natural gas or nuclear power), thereby inducing firms to substitute low-carbon inputs. Third, it will give market incentives for inventors and innovators to develop and introduce low-carbon products and processes that can replace the current generation of technologies. Fourth, and most important, a high carbon price will economize on the information that is required to do all three of these tasks. Through the market mechanism, a high carbon price will raise the price of products according to their carbon content


Environmental restrictions and activities have been imposed on businesses through regulation. Many are uneasy with this approach to managing emissions.

The Kyoto mechanism is the only internationally-agreed mechanism for regulating carbon credit activities, and, crucially, includes checks for additionality and overall effectiveness. Its supporting organisation, the UNFCCC, is the only organisation with a global mandate on the overall effectiveness of emission control systems, although enforcement of decisions relies on national co-operation. The Kyoto trading period only applies for five years between 2008 and 2012. The first phase of the EU ETS system started before then, and is expected to continue in a third phase afterwards, and may co-ordinate with whatever is internationally-agreed at but there is general uncertainty as to what will be agreed in Post-Kyoto Protocol negotiations on greenhouse gas emissions. As business investment often operates over decades, this adds risk and uncertainty to their plans. As several countries responsible for a large proportion of global emissions (notably USA, Australia, China) have avoided mandatory caps, this also means that businesses in capped countries may perceive themselves to be working at a competitive disadvantage against those in uncapped countries as they are now paying for their carbon costs directly.

A key concept behind the cap and trade system is that national quotas should be chosen to represent genuine and meaningful reductions in national output of emissions. Not only does this ensure that overall emissions are reduced but also that the costs of emissions trading are carried fairly across all parties to the trading system. However, governments of capped countries may seek to unilaterally weaken their commitments, as evidenced by the 2006 and 2007 National Allocation Plans for several countries in the EU ETS, which were submitted late and then were initially rejected by the European Commission for being too lax.

A question has been raised over the grandfathering of allowances. Countries within the EU ETS have granted their incumbent businesses most or all of their allowances for free. This can sometimes be perceived as a protectionist obstacle to new entrants into their markets. There have also been accusations of power generators getting a 'windfall' profit by passing on these emissions 'charges' to their customers. As the EU ETS moves into its second phase and joins up with Kyoto, it seems likely that these problems will be reduced as more allowances will be auctioned.

Establishing a meaningful offset project is complex: voluntary offsetting activities outside the CDM mechanism are effectively unregulated and there have been criticisms of offsetting in these unregulated activities. This particularly applies to some voluntary corporate schemes in uncapped countries and for some personal carbon offsetting schemes.

There have also been concerns raised over the validation of CDM credits. One concern has related to the accurate assessment of additionality. Others relate to the effort and time taken to get a project approved. Questions may also be raised about the validation of the effectiveness of some projects; it appears that many projects do not achieve the expected benefit after they have been audited, and the CDM board can only approve a lower amount of CER credits. For example, it may take longer to roll out a project than originally planned, or an afforestation project may be reduced by disease or fire. For these reasons some countries place additional restrictions on their local implementations and will not allow credits for some types of carbon sink activity, such as forestry or land use projects.

Carbon Tax

Carbon tax is a form of pollution tax. It levies a fee on the production, distribution or use of fossil fuels based on how much carbon their combustion emits. The government sets a price per ton on carbon. Carbon tax also makes alternative energy more cost-competitive with cheaper, polluting fuels like coal, natural gas and oil.

Carbon tax is based on the economic principle of negative externalities. Externalities are costs or benefits generated by the production of goods and services. Negative externalities are costs that are not paid for. When utilities, businesses or homeowners consume fossil fuels, they create pollution that has a societal cost; everyone suffers from the effects of pollution. Proponents of a carbon tax believe that the price of fossil fuels should account for these societal costs.


The primary purpose of carbon tax is to lower greenhouse-gas emissions. The tax charges a fee on fossil fuels based on how much carbon they emit when burned (more on that later). So in order to reduce the fees, utilities, business and individuals attempt to use less energy derived from fossil fuels. An individual might switch to public transportation and replace incandescent bulbs with compact fluorescent lamps (CFLs). A business might increase energy efficiency by installing new appliances or updating heating and cooling systems. And since carbon tax sets a definite price on carbon, there is a guaranteed return on expensive efficiency investments.

Carbon tax also encourages alternative energy by making it cost-competitive with cheaper fuels. A tax on a plentiful and inexpensive fuel like coal raises its per British Thermal Unit (Btu) price to one comparable with cleaner forms of power. A Btu is a standard measure of heat energy used in industry.

The money that is raised by carbon tax can help subsidize environmental programs or be issued as a rebate. Many fans of carbon tax believe in progressive tax-shifting. This would mean that some of the tax burden would shift away from federal income tax and state sales tax.

Economists like carbon tax for its predictability. The price of carbon under cap-and-trade schemes can fluctuate with weather and changing economic conditions. This is because cap-and-trade schemes set a definite limit on emissions, not a definite price on carbon. Carbon tax is stable. Businesses and utilities would know the price of carbon and where it was headed. They could then invest in alternative energy and increased energy efficiency based on that knowledge. It's also easier for people to understand carbon tax.

The Logistics of Carbon Tax

The carbon content of oil, coal and gas varies. Proponents of a carbon tax want to encourage the use of efficient fuels. If all fuel types were taxed equally by weight or volume, there would be no incentive to use cleaner sources like natural gas over dirtier, cheaper ones like coal. To fairly reflect carbon content, the tax has to be based on Btu heat units -- something standardized and quantifiable -- instead of unrelated units like weight or volume.

Each fuel variety also has its own carbon content. Bituminous coal, for instance, contains considerably more carbon than lignite coal. Residual fuel oil contains more carbon than gasoline. Every fuel variety needs to have its own rate based on its Btu heat content.

Carbon tax can be levied at different points of production and consumption. Some taxes target the top of the supply chain -- the transaction between producers like coal mines and oil wellheads and suppliers like coal shippers and oil refiners. Some taxes affect distributors -- the oil companies and utilities. And other taxes charge consumers directly through electric bills. Different carbon taxes, both real and theoretical, support varying points of implementation.

The only carbon tax in the United States, a municipal tax in Boulder, Colo., taxes the consumers -- homeowners and businesses. People in Boulder pay a fee based on the number of kilowatt hours of electricity they use.

Like Boulder, Sweden also taxes the consumption end. The national carbon tax charges homeowners a full rate and halves it for industry. Utilities are not charged at all. Since the majority of Swedish power consumption goes to heat, and because the tax exempts renewable energy sources like those derived from plants, the biofuel industry has blossomed since 1991.

Even though the tax is toward the top end, companies can, and probably will, pass on some of the cost to consumers by charging more for energy.

It's easier to tax consumption than production. Consumers are more willing to pay the extra $16 a year for a carbon tax. Producers are usually not. Taxes on production can also be economically disruptive and make domestic energy more expensive than foreign imports. That's why existing carbon taxes target consumers, or, in the case of Quebec, energy and oil companies.

Carbon tax has a patchy history around the world. It's widely accepted only in Northern Europe -- Denmark, Finland, the Netherlands, Norway, Poland and Sweden all tax carbon in some form.

Carbon Tax Vs Carbon Credit

Carbon Tax is better alternative than Carbon Credit mainly because of the following six reasons

  1. Energy Prices are easily predictable by the mechanism of tax than by the mechanism of Cap and Trade. The high volatility of the carbon credits that are generated by the mechanism of Cap and Trade has consistently discouraged energy efficient schemes.

  2. Tax system can be quickly implemented than Cap and Trade. Since the environment is getting polluted at a faster rate, it is high time that necessary actions are taken quickly and efficiently. Tax system

  3. Carbon taxes are transparent and easily understandable, making them more likely to garner public support than complex Cap and Trade.

  4. Carbon taxes cannot be easily manipulated and hence cannot be easily exploited whereas the complexity of Cap and Trade always provides room for exploitation for special interests

  5. Carbon taxes address emissions of carbon from every sector, whereas some cap-and-trade systems discussed to date have only targeted the electricity industry.

  6. Carbon tax revenues would most likely be returned to the public through dividends or progressive tax-shifting, while the costs of cap-and-trade systems are likely to become a hidden tax as dollars flow to market participants, lawyers and consultants.

Carbon Taxes Will Lend Predictability to Energy Prices. With carbon taxes ramped up through a multi-year phase-in, future energy and power prices can be predicted with a reasonable degree of confidence well ahead of time. This will make it possible for literally millions of energy-critical decisions — from the design of new electricity generating plants to the purchase of the family car to the materials used in commercial airframes — to be made with full cognizance of carbon-appropriate price signals. In contrast, a cap-and-trade program will worsen the volatility of energy prices since the price of carbon allowances will fluctuate as weather and economic factors affect the demand for energy. The vaunted advantage of cap-and-trade — that future levels of carbon emissions can be known ahead of time — is mostly notional. And even certainty in future emission levels is of questionable value, since there is no agreed-upon trajectory of emissions for achieving climate stability and preventing disaster.

Carbon Taxes Will Provide Quicker Results. The taxes themselves can be designed and adopted quickly and fairly. Cap-and-trade systems, by contrast, are highly complex and will take years to develop and implement. Disruptive issues must be addressed intellectually and resolved politically; the proper level of the cap, timing, allowance allocations, certification procedures, standards for use of offsets, penalties, regional conflicts, the inevitable requests for exceptions by affected parties and a myriad of other complex issues must all be resolved before cap-and-trade systems can be implemented. During this time, polluters will continue to emit carbon with no cost consequences.

Carbon Taxes Are Transparent and Are Easier to Understand than Cap-and-Trade. A carbon tax is transparent and easy to understand; the government simply imposes a tax per ton of carbon emitted, which is easily translated into a tax per kWh of electricity, gallon of gasoline or therm of natural gas. By contrast, the prices for carbon set under a cap-and-trade system will vary with market fluctuations and be impossible even for big to predict. A cap-and-trade system will require a complex and difficult to understand market structure in order to balance the many competing interests and ensure that the trading system minimizes distortions and maximizes real carbon reductions.

A Carbon Tax's Simplicity prevents it Against Incentives and Potential for vested interests that Will Accompany Cap-and-Trade. In contrast to the simple and straightforward process of implementing a carbon tax, the protracted negotiations necessary to implement a cap-and-trade system will provide constant opportunities for the fossil fuel industry and other invested parties to shape a system that maximizes their financial self-interests as opposed to an economically efficient system that maximizes societal well-being. If allowances are allocated based on some type of baseline reflecting past pollution (which has been the practice with NOx and SO2trading programs), rather than being auctioned, polluters will have perverse incentives to maximize emissions before the cap-and-trade system goes into effect in order to “earn” those pollution rights.

Carbon Taxes Address All Sectors and Activities Producing Carbon Emissions. Carbon taxes target carbon emissions in all sectors — energy, industry and transportation — whereas at least some cap-and-trade proposals are limited to the electric industry. It would be unwise to ignore the non-electricity sectors that account for more than 50% of CO2 emissions.

Carbon Taxes Can Produce a Far More Equitable Result than Cap-and-Trade. As discussed in our Issue Paper, Managing the Impacts, carbon tax revenues can be returned through dividends or can be used to fund progressive tax-shifting to reduce regressive sales taxes. The costs of cap-and-trade systems, both implementation and the costs incurred as more expensive technologies replace older and less expensive coal-fired combustion, are far more likely to be imposed upon consumers with less possibility of rebating or tax-shifting. Moreover, because cap-and-trade relies on market participants to determine a fair price for carbon allowances on an ongoing basis, the complications involved are severe with economists, lawyers and politicians getting involved constantly.


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