What are Carbon Credits and how do they work?

CARBON CREDITS

What are CARBON CREDITS?

Technically, they are defined as INTERCHANGEABLE UNITS (tradable in the market as a product that is sold) that represent one ton of carbon dioxide equivalent (1 ton $CO2e$ ) that has been avoided (reduction) or eliminated (removal or capture) from the atmosphere.

Why are they called "credits"?

Carbon credits are named this way due to the analogy that can be made between them and the traditional financial system, in which a credit represents a right to receive payment or collection of money in the future.

For example, when a person takes out a bank loan, they receive a credit from the bank that gives them the right to use the borrowed money, and at the same time, they acquire the commitment or responsibility to pay it back to the bank in the future, including interest. That is, the bank that issues the credit (as a tradable product) acquires the right to receive the loaned money back with a profit (the interest).

Similarly, a carbon credit represents a right to emit one ton of carbon dioxide ( $CO2$ ) into the atmosphere in the future. The holder of a carbon credit—meaning both the one who issues or produces the carbon credits (through the development of a verified project) and the one who purchases or pays for the carbon credit in the market—can:

Emit one ton of $CO2$ : This can be useful for companies or sectors that have difficulty reducing their emissions directly (Recommended reading: What is GHG Emissions Offsetting?).
Sell the credit to another person or company: This can be a source of income for the projects that generate carbon credits (Learn about the Verra ID3927 Project - Carbon Credits with Regenerative and Sustainable Livestock in Colombia).

Main Characteristics of Carbon Credits

The analogy with the financial system helps to understand how carbon credits work:

Each carbon credit represents one unit of $CO2$ : Just as each unit of currency represents a specific monetary value.
Carbon credits can be bought and sold: Just like stocks, bonds, or other financial instruments.
The price of carbon credits varies: Based on supply and demand, just like the price of other financial assets.

The use of the term "credit" also reflects the idea that $CO2$ emissions are a limited resource. Like money, $CO2$ emissions must be managed responsibly to avoid a negative environmental impact (Recommended reading: What is Carbon +?).

How Does the Carbon Credit Market Work?

They function as a market system that allows:

1. Companies and Individuals that Produce Emissions:

Reduce their carbon footprint: By purchasing carbon credits, companies or individuals finance projects that reduce or eliminate the same amount of $CO2$ they emit. This allows them to "neutralize their environmental impact," even if they have not directly reduced their own emissions. This, in fact, generates much controversy, as there are those who oppose carbon credits with the argument that they are not an effective measure to genuinely commit companies to reducing or eliminating their emissions and thereby contributing correctly and effectively to the fight against climate change. They argue that if companies can avoid reducing their emissions by paying for them (acquiring credits that give them the right to continue emitting), they will continue to emit as much as their economic capacity allows.
Comply with regulations: In some countries, regulations exist that compel companies to limit their $CO2$ emissions. Carbon credits can be used to comply with these limits.

2. Projects that Reduce Emissions:

Obtain financing: Projects sell their generated carbon credits to companies or individuals seeking to offset their emissions. The income obtained allows them to finance the implementation and operation of their projects, which is why it is also known as a "climate financing mechanism."
Incentivize emission reduction: Projects focused on issuing and selling carbon credits, whether in the official market (state-run projects) or the voluntary market (private projects), drive the development of a market that incentivizes the development and implementation of projects that reduce or eliminate $CO2$ emissions.

How are Carbon Credits Generated?

They are generated through certified projects (which involve Measurement + Reporting + Verification = $MRV$ ) that can ensure the projects comply with rigorous international standards. The certificates, in turn, confer quality on the credits, and the higher the quality, the better value they can achieve in the market. These projects can be of various types, such as:

Renewable Energy: Projects that replace energy generation with fossil fuels with renewable sources such as solar, wind, or geothermal energy.
Energy Efficiency: Projects that improve energy efficiency in buildings, industries, or production processes, thereby reducing energy consumption and associated emissions.
Afforestation/Reforestation: Projects that plant trees or restore forests, which absorb $CO2$ from the atmosphere through photosynthesis.
Forest Management: Projects that optimize the management of existing forests to increase their carbon sequestration capacity.
Carbon Capture and Storage ( $CCS$ ): Projects that capture $CO2$ from point-source emissions, such as those generated by power plants or industries, and store it safely underground. Agricultural projects, such as those involving regenerative agriculture and/or livestock farming, for example, fall under this classification, as they capture emissions from the atmosphere and store them as Soil Organic Carbon ( $SOC$ ), where captures or removals can be greater than emissions (Recommended reading: Can I be Carbon Positive (C+) in Livestock Farming?).

How are Carbon Credits Bought and Sold?

They are traded in specialized markets, where a price is established per ton of $CO2$ equivalent. The price varies depending on the project's quality, the type of technology used, and market demand.

What Are the Advantages and Disadvantages of Carbon Credits?

Main Identified Advantages:

Quantify Emissions: They allow for the quantification and monetization of $CO2$ emissions, which facilitates comparison and tracking of progress in emission reduction.
Incentivize Investment: They create a market that incentivizes investment by companies or individuals in projects that reduce or eliminate $CO2$ emissions.
Flexibility: They offer companies and individuals flexibility in offsetting their emissions in various ways.

Main Identified Disadvantages:

Not a Long-Term Solution: They should not be seen as an excuse for not reducing one's own emissions. It is crucial to implement measures to continuously reduce the carbon footprint.
Project Quality: It is important to select carbon credits that come from reliable, high-quality projects that effectively reduce or eliminate $CO2$ emissions.
Double Counting: There is a risk that the same carbon credits might be counted twice, which could reduce their actual impact on emission reduction.

In Summary, Carbon Credits:

Represent a right to emit $CO2$ .
Function similarly to financial credits.
Reflect the idea that $CO2$ emissions are a limited resource.

In conclusion, carbon credits can be a useful tool to complement emission reduction strategies, but they are not a solution on their own. Therefore, it is important to emphasize that carbon credits are not a magical solution for decarbonization and mitigating the effects of climate change. It is essential for companies, individuals, and governments to adopt measures to reduce their $CO2$ emissions directly and continuously, while simultaneously supporting the development and implementation of high-quality projects that contribute to the decarbonization of the economy.

What is the Difference Between Carbon Credits and Carbon Offsets (or Carbon Bonds)?

In reality, there is no fundamental difference between carbon credits and carbon offsets (or carbon bonds). Both terms are used interchangeably to refer to interchangeable units that represent one ton of carbon dioxide ( $CO2$ ) equivalent that has been avoided or eliminated from the atmosphere. The use of both terms is common. In some cases, a subtle distinction may be made:

Carbon Credits: Used more frequently in the context of specific projects that generate and sell credits.
Carbon Offsets (or Carbon Bonds): Used more frequently in the context of government programs or initiatives that establish emission limits and allow the trading of offsets/bonds to comply with those limits.

However, in general practice, there is no significant difference between carbon credits and carbon offsets (or carbon bonds). Both terms refer to the same financial instrument and are used interchangeably.

Despite this, the Colombian Association of Carbon Market Actors (ASOCARBONO) clarifies that it is important not to confuse the two terms, and defends the criterion that they should not be understood as if they were the same. They affirm that the term "Carbon Bonds" can be confusing (especially for those who are just beginning to understand this language), and that it does not accurately reflect how the carbon market truly functions.

They explain that "Carbon Bonds" are not, strictly speaking, a financial instrument: "In finance, a bond implies a debt that generates interest." In contrast, what is commonly being called a "Carbon Bond" does not in itself represent a debt, but a verified climate action—that is, having avoided or reduced Greenhouse Gas Emissions ( $GHG$ Emissions). This is the reason it can cause confusion, especially when dealing with investors or legislators.

The correct term to avoid these potential confusions, therefore, is: "Verified Carbon Credit (VCC)". This, as explained, represents 1 Ton $CO2e$ avoided or removed (captured), and is the result of concrete actions taken to avoid or remove $GHG$ emissions, which are duly quantified and verified (and therefore certified) by a competent authority.

This is why International Standards (such as the $IPCC$ -Intergovernmental Panel on Climate Change- and the main Certification programs) do not use the term "Carbon Bonds", and only use the term "Carbon Credits."

Thus, carbon credits function in the following way:

They are generated through certified projects that reduce or eliminate $CO2$ emissions.
They are traded in specialized markets, where a price is established per ton of $CO2$ equivalent.
They allow companies and individuals to neutralize their carbon footprint by purchasing verified credits or offsets (not bonds) and financing projects that reduce the same amount of $CO2$ they emit.

The important thing is to understand that verified carbon credits/offsets (VCC) are a tool that can be useful to complement emission reduction strategies, but they are not a solution on their own.

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