What are carbon credits, and do they help or hinder the fight against climate change? - Raphael Chaskalson

Let’s begin with a quick thought experiment. You, or your company, want to do your bit to fight climate change, and have made a big effort to reduce your own emissions. Wouldn’t it be great if you could spend some additional money to fund emissions reductions elsewhere in the world, to go above and beyond your own emissions reduction efforts? This idea underpins the concept of a carbon credit. You might not have bought carbon credits yourself – but you’ve helped finance them if you’ve ever purchased a product claiming to be “carbon neutral”, for example, or if you’ve chosen an electricity provider that claims to supply you with zero carbon electricity. These instruments are elegant in their simplicity – but have proven extremely controversial in climate policy circles. This article is intended to give you a primer on what these instruments are, what they can (and can’t) be used for, and why – despite their noble aims – their merits continue to be vigorously debated.

We need to go back at least 35 years to understand why these instruments were originally developed. But before we do, let’s be clear on what they are. A carbon credit is a tradeable instrument that is meant to represent a tonne of greenhouse gas emissions reduced or removed from the atmosphere. They are expressed as tonnes of “CO2 equivalent” – meaning that they can include reductions in other greenhouse gases (like methane), whose climate impacts have been normalised to be fungible with carbon dioxide. The money used to purchase the credit should, in theory, be used be used to fund an intervention that has positive outcomes for the climate – for example, reforesting a vacant area of land, or shutting down a coal power plant earlier than planned. This is the supply side of the market – one factor that determines the credit’s price. The demand-side, which also determines price, is less straightforward. Buyers of carbon credits will want them more – and pay higher prices for them – if there is a strong use case for “owning” an asset that represents a climate benefit.

This is where it is critical to understand the different use cases for credits. Many people refer consider carbon credits and “carbon offsets” synonymous. This is a common error. Carbon offsetting is a specific use case for carbon credits, by which their CO2 equivalent value is netted directly against your or your company’s emissions, and the value that you report is the difference between the two. You could equally buy credits and report their total separately, to show how much you’ve contributed to the fight against climate change in excess of you or your company’s direct emissions. These nuances are critical to understanding why these instruments are controversial. We will return to this point later on.

“We were never under any illusion that carbon offsets were going to save the world”

But first: some history. It was an American Energy Company – Applied Energy Services (AES) – who, together with the World Resources Institute (WRI), conceived of the first carbon crediting programme in 1989. AES operated small coal-fired power stations. Climate science was already aware of the impacts burning coal has on the atmosphere, as was the CEO of AES, who wanted to reduce the company’s impact on the planet but saw no cost-effective alternative to producing electricity at scale other than by burning coal. So, with WRI’s technical assistance, AES designed and funded a conservation project in Guatemala to slow down deforestation, and hence reduce the total greenhouse gases in the atmosphere. Mark Trexler, who WRI contracted to lead the project, saw this as a purely philanthropic exercise. “We were never under any illusion that carbon offsets were going to save the world”, he later told Carbon Brief.

However, the idea of incentivising emitters to pay for cost-effective emission reductions quickly gained mainstream policy traction in the 1990s. It’s easy to see why: planting trees in a developing country is far cheaper than, say, flying an aeroplane off sustainable fuel. Carbon credits were arguably a climate economist’s dream, offering efficient solutions to complex problems. The landmark Kyoto Protocol (1997) included provisions to create a UN-supervised platform for trade in credits to fund emissions reductions around the world, known as the Clean Development Mechanism (CDM). This, it was believed, would channel billions of dollars in climate finance towards green activities in emerging markets, and spur on a broader process of sustainable development.

It didn’t work out that way – here’s why.

“Sham consultations, ruthless exploitation”

In the early 2010s, it became clear that many CDM projects were either very likely to happen anyway (given government policy and global economic trends at the time), or were based on unrealistically high assumptions of what emissions would be in the absence of the carbon credits. In the climate jargon, this is referred to as failing to meet the test of “additionality”. Early crediting programmes also suffered from an issue known as “carbon leakage” – the counterintuitive phenomenon where emissions reductions in one place lead to emissions increases elsewhere. For example, a carbon crediting programme to conserve forest from illegal logging in the Amazon would not represent genuine emissions reductions if those same illegal loggers simply moved to another tract of forest. Finally, several journalistic investigations revealed that CDM projects often benefited large corporations at the expense of local communities. A Carbon Market Watch article in 2018, assessing CDM projects in India, catchily dubbed the CDM reality as “sham consultations, ruthless exploitation”.

In response to the CDM’s perceived failures, voluntary carbon standards began to emerge claiming to address these issues more reliably. The largest of these standards are Verra (based in Washington D.C.) and Gold Standard (based in Geneva). Credits certified by these standards and subsequently bought by companies came to be known as “voluntary carbon markets” (VCMs), because they sat outside the UN infrastructure and regulated markets like the EU Emissions Trading Scheme. VCMs grew rapidly after 2012 – reaching a peak of $2bn in 2022 – but Gold Standard, Verra, and other standard setters eventually found themselves subject to similar critiques that were originally levelled at the CDM. A series of recent articles by The Guardian and New Yorker accused the major carbon standards of certifying credits that vastly overstated the climate impacts of forest conservation projects, as well as presiding over programmes involving corruption or dispossession of local communities. Verra’s CEO David Antonioli resigned shortly after the Guardian investigation was published in 2023.

As the entities selling the credits were scrutinised, the buy-side of the market was also profoundly transformed. In the early 2010s, the CDM had a guaranteed source of demand – the European Union’s Emission Trading Scheme (ETS). Put simply, the ETS set limits on how much firms could emit in heavy industries, and then allowed companies to trade “excess” emissions if they undershot targets. In the early phases of the ETS, companies could reduce their carbon liabilities by buying CDM credits. But when it became clear that the CDM was producing “junk” credits, the European Commission quickly acted – and phased them out of the ETS entirely in 2013.

In parallel, advertising regulators began to take a heightened interest into why companies bought these credits, and what they were telling the public as a result. In one particularly infamous example, the UK start-up Brew-Dog – which sells craft beer – marketed its products as “carbon negative”. But consumer groups rightly questioned whether Brew-Dog’s operations really sucked carbon out of the atmosphere and demanded more transparency on the extent to which their claims relied on offsetting. Controversies like these paved the way for a broader backlash against offsetting as a use case for carbon credits. The EU’s Green Claims Directive now explicitly bans carbon neutrality claims using carbon credits. The Science-Based Targets Initiative (SBTi) – the leading net-zero standard for corporates – supports companies purchasing carbon credits as part of a broader climate strategy, but requires them to be reported separately from a company’s emissions. In other words, under SBTi, you can’t offset. These developments have contributed to a huge slump in the market. While roughly $2bn worth of carbon credits were traded in 2022, this number slumped to $700m in 2023.

“Stop debating carbon markets and start building them”

Given the clear difficulties in designing carbon credits that do what they say on the tin, and the challenges in safeguarding consumers from misleading claims, should we stop producing and using these instruments entirely? The answer depends on who you ask.

Many environmental publications, and most climate activist organisations, would shout “no” from the rooftops. Greenpeace, for example, brand carbon offsetting “a bookkeeping trick intended to obscure climate-wrecking emissions” and suggest that the market is funded by “big polluters who want to keep putting profits over people and planet”. Carbon Market Watch, meanwhile, claim that many of the largest companies use carbon credits as a cover for low climate ambition, and even that purchases of credits could be used to divert attention from human rights abuses (the 2022 FIFA World Cup in Qatar was marketed as “carbon neutral”).Whether carbon credits slow down “real” decarbonization is debated in the literature. A 2023 study by Trove Research – recently acquired by MSCI – claimed that companies using carbon credits decarbonize twice as fast as those that don’t, implying that the primary credit buyers are already climate leaders. Nonetheless, these views are influential with some policymakers, particularly in the EU and among some small-island states most vulnerable to the effects of climate change.

But many countries, standard-setters and international organisations disagree. Carbon credits as a financing solution continue to be supported by most UN agencies, advanced economies like the USA and Singapore, as well as many developing countries in Africa and Latin America. There is one primary reason why: the potential of carbon credits to channel climate finance to emerging markets. According to the International Energy Agency, these countries will need up to a seven-fold increase in investment to between USD 1.4-1.9 trillion per annum in clean energy by 2030 – compared to just $260bn currently. With such a rapid step-up in cross-border climate finance required, the argument goes, we cannot leave any potential source of climate finance untapped, including carbon credits. Even under the UN’s landmark Paris Agreement (2015), countries are still encouraged to engage in “cooperative approaches” to reduce emissions, a euphemism for cross-border carbon trading by sovereigns in pursuit of national climate targets. A Swiss Foundation, for example, has recently agreed to fund the electrification of Bangkok’s bus fleet, in return for the right to claim the resultant emissions benefits. In a recent op-ed for the Financial Times, Mark Carney – the UN Special Envoy on Climate Action and Finance – came out strongly in support of these arguments. He called on policymakers to “stop debating carbon markets start building them.”

Within the broader climate finance challenges, carbon credits may be particularly useful to fund interventions that otherwise struggle to attract private capital. To take one example: if the relatively young coal fleet in the Asia Pacific is allowed to run to its natural life, it will exhaust most of the 1.5-degree carbon budget before 2030. The challenge of phasing out unabated coal power is therefore extremely urgent. But the private sector has been unwilling to fund early coal phaseout, in part because breaking existing power purchase agreements is a significant up-front cost with no returns. Carbon credits could – if designed with the right safeguards – offer an additional revenue stream to make these transactions bankable, by putting a price on the emissions reduced by shutting down the asset early. Major international development funders – including the World Bank – are likewise betting heavily on carbon markets continuing to fund similar interventions in the forestry space for years to come.

“Core carbon principles”

What, then, will be necessary for these efforts to cut through the noise, and show the world that carbon credits have a role as a climate finance source? One critical ingredient must surely be international consensus on what constitutes a “reliable” credit (i.e., supply-side integrity) and what constitutes appropriate use cases (demand-side integrity). Thankfully, standard-setters are beginning to offer some answers. Following a stakeholder-led process launched at COP26 in Glasgow, The Integrity Council for the Voluntary Carbon Market (ICVCM) emerged as the first supply-side credibility standard for VCMs. It now offers a “Core Carbon Principle” certification to credits that meet minimum criteria for addressing leakage, additionality, and human rights concerns. On the demand side, the Voluntary Carbon Markets Integrity Initiative released a detailed standard last year, setting out what claims can be made based on credit purchases, and what preconditions companies need to meet to make them. Moreover, UNFCCC has just adopted technical guidance for carbon credits to be traded through Article 6.4, the successor to the CDM, which are widely expected to improve credit quality.

But standard-setting initiatives can only go so far. Early indications suggest that the overall market size will not recover in value to 2022 levels this year. Policy debates on the topic continue to be heavily ideological and combative, between those who think carbon credits are a greenwash with exceptions, and those who think they are a panacea to addressing the climate finance gap. Mark Trexler may have been right that carbon credits aren’t going to save the world – but with better alignment between policymakers – and less noise in a sometimes-toxic debate – they might be making a better attempt at it.