The carbon market is a financial and regulatory mechanism that aims to reduce greenhouse gas emissions. Many countries contribute to the cause through trading systems like the European Emissions Trading System. Both carbon credits and offsets were envisioned as ways of mitigating climate change.
Although often used interchangeably, carbon credits and carbon offsets are not the same. For the sake of simplicity, this article will focus on the EU ETS which has a clear division between the voluntary and mandatory carbon markets. This division makes it easy to understand why carbon offsets and carbon credits are two different things.
Carbon credits and the mandatory market
Carbon credits in the EU ETS system are emission allowances. They come in the form of tradable certificates. The European Union sets a limit (cap) on the number of greenhouse gas emissions companies within various industries can emit each year.
Each emission allowance or carbon credit grants its holder the right to emit one tonne of CO2 or the equivalent of other greenhouse gases. They are allocated to each company within the set cap. Companies can buy and/or sell allowances according to their needs.
Mandatory markets are also called regulatory or compliance markets. In a mandatory market, companies are required by governments to limit their CO2 emissions. The consequences of not being able to operate within the imposed limits are hefty fines.
Companies that emit large amounts of CO2 buy emission allowances from those that have reduced their emissions. This provides a financial incentive for reducing emissions and investing in technologies that help do this.
Carbon offsets and the voluntary market
Carbon offsets are also tradable certificates that each represent a one-ton reduction in CO2 emissions. However, unlike allowances or carbon credits, they usually do not interact with the mandatory market. Carbon offset initiatives include reforestation, wetland restoration, forest conservation and renewable energy projects. They generate carbon offsets in proportion to the emissions avoided or compensated by such activities.
Carbon offsets are traded in voluntary markets, where businesses and individuals can offset their emissions freely and are not required to do so by the government. Due to this, carbon offsets are usually not purchased to comply with emission restrictions or mandates. Instead, they are bought by parties that want to mitigate the negative environmental impact of their CO2 emissions. In many cases, carbon offsets are used by companies for PR purposes and as a way to improve their ESG and CSR ratings.
Because carbon offsets are traded in the voluntary market, they are barely subject to any form or level of scrutiny or regulation. For example, carbon offsets can be audited and certified by an external party but that is rarely the case. This is one of the reasons why many doubt their effectiveness and call their accountability and transparency into question.
Where does the confusion come from?
Both terms are often used interchangeably. This is due to the differing regulatory approaches to tackling climate change around the world. However, this causes confusion and further complicates things.
In Europe, allowances (or carbon credits) are traded in the mandatory market, while carbon offsets are traded in the voluntary market. In a few places around the world, mandatory and voluntary markets interact. An example would be the state of California.
Unlike the EU ETS, the California cap and trade system allows participants to also purchase carbon offsets and use them towards the mandated limit. As a result, companies can meet emission restrictions in three ways. Reducing their emissions, buying allowances and buying carbon offsets. Under the system in California, these offsets are recognized by the compliance market.
Both allowances and carbon offsets are tools created to tackle global warming. Carbon credits or allowances are a product of regulatory restrictions that aim to reduce emissions. Carbon offsets are a way to compensate for a person or a company’s carbon footprint.
On paper, carbon offsets sound like a net positive for the environment. In reality, the harm they cause far outweighs their benefits.