A carbon credit exchange is a trading system in which entities trade credits representing greenhouse gas reductions. One tradable credit represents one tonne of carbon dioxide equivalent (CO2e) or the equivalent amount of another greenhouse gas reduced, sequestered, or avoided. Credits are created and sold in a range of regulatory markets worldwide. A credit is a claim on an emission-reduction project, such as an electric vehicle manufacturing plant or a wind farm. Credits may also be purchased by entities seeking to offset their own emissions. These purchases are known as pre-compliance buyers, and they are motivated by a desire to demonstrate environmental sustainability or by corporate social responsibility.
In regulated carbon markets, the trade of carbon credit exchange is tightly controlled. Participating businesses are allocated an allowance, or credit, for each tonne of CO2e they emit. In exchange for their allowance, companies can purchase and “retire” credits generated by other projects. The resulting reductions are reported in a public registry.
The market for carbon credits in the voluntary sector, however, is unregulated. Buyers, suppliers, and other participants in the voluntary market are motivated by a variety of factors—corporate social responsibility, ethics, the pursuit of investment opportunities, or the desire to enhance their reputations. They may also be compelled by regulations or a commitment to the Paris climate accord.
As the global economy shifts toward a lower-carbon future, McKinsey estimates that annual demand for carbon credits could reach 1.5 to 2.0 gigatonnes of CO2e by 2030 and up to 7 to 13 GtCO2e by 2050. To meet this demand, the world needs a large, transparent, verifiable, and environmentally robust voluntary carbon market.
The current carbon credit market is fragmented, with some credits proving to represent questionable reductions. Moreover, limited pricing information makes it difficult for buyers to ensure they are paying a fair price and for suppliers to finance carbon-reduction projects without knowing how much demand will ultimately drive prices.
To unlock the potential of the voluntary carbon market, we need to establish a core set of carbon-market principles and an attribute taxonomy that identifies key quality features for all credits. Then we need liquid reference contracts—spot or futures—that signal a daily price that will enable price risk management and facilitate the growth of supplier financing.
A new generation of carbon-reduction projects is being designed to reduce greenhouse-gas emissions. These projects are more innovative in terms of finance, monitoring, and methodologies than the older Clean Development Mechanism and Article 6 projects that were based on carbon credits issued under the Kyoto Protocol. These include projects such as the Plan Vivo standard, which promotes community land-use and forestry projects with an ecological impact.
But even the best-designed projects are not immune to fraud and other market failures. For example, the international soccer governing body FIFA purchased credits from a Brazilian forest project that promised to preserve trees, but instead saw those trees cut down and sold off as carbon credits. In such cases, buyers must take steps to verify the quality of their purchase and protect themselves from fraudulent transactions.