The global carbon credit market is rising as more and more companies understand the benefit of reducing emissions and achieving sustainability goals whilst being able to see the upside from traditional investment avenues.

To gain a better understanding of this global market, we will explore the concept of carbon credits, mechanisms of carbon financing, critical trends in carbon financing and the role of ESG considerations in carbon financing

Carbon credits are like “green points” earned by individuals and companies due to their efforts to reduce carbon emissions. These credits play a crucial role in offsetting the negative impact on the environment by investing in emission reduction projects and creating a global system where positive actions counterbalance harmful ones.

Carbon credits are a market-based approach used to reduce greenhouse gas (“GHG”) emissions. Carbon credits are elements of a ‘cap and trade’ system where a government limits the total amount of carbon dioxide or other greenhouse gasses allowed in a given period. Many governments limit the number of tons specific industries can emit, in line with Article 6 of the Paris Agreement.

In other words, a company that buys these carbon credits would have the right to emit a certain amount of carbon or other greenhouse gases within that limit. In addition, projects that reduce, eliminate, cut or collect emissions are eligible to earn carbon credits which can be sold on an open carbon credit market. These carbon credits are commonly referred to as ‘carbon offsets’.

Companies can trade surplus unused or earned carbon credits, thereby creating a financial incentive to understand how to track and monitor their carbon footprint and ensure these tradable carbon credits are issued.

Every carbon credit is the equivalent of one ton of carbon dioxide (or another greenhouse gas) released. Companies use carbon credits to compensate for gas emissions and are incentivised to invest in eco–friendly projects and reduce their carbon footprint.

For companies, carbon credits provide a way to meet their sustainability goals, reduce their carbon footprint and invest in clean energy and other low-carbon technologies. By having these companies participate in the cap and trade system, they can offset their emissions and support projects that reduce greenhouse gas emissions, such as renewable energy projects or energy efficiency improvements.

Carbon financing is a method of providing financial support to projects that aim to reduce greenhouse gas emissions. This financial support can come from various sources, including governments, private investors and international organisations. In exchange for their support, investors receive generated carbon credits that they can use to balance out their carbon footprint or sell in the carbon credit market.

To demonstrate the practical application of the above, let us consider the following example:

Company A specialises in the production and distribution of highly efficient biomass cookstoves. They distribute these to rural areas where traditional means of cooking (such as the use of biomass fuels like wood, charcoal or agricultural residues) are currently used. As these cookstoves are more efficient in energy consumption than the traditional cooking methods currently employed, they save energy and reduce greenhouse gas emissions.

Since Company A is reducing greenhouse gas emissions with the use of their efficient cookstoves instead of traditional cookstoves or open fires, Company A is eligible to earn carbon credits from the sale and use of these stoves and can therefore sell the carbon credits and use this income to reduce their operating expenses.

Another illustration considers Company B, an investor in climate solutions projects that actively invests in projects around the world to decarbonise the planet. Company B invests money in Company A to equip them to manufacture and distribute higher quantities of these efficient, eco-friendly cookstoves in return for the carbon credits generated.

Company A, therefore, receives investment in the form of traditional sources of financing such as debt, equity, working capital financing, etc., to expand and reduce its operating income. Company B receives their carbon credits which can, in turn, be sold in the open carbon credit market. Illustrating how seamlessly these new credits have slotted into the global market.

Carbon financing is a continuously evolving field, with new trends emerging continuously.

Alongside the key trend of carbon pricing and emission trading systems,  nature-based solutions, such as reforestation and conservation projects, which can provide significant carbon sequestration benefits and help mitigate climate change, have also gained attention. These projects are often seen as a cost-effective way for companies to offset their emissions or join the race to carbon neutrality (net zero).

One of the primary benefits of carbon credits and carbon offsets is that they incentivise companies to reduce their carbon emissions and invest in sustainable technologies and projects. 

In addition, carbon credits promote the development of sustainable projects and technologies by creating a market for carbon reductions. Companies that invest in renewable energy or energy efficiency can generate carbon credits and sell them to companies that need to offset their emissions, thus creating financial incentives for companies to invest in developing and deploying sustainable energies, which can reduce operating costs and accelerate their adoption.

Alongside the benefits, there are, however, some risks associated with carbon credits that need to be acknowledged.

One of the primary risks is the potential for fraud. As with any market-based system, there are always risks that some companies will try and find loopholes or engage in fraudulent behaviours to generate and sell carbon credits that don’t actually represent real emission reductions. 

Alongside potential fraud risks, measurement, monitoring, and reputational risks need to be considered.

Accurate measurement and monitoring of carbon emissions and carbon emissions reduction can also be challenging, especially for projects in remote areas or highly complex projects. Inadequate monitoring systems, insufficient collection and technical errors can compromise and cast doubt on the validity and credibility of these carbon credit projects. This can lead to claims of greenwashing and damage a company’s reputation in the market.

Therefore, it is vital that the monitoring and verification systems in place are robust to ensure that the carbon credits generated and sold are for legitimate emission reductions and that the generation and selling of these carbon credits are transparent and accountable.

Carbon credits and carbon offsets have enormous potential to encourage sustainable practices and investments, driving the development of renewable energy and energy efficiency initiatives. While it is important to acknowledge the potential risks, such as fraudulent behaviour, this can be mitigated through transparent and accountable systems for monitoring and verification.

Environmental, Social and Governance (“ESG”) considerations are becoming a critical factor in the investment decision-making process, and this trend has extended to carbon financing. Companies and investors are now seeking projects that not only reduce emissions but also create a positive social impact such as creating employment opportunities in local communities, promoting biodiversity conservation and facilitating sustainable practices. 

Integrating ESG considerations into carbon financing investment strategies helps companies align with their sustainability goals and mitigate potential environmental and social risks. Companies can prioritise projects that are resilient to changing climate challenges and demonstrate a commitment to sustainability. Recently, this has proven to be increasingly important to all stakeholders, including investors, customers and employees.

Carbon financing will continue to be an increasingly important and widely discussed tool amongst companies and investors as they seek to reduce carbon emissions and continue the journey to net zero. Understanding the evolving trends and incorporating ESG considerations can help companies and investors make informed decisions and support projects with positive environmental, social and financial outcomes. As the global push to carbon neutrality continues, carbon credits will likely remain a key mechanism for driving climate action and achieving a more sustainable future.