Carbon Offsets

What are Carbon Offsets?

Carbon offsets serve as “compensation” to an organization or an individual that invests in a project or solution that will reduce future emissions or sequester existing CO2 from the atmosphere.

Once created, however, carbon offsets are also an asset class that trades freely on voluntary carbon markets. An offset’s “value” is based on the perception of its quality, the level of third-party validation, and its range of potential co-benefits (among other considerations). 

Many people erroneously confuse the terms carbon offset and carbon credit, but this is absolutely incorrect. Carbon offsets are very different from carbon credits.

Carbon Credits vs. Carbon Offsets

Both carbon credits and carbon offsets are measured in tons of CO2e (carbon dioxide equivalent). This makes them comparable, but it can also make the concepts more confusing; carbon credits and offsets are not the same.

Carbon credits, often called carbon allowances, are established by regulatory bodies in jurisdictions that operate under what’s referred to as a Cap & Trade system. 

From a non-regulatory standpoint, however, both individuals and companies may purchase offsets as an investment, assuming that management feels they will be worth more in the future than they are today. The same is true of credits, although carbon credits are only valuable within a particular Cap & Trade network system (but can be very valuable as a result).

What’s really different is how they’re created and what they represent.

Carbon Credits

Carbon credits are issued to organizations (businesses, government agencies, etc.). The number of carbon credits an organization receives from the regulatory body represents “permissible emissions,” meaning it’s the maximum amount of CO2e that this organization is allowed to emit under the “cap” system.

If an organization emits less than its cap, then management may hold its credits (as an investment asset), or they may sell the surplus carbon credits into the compliance market.

A different organization in the same jurisdiction (one that exceeded its emissions cap) can go to this same compliance market and purchase another firm’s excess carbon credits. This effectively ensures that, in aggregate, all organizations within that jurisdiction collectively emit less than the total cap amount.

Carbon Offsets

Unlike credits (which represent a “cap” on permissible emissions), carbon offsets represent emissions that have been “removed” from the atmosphere, either through natural sequestration or technological reduction projects.

From a regulatory standpoint, there is no use case for purchasing carbon offsets from a voluntary market. But that doesn’t mean they’re not useful or valuable; they may, after all, increase in value – making them an interesting, emerging asset class.

A big benefit of purchasing carbon offsets is that a management team may wish to “offset” all of the carbon emissions created by the company’s core operations. This would make the company a “net zero” emitter, regardless of whether they’re in a Cap & Trade system or not, which itself has some qualitative benefits (like marketing to customers, improving its ESG score, and attracting talent to the organization).

What Qualifies as a Carbon Offset Project?

There are two overarching categories of projects (or solutions) that can create carbon offsets; these are nature-based and mechanical.

Nature-Based

Nature-based projects leverage carbon sequestration functions that exist in our natural environment. 

Flora populations like trees and grasslands absorb and therefore remove carbon dioxide from the atmosphere, so wetland restoration and reforestation projects fall into this category.

Mechanical Projects

Mechanical projects use technologies to reduce or sequester atmospheric carbon dioxide. 

Examples include the development of renewable energy projects (like solar and wind) as well as waste-to-energy conversion projects or investments in direct air capture and storage technologies.

How are Offsets Validated and Valued?

The premise of a carbon offset is that an eligible project will either remove carbon dioxide from the atmosphere (like reforestation) or it will reduce or eliminate future emissions, meaning they won’t even enter the atmosphere (like a renewable energy project). Every tonne of CO2e that is saved or removed from the atmosphere translates into one carbon offset. 

Estimates of removed CO2e vary, however. On the voluntary carbon markets, for example, project developers are generally permitted to self-declare the estimated carbon reduction impacts of their various initiatives. Obviously, this presents some potential validity issues.

To mitigate some of this moral hazard, certification programs have emerged. They vary based on region and project, but in general, organizations like these provide much greater credibility to a project’s impact claims. As of 2021, three of the largest and most well-recognized standards were Verra, the Gold Standard Program, and the Verified Carbon Standard.

An offset is considered most valuable if it has been certified by one of these programs. However, there are also a variety of “other” secondary benefits that may improve perceived value. Arguably the most important of which is “co-benefit” – meaning that, along with the purported environmental impacts, there is some other marginal environmental or social benefit (like rural economic development, improved biodiversity, or better relations with First Peoples’ communities, etc.) 

Related Resources

CFI offers the ESG Specialization program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• ESG Fund
• Corporate Governance
• Greenwashing
• Greenhouse Gas Accounting
• See all ESG resources