By Harry Prabandham · Updated September 28, 2026
Investing & Markets
Carbon Credits and Carbon Markets: How They Work
A carbon allowance or credit covers one metric ton of CO2-equivalent. Compliance markets cap emissions; voluntary offsets vary widely in quality.
Carbon Credits and Carbon Markets: How They Work
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What is a carbon credit?
- A carbon allowance or credit generally represents the right to emit, or a claimed reduction of, one metric ton of carbon dioxide equivalent.
- Compliance markets use government-issued allowances under a legal cap; voluntary markets use offset credits generated by projects.
- Putting a price on emissions is meant to make lower-emission choices cheaper relative to higher-emission ones.
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What is a carbon credit?
- A carbon allowance or credit generally represents the right to emit, or a claimed reduction of, one metric ton of carbon dioxide equivalent.
- Compliance markets use government-issued allowances under a legal cap; voluntary markets use offset credits generated by projects.
- Putting a price on emissions is meant to make lower-emission choices cheaper relative to higher-emission ones.
How does cap-and-trade work?
- A regulator sets a declining cap, issues allowances by auction or free allocation, and requires covered firms to surrender allowances equal to their emissions.
- The EU Emissions Trading System covers power, heavy industry and aviation, and added maritime shipping in 2024.
- California's program, renamed cap-and-invest and extended through 2045 in 2025, and the Regional Greenhouse Gas Initiative in several Northeastern states are the main U.S. systems.
- Allowance prices depend on the cap, economic activity and policy choices, and can swing sharply.
What is the voluntary carbon market?
- Companies buy offset credits voluntarily, often to support climate pledges, from projects such as forestry, methane capture, cookstoves and direct air capture.
- Quality depends on additionality, permanence, leakage and accurate measurement, and investigations have found projects that overstated reductions.
- The Integrity Council for the Voluntary Carbon Market publishes Core Carbon Principles as a quality benchmark for credits.
- Registries issue and track credits, but a credit's label doesn't settle whether the claimed reduction happened.
Ways investors get exposure to carbon prices
- Futures on compliance allowances, such as EU and California allowances, trade on regulated futures exchanges.
- Some exchange-traded products hold allowance futures, which adds roll costs and fund-specific tax treatment.
- Stocks of companies that develop projects or sell emissions technology give indirect exposure with company risk.
- Voluntary credits are mostly traded over the counter, with limited price transparency.
Risks of investing in carbon markets
- Policy risk dominates: governments can change caps, release supply, delay programs or end them.
- Voluntary credits carry integrity risk, and a credit can lose value if its project is discredited.
- Prices are volatile and futures-based funds can lag the spot price over time.
- Allowances produce no cash flow, so their value rests entirely on regulation and demand.
Key takeaways
- Compliance allowances and voluntary offsets are different instruments with different drivers.
- Major compliance systems include the EU ETS, California's cap-and-invest program and RGGI.
- Voluntary credit quality varies widely, and standards are still developing.
- Carbon exposure is driven mainly by policy, which makes it volatile and hard to value.
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