There’s a New Commodity in Town – Understanding the Terminology of Carbon Credits and Offsets

It’s not often that a new, tradeable commodity comes to the market.

We see derivatives upon derivatives—some so complex, even the people who buy and sell them aren’t quite sure what they mean—but the underlying commodity is still the same: crude oil, natural gas, electricity, etc.

Recently, however, the concepts of carbon credits and offsets have emerged as an important commodity class for businesses whose operations inevitably emit carbon dioxide (or its equivalent in other greenhouse gases).

We’re going to be reading and writing a lot about them in the coming months and years.

To engage in productive conversations, we must embrace a related—and growing—array of terminology and acronyms.

In this post, we will cover a starter set of terms to help kick-start your understanding.

Let’s begin at the beginning…

What is a Carbon Credit?

A Carbon Credit is a permit that allows the holder to emit a certain amount of carbon dioxide or other greenhouse gases.

One credit generally permits the emission of one metric tonne of carbon dioxide or its equivalent in other greenhouse gases, usually reported as CO₂e—Carbon Dioxide Equivalent—more on which in a moment.

When an entity reduces its emissions—or captures existing emissions—below what is required by regulation, it can create carbon credits.

The entity can then sell those credits to other entities that are unable to meet their emission reduction obligations or find doing so too costly.

Such transactions form the basis of Cap-and-Trade systems, a method of Carbon Pricing aimed at incentivizing the reduction of emissions.

How are Carbon Credits Managed?

The management of carbon credits is a complex process, stretching from project development to the trading and retirement of credits.

A project begins with a Baseline Study, which measures the quantity of emissions that would occur without a project to reduce them.

The project must then prove Additionality, a criterion that requires a carbon offset project to result in additional carbon reductions that would not have occurred in a business-as-usual scenario.

Next comes the process of Validation, where the project plan is independently evaluated to ensure it meets the requirements of whichever carbon accounting standard is to be applied.

Verification is an essential next step, where another independent body checks actual carbon reductions from a project.

Once they have been verified, carbon credits are issued and recorded by a Carbon Registry—an organization that ensures transparency and integrity of carbon transactions.

Finally, Retirement of credits occurs when a carbon credit is permanently removed from circulation, preventing it from being sold or traded again.

Relevant Treaties and Agreements

You will have heard the names of several international treaties and agreements that have shaped the landscape of carbon credits, with the Kyoto Protocol and the Paris Agreement among the most prominent.

The Kyoto Protocol is an international treaty that extends the United Nations Framework Convention on Climate Change (UNFCCC). It introduced three flexible, market-based mechanisms to assist signatories—known as ‘Annex B’ countries—in meeting their emission reduction targets: the Clean Development Mechanism (CDM), Joint Implementation (JI), and the issuance of Assigned Amount Units (AAUs).

The CDM allows Annex B countries to implement an emission reduction or emission removal project in developing countries. Such projects earn saleable Certified Emission Reduction credits (CERs), equivalent to one tonne of CO₂, which can be counted towards meeting Kyoto targets.

Joint Implementation (JI) allows an Annex B country to earn Emission Reduction Units (ERUs) from an emission reduction or emission removal project in another Annex B country. This encourages technology transfer between countries.

Finally, Assigned Amount Units (AAUs) are tradable emission permits that each Annex B country is issued according to their Quantified Emission Limitation and Reduction Commitments (QELRCs) under the Protocol. Countries that have emission units to spare—permitted but not used—can sell them to countries that exceed their targets. This allows emission reductions to take place where they are most economical.

The Paris Agreement aims to limit global warming to less than 2° Celsius above pre-industrial levels. It shifted the focus toward voluntary participation and nationally determined contributions.

There are also many sector-specific agreements, such as CORSIA (the Carbon Offsetting and Reduction Scheme for International Aviation) initiated by the ICAO (International Civil Aviation Organization) to offset CO₂ emissions from international aviation.

Carbon Credit Markets

There are two primary types of carbon credit market: a Compliance Market and a Voluntary Market.

In a compliance market, companies, governments, and other entities are required to buy carbon credits to comply with caps on their CO₂ emissions.

In a voluntary market, entities choose to purchase Carbon Offsets to reduce their carbon footprint without being compelled to do so by regulation.

Examples of carbon markets include the European Union Emission Trading Scheme (EU ETS), the Pan-Canadian Framework, the Regional Greenhouse Gas Initiative (RGGI), the first mandatory market-based program in the United States, and the Oregon Carbon Dioxide Standard.

Launched in 2005, the EU ETS remains the largest program of its kind in the world. It was established as a result of the Kyoto Protocol and functions as a cap-and-trade system, setting an emissions limit for each company. Companies that reduce emissions below their quotas can sell surplus credits to companies that exceed their caps.

The EU ETS has been developed in phases. The first phase (2005-07) was a "learning by doing" phase, with free allowances leading to oversupply and low carbon prices. The second phase (2008-2012) coincided with the Kyoto Protocol commitment period and aimed to rectify issues from Phase I.

The third phase (2013-2020) introduced more stringent caps, auctioning as the default allocation method for allowances, and broadened sector coverage. The current fourth phase (2021-2030) further reduces the cap on emissions and aligns EU ETS with the EU's 2030 climate and energy goals.

Despite facing numerous challenges, the EU ETS has been instrumental in shaping carbon markets globally and has inspired several other emission trading schemes worldwide.

In Canada, the carbon market revolves around provincial programs and the Pan-Canadian Framework on Clean Growth and Climate Change.

Alberta was the first province to implement a carbon pricing system in 2007—the Specified Gas Emitters Regulation (SGER), which targeted large emitters. SGER was replaced in 2018 with the Carbon Competitiveness Incentive Regulation, which covers a wider range of emissions and establishes output-based allocations of credits.

In 2016, the Canadian government introduced the Pan-Canadian Framework, requiring all provinces and territories to implement carbon pricing systems by 2018. Jurisdictions could choose between a cap-and-trade system, a performance-based system (like Alberta), or a carbon levy combined with an output-based pricing system.

An Offsets System, created under the Greenhouse Gas Pollution Pricing Act, also allows industries to earn offset credits by undertaking projects that reduce emissions.

In the US, the Regional Greenhouse Gas Initiative (RGGI) is a cap-and-trade program involving several Northeastern and Mid-Atlantic states.

Established in 2009, it targets CO₂ emissions from the power sector. Participating states sell emission allowances through auctions and invest proceeds in energy efficiency, renewable energy, and other programs benefiting consumers and reducing emissions.

Oregon has implemented the Oregon Carbon Dioxide Standard, also to control CO₂ emissions from power plants. While it doesn't have a cap-and-trade program, the state requires new energy facilities to offset a portion of their emissions through direct investments in carbon reduction projects or payments to non-profits that invest in such projects.

Washington State adopted a Clean Air Rule in 2016—essentially a cap-and-trade system that targets large CO₂ emitters, such as power plants, natural gas distributors, and fuel suppliers. After multiple legal challenges, it was fully enacted in 2020.

Carbon Offsetting Methods

Various methods and technologies exist to offset carbon emissions.

Among the most widely discussed and applied are:

Afforestation and Reforestation, which involves either planting trees in previously unforested areas or restoring forests to previously forested land, respectively.

Blue Carbon, which refers to carbon sequestered in coastal and marine ecosystems.

Carbon Capture and Storage (CCS) and Direct Air Capture (DAC) technologies that aim to capture CO₂ from effluent streams—e.g., power plant exhaust—or directly from the atmosphere and either store it underground or compound it into another material.

Carbon Farming, which refers to a suite of agricultural methods aimed at sequestering atmospheric carbon into the soil and plant roots.

How is Carbon Dioxide Equivalent Defined?

Let's return briefly to the concept of Carbon Dioxide Equivalent (CO₂e), a standard unit for expressing the carbon footprints of different emission streams.

It allows us to express the impact of different greenhouse gases in terms of the amount of CO₂ emission that would create the same warming effect.

This is achieved using the Global Warming Potential (GWP) of each gas.

The GWP of a gas is based on the total amount of heat it will absorb over a certain period (usually 100 years), compared to the same amount of carbon dioxide. Carbon dioxide, as the benchmark, has a GWP of 1.

Methane (CH₄) is about 25 times more potent at trapping heat than carbon dioxide. This means that 1 ton of methane emissions would be equivalent to 25 tons of CO₂ emissions, or 25 tCO₂e.

Similarly, Nitrous Oxide (N₂O) has a GWP of 298, which means its potential to absorb heat is 298 times that of CO₂. Hence, 1 ton of N₂O emissions is equivalent to 298 tCO₂e.

GWP values are periodically updated as scientific understanding of gases evolves.

By converting all greenhouse gas emissions to CO₂e, we can make comparable measurements and establish a single standard for comparing and aggregating the effects of different emissions, an essential step in reducing the complexity of emissions reduction.

Other Definitions

The concepts of Carbon Neutral and Carbon Negative relate to achieving net zero or negative carbon emissions by balancing the amount of carbon released by an entity with an equivalent amount it sequesters or offsets.

Decarbonization refers to the overall process of reducing the carbon intensity of an industry or national economy, while a Carbon Budget refers to the amount of carbon dioxide emissions we can emit while theoretically limiting global temperature rise to Paris Agreement levels.

In the related world of renewable energy generation, Renewable Energy Certificates (RECs) represent the tradeable rights to non-power attributes of renewable electricity generation.

A REC—or, more generally, an Energy Attribute Certificate (EAC)—is issued for each megawatt-hour of electricity generated and delivered to the grid from a renewable energy resource.

RECs can be traded on the open market, allowing renewable energy producers to fund their operations while giving other entities a way to offset their carbon emissions.

For example, the Midwest Renewable Energy Tracking System (M-RETS) is a web-based system that tracks renewable energy generation in participating states and Canadian provinces and assists in verifying compliance with state and provincial standards.

An Important New Piece in the Energy-Commodity Landscape

Carbon credits provide an innovative approach for the energy and commodity trading industries to contribute to meeting climate-related targets, bringing together environmental goals and market mechanisms.

They are thus becoming a vital tool in the transition towards a lower-carbon, more sustainable global economy.

Carbon credits create an economic incentive for businesses to reduce their greenhouse gas emissions. By putting a price on carbon emissions, businesses can incorporate the environmental cost of their activities into economic decision-making processes.

Projects that generated carbon credits by reducing or eliminating greenhouse gas emissions create a new revenue stream for projects in renewable energy, energy efficiency, and other sectors aligned with the carbon transition. The generation and sale of carbon credits can thus make sustainable practices more profitable, leading to larger scale adoption.

And by taking a market-based approach, the trading of carbon credits leverages the efficiency of the market to find the most cost-effective ways to reduce emissions.

Importantly, the emerging carbon credit system and markets are not limited to any specific geography. Companies, projects, and buyers can participate from around the world, making carbon accounting a global tool for reducing greenhouse gas emissions.

Finally, all this fast-paced development and excitement creates its own set of risks and rewards.

There's an increasing risk associated with high-carbon business activities, but also volatility and risk in the valuation and trading of carbon credits and offsets. And regulatory pressure is rising as public awareness grows.

This all sounds very familiar to those of us working in established corners of the commodity trading and energy trading industries.

Who better, then, than us to play a leading role in organizing and managing this new commodity market?