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What is Carbon Credit?

A carbon credit is a generic terminology used to define any tradable permit, which stands for the right to emit one ton of CO2 (carbon dioxide) or any CO2e (carbon dioxide equivalent gasses) or greenhouse gasses. It is a financial instrument that represents a ton of CO2 (carbon dioxide) or CO2e (carbon dioxide equivalent gases) moved out or cut down from the atmosphere from an emission reduction project, which can be used, by any government, industry or private individuals to compensate for damaging carbon emissions that they are producing.

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What is its usage?

Existing emissions can be majorly removed from afforestation and reforestation activities and can create carbon credits while using the renewable source of energy (wind farm) rather than a coal-fired power station may create carbon credits for reducing the future carbon dioxide emissions. This carbon credit system looks forward to reducing emission by making countries set their own emission quotas and offer rewards if they stand below those quotas.

What is its origination?

The origination of carbon credit is commonly known as METHODOLOGIES. Methodologies are a range of emission reduction activities linked with the removal of existing emissions from the environment and the reduction of future carbon dioxide emissions.

This system originated from various emission reduction activities which were created under a variety of voluntary and compliance market mechanism, standards and schemes.

Compliance markets are those, who are under strict legal rules and regulation regarding emission trading schemes which are established under the KYOTO PROTOCOL.

Whereas, the voluntary market functions are outside the domain of the compliance market. In this, it enables the companies and general individuals to buy carbon credit on a voluntary basis and satisfy personal and CSR needs.

What is the Kyoto Protocol?

The proposal of carbon credits is headed by the International Panel on Climate Change (IPCC) as a market mechanism to reduce the emission level. Initially, it was taken up in KYOTO, JAPAN on 11th December 1997 and came into force on 16th February 2005. There are 192 countries (parties) ratifying the protocol. The international carbon credit system was ratified and accepted by countries with the conjunction of Kyoto Protocol.

According to this Protocol, it divides countries between industrialized economies and developing economies. Developed economies are industrialized or Annex 1 countries which operate in an extensive emission trading market. It gives each country a set of emission standard to meet. If any country surpasses the standard limit, they have to buy carbon credit from the country which hasn’t utilized the set standard.

There is a different Clean Development Mechanism for developing economies which issues carbon credits called Certified Emission Reductions (CER). These are issued for inducing sustainable development initiatives in developing countries. It can be easily traded on separate markets.

The Kyoto Protocol facilitates three different mechanisms which enables the countries to gain carbon credits.

  • Joint implementation when a developed country finds relatively expensive to set up domestic greenhouse gas reduction program then the country can set up a project in other developed country.
  • Clean development mechanism when a developed country invests in a greenhouse gas reduction project in any developing country which is relatively inexpensive to the developed country. This is a low-cost operation for developed country but the overall effect on the environment is equal. Developed country will be rewarded with credit whereas the developing countries would get capital investment and clean technology.
  • Emission trading it facilitates the countries to trade their carbon credit requirement in international carbon credit market. Countries, when fall short on their targeted assigned units can buy the credits and countries have a surplus, can sell in the market.

Which are the Emission Markets?

For the trading purpose, one unit is equivalent to one metric ton of carbon dioxide emissions. These credits can be traded privately or in the international markets at the prevailing market prices. Once these trades settled internationally and hence allow the parties to transfer the credits. Each international transfer is validated by the UNFCCC or if the transaction is between European countries then validated by the European commission.

Climate Exchanges have been set up to provide Spot market as well as future and options market to help to discover a market price and maintain liquidity. Its price is generally quoted in Euros/per ton of carbon dioxide.

In Asia, the only exchange which offers the trade of carbon credits certificates (CER) is MCX (Multi Commodity Exchange, India). MCX offers trading in carbon credits of 200 tonnes unit each that expire on December 15th every year. For each tonne of carbon dioxide emission brought down, the organisation receives a carbon emission certificate or CER, which it can sell, either directly or by a futures market, just like any other intangible commodity.

Currently, there are five exchanges trading in carbon credit.