What is carbon trading? How does it work?

Carbon emissions, primarily in the form of carbon dioxide (CO₂) and methane (CH₄), contribute to global warming, climate change,  and sea-level rising which in turn increase the frequency and intensity of natural phenomena, and disasters like cyclones, floods, wildfire, drought, heatwave, etc.

Reduction of carbon emissions has multifarious environmental, economic, social, and health benefits. Carbon trading is both a benefit and a mechanism for reducing carbon emissions. Here's how it works and why it can be beneficial. 

What is carbon trading?

Carbon trading, also known as carbon emissions trading, is a market-based approach to reducing greenhouse gas (GHG) emissions. It allows countries, companies, or organizations to buy and sell permits that represent the right to emit a certain amount of carbon dioxide or other greenhouse gases. By putting a price on carbon emissions, it incentivizes participants to lower their emissions and invest in cleaner technologies.

Carbon emissions trading operates under a cap-and-trade system where governments or organizations set a limit (cap) on total emissions. Companies receive or buy carbon credits, which allow them to emit a certain amount of CO₂. If a company emits less than its allowance, it can sell its excess credits to others. If a company exceeds its limit, it must buy more credits or face penalties.

Carbon trading is a benefit of reducing emissions because it creates financial incentives for businesses to go green. However, it works best when proper regulations and transparency ensure that actual emission reductions occur.

What is the process of carbon credit sale?

The process of selling carbon credits involves several steps, from generating the credits to finding buyers and completing the transaction. Here's a step-by-step breakdown:

Carbon credit generation

A company or project must first reduce or remove greenhouse gas (GHG) emissions through activities like reforestation, renewable energy projects, or carbon capture. The emission reduction must be measured, verified, and certified by an independent third party.

Verification & certification

The project must be validated by recognized carbon standards such as: Verified Carbon Standard (VCS), Gold Standard, Clean Development Mechanism (CDM), Climate Action Reserve (CAR), etc. These standards ensure that each credit represents one metric ton of CO₂ reduced or removed.

Registration on a carbon registry
Verified carbon credits are registered on platforms like: Verra, American Carbon Registry (ACR), Gold Standard Registry, etc. Each credit receives a unique serial number to prevent double counting.

Finding buyers

There are two main types of carbon markets:

Compliance or Regulated Markets are created by government regulations to limit carbon emissions. Companies must buy carbon credits if they exceed their allowed emissions cap.

In the Cap-and-Trade system, governments set a maximum emission limit (cap). Companies emitting less than their limit can sell excess credits to others exceeding their cap.

Some countries impose a carbon tax, but companies can reduce their tax burden by purchasing credits.

Major Compliance Markets include the European Union Emissions Trading System (EU ETS), California Cap-and-Trade Program, China's National ETS, Regional Greenhouse Gas Initiative (RGGI), etc.

In the Voluntary Carbon Markets (VCM) markets, companies and individuals buy carbon credits voluntarily to offset their emissions. These credits come from projects that remove or reduce CO₂ emissions, such as reforestation, renewable energy, and carbon capture.

Here no government mandate works; rather purchases are made for corporate sustainability goals or brand reputation.

Credits are typically verified by independent standards such as Verified Carbon Standard (VCS) by Verra, Gold Standard, American Carbon Registry (ACR), Climate Action Reserve (CAR), and Common buyers like tech companies, airlines, and global brands committed to net-zero goals.

Sale & transaction

Sales can occur through carbon exchange systems such as Chicago Climate Exchange, Climate Impact X, etc. Brokers or traders specializing in carbon credits can create direct agreements between buyers and sellers. Payment terms and prices of carbon credits depend on credit quality, demand, and market conditions.

Retirement or trading

Buyers can retire credits which means removal from circulation to claim the offset. Retirement is recorded in the registry to ensure transparency. However, they can also resell credits to other buyers. 

Benefits of carbon trading

The system of carbon emissions trading can encourage emission reductions. Companies have a financial incentive to cut emissions to save or sell credits.

It supports green innovation. Businesses invest in cleaner technology to reduce emissions and trade surplus credits.

It strengthens global cooperation. Countries and companies can trade credits internationally, helping developing nations adopt greener practices.

It promotes cost-effective climate action. Companies can choose the most efficient way to reduce emissions, balancing economic and environmental goals.

It creates scope for generating revenue for sustainability projects. Governments can use revenue from carbon trading to fund renewable energy and conservation projects.

Challenges and limitations of carbon trading

Carbon trading can create the risk of "Greenwashing"; which means some companies may buy credits instead of making real emission cuts.

Price volatility is another challenge in carbon emissions trading. Carbon credit prices fluctuate, making it uncertain for businesses.

Enforcement issues can also hinder the process of carbon trading in many countries. Weak regulations or loopholes can allow companies to exploit the system. 

The concept of carbon trading offers financial incentives to industries and businesses to reduce emissions. Companies that reduce their emissions below their allocated limit can sell their excess allowances to those who exceed their limits. This creates a financial motivation to cut emissions, as businesses can profit from their sustainability efforts while contributing to overall environmental goals.

Understanding how carbon trading operates is crucial for grasping its role in combating climate change. The mechanisms and regulations governing the carbon trading markets can vary significantly, influencing their effectiveness and efficiency. Exploring these aspects provides insight into how carbon trading can contribute to a more sustainable future.