In this article, we explore the different types of carbon credits, the development of the markets on which they are bought and sold, and how institutions can use them to achieve their investment and sustainability goals.
Read this article to understand:
- How carbon credits work
- The nature-based and technological projects from which they derive
- The benefits to investors
Simply put, a carbon credit is a certificate representing one tonne of carbon dioxide that has been avoided, reduced, or removed from the atmosphere. Organisations buy them to offset emissions – either to meet regulatory obligations or to support voluntary sustainability targets.
These credits are bought and sold under two types of market. 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.
Carbon credits have grown in popularity among businesses
But voluntary carbon markets have also emerged to accommodate the trade in credits taking place outside of these legally mandated systems. They have grown in popularity as more businesses seek to manage and reduce their own carbon footprints and meet their net-zero targets.
In voluntary markets, three main types of carbon credit are traded, each defined by the nature of their net emissions impact: carbon avoidance, carbon reduction and carbon removal (see Figure 1). Purchasing these credits and then retiring them (or taking them out of circulation) offers companies a way to decarbonise their own value chains. On a broader scale, they could provide a tangible lever in the global transition to net zero.
Figure 1: The three types of carbon credit
Source: Aviva Investors, as of September 30, 2024.
Credit where it’s due: comparing credits by impact
Historically, the global voluntary carbon credit market had been dominated by avoidance credits, projects that avoid emissions that otherwise would have occurred, like those that prevent deforestation. The challenge here is that it is difficult to prove what might have happened without project funding. In the case of preventing deforestation, for instance, we cannot be certain these investments would not have been made without the carbon credit, because they may offer different revenue streams in their own right – such is the case with timber projects, for example.
One further challenge is that carbon avoidance estimates are determined through a consideration of what emissions might have been produced but, ultimately, were not. Because of this, there can be uncertainty over the number of credits an avoided emissions project should accrue, and if the baseline is not set accurately, a project can “over-credit”. (This is one reason why avoidance credits are rarely accepted by regulators in compliance markets.)
Removal credits are easier to measure, audit and trust
More recently, emphasis has shifted towards removal credits that certify the removal and sequestration of carbon. Removal credits are easier to measure, audit and trust. They derive from projects that take carbon out of the air and store it, such as large-scale reforestation or cutting-edge engineered solutions. Their additionality – or the positive climate impact that wouldn’t have happened without the investment – is easier to prove.
There are also measurable, science-based ways of forecasting the amount of carbon a project is likely to remove over its lifespan and a selection of approved auditors available to independently verify the project’s progress, using rigorous criteria for quality and impact. For example, carbon credit registries such as Verra provide transparent, verified listings on carbon removal projects and independently attest to the quality and integrity of issued and retired credits. Figure 2 shows some key criteria used to assess the quality of carbon removal projects.
Figure 2: Characteristics of high-integrity carbon removal credits
Source: Aviva Investors, as of September 30, 2024.
From an investor’s perspective, holding high-integrity carbon removal credits can offer several key benefits. First, they can be used to offset emissions from elsewhere in portfolios and contribute to the achievement of net-zero targets. Second, credits can offer a useful hedge against a rise in carbon prices in the future. Third, investments in natural capital assets that generate removal credits can bring about a positive impact in the form of improved biodiversity and other benefits (see part one in this series).
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 – it can, for instance, be helpful to spread investments across both relatively lower-risk projects in developed markets and projects in emerging markets with stronger growth potential but also higher risk (due to greater exposure to climate impacts in tropical regions). Another is the expectation that engineered carbon removals will play a bigger role in carbon removal over time. There is a finite amount of land globally, so while nature-based solutions are vital, engineered carbon removal will likely become more prominent in the years ahead.
The next article in this series will explore how Aviva Investors’ own Carbon Removal Fund has been constructed to offer a profile of assets that is diversified both geographically and by sector, and how it could potentially enable investors to capture value and achieve their particular objectives.
