Carbon Pricing: Carbon Prices are Determined in This Way

Have you ever heard about “carbon pricing”? The concept can sound a bit complicated, but it’s actually one of the most important tools we have to fight climate change. So, let’s break it down together. We’ll talk about what carbon credits are, and how carbon pricing works!

What are Carbon Credits?

Let’s start with the basics. Carbon credits are essentially certificates that allow companies to emit a certain amount of carbon dioxide (CO₂). Each carbon credit typically represents one metric ton of CO₂ or its equivalent in other greenhouse gases. Think of it as a “permission slip” to release carbon into the atmosphere—but here’s the catch: these “permissions” come with an environmental cost.

So, where do these credits come from? They’re generated by organizations including non-governmental and non-for-profit organizations. These organizations develop or run projects that reduce or remove emissions, thus contributing to cleaner environment. Fundamentally, by supporting these initiatives, companies, governments, or even individuals can “offset” the carbon they produce, balancing out their emissions.

Two Types of Credits

There are two main types of carbon credits:

1. Voluntary Carbon Credits: This market provides an option for businesses, organizations, and individuals to purchase carbon credits to offset their emissions. The key aspect is that participation remains completely voluntary, meaning no legal requirement exists. Companies typically drive participation through sustainability goals, consumer expectations, or personal commitments to lowering their carbon footprint.
2. Compliance Carbon Credits: The compliance market, also known as the regulated carbon market, is a government-regulated system where companies must meet legally mandated carbon reduction targets or face penalties. Compliance markets typically form part of a broader regulatory framework that aims to reduce greenhouse gas emissions in specific regions or industries.

Carbon credits help create a marketplace that incentivizes reducing emissions.

What is Carbon Pricing?

Some of you might have known about these basics carbon credits. But isn’t it challenging to understand their costs? This is because the market and the concepts around it are still new and rapidly evolving. Don’t worry; we’re here to help. Now, let’s take a closer look at the factors that determine the price of these credits.

Carbon pricing is a system designed to put a price tag on carbon emissions. Why? If emitting carbon becomes more expensive, it creates an incentive for businesses to rethink their practices. This encourages them to actively reduce their carbon footprint. There are two main ways this happen:

1. Carbon Tax: With a carbon tax, the government charges a fee for every ton of CO₂ that gets released into the atmosphere. The more carbon you produce, the higher your tax. It’s a clear financial incentive for businesses and individuals to reduce emissions. In Canada, since 2019, the government has implemented a national minimum price on carbon emissions, starting at $20 per ton. This price increased by $10 per ton annually, reaching $50 per ton by 2022, making it costly to pollute rather than free.　

2. Cap-and-Trade Systems: This works in a similar way but is a bit more complicated. The government sets a “cap” on the total emissions allowed for a certain period and gives companies a specific number of carbon credits. If a company emits less than its cap, it can sell the extra credits. If it emits more, it has to buy additional credits. The idea is to create a market where companies can “trade” emission reductions to find the most cost-effective way to meet the cap.

There are already many companies trading carbon credits. For example, Tesla has generated substantial revenue from selling carbon credits over the years. In 2023, the company earned approximately $1.79 billion from this source.　Microsoft is also actively involved in the voluntary market. This company has found a way to generate subsequent revenue through its carbon offset purchases. The company is not just offsetting its own emissions; it has also become a key player in the voluntary carbon market. Microsoft purchases carbon credits to support various environmental projects, creating a market where other companies can buy them.

Now, you might be wondering, “Okay, but how is the price of carbon determined?” Great question. Let’s dive into that!

How is the Price of Carbon Determined?

1. Project Types and Standards of Verification

To start, we need to understand how carbon credits are created, and then how their prices are determined.

• Project Type and Scope: Carbon offset project costs and CO2 reduction vary by type. Reforestation credits are more expensive due to long-term forest maintenance and carbon storage. The pricing of renewable energy projects depends on the costs of infrastructure and technology.
• Certification Standards and Audits: Carbon credits are verified by third-party organizations like Verra or the Gold Standard, which apply strict criteria. The more rigorous the certification, the higher the credit price, with highly regarded certifications commanding a premium.
• Project Effectiveness and Risk: The credibility and success of a project affect the price of carbon credits. Projects with higher risks or uncertainties may be cheaper, while those that guarantee long-term reductions or are more reliable typically command higher prices.

As for actual prices, carbon credit prices can vary widely. For example, voluntary carbon credits have recently ranged. For instance, credits from renewable energy projects are typically priced between $5 and $15 per ton, while credits from Carbon Capture and Storage (CCS) can range from $30 to $50 per ton or even higher. In some cases, credits with high demand can exceed these prices, reaching as much as $300 per ton. Now that we’ve gone over the basics of how the market prices carbon credits. let’s move on to the next step.

2. Carbon Tax: Government-Set Prices

In a carbon tax system, the government decides what to charge per ton of carbon emitted. Several factors influence the price of carbon in a carbon tax system, including:

• Political Decisions: The government often determines the tax rate, which can change based on policy shifts, environmental goals, and economic conditions.
• Economic Considerations: Governments try to find a balance between encouraging carbon reductions and keeping the economy stable. If the tax is too high, it could cause economic hardship; if it’s too low, it might not drive meaningful change.
• Global Influence: Countries with international climate agreements may adjust their carbon tax to align with global expectations or to stay competitive with other nations.

Businesses often face a fee that increases over time, encouraging them to innovate and find cleaner alternatives.

3. Cap-and-Trade Systems: Market Forces at Work

In these systems, the price of carbon is determined by supply and demand in the market as well. Then, what specific factors influence the price?

• The Cap: Let’s say the emissions cap is low, meaning fewer credits are available now. The price of carbon credits tends to go up. This is because companies are racing to acquire enough credits to offset their emissions.
• Demand from Companies: If a lot of companies are close to exceeding their emissions limits, they’ll need to buy more credits, pushing the price higher.
• Government Actions: The government may intervene to stabilize the market, such as by introducing more credits or buying back excess credits to keep prices from swinging too wildly. For example, the European Union has occasionally adjusted the supply of carbon allowances within its Emissions Trading System (EU ETS) to prevent price volatility.
• International Trading: Some systems allow carbon credits to be traded between countries. So, if there’s more supply from overseas, the price might drop, but if demand spikes, the price could increase globally.

Crucial Aspect to Know: Expiration

When you try offset your emissions by carbon credits, you need to know about the expiration of the credits. Once a carbon credit expires, it loses its ability to offset emissions. Expiration is important because companies and organizations that purchase carbon credits want to ensure the credits remain valid. They worry about whether they can still use the credits for future carbon offsetting or to meet compliance requirements. How expiration and credit value typically interact:

1. Expiration Dates: In many compliance markets, carbon credits come with an expiration date or are valid for a limited period. If credits are nearing expiration, they might lose value as companies are less likely to purchase them, knowing they won’t be usable after a certain time. This is especially true in systems like the EU ETS, where regulations set a specified period for using credits.
2. Discounting of Expiring Credits: As expiration approaches, the market may apply a discount to credits that are close to expiring. This reduces their attractiveness to buyers, lowering their market price. Buyers may prefer credits with longer validity to avoid potential losses​.
3. Market Pressure and Supply and Demand: If a large volume of credits is nearing expiration, there could be a market shift, where the excess supply of soon-to-expire credits depresses the price. However, if demand for carbon credits remains strong due to tighter emissions regulations, even expiring credits may maintain some value, albeit typically lower than credits with longer terms.
4. Types of Carbon Credits: Voluntary credits, unlike compliance credits, are not tied to strict expiration policies, so they may not lose value due to expiration. However, they may still lose value if they become outdated due to changes in project standards or certification rules.

Conclusion: Carbon Pricing

In the end, carbon pricing is about putting a price on pollution to drive real change. Whether through carbon taxes or cap-and-trade systems, carbon pricing incentivizes businesses to reduce emissions by making carbon pollution more expensive, leading to cleaner practices. So, whether you’re a business owner, a policymaker, or someone who cares about the planet, understanding how carbon pricing works will be useful in the future.

As I mentioned, carbon credits have expiration dates, so the sooner you take action, the more you can contribute to a cleaner, greener environment. At Carbon Da Capo, we are committed to providing reliable carbon credits that make a real difference. Let’s take the next step together!