What Are Carbon Credits? How They Work and Who Buys Them

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Carbon credits are tradable permits or certificates, each representing one metric ton of carbon dioxide (CO2) or the equivalent amount of another greenhouse gas. The term covers two related instruments. In a regulated cap-and-trade program, a credit (often called an allowance) is a government-issued right to emit one ton. In the voluntary market, a credit (usually called an offset) certifies that a project avoided or removed one ton of emissions somewhere else. Both are measured in the same unit and both can be bought and sold. They differ in who issues them, who must buy them, and what the buyer can claim afterward.

What “One Ton of CO2e” Means

Carbon dioxide is not the only greenhouse gas. Methane, nitrous oxide and several industrial gases trap heat too, and some do it far more strongly per ton. To put them on one scale, emissions are converted to CO2-equivalent using each gas’s global warming potential (GWP), which compares its warming effect with CO2’s over a set period, usually 100 years.

The conversion is:

CO2e (tons) = tons of gas emitted × GWP of that gas

Methane is the common example. The IPCC’s Fifth Assessment Report put its 100-year GWP at about 28. On that basis, a hypothetical landfill project that destroys 100 tons of methane prevents about 2,800 tons of CO2e and could, if verified, generate about 2,800 credits. This is why projects that capture methane from landfills, farms or natural gas operations can produce large numbers of credits from relatively small physical volumes of gas.

How Carbon Credits Work

Compliance Markets: Cap and Trade

In a cap-and-trade system, a government sets a cap: a ceiling on the total emissions allowed from the sectors it covers. It then issues allowances equal to that cap, either for free, by auction, or through a mix of both. Each covered company must surrender one allowance for every ton it emits during the compliance period.

The trading part comes next. A company that cuts emissions below its holdings can sell the extra allowances on an exchange or through brokers; a company that emits more than it holds must buy from others. The cap fixes the total quantity of emissions, and trading determines the price. Reductions therefore happen first where they are cheapest: a firm that can cut a ton for less than the market price cuts it and sells the allowance, while a firm facing higher costs buys instead.

Many programs lower the cap over time. A shrinking supply of allowances is meant to push prices up and make cleaner technology more attractive each year.

Voluntary Markets: Offsets

The voluntary market works differently. No regulator sets a cap. Instead, a project developer runs an activity that reduces or removes emissions, such as planting trees, protecting a forest, capturing landfill gas, or building renewable energy. The developer measures the result under a methodology and has it verified. A registry then issues credits for each ton.

When a buyer uses a credit to claim it has compensated for a ton of its own emissions, the credit is retired on the registry, which takes it out of circulation so it cannot be sold or claimed again.

Interpreting a Credit Position

For a company in a compliance program, the basic calculation is:

Surplus or shortfall = allowances held − verified emissions (tons CO2e)

A positive result is a surplus the company can sell or, where the program’s rules allow it, bank for a later period. A negative result is a shortfall it must cover by buying allowances (or eligible offsets, where permitted) before the compliance deadline. Programs impose penalties for falling short.

Example of Carbon Credits

In a hypothetical example, two manufacturers operate under the same cap-and-trade program. Each must surrender one allowance per ton emitted, and an allowance trades at $30.

Company A installed more efficient equipment and finished the year 10,000 tons under its holdings. Company B expanded production and ended 8,000 tons over.

If Company B buys 8,000 allowances from Company A at $30, it pays $240,000 and meets its obligation. Company A receives $240,000 and still holds 2,000 surplus allowances. Total emissions from the two firms (148,000 tons) stay within their combined allowances (150,000), so the cap holds.

For Company B, the $30 price is the benchmark: if it could cut a ton for less, reducing emissions would be cheaper than buying allowances; if not, buying is cheaper.

Who Buys Carbon Credits and Why

Regulated emitters buy compliance allowances because the law requires it. Programs typically cover large sources such as power plants, industrial facilities and fuel distributors.

Companies with climate commitments buy voluntary offsets. Many have pledged to reach net-zero emissions: they cut what they can and compensate for the rest, especially emissions that are hard to eliminate with current technology, such as in aviation or heavy industry.

Traders and investors buy credits as a financial position, betting on price changes driven by policy and demand. Some exchange-traded products, such as an exchange-traded fund, track carbon allowance futures.

Individuals can buy voluntary offsets directly from project developers or retailers, often to compensate for flights or household energy use.

Who Sells Carbon Credits and Who Gets the Money

In compliance markets, governments are the original source and keep the proceeds when they auction allowances. After that, any covered company with a surplus can resell and keep the money, as Company A did in the example.

In the voluntary market, sellers are project developers, nonprofits, businesses and sometimes landowners. A landowner can earn credit revenue by enrolling land in a registered reforestation, afforestation or improved forest management project that meets the program’s measurement and verification requirements. Payment goes to the project sponsor, often through intermediaries who take a share.

Carbon Credit Programs in the U.S.

The U.S. has no national carbon market, but it has a long history with emissions trading.

• Clean Air Act Amendments of 1990. The acid rain program created tradable sulfur dioxide allowances for coal-fired power plants. Widely cited as the first large-scale cap-and-trade program, it sharply cut SO2 emissions. It covered SO2, not carbon, but it established the model later carbon markets copied.
• Regional Greenhouse Gas Initiative (RGGI). A cap-and-trade program for power-sector CO2 covering a group of Northeastern and Mid-Atlantic states.
• California’s cap-and-trade program. Launched in 2013, it covers power plants, industrial facilities and fuel distributors and is one of the largest carbon markets in the world.
• Washington’s Climate Commitment Act. A state program that also uses a cap-and-invest market approach.

The Inflation Reduction Act of 2022 works through a different channel: rather than creating a carbon market, it expanded federal tax credits for carbon capture and storage, clean energy and other emissions-reduction projects.

International Carbon Credit Systems

The Kyoto Protocol, adopted in 1997, set binding emissions targets for industrialized countries and allowed them to trade emission units. Its Clean Development Mechanism (CDM) let projects in developing countries earn credits for reducing emissions, which industrialized countries could buy toward their targets.

The Paris Agreement of 2015 replaced Kyoto’s framework. Its Article 6 allows countries to cooperate by transferring emissions reductions, so a country that beats its target can sell reductions to one that falls short.

The European Union Emissions Trading System, launched in 2005, is the largest and longest-running compliance carbon market and covers power generation, industry and aviation within the EU.

How Much Is a Carbon Credit Worth?

There is no single carbon price. Each compliance market has its own price set by its cap, rules and demand, and voluntary credits vary with project type, location, vintage and certifying standard. Regulated allowances such as those in the EU and California have generally traded well above typical voluntary offsets, because compliance buyers have a legal obligation and supply is capped.

Prices in all of these markets can move sharply with changes in government policy, economic activity (lower production means lower emissions and less demand), and the supply of new projects.

Limitations of Carbon Credits

Critics raise several problems, mostly concentrated in the voluntary market:

• Additionality. A credit only represents a real reduction if the project would not have happened without credit revenue. Paying to protect a forest that was never at risk produces credits without changing emissions.
• Permanence. Carbon stored in trees can be released by fire, disease or later logging. Many forestry programs hold back a buffer of credits to cover reversals.
• Leakage. Protecting one forest can push logging to another, shifting emissions rather than eliminating them.
• Measurement and double counting. Estimates depend on baselines and methodologies, and the same reduction can be claimed by more than one party if registries and national accounts do not line up.
• Oversupply in cap-and-trade. If a cap is set too loosely, or emissions fall faster than regulators expected, surplus allowances can pile up, depress prices and weaken the incentive to cut further.

Supporters counter that pricing emissions lets the market find the cheapest reductions, though results depend heavily on program design.

Carbon Credits vs. Related Terms

Carbon credits vs. carbon offsets. The terms are often used interchangeably, and “emission permits” and “allowances” are other names for compliance credits. Strictly, an allowance is a right to emit under a regulated cap, while an offset represents a ton reduced or removed by a project and is usually bought voluntarily. Some compliance programs accept a limited number of certified offsets toward obligations, which is part of why the terms blur.

Carbon tax. A carbon tax fixes the price per ton and lets the quantity of emissions adjust. Cap-and-trade fixes the quantity through the cap and lets the price adjust. Both put a cost on emissions, but a tax gives businesses price certainty, while a cap gives regulators certainty about total emissions.

Tax credits. Incentives such as those in the Inflation Reduction Act reduce a company’s tax bill for qualifying projects. They are not measured in tons and are not traded on carbon markets.

Renewable energy certificates (RECs). A REC represents one megawatt-hour of electricity generated from a renewable source. It supports claims about clean electricity use, not a verified ton of emissions reduced, so it is not interchangeable with a carbon credit.

The Bottom Line

Carbon credits matter most to regulated emitters, companies with net-zero pledges, and investors trading on policy-driven prices. A compliance allowance is a legal right to emit, while an offset depends on a project proving its reduction is additional, permanent and free of leakage. Buyers should judge each credit by its program and verification, because prices and quality vary widely across markets.