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What Are Carbon Credits & How Do They Work?

Have you heard of carbon credits but aren’t sure what they are or how they work? Read this comprehensive guide to find out all your need to know about carbon credits.

Carbon credits are a way to reduce greenhouse gas emissions by trading or purchasing the right to emit a certain amount of carbon dioxide or its equivalent. This system encourages companies and individuals to limit their own emissions while giving them the incentive to reduce their environmental impact.

What Are Carbon Credits?

Carbon credits represent specific amounts of greenhouse gas (GHG) emissions. One carbon credit is equivalent to one metric tonne of CO2-equivalent—or the amount of carbon dioxide or other GHGs with the same global warming potential as one tonne of carbon dioxide. The market for carbon credits allows companies and individuals to purchase and trade them, enabling them to reduce their own greenhouse gas emissions while also providing an incentive to reduce environmental impact.

Benefits of Carbon Credits:

Carbon credits are a market-based approach that offers the potential for scaling up the reduction of greenhouse gases. They provide businesses, organizations, and individuals with more cost-efficient ways to invest in emissions reductions without having to reduce their own emissions directly. The monetization of carbon taxes also rewards those who invest in emissions reductions by providing them with additional revenue from the sale of credits. Carbon credits also create incentives for investments in clean technologies and renewable energy sources.

Risks of Carbon Credits:

One downside of carbon credits is that they may not adequately reflect the true cost of emissions reductions. Carbon credits could also potentially create perverse incentives, such as companies or individuals gaming the system in order to generate additional revenue from trading credits without actually reducing their own emissions. Additionally, carbon credits are not a panacea for addressing climate change–more must be done to reduce global emissions alongside implementing carbon credit programs.

Carbon credits are associated with a range of financial risks, including currency risk, political risk, project-related risk, counterparty risk and liquidity risks. Currency risk is particularly relevant given the increased scope of carbon investments and the prevalence of international compliance regimes that use tradable credits as a form of currency exchange. Also, there is much market uncertainty about how carbon pricing will be implemented and what impact it could have on overall costs for developing countries and industries. Inefficiencies in carbon markets could mean higher costs for consumers or reduced environmental benefits. Thus, it is essential to consider potential risks when assessing investment strategies involving carbon offsets.

Different Types of Carbon Credit Programs:

There are several different types of carbon credit programs which have been used around the world. These include national and regional cap and trade systems, offsetting schemes, voluntary markets, and sectorial agreements, among others. Under these programs, governments or organisations set up a trading system whereby businesses or individuals can ‘trade’ in order to reduce their carbon emissions.

A carbon credit is a tradable certificate that represents the reduction of one tonne of carbon dioxide (CO2). The EU Emissions Trading System (EU ETS) is the world’s largest system for trading carbon, with the goal of reducing greenhouse gas emissions. It works by setting up a limit on total emissions from large companies in certain sectors. Companies must then purchase credits to cover any excess beyond their quota – with organisations or countries paying for emission reductions elsewhere in order to meet their own targets being credited for this action. This creates a market for carbon in which entities can buy and sell credits, and thereby financially reward those who reduce emissions.


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