Carbon Knowledge

What are Carbon Credits and How Do Carbon Credits Work?

Businesses in some jurisdictions will need to invest in carbon credits. Are you one of those companies? This guide may help.  

What are carbon credits? 

Carbon emissions from human activities need to go down in order to reduce the risks of climate warming. Some governments are choosing to regulate emissions reductions directly. A variety of approaches are used, the most common of which is “cap-and-trade”. Cap-and-trade programs sell carbon credits to affected companies, allowing them to emit a fixed amount of CO2.  Acquiring a carbon credit is like getting a tradeable permission slip to emit a tonne of CO2.  

Regulators may use a different term than “carbon credit” to describe these permits.   

How do carbon credits work? 

“Cap” refers to the limit governments place on the number of carbon credits they make available each year. “Trade” refers to the sales transactions that take place under this program. Businesses that emit less CO2 than their permitted limit, can sell their surplus carbon credits to others that need to emit more carbon than they are permitted. If one party finds it hard to reduce their CO2 emissions, they can purchase carbon credits from another party who has found it easier to reduce CO2 emissions. 


The regulated cap on carbon credits is supposed to decrease over time, ensuring the amount of COallowed to go into the atmosphere each year is reduced.  

Emitters have to control energy and carbon emissions in their business operations to stay under increasingly restricted emissions limits.  

Governments that adopt this approach effectively create a commodity market for COemissions. As the supply of carbon credits decreases over time, the price of emitting each tonne of CO2 goes up. The desired outcome is for price discovery to reward the most cost-effective carbon reduction solutions.  


Are carbon credits different from carbon offsets?  

carbon credit permits a limited amount of CO2 to be emitted within a compliance market designed to reduce carbon emissions.  

carbon offset is proof that a business has voluntarily taken action to permanently reduce, or remove, a tonne of CO2 emitted into the atmosphere. Such actions “offset” emissions generated elsewhere. The market for carbon offsets is entirely optional, and the sale and purchase of offsets are voluntary.  

What are the attributes of carbon credits? 

Carbon credits, like carbon offsets, are measured in tonnes of CO2. Carbon credits can be bought and sold. In jurisdictions with cap-and-trade, carbon credits help establish a price for carbon. Companies subject to compliance markets must have their CO2 emissions verified annually by a qualified third party.  

A price on carbon attempts to capture the true cost of excess CO2 in the atmosphere. Climate warming is costly. It damages crops from drought and harms health from heat waves. Climate costs include the destruction of capital and livelihoods from flooding and wildfires. A price on carbon is an incentive for fossil fuel energy users to shift to less damaging, non-carbon emitting sources of energy.  

Are there market problems for carbon credits? 

All markets demand certainty. Commodity market assets must be tangible, accurate and add value. Carbon credits in compliance markets and carbon offsets in voluntary markets both have to achieve greater market transparency and disclosure standards. Worldwide efforts are being made to expand carbon markets. As these markets mature, verifying the compensating activity behind carbon credits and carbon offsets will become more stringent. By aligning and standardizing the rules across jurisdictions, non-carbon emitting assets should become more liquid and increase in value.  

Which jurisdictions have compliance programs using carbon credits? 

North American cap-and-trade programs have coalesced around the Western Climate Initiative (WCI). Two American states and two Canadian provinces are currently affiliated with the WCI. 

California: Revenues from California’s cap-and-trade program are allocated through the state’s Greenhouse Gas Reduction Fund to implement further CO2 emissions reductions. Since cap-and-trade commenced, the program has generated $5 billion in total revenues.  

Québec: Quebec established a regulated carbon market in 2013, making it a sector pioneer. Companies subject to the program must obtain carbon credits, or what Quebec terms “emission units”, which are sold at auction with a minimum reserve bid.  Quebec companies facing national and international competition can receive a certain number of emission units free of charge. 

Nova Scotia: Nova Scotia joined the WCI in 2018. They established their own provincial cap-and-trade program in 2019. 26 entities have registered under the program. Only one transaction has been reported as of mid-2022.  

Washington State: Washington joined the WCI at the end of 2021 to support the implementation of its “cap and invest” program, which will begin in 2023. Washington will auction off allowances (i.e., carbon credits) for companies and facilities that emit greenhouse gases until their regulated cap is reached. 

Canada: The Canadian Federal government’s climate program includes an Output-Based Pricing System (OBPS). Businesses subject to the OBPS have an annual limit placed on their emissions. Facilities that exceed their limits, pay the carbon tax on their excess emissions. Facilities that emit less than their limit are issued “surplus credits” (i.e., carbon credits) which can then be used in subsequent years or sold to others needing to avoid penalty costs. 


Ontario: Ontario left the Western Climate Initiative and repealed its cap-and-trade program in 2018. The Ontario Emission Performance Standards (EPS) is now in effect. The EPS takes the place of the federal program in Ontario. Covered facilities can comply by reducing their carbon emissions, by purchasing non-tradeable carbon credits directly from the Ontario government or by submitting “emissions performance units” (i.e., carbon credits). Ontario issues emissions performance units to facilities that emit less than their limits in a given year. These can be banked or sold to other facilities covered under the Ontario program for up to 5 years.  

European UnionThe EU Emissions Trading System (EU ETS) is the EU’s key tool for “fighting climate change”. It is the world’s first major carbon market and remains the biggest one. Europe’s most energy-intensive industries, including airlines operating flights between EU member countries, can use carbon credits to meet mandatory limits. This program has been operating since 2005. 

Carbon credits are integral to compliance markets.  

As compliance-based and voluntary carbon markets grow, businesses will have opportunities to monetize their emissions reductions. Businesses will also face financial, regulatory and reputation risks if they can’t pivot quickly enough to navigate these markets. It is vitally important to understand and remain informed as these markets emerge. 

Ask how 360 Energy can help you comprehensively assess your opportunities and risks in emerging carbon markets.

Learn More about Carbon Offsets in our podcast here.

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