Carbon Instruments: An Overview

As the world races to price emissions, the conversation around carbon credits and allowances has never been more important. These instruments offer the opportunity to deliver auditable carbon pricing that can be hedged, benchmarked, and embedded into valuations and financing.

Here we will unpack the two main types of carbon instruments, the markets in which they operate, and the rules that underpin their use as tradable assets.

Carbon Credit vs Carbon Allowance

There exists two primary types of carbon instruments:

• Carbon credit: generated by a specific activity taking place (such as reforestation, capturing landfill gas, or removing carbon dioxide from the atmosphere). Each carbon credit represents one metric tonne of CO₂ removed from or prevented from entering the atmosphere.

• Carbon allowance: regulated into existence – it does not reflect an activity having taken place. Each allowance is a permit to emit one metric tonne of CO₂.

Voluntary/Verified vs Compliance Carbon Markets 

These instruments are traded within two distinct market categories: the Voluntary/Verified Carbon Market (VCM) and Compliance Carbon Markets (CCMs):

• CCM: established under regulatory frameworks that define emission benchmarks to be met through a mixture of direct emission reductions and the use of carbon allowances and, in certain instances, the use of carbon credits.  

• VCM: aims to support the development and deployment of novel carbon reduction and removal technologies - beyond the scope of CCMs - through the generation of carbon credits (also called Voluntary Carbon Credits, VCCs).

Carbon credits, unlike allowances, exist in both the VCM and some CCMs. To achieve net zero, credit use in CCMs will ultimately become more widespread: the ‘net’ in ‘net zero’ defines the use of carbon credits.

Reductions vs Removals 

Carbon credits are not a single category of interchangeable commodities. There exist 2 primary categories of carbon credit: removals and reductions. 

• Removals: the action taking place removes carbon dioxide from the atmosphere. 

  • E.g., Reforestation, Direct Air Capture, Biochar. 

• Reductions: the action taking place prevents carbon dioxide from reaching the atmosphere. 

  • E.g., protecting existing forests, plugging a leaking orphaned well, and capturing landfill gas. 

Basic Credit Requirements 

Credits must meet several key requirements:

• Additionality: The project would not have taken place without carbon finance.

• Accurate Measurement: Each credit must equal one metric tonne of CO₂ either reduced or removed.

• No Double Counting: Credits can only be claimed once. Once sold, the emission reduction associated with that credit can only be counted by the holder of the credit.  

• Permanence: The reduction or removal must not be reversed.

• Leakage Prevention: Emission cuts in one area shouldn’t trigger increases elsewhere.

Credit Heterogeneity

Whilst all credits are defined as one metric tonne of CO₂ removed from or prevented from entering the atmosphere, the reality is far more complex.

Activities that have historically generated credits are incredibly diverse, ranging from the readily measurable and measured, through those based on highly complex statistical counterfactuals.

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