Carbon trading explained: what is a carbon credit and how do you trade it?

What are carbon emissions?

Carbon emissions are the greenhouse gases emitted from the burning of coal, oil and natural gas – collectively known as fossil fuels. Carbon dioxide (CO2) is released naturally during a variety of processes, such as respiration and decomposition. But human activity is producing carbon at such high rates that nature can’t keep up.

As a result, we’ve got global warming. While scientists and activists have been encouraging consumers and businesses to switch to carbon-neutral technologies – such as wind, solar and hydropower – the process of sequestration has also started.

Sequestration covers any process that reduces the impact of the carbon that’s being emitted. You might also know it as ‘carbon offsetting’.

What is a carbon credit?

A carbon credit is a standardised permit that allows the holder to emit one tonne of carbon dioxide – or another greenhouse gas. The credit system is intended as a measurable form of carbon offsetting that aims to reduce, remove or avoid CO2 as far as possible.

The carbon credit programme was introduced by the European Commission (EC) in January 2005 as part of efforts to limit how much companies can pollute the environment, and to foster early compliance with emissions reductions targets set out under the Kyoto Protocol.

Each company or nation is given a certain number of credits that allow them to emit a certain amount of carbon. If they go beyond this, they have to buy extra credits, but any unneeded credits can be sold to another party.

This encourages companies to reduce their pollution faster so that they can sell allowances to others or save them for future use.

The total cap will decline over time to encourage companies to continue their efforts to reduce their output. In 2017, the EU decided to lower the carbon cap by 2.2% every year until 2030 – the cap reduction factor had previously been set at 1.74%.

The scheme was so popular that the price of carbon credits surged by 989% throughout 2021 as companies attempted to reach net-zero by 2050 – the price rose from 80 cents per metric tonne on January 4 2021 to $8.71/mt on November 22.  

But the system was a mess. Too many credits were created, sometimes they were counted twice – by the country where it was created and where it was sold – and there was no way to really assess whether emissions were being reduced.

So, at the Glasgow Cop26 climate summit in November 2021, it was agreed that a global carbon credit market would be created with higher-quality credits and more stringent rules. Although the market will be more regulated, the increased trust and transparency could see a boost in trading volume.

What is carbon emission trading?

Carbon emission trading is the speculation on the price of carbon. The carbon price is set using European Union Allowance (EUA) Futures contracts. One contract is one credit, so gives the holder the entitlement to emit one tonne of carbon-equivalent gas.

As a result of the growing popularity of EUAs, the futures have become the new choice for individuals who want to make profits and hedge risks across carbon market conditions. There are other providers of carbon futures, but EUAs account for the majority of the global market value.

Unlike other futures contracts – where the buyer receives the underlying asset upon expiry – the buyer of an EUA would have the legal obligation to surrender their contracts commensurate to the amount of greenhouse gases they produced in the year. If they don’t surrender the correct amount, they would be fined €100/tonne CO2 equivalent for every excess tonne of carbon, and would then need to buy the correct amount of additional EUAs to make up the difference.

The price of EUA Futures has fluctuated between $57 and $96 in the first three months of 2022. The rising price will likely cause a rise in the price of the €100/tonne fine too.

What impacts the price of carbon credits?

As there is no fixed price of carbon, it’s driven by market supply and demand in the same way as other commodity markets, which means individual traders can take a position on whether the price will rise or fall. 

If companies need more credits than there are currently available to purchase, demand outweighs supply and the market price will rise. But, if companies cut their demand and start to sell their credits, supply increases beyond demand and the price will fall. This makes the carbon market fairly unique because the aim is for it to become obsolete once companies no longer have any need to buy carbon credits. 

Research has shown that economic activity has the greatest impact on pricing. When the economy is healthier, industrial production increases as the demand for infrastructure, housing starts and consumer products grows. This translates to an increase in polluting activity.

For example, from December 2020 – in the depths of the pandemic – to November 2021, when the economy was growing again, the price of EUAs increased from €33/tonne CO2 to €73/tonne CO2.

The carbon market also tends to see the most liquidity – and most stable pricing – in December, as there is a clearer view of companies’ actual annual emissions as the end of the compliance period approaches (it ends on December 31). They’ll have to start thinking about whether they’ve bought enough credits to cover the current year, and how many contracts they’ll need to buy to hedge next years’ obligations.  

How to trade carbon credits

You can go long or short on Carbon Emissions (EUA futures) with City Index, allowing you to speculate on with the price of the market will rise or fall. Our market is open daily from 7:01 to 17:00 (GMT).

To get started trading carbon futures, follow these quick steps:

1. Open a City Index account or log in to an existing account
2. Search for ‘Carbon Emissions’ in our award-winning platform
3. Choose whether to ‘buy’ or ‘sell’
4. Set your position size and manage your risk with stops and limits
5. Place your trade and monitor the market

Alternatively, you can practise trading carbon credits in a risk-free environment using a City Index demo account.