How does carbon finance work?

Carbon finance is a mechanism that allows developed countries to support low-carbon development in developing countries. The diagram below shows how the sale of carbon credits to developed countries provides the money required to finance projects that reduce emissions in developing countries.

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Organizations buying carbon credits that support clean cooking may do so because they want to or because they have to. Depending on the methodologies used to measure GHG emissions reductions cookstove project developers can generate and sell offsets to compliance buyers driven by regulation; or to voluntary buyers driven by social responsibility, branding, or other motivations, to offset their carbon footprint.

What are carbon credits?

A carbon credit is the emission reduction equivalent of one tonne of carbon dioxide. A carbon credit could also reflect the reduction of other GHGs, such as methane or nitrous oxide.  Due to the fact that each gas has a different impact on global warming (some gases have a greater impact than others), and in order to standardize the language and units, each gas is expressed in terms of its carbon dioxide equivalency. Carbon credits are the “currency” of the carbon market and are issued as a result of the assessment after third party validation and verification in compliance with a certain methodology and a carbon standard.

Compliance carbon markets

In a compliance carbon market, a central regulator caps the level of emissions allowed from regulated sectors (e.g. power generators, heavy industry, transport). Emissions allowances, each one representing one metric ton of CO2e, are distributed to participants, either for free or at auction. Participants can sell unneeded allowances and those that emit more than their cap can purchase allowances or regulator-approved carbon offsets to balance excess emissions.

The largest source of international offsets for compliance carbon markets is the UN’s Clean Development Mechanism (CDM). The CDM has methodologies to produce certified emissions reductions (CERs) that are approved by regulators like the European Commission and can also be used for compliance with commitments made under the Kyoto Protocol, an international agreement that set binding targets for 37 developed nations to reduce their GHG emissions. CDM projects can additionally certify their sustainable development co-benefits to the Gold Standard, thus creating Gold Standard CERs.

Voluntary carbon markets

In the voluntary carbon offset market, demand is not driven by regulation, but by businesses seeking to offset emissions from their activities (like transport), often in pursuit of corporate social responsibility (CSR) commitments. NGOs, individuals and governments may also wish to offset their emissions.

Although CERs can be sold into the voluntary market, there are also several standards that guide the development of voluntary emissions reductions (VERs), like the Gold Standard and Verified Carbon Standard. Each standard offers their own rules for carbon accounting and registry systems to track offsets as they change ownership. Voluntary buyers typically look for interesting projects with a unique story behind them – these types of offsets are also known as “charismatic offsets”. Clean cooking offsets are often very desirable to these types of buyers.

Selling carbon credits

In order to generate revenue, carbon credits must be sold. There are several options to sell carbon credits, these include:

  • Exchanges – Buyers and sellers use an exchange platform to trade, which is like a stock exchange for carbon credits.
  • “Over-the-counter” (“OTC”) transactions – Buyers and sellers engage in bilateral discussions to define the terms of payment and offset delivery and transfer the credits from one registry account to another.
  • Broker/Retailer – An intermediary facilitates the transaction, in exchange for a commission.

The most common ways of selling cookstoves carbon credits are OTC, sometimes involving intermediaries like retailers.The following steps are normally taken to complete an OTC transaction for issued carbon credits:

  • Buyer and Seller meet and sign a Non Disclosure Agreement (NDA) – indicative samples of NDAs can be found on the websites of SEQ Legal and My Capital;
  • Buyer reviews the carbon project and credit details received from the Seller and both agree on the volume (tCO2e), price (say $ per tCO2e), delivery date and payment date of carbon credits;
  • Emission Reduction Purchase Agreement (ERPA) is signed between the Buyer and Seller – indicative samples of ERPAs are available on the Forest Carbon Asia website and on the IETA website;
  • Delivery of carbon credits from the Seller’s registry account to the Buyer’s registry account and payment for the credits by the Buyer to the Seller.

This type of transaction can also take place for a forward contract, where the ERPA is signed prior to the issuance of carbon credits.