A “carbon credit” is a licence that sanctions any company or country to emit a certain amount of carbon dioxide or greenhouse gases like methane, nitrous oxide or hydrofluorocarbons over a given period. One carbon credit restricts the emission to one ton of carbon dioxide or equivalent amount of other greenhouse gases (tCO2e). A credit becomes tradeable as it helps in the reduction of net emissions.
The Kyoto Protocol has established the proportions of greenhouse gases (denominated in individual units) that each developed country could emit. These were called Assigned Amount Units (AAUs) and were corresponding to an allowance to emit a ton of CO2 or any equivalent amount of greenhouse gas. Each country then divided its quotas, assigning them to local businesses and organisations, setting a limit on the emissions of CO2 for each of them.
Any government or administrative body keen on limiting their carbon dioxide emissions could issue Carbon Credits. Carbon trading follows the norm of an emissions capping and trade approach, i.e., a market-based approach in which economic motivations are used to encourage reductions in the emissions of pollutants. Carbon Credits being tradable, when a credit is sold, the buyer is purchasing the seller’s allowance of emissions.
But who buys Carbon Credits? These are subscribed, on a voluntary basis, by any nation or company concerned about lowering its carbon footprint.
Major three types of carbon credits are:
The Kyoto Protocol categorises nations into two groups according to the level of development: Industrialised and Developing economies. The first group functions in an emissions trading marketplace, assigning to each country a definite emissions standard to fulfill.
Suppose if a nation emits less than its aimed amount of CO2, it can sell the excess credits to other nations that do not meet their emission standards established by the Kyoto Code. This buying and selling of Carbon Credits is controlled by a legal contract called the ERPA (Emission Reduction Purchase Agreement).
Buyers and sellers can also run through an exchange platform to trade, which is like a stock exchange for carbon credits. In some situations, it is more cost-effective to pay a fine than to buy Carbon Credits due to its high price.
Another instrument, called Clean Development Mechanism, which is specifically for developing countries, issues Carbon Credits for backup sustainable development initiatives (these Carbon Credits are named Certified Emission Reduction, or CER).
Country A emits less than its target amount of CO2; this means that Company A has an excess of Carbon Credits. Country B, on the other hand, emits more than its target quantity of hydrocarbons, so either Country B pays a fine or tries to buy Carbon Credits from another nation. At this point, Nation A and Nation B get to an agreement and trade Carbon Credits: country A sells its surplus to country B, getting money as well as a positive image, while Country B buying Carbon Credits from Country A avoids paying a fine.