A carbon credit is a tradable certificate representing the reduction or removal of one tonne of carbon dioxide or its equivalent; carbon markets are systems in which such credits or emission allowances are bought and sold to cut emissions at the lowest cost.
Economists have long argued that pollution is a "negative externality": a cost imposed on others that does not show up in the polluter's price. One solution is a tax; another is to create a limited number of permits to pollute and let firms trade them. The United States used tradable permits successfully in the 1990s to cut sulphur dioxide from power plants, which reduced acid rain more cheaply than expected. The Kyoto Protocol applied the same idea to greenhouse gases.
There are two main designs. Under cap-and-trade, a government sets a total cap on emissions for covered sectors and issues allowances; firms that cut more than required can sell spare allowances to those who cut less. The European Union Emissions Trading System, launched in 2005, is the largest example. Under baseline-and-credit systems, projects or firms earn credits for reducing emissions below a baseline. Alongside these compliance markets, a voluntary market has grown in which companies buy credits to offset their emissions to meet their own climate pledges.
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