Understanding the Functioning, Effectiveness, and Limitations of the Carbon Credit Industry

Part 1 of 2: Carbon credit offsets are regarded as one of the key drivers to a net-zero future. But how effective are they? In this article, we explore the operation of the carbon offset market, its current and future outlook, and the controversies surrounding aspects that contribute to greenwashing.

CARBON CREDIT INDUSTRY

Sumedh Joshi

7/5/20257 min read

Most of us are familiar with the ubiquitous sustainability buzzword “net-zero,” which refers to the absolute abatement or removal of equivalent carbon emissions released by government and private entities. This absolute abatement with current decarbonizing technologies could surpass trillions of dollars in spending, rendering them as potential but costly contenders in the race towards a sustainable future. This is where carbon offsets fill the gap by offering a platform to trade cheaper, transferable instruments equating to the emission reduction of one metric tonne of CO2 or an equivalent amount, realized through emissions avoidance and removal strategies. These strategies can be differentiated between nature-based and engineered solutions. Nature-based solutions include the preservation of forest land and regenerative agriculture practices that sequester atmospheric carbon into soils and vegetation. Engineered solutions are Carbon Capture and Storage (CCS) of GHGs from fossil-fuel-fired power plants and other industries, substituting fossil-fuel electricity with renewable energy, combustion of stockpiles of ozone-depleting substances and methane from landfills, and direct air capture of GHGs from the atmosphere with storage.

Let us first explore how the carbon credit market works.

Carbon credits typically trade on dark pools, where standardization and regulation do not prevail. However, there are some entities that provide verification and list standards. As with equities and bonds, these projects are rated on their effectiveness based on specific criteria. Essentially, three entities make up the offset market.

1. Carbon Credit Verifiers

These entities asses the projects to verify if they meet certain standards. These are companies and independent groups that focus on just one type of offset project. Examples are SCS Global Services and DNV

2. Carbon Credit Brokers and Marketplaces

Just like secondary financial markets, brokers match buyers with sellers. Examples are 3Degrees, Cloverly, South Pole Group, Patch, and Terrapass.

3. Carbon Credit Rating Agencies

These are the S&P, Moody’s, and Fitch of the offset market. These entities sell their ratings to prospective buyers and provide transparency. Examples are – BeZero, Calyx, and Sylvera

Due to non-standardization, companies find it difficult to navigate the right set of offsets. Selecting from a huge number of players with their own standards and offerings adds to the complexity. Nevertheless, this market is very nascent, and further growth will essentially simplify it.

Let us now delve into the basic lifecycle of a carbon offset credit.

1. Methodology development

It all starts with a plan. An offset that realizes GHG reductions should follow a basic protocol specific to the type of project realizing the reductions. Most carbon offset project programs have a library of approved methodologies. Sometimes, provisions for new methodologies are reserved for the evolving technology landscape. Once the methodology satisfies the protocol, it is accepted for execution.

2. Project Development

Carbon offset projects are developed by project developers, funded by investors, validated by independent verifiers, and registered with official programs to begin generating credits. Buyers can either invest directly in projects for rights to future credits, gaining deeper project insight, or contract with developers through Emission Reduction Purchase Agreements (ERPAs). ERPAs offer developers certainty and allow buyers to secure credits at below-market prices, albeit with some delivery risk.

3. Project Implementation, Verification, and Offset Credit Issuance

After implementation, an offset project is monitored and verified—typically annually—to measure emission reductions. Verified reductions are approved by the carbon offset program, which then issues an equivalent number of offset credits, deposited into the developer’s registry account. Buyers can purchase these unsold credits directly from developers, potentially lowering transaction costs, though such credits may sometimes raise quality concerns if not secured through prior contracts like ERPAs.

4. Offset Credit Transfer

After issuance, carbon offset credits can be transferred between registry accounts through sales or trades. Buyers may hold, transfer, or retire them, and credits can change hands multiple times before retirement. Purchases can be made via brokers, who offer access to various project types and transaction sizes, though potential conflicts may arise if they sell credits from their own investments. Credits can also be bought on exchanges, which offer convenience but less transparency on credit quality.

5. Offset Credit Retirement

To use offset credits and claim their associated emission reductions, holders must retire them through a registry-specific process, making them non-transferable and permanently removed from circulation. Small buyers, like individuals or small companies, typically purchase credits through retailers, who offer access to various projects and handle retirement on the buyer’s behalf.

Despite the merits, the carbon offset market has failed to grow in the past couple of years. According to Reuters, the carbon offset market was sized at USD 1.4 billion, about 15% lower than the peak in 2022. This is due to the failure of major carbon offset projects, presence of bogus offsets in the market, and the lack of market oversight and legislation. It is interesting to note that carbon offset buyers have been switching to offsets derived from renewable energy sources which account for 50% of the total offsets, often deemed by experts as controversial, partly because they are already the cheapest option in the most parts of the world and any funding from the sale of carbon offsets from renewable sources wouldn’t move the needle on emissions. In other words, companies focus on the cost of these offsets rather than their effectiveness and credibility. Realistically, a lot of major corporations that make carbon neutral claims own these bogus carbon offsets. The recent controversy with South Pole, the largest carbon offset seller around its forest protection project at Kariba in Zimbabwe due to the termination of its contract with the site developer puts big firms like who purchased their carbon offset credits such as Volkswagen AG, Nestle, Gucci, and L’Oreal SA in a tough spot. There have been many such cases Many experts have cited that 60-70% of offset credits may not represent valid GHG emissions.

Talking about the future outlook, a BloombergNEF report expounded on two realistic scenarios for the future of carbon offsets, voluntary market and removal scenario. The voluntary market scenario deals with the freedom to purchase any type of carbon offset to achieve net-zero goals, imputing to 5.4 billion offsets annually by 2050. In this scenario, a constant oversupply of offsets, primarily from avoided deforestation, and prices just shy of $ 15/ton in 2030 would be prevalent, allowing companies to purchase cheap offsets with dubious environmental value. In this undesirable, but likely scenario, the market would be valued at USD 15 billion annually in 2030.

Under the removal scenario, a desirable and ideal scenario, the supply-demand balance would be tighter, owing to the sale of offsets from projects that actually remove carbon. This scenario disregards credits from avoided deforestation or clean energy projects (renewable projects) highlighting an important aspect called as additionality, which is explained later. This market would be undersupplied with carbon credits and would be expensive with offset prices above $ 250/ton by 2037, with the annual market reaching USD 1 trillion!

Experts have identified the criteria to assess the quality of carbon offset credits. Greenwashing or falsifying claims related to carbon offsets is prevalent and is based on non-conformance to these factors. These are as follows –

1. Additionality

Additionality means that GHG reductions only count if they wouldn’t have occurred without the incentive of selling carbon offset credits. If a project would have happened anyway—due to laws, profitability, or other reasons—it’s not additional, and claiming such credits worsens climate change. Assessing additionality is difficult and subjective, relying on predicted scenarios without offset revenue. While terms like “financial” or “regulatory” additionality are used, the only relevant standard is whether offset sales were essential to the project’s implementation. Because developers have incentives to claim additionality, it's best viewed as a risk.

2. Overestimating

Overestimation of GHG reductions undermines carbon offset integrity. If a project reports reducing more emissions than it actually does, excess credits are issued, leading to false climate benefits. This can occur through inflated baseline emissions, underestimated actual emissions, unaccounted indirect effects (leakage), or issuing credits for future reductions (forward crediting). Accurate, conservative methods and rigorous third-party verification are essential to ensure data reliability, as developers are incentivized to maximize credit issuance.

3. Permanence

Carbon offsets must represent permanent GHG reductions to effectively compensate for long-lived CO2 emissions. While many projects pose minimal reversal risk, those storing carbon in forests are vulnerable—fires or decay can re-emit stored carbon. Though offset programs often define “permanence” as 100 years, true scientific permanence requires preventing reversals indefinitely. Any reversal undermines the offset’s value and climate impact.

4. Double Counting

Carbon offset integrity can be compromised by double-counting. Double issuance happens when more than one credit is issued for the same GHG reduction, often due to overlapping claims across projects or programs. Double use occurs when the same credit is counted by multiple buyers, typically through fraud, which can be prevented by transparent registry records. Double claiming arises when both a project and another entity (like a government) count the same reductions toward their goals. Preventing these issues is crucial, especially under frameworks like the Paris Agreement.

5. Social and Environmental Harm

High-quality offset projects must avoid causing significant social or environmental harm. They should comply with local laws, and in some cases, require additional safeguards to prevent negative impacts beyond GHG emissions.

In the next article, we will explore the in-depth solutions to these aspects and other measures that the government and companies should be considering for effective carbon credit offset programs.

References