Simply put, a carbon credit is a certificate representing one tonne of carbon dioxide avoided, reduced, or removed from the atmosphere. Organisations buy them to offset emissions, voluntarily or to meet regulatory obligations.
Compliance markets, which operate under mandatory regulatory carbon reduction regimes, such as the Emissions Trading Systems of the European Union and the UK, are intended to limit the maximum allowable emissions and incentivise further reductions. The credits exchanged here are mostly known as allowances, or the right to emit carbon without incurring fines.
Voluntary carbon markets have emerged to accommodate the trade in credits outside these legally mandated systems. They have grown in popularity as more businesses seek to manage and reduce their own carbon footprints.
In voluntary markets, three main types of credit are traded: carbon avoidance, carbon reduction and carbon removal credits (see Figure 1). Purchasing and then retiring these credits offers companies a way to decarbonise their value chains. On a broader scale, they could provide a tangible lever in the transition to net zero.
Figure 1: The three types of carbon credit
Source: Aviva Investors as at 30 September 2024.
Credit where it's due: comparing credits by impact
Historically, the global market had been dominated by avoidance credits – projects that avoid emissions that otherwise would have occurred, like those that prevent deforestation. One challenge is that it is difficult to prove what might have happened without funding. Another is that avoidance credits are determined through an estimate of what emissions might have been produced but, ultimately, were not. Because of this, there can be uncertainty over the number of credits a project should accrue, and a risk a project can "over-credit". This is one reason why avoidance credits are rarely accepted in compliance markets.
More recently, emphasis has shifted towards removal credits that certify the removal and sequestration of carbon. They derive from projects that take carbon out of the air and store it, such as large-scale reforestation or engineered solutions and are easier to measure, audit and trust.
For investors, holding high-integrity carbon removal credits can offer several benefits. First, they can be used to offset emissions from elsewhere in portfolios with net-zero targets. Second, they can offer a hedge against a future rise in carbon prices. Third, investments in natural capital assets that generate removal credits can deliver a positive impact through improved biodiversity and other benefits (read more here)
At the same time, investors in the nascent carbon removal market should keep some key factors in mind. One is the importance of diversifying across geographies and sectors. Another is the expectation that engineered carbon removals will play a bigger role over time. There is a finite amount of land, so while nature-based solutions are vital, engineered carbon removal will likely become more prominent in the years ahead.
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