As a tool for managing carbon emissions, carbon credits (aka “carbon offsets”) play an increasingly significant role in the realm of sustainability-linked loans, finance and renewable energy.
What Are Carbon Credits?
Carbon credits are a key component in market-based strategies to reduce greenhouse gas emissions.
A carbon credit is a generic term for a tradable certificate that, like a permit, allows the holder to emit a certain amount of carbon dioxide or other greenhouse gases… One credit permits the holder to generate carbon emissions equal to one metric ton of carbon dioxide equivalent (tCO2e).
The primary goal of carbon offsets is to reduce the emission of greenhouse gases into the atmosphere, the main driver of climate change.
Cap and Trade System
Carbon offsets are used within a “cap-and-trade” system… A cap and trade system introduces a market based incentive for organizations to reduce carbon emissions because they can sell unused credits to others for a profit.
In a cap and trade system, a cap is set on the total amount of certain greenhouse gases that can be emitted by a particular industry sector or entity. The sector or entity is given a certain number of carbon credits or it can purchase them.
If the amount of carbon emitted by an entity is less than its allowance, it can sell its excess credits to another entity that expects to exceed its emissions cap.
Carbon credits may also be referred to as carbon offsets… This is because a 3rd party may choose to offset their emissions by purchasing unused or excess carbon credits through the voluntary market, as described below.
For example, an organization that is not producing much carbon emissions, such as the owner of a renewable energy, reforestation, or other project that produces carbon-free energy, may sell their credits to entities (or individuals) who want to offset their own carbon emissions to reduce their carbon footprints.
How Are Carbon Offsets Valued?
The value of a carbon offset/credit is determined by its measurability and verifiability.
However, determining the value of a carbon offset is not an easy task because carbon offsets may be based on hypothetical future scenarios, such as avoided nature loss or avoided emissions.
And while there are prominent centralized organizations that are recognized as being a trusted verifier of carbon credit value, the methodologies of valuing carbon credits globally is not standardized.
As such, questions may arise about the real impact of the projects behind carbon offsets, not to mention concerns about ensuring that tokenized – or financialized – carbon credits actually deliver the promised emissions reductions.
How Do You Buy Carbon Credits?
There are several ways to get involved and purchase carbon credits. Depending on the type of business you are in, there are two types of carbon credit markets:
- Compliance Market Credits: Used by companies in regulated industries under cap-and-trade schemes.
- Voluntary Market Credits: Purchased voluntarily by individuals or companies wanting to reduce their carbon footprint.
In the voluntary market for carbon offsets, companies that want to reduce their carbon footprint (such as Google or Apple), will purchase carbon credits to offset their emissions.
Purchasing carbon offsets should not be confused with taking advantage of tax credits through tax equity investing, or other tax credit monetization strategies.
How Do Carbon Credits Work With Sustainability Linked Loans (SLLs)?
Both carbon credits and sustainability linked loans are geared towards promoting environmental sustainability.
While carbon offsets focus on offsetting emissions, SLLs encourage borrowers – through lower interest rate incentives – to achieve sustainability-linked performance targets within their organization.
Sustainability linked loans drive companies’ sustainability performance by linking interest rates to the improvement of sustainability key performance indicators (KPIs).
In some cases, the performance targets of a SLL could be directly related to carbon emissions. A company might secure an SLL with the agreement that they will lower their carbon footprint by direct investment in decarbonization measures, or potentially through the purchase of carbon offsets.
Alternatively, a sustainability linked loan could also be used to fund decarbonization projects that could produce carbon offsets thereby integrating both tools into their broader sustainability and financial strategies. For example, the capture of methane gas that would otherwise be vented or flared, can significantly reduce carbon emissions. 2
- The Paris Agreement is a legally binding international treaty on climate change. It was adopted by 196 Parties at the UN Climate Change Conference (COP21) in Paris, France, on 12 December 2015. It entered into force on 4 November 2016. Its overarching goal is to hold “the increase in the global average temperature to well below 2°C above pre-industrial levels” and pursue efforts “to limit the temperature increase to 1.5°C above pre-industrial levels.”
- In the photo above, an example of flare gas on the drillship Discoverer Enterprise. The flare gas emissions may be offset by purchasing carbon credits, if needed. Photo credit to DVIDSHUB on Flickr c/o Petty Officer 3rd Class Patrick Kelley.