Carbonomics 101: Everything you need to know about how carbon credit prices are calculated

Published: June 13, 2022

With carbon markets gaining more prominence in corporate sustainability strategies, we take a closer look at how carbon credit prices are calculated and key factors that companies should consider when purchasing carbon credits for offsetting their residual emissions.

With 2050 fast approaching, there is growing awareness that putting a price on carbon will play an important role in achieving net-zero emissions. At the core of carbon pricing is the concept of capturing the costs of externalities arising from the emission of greenhouse gases (GHGs). In doing so, carbon pricing changes corporate and public sector decision-making by steering producers and consumers towards low-carbon production processes, while also stimulating innovation to bring down the cost of emission abatement measures.

In this article, we look at how the price of carbon is determined and discuss key factors that should be considered by any company looking to leverage carbon markets as part of a wider sustainability strategy.

Which instruments and markets help to put a price on carbon?

Carbon pricing is influenced by a number of different instruments, markets, and factors. Some of the key instruments that influence the price of carbon include:

How do carbon markets influence the price of carbon credits?

Quantifying emissions is relatively straightforward, but the pricing of carbon credits remains elusive, mostly because of the wide variety of credits in the market and the number of factors influencing the price.

The nature of the underlying project is one of the main factors affecting the price of carbon credits, and projects are grouped into two large categories or baskets:

A carbon credit represents the verified removal, or avoidance/reduction of one tonne of carbon dioxide from the atmosphere. A purchased carbon credit may be ‘retired’ by the owner to offset one tonne of carbon dioxide emissions.

Removal credits tend to trade at a premium to avoidance credits, not just because of the higher level of investment required by the underlying project but because of the high demand for this type of credits. They are also believed to be a more powerful tool in the fight against climate change.

Beyond the type of the underlying project, the price of a carbon credit is also influenced by:

The structure of the voluntary carbon market

Carbon credit prices will rise in the near- and medium-term

Carbon prices are mainly driven by supply and demand in the carbon markets. As such, they cover only a small proportion of the societal costs of emissions. Hence, there is a significant divergence between the price of carbon across different markets and the price that experts say is necessary to reach the temperature goals set by the 2015 Paris Agreement. In their paper The Social Cost of Carbon, Risk, Distribution, Market Failures: An Alternative Approach, Nicholas Stern and Joseph E. Stiglitz argue that the social cost is close to $100 per tonne – this compares with high-quality carbon credits currently priced around the $7-17 per tonne.

Clearly, a gap needs to be bridged. Charging $100/tonne today would cause social and economic upheaval: given the limited range of cost-effective alternative technologies, simply driving up the price of carbon would not immediately reduce emissions. Many businesses wouldn’t be able to afford the price and, facing a lack of alternatives, wouldn’t be able to easily switch (or even stay in business). Nor would they be able to fully decarbonise their operations.

Yet other factors also put upward pressure to prices. Typically, nature-based projects don’t start to deliver credits until year three or four of operation. Tech-based carbon credits tend to start at a high price, which will start moving lower as investments bring efficiencies. But innovation takes time. And with demand on the rise, we can expect the demand/supply imbalance to persist for a while.

But in the long run, platforms that increase the frequency of carbon-credit trading, broaden the types of organisations participating in carbon markets, and enhance market transparency will bring much-needed liquidity and hopefully a stable price.

Follow NatWest’s Carbonomics 101 series to keep informed about the development of the carbon markets and learn about the role they could play in your sustainability strategy. Access forthcoming articles in this series the moment they’re published by following NatWest on social media, and visit the bank’s Carbon Hub for essential tools & insights to help you on your sustainability journey.

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