What is a carbon credit?
– A carbon credit is a tradable permit that represents the right to emit one metric ton of carbon dioxide (CO2) or the equivalent amount of another greenhouse gas (GHG). “GHG” stands for greenhouse gas; common examples include CO2, methane, and nitrous oxide.
– Purpose: to put a measurable value on emissions and create financial incentives to reduce them.
How carbon-credit systems work (basic mechanics)
1. A regulator (usually a government) sets an emissions cap for a sector, region, or country.
2. The regulator issues a limited number of credits or allowances equal to the cap.
3. Regulated entities (power plants, large industrial firms, fuel suppliers, etc.) must hold enough credits to cover their reported emissions.
4. Firms that emit more than their holdings must buy credits. Firms that emit less can sell surplus credits on a market.
5. Credits that are bought and then “retired” cannot be reused; that retirement removes the right to pollute again by that amount.
Key definitions
– Carbon credit / allowance: a permit to emit one metric ton of CO2-equivalent.
– Carbon offset: a credit representing an emissions-reduction activity (e.g., tree planting, methane capture) that offsets emissions elsewhere; often traded in the voluntary market rather than under regulation.
– Cap-and-trade: a regulatory system that combines a hard cap on emissions with market trading of allowances.
– Compliance market: regulated market where credits are used to meet legal requirements.
– Voluntary market: non‑regulated market where organizations buy offsets to meet voluntary climate goals.
U.S. context — laws and programs
– The U.S. has used market-based approaches to control air pollution for decades. The 1990 Clean Air Act amendments created an early cap-and-trade-style program for sulfur dioxide that helped reduce acid-rain–causing emissions from coal-fired power plants.
– Several U.S. states run or participate in cap-and-trade schemes. For example, a group of Northeastern states runs the Regional Greenhouse Gas Initiative (RGGI). California launched a statewide cap-and-trade program covering large electricity generators, industrial facilities, and fuel distributors; it began in 2013 and is one of the largest systems globally.
– Federal policy: the Inflation Reduction Act (signed 2022) expanded tax incentives for carbon capture and storage/use (the 45Q tax credit). Under the updated rules, the subsidy for each metric ton of CO2 permanently stored underground rose (from previous levels to $85/ton in some cases), and credits for captured CO2 used in manufacturing or enhanced oil recovery increased as well (to $60/ton for some uses). These changes aim to boost private investment in carbon-capture technologies.
Who can sell and who can buy?
– In compliance markets, governments issue and sell allowances to regulated entities; firms can resell surplus allowances among themselves on regulated exchanges.
– In voluntary markets, project developers, landowners, NGOs, or companies can develop emissions-reduction projects (reforestation, avoided deforestation, methane capture, etc.) and sell offsets once projects are validated and verified by an accepted registry.
– Individuals cannot sell compliance allowances, but anyone can buy voluntary offsets to fund a project and claim a voluntary reduction.
Why companies buy credits and offsets
– Compliance: to satisfy legal obligations when emissions exceed permitted levels.
– Voluntary: to meet corporate “net-zero” or other sustainability commitments when full internal reductions are not feasible.
– Financial management: firms compare the cost of buying credits against the cost of reducing emissions directly; a rising price for allowances is intended to push more investment into low‑carbon technologies.
Key criticisms and limitations
– Timing and oversupply: if caps are set too loosely or reductions happen faster than anticipated, a surplus of credits can depress prices and weaken incentives.
– Integrity concerns: voluntary offsets vary in quality; some projects may overstate actual carbon reductions or fail to ensure permanence (e.g., trees that later burn down).
– Distributional questions: revenue from allowance sales can flow to governments, project developers, or third parties; who benefits depends on program design.
International background
– The Kyoto Protocol (1997) created internationally transferable mechanisms and categories for emissions trading, with rules later clarified in agreements like the Marrakesh Acc
sords) that detailed implementation rules. After Kyoto, international carbon markets evolved through mechanisms such as the Clean Development Mechanism (CDM) and Joint Implementation (JI). The Paris Agreement (2015) then reshaped the landscape again: Article 6 creates pathways for countries to transfer mitigation outcomes across borders (so‑called Internationally Transferred Mitigation Outcomes, ITMOs) and establishes a centralized mechanism under Article 6.4 to govern certain transfers and create credits with international use. Implementation details for Article 6 have been negotiated but remain an area of active policy development and market design.
Standards, registries, and verification
– Standards: Independent program rules define eligible project types, methodologies to calculate emission reductions, monitoring requirements, Additionality (proof the reduction would not have happened but for the project), permanence (for removals like forestry), and safeguards. Major standards include Verra (VCS), the Gold Standard, and others that set the technical and social safeguards buyers often require.
– Registries: A registry issues, tracks, and retires credits. Each credit usually has a unique serial number and metadata (project, vintage year, standard). Registries help prevent double counting and allow buyers to verify retirement (permanent cancellation).
– Verification: Accredited third‑party auditors (verifiers) check project documentation, monitoring reports, and measurement to confirm reductions before credits are issued. Verification frequency depends on the project and standard.
How a carbon credit is created — step‑by‑step
1. Project identification: developer selects a mitigation activity (e.g., wind farm, methane capture, reforestation).
2. Methodology selection: choose an approved methodology that defines baseline calculation, monitoring, and leakage treatment.
3. Baseline calculation: estimate what emissions would have been without the project (baseline scenario).
4. Project implementation and monitoring: install technology and record emissions/outputs per the monitoring plan.
5. Third‑party verification: an independent auditor reviews data and confirms achieved reductions.
6. Issuance: registrar issues credits equal to verified reductions (usually denominated in metric tonnes of CO2 equivalent, tCO2e).
7. Retirement/cancellation: when a buyer wants to claim the reduction, they retire the credit on the registry so it cannot be resold.
Worked numeric example
– Project: landfill gas capture.
– Baseline emissions (without project): 10,000 tCO2e per year.
– Project emissions (with capture system): 2,500 tCO2e per year.
– Verified reduction: 10,000 − 2,500 = 7,500 tCO2e → 7,500 credits issued for that vintage year.
– Revenue example: if credits sell at $12 per tCO2e, gross revenue = 7,500 × $12 = $90,000.
– Adjustments: subtract verification fees, registry fees, and any buffer pool contributions for permanence. Net to developer will be lower.
Types of markets
– Compliance markets: Created by regulations (e.g., regional cap‑and‑trade programs). Credits/allowances are used to meet legal obligations. Examples: European Union Emissions Trading System (EU ETS), California Cap‑and‑Trade.
– Voluntary markets: Corporates, institutions, or individuals buy credits to offset emissions beyond legal requirements. Quality varies more; buyers must perform due diligence on standards and co‑benefits.
Key attributes buyers should check (checklist)
– Standard and methodology used.
– Registry and serial number (verify issuance and retirement).
– Vintage year (the year reductions occurred).
– Additionality demonstration and baseline assumptions.
– Permanence guarantees (especially for removals like forestry).
– Co‑benefits (biodiversity, community outcomes) and any associated claims.
– Risk of reversal, leakage, or over‑crediting.
– Price and counterparty reliability.
Common pricing drivers
– Policy and regulation (e.g., emissions caps tightening increases demand).
– Supply dynamics (number and type of projects issuing credits).
– Credit quality (robust methodologies and high verification standards command premiums).
– Market sentiment and corporate net‑zero pledges.
– Macroeconomic factors and energy prices (which affect abatement costs).
Risks and how to mitigate them
– Over‑crediting: ensure methodologies are conservative; prefer projects with transparent documentation.
– Double counting: confirm credits are retired and not claimed by another party or country (follow registry records and Article 6 guidance).
– Non‑permanence: for removals (trees), require buffer pools, insurance or conservative accounting.
– Verification failure or fraud: buy credits from established standards and reputable registries; check verifier accreditation.
– Regulatory change: be cautious about relying on credits for compliance until program rules are stable.
Practical steps for an organization that wants to buy credits
1. Define objective: compliance vs. voluntary offsetting, and whether the purchase is for a public claim.
2. Set criteria: acceptable standards, co‑benefits, vintage range, and price band.
3. Search markets: use exchanges, brokers, or project developers; verify listings in registries.
4. Due diligence: review project documentation, verification statements, and registry entries.
5. Purchase and retire: buy credits and retire them on the chosen registry if claiming the reductions.
6. Report transparently: disclose the purchase, vintage, standard, quantity retired, and the exact claim being made.
Accounting and reporting notes
– Follow established guidance such as the GHG Protocol for corporate inventories. A credible claim typically requires retiring credits
on a public registry so the credits cannot be resold and the emission reduction is uniquely linked to your claim.
Retirement mechanics and why they matter
– Retiring a credit: mark a specific serial-numbered credit in a public registry as used (retired) for a particular purpose and date. The registry then prevents further transfers of that serial number.
– Prevents double selling: retirement ensures the same credit is not sold to multiple buyers.
– Enables transparent claims: registries publish retirements so third parties can verify your quantity, standard, vintage, and serial numbers.
– Does NOT change your reported gross emissions: you should still report and disclose your actual (gross) emissions by scope; offsets are a separate line item unless specific accounting guidance permits otherwise.
Practical retirement checklist (step-by-step)
1. Confirm the registry and serial numbers before payment. Typical registries: Verra, Gold Standard, American Carbon Registry, Climate Action Reserve.
2. Purchase the credits and obtain seller documentation showing serial numbers and project details.
3. Request retirement on the chosen registry. Required fields usually include: buyer/claimant name, retirement date, purpose of retirement (e.g., “to neutralize residual Scope 1 emissions 2024”), and the serial numbers.
4. Obtain the retirement certificate/receipt from the registry. Save the URL or PDF and archival metadata (retirement ID, timestamp).
5. Disclose the retirement in your public reporting with precise facts: registry, standard, serial numbers or retirement ID, vintage, quantity, and the exact claim language you are making.
6. Retain originals and backups for audits and due diligence.
Reporting language — examples and cautions
– Precise example: “On 2025-03-10 we retired 2,000 Verra VCU credits (serials VCU12345–VCU14344), vintage 2019, to offset our residual Scope 1 emissions for calendar year 2024.”
– Avoid vague or misleading phrases like “carbon neutral” without context. If you use such labels, define the boundary, baseline year, which emissions were reduced versus offset, and whether removals or avoidance credits were used.
– State the limitation: credits are not a substitute for near‑term internal emission reductions; most standards and stakeholder frameworks expect emissions reduction first, offsets for residuals.
Accounting: how to show credits in corporate inventories
– Report gross emissions by scope (Scope 1: direct emissions; Scope 2: indirect emissions from purchased energy; Scope 3: other indirect emissions) following the GHG Protocol.
– Separately disclose credits acquired, retired, standard, vintage, and quantity. Present these in an offsets or purchased emission reductions section; do not net them off Scope 1 or Scope 2 in the primary gross totals unless you’re following a specific national or sector accounting rule that allows it—always be transparent.
– For “net” or “neutral” claims, follow applicable guidance (for example, GHG Protocol Mitigation Goal Standard and SBTi guidance) and ensure removals used for neutralization
are verifiable, additional (they would not have happened without the finance), permanent (or durably stored), and properly retired to prevent reuse. Keep traceable documentation: project ID, registry entry, retirement date, and serial numbers.
Practical checklist for corporate disclosure and use of credits
– Report gross emissions by scope (as required). Do not net credits into those primary totals.
– Separately disclose credits acquired: standard (e.g., Verra, Gold Standard), registry name and link, project ID, vintage (year of emissions reduction), quantity (tCO2e), and retirement date if retired. Define terms:
– Vintage: year the emission reduction/removal occurred.
– Registry: an electronic ledger that issues and retires carbon credits.
– Retirement: the administrative step that marks a credit as used so it cannot be resold.
– State the purpose of credits (temporary bridging, compensation for residuals, support for removals) and whether they are emission reductions or carbon removals.
– If making “net” or “neutral” claims, explain the boundary (which emissions included), the types of credits used, and cite the methodology followed (GHG Protocol, SBTi, etc.).
– Disclose limitations and risks (e.g., permanence concerns, measurement uncertainty, potential double counting).
– Keep supporting documents available (purchase contracts, registry screenshots, third‑party verifications).
Step‑by‑step: how to buy and retire a credit (operational)
1. Define objective: compliance vs voluntary; reduction vs removal; vintage preferences.
2. Screen projects by standard and registry (e.g., Verra, Gold Standard).
3. Perform due diligence: additionality, permanence, leakage mitigation, co‑benefits, verification schedule.
4. Purchase credits from seller or marketplace. Obtain serial numbers and registry transfer details.
5. Retire credits on the registry in the name of your organization (or designated beneficiary). Record retirement ID and date.
6. Disclose purchase and retirement in sustainability/annual report, with links to registry records.
Worked numeric example — how to present numbers (not advice)
Assumptions:
– Company A gross emissions (most recent year): Scope 1 = 30,000 tCO2e; Scope 2 = 50,000 tCO2e; Scope 3 = 120,000 tCO2e. Total gross = 200,000 tCO2e.
– Company purchases and retires 20,000 tCO2e of verified removals (vintage 2023) on Verra.
Presentation (recommended):
– Primary table: Show gross emissions by scope (Scope 1/2/3) = 200,000 tCO2e. Do not subtract credits here.
– Offsets/credits table: List 20,000 tCO2e retired; standard = Verra VCS; registry retirement ID = VR-xxxx; vintage = 2023; project description = afforestation (removal).
– Net or residual calculation (for supplemental disclosure only): Residual emissions = gross emissions − retired removals = 200,000 − 20,000 = 180,000 tCO2e. Clearly state this is a supplemental “net residual” figure and reference the methodology used to justify the net claim.
Key risks and how to mitigate them
– Greenwashing risk: avoid ambiguous advertising; provide full disclosure and links to retirement records.
– Additionality failure: prefer projects with third‑party verification and conservative baselines.
– Permanence and reversal (especially for nature‑based removals): favor long‑term storage solutions, insurance or buffer pools, and conservative accounting.
– Double counting: ensure credits are uniquely retired on a credible registry and that host countries do not also count the same reductions toward their NDCs unless accounting rules allow.
– Measurement uncertainty: use projects with independent verification at appropriate intervals and conservative discounting where uncertainty is high.
Accounting and financial reporting notes (high level)
– Carbon credits are often treated as inventory or intangible assets under financial accounting, depending on jurisdiction and intent; consult your accountant.
– For sustainability disclosures, follow the GHG Protocol and relevant market or regulator guidance; national accounting rules may differ.
– Document assumptions and valuation methodology for any balance‑sheet presentation; include sensitivity analysis for price volatility.
Useful standards, registries, and guidance (select sources)
– GHG Protocol — Mitigation Goal Standard and Corporate Standard: https://ghgprotocol.org
– Science Based Targets initiative (SBTi) guidance on corporate use of offsets and net‑zero claims: https://sciencebasedtargets.org
– Verra (Verified Carbon Standard) registry information: https://verra.org
– Investopedia — carbon credit overview: https://www.investopedia.com/terms/c/carbon_credit.asp
– UN Framework Convention on Climate Change (UNFCCC) — market mechanisms and guidance: https://unfccc.int
Educational disclaimer
This information is educational only and not individualized investment, accounting, or legal advice. For decisions affecting financial statements, tax treatment, or compliance, consult qualified professionals.