The carbon credit market, or carbon trading exchange (CX), is a mechanism for entities to compensate for the emission of greenhouse gases by purchasing credits from projects that reduce or remove emissions. One metric ton of CO2 equivalent avoided emissions or removals from a project generates one credit. Each credit is unique, with each claiming an exclusive claim on the same amount of reduced or removed GHG emissions. Once a carbon credit has been used to offset a specific ton of emissions, it is retired and no longer tradable.
The crediting process starts with a project developer, which could be a person or company that initiates a GHG reduction activity like reforestation or a technology-based carbon capture and storage (CCS) project. The project developers will then work with consultants to turn their idea into a full-fledged project design document that meets an internationally recognized standard, which requires rigorous due diligence, including an assessment of the project's feasibility and risks.
Once the project has been implemented and verified, it can be issued credits by the crediting program, which verifies and approves the verification report. The credits are then deposited into an account in the crediting program's registry system, where they may be transferred among accounts, such as when someone purchases or sells a carbon credit.
There are two types of markets in which a carbon credit exchange can be traded: compliance and voluntary. The former is a mechanism created by governments to regulate the amount of emissions that a business or individual can generate and trade credits for in order to stay below their allotted emissions limit. The latter is a non-regulated trading system where companies or individuals purchase and trade credits to make up for their own emissions, usually in conjunction with their carbon offsets.
Several different methodologies exist for quantifying and verifying carbon projects, and each has its own advantages and disadvantages. Some methodologies are more accurate than others, and the quality of a credit will generally be reflected in the price it commands on the CX. Some of the most common methodologies include reforestation, wind farms and a variety of CCS technologies.
In the carbon credit market, five main players play a role in the trading of credits. These are brokers, traders, project developers, financiers and end buyers. Some brokers also act as traders and project developers, while some have separate brokering and project development arms.
The price of a carbon credit can vary widely depending on the type of project in which it was generated, the geography where the project is located, its vintage (the older the credits the higher the cost), delivery time and the number of available credits at that particular moment in time. The pricing methodology for each of these variables is constantly being adapted to ensure that the market is working as efficiently as possible, in line with best practices.
There are a few additional factors that can influence the price of a credit, such as whether or not it is permanent and whether it contributes to the UN's Sustainable Development Goals. Projects that are deemed to be permanent and contribute SDGs tend to trade at a premium to other types of projects in the market.