Carbon Credits Explained: How Emissions Trading Markets Actually Work

The Basic Idea: Putting a Price on Carbon

The fundamental challenge of climate change is that emitting greenhouse gases is free for the emitter while the costs — rising seas, extreme weather, crop failures — are borne by everyone. Carbon pricing aims to fix this market failure by making polluters pay for the damage their emissions cause.

There are two main approaches to carbon pricing: carbon taxes and cap-and-trade systems (also called emissions trading systems, or ETS). Both put a price on carbon dioxide and other greenhouse gases. They differ in mechanism, but the economic goal is the same: make clean alternatives relatively cheaper and dirty ones relatively more expensive.

As of early 2026, 73 carbon pricing instruments are in operation or scheduled for implementation worldwide, covering approximately 23% of global greenhouse gas emissions, according to the World Bank's Carbon Pricing Dashboard.

Carbon Tax: Simple and Direct

A carbon tax sets a fixed price per ton of CO2 emitted. Companies pay the tax based on how much they emit, creating a direct financial incentive to reduce emissions.

Advantages: Simplicity and price certainty. Businesses know exactly what carbon will cost, enabling clear investment planning. Revenue can be recycled as dividends to citizens (as in Canada) or invested in clean energy.

Disadvantages: Emissions outcomes are uncertain. The tax might not reduce emissions as much as needed if the price is set too low, or it might cause economic disruption if set too high.

Notable examples:

• Sweden implemented a carbon tax in 1991 at $26 per ton. It now exceeds $130 per ton — the world's highest — and has contributed to a 27% reduction in Swedish emissions since 1990 while the economy grew by 85%.
• Canada operates a federal carbon tax (formally the "fuel charge") that reached CAD $80 per ton in 2024, rising $15 per year. Revenue is returned to households as quarterly Climate Action Incentive payments.
• British Columbia pioneered North America's first broad-based carbon tax in 2008. Studies have shown it reduced emissions by 5-15% without measurably harming economic growth.

Cap-and-Trade: The Market-Based Approach

Cap-and-trade works differently. The government sets a cap — a maximum total amount of emissions allowed from covered sectors. It then issues emission allowances (permits) equal to that cap, each allowing one ton of CO2. Companies must surrender enough allowances to cover their actual emissions each year.

The key innovation: allowances can be traded. Companies that can reduce emissions cheaply do so and sell their surplus allowances to companies where reductions are more expensive. This creates a market that finds the lowest-cost path to meeting the overall emissions cap.

Over time, the government reduces the cap — typically by 2-4% per year — tightening the screw and forcing continued emission reductions across the covered economy.

The EU Emissions Trading System: The Gold Standard

The EU ETS, launched in 2005, is the world's largest and most mature cap-and-trade system. It covers approximately 40% of EU greenhouse gas emissions across power generation, heavy industry, aviation (intra-EU flights), and — starting in 2024 — maritime shipping.

How it works in practice:

1. The European Commission sets the annual emissions cap for all covered installations.
2. Allowances (called EUAs — EU Allowances) are distributed, primarily through auction. Power generators buy all their allowances at auction; some industrial sectors receive free allocations to prevent carbon leakage (production shifting to countries without carbon pricing).
3. Companies trade EUAs on exchanges like ICE and EEX. The price fluctuates based on supply (the cap, banking of surplus allowances) and demand (economic activity, weather, fuel switching).
4. Each year, covered installations must surrender enough EUAs to cover their verified emissions. Non-compliance triggers a penalty of EUR 100 per ton (far above the market price).

The price signal: EU carbon prices hovered below EUR 10 per ton for most of the system's first decade, widely criticized as too low to drive meaningful change. Reforms in 2018 (the Market Stability Reserve, which removes surplus allowances from circulation) transformed the market. Prices reached a record EUR 100 per ton in early 2023 before stabilizing in the EUR 60-80 range through 2025.

At these levels, the ETS has driven measurable outcomes. Coal-to-gas switching in European power generation accelerated dramatically. Industrial installations invested in efficiency improvements that would not have been economic at lower carbon prices. EU ETS-covered emissions fell by approximately 37% from 2005 to 2023.

The EU ETS is not without criticism. Free allocation to heavy industry has been called a subsidy that delays decarbonization. Windfall profits for power generators who passed carbon costs to consumers while receiving free allowances were a scandal in the system's early years. And the system's complexity creates opportunities for fraud — the EU ETS suffered a VAT carousel fraud that cost several billion euros before enforcement was tightened.

Voluntary Carbon Markets: A Different Animal

Alongside government-mandated compliance markets, a parallel voluntary carbon market has developed. Companies and individuals that want to offset emissions beyond regulatory requirements purchase voluntary carbon credits from projects that reduce or remove greenhouse gases.

Common voluntary offset project types include:

• Nature-based solutions: Forest conservation (REDD+), reforestation, mangrove restoration, soil carbon sequestration. These are the most common and the most controversial.
• Renewable energy: Financing solar, wind, or biomass projects in developing countries. Increasingly criticized because renewables are now cost-competitive without offset financing.
• Methane capture: Landfill gas capture, coal mine methane recovery, livestock methane digesters.
• Engineered removal: Direct air capture (DAC), biochar, enhanced weathering. The highest-quality but most expensive offsets.

The voluntary market grew rapidly, reaching an estimated $2 billion in 2023, before contracting amid an integrity crisis. Investigative reporting by The Guardian and research published in Science found that many REDD+ forest conservation credits — which dominated the market — had dramatically overstated their climate benefits. Some projects claimed to be preventing deforestation in areas where deforestation was never a significant threat.

Quality and integrity frameworks are now rebuilding trust. The Integrity Council for the Voluntary Carbon Market (ICVCM) launched its Core Carbon Principles assessment framework in 2024, establishing baseline quality criteria. The Voluntary Carbon Markets Integrity Initiative (VCMI) provides guidance for companies on credible use of carbon credits. The direction is clear: credits must represent real, additional, permanent, and verified emission reductions.

Article 6 of the Paris Agreement

The Paris Agreement's Article 6 establishes rules for international carbon market cooperation — how countries can trade emission reductions to meet their national climate targets (Nationally Determined Contributions, or NDCs).

After years of negotiation, Article 6 rules were finalized at COP26 in Glasgow (2021) and operationalized through subsequent decisions. Two key mechanisms:

Article 6.2 allows bilateral agreements between countries to transfer "internationally transferred mitigation outcomes" (ITMOs). Switzerland has been an early mover, signing bilateral agreements with several developing nations to finance emission reduction projects whose credits count toward Swiss climate targets.

Article 6.4 establishes a UN-supervised crediting mechanism — essentially a successor to the Kyoto Protocol's Clean Development Mechanism (CDM). A supervisory body oversees methodology approval, project registration, and credit issuance. The mechanism's methodologies are being developed with more rigorous additionality and permanence requirements than the CDM.

Article 6 addresses a critical problem: double counting. Without clear rules, an emission reduction could be counted by both the country where the project occurs and the country purchasing the credits. The "corresponding adjustment" mechanism requires the host country to add the transferred credits to its own emissions tally, ensuring each reduction is counted only once.

Carbon Pricing: Criticisms and Limitations

Carbon pricing is widely supported by economists but faces legitimate criticisms:

• Distributional impacts. Carbon prices increase energy and product costs, disproportionately affecting lower-income households. Revenue recycling (returning carbon pricing revenue as dividends or tax cuts) can offset this, but policy design matters enormously.
• Carbon leakage. If only some jurisdictions price carbon, production may shift to unregulated regions, increasing emissions there. The EU's Carbon Border Adjustment Mechanism (CBAM) — a tariff on carbon-intensive imports — is the most ambitious attempt to address this.
• Price volatility. Cap-and-trade prices fluctuate, creating investment uncertainty. Floor and ceiling prices (as used in California's ETS) can moderate this but reduce the market's efficiency.
• Insufficient ambition. The World Bank estimates that carbon prices need to reach $50-100 per ton by 2030 to align with Paris Agreement goals. Most operational carbon pricing instruments are below this range.

Where Carbon Markets Are Heading

The trajectory is toward more coverage, higher prices, and tighter integrity standards. China's national ETS — covering the world's largest emissions base — is expanding beyond power generation to include additional industrial sectors. Brazil is developing a cap-and-trade system. India is implementing a carbon credit trading scheme.

Carbon pricing alone will not solve climate change. It is one tool among many — alongside regulation, public investment, technology development, and behavior change. But by making the invisible cost of emissions visible and financial, carbon markets create the economic foundation on which every other climate policy is built.