Due to the dramatic increase in greenhouse gas (GHG) emissions over the past several decades, there have been different policy measures and regulations initiated in an attempt to reduce the level of GHGs, especially carbon dioxide. Governments and organizations can use a variety of tools to reduce GHGs, including carbon credits, carbon offsets, and renewable energy credits, however, all these tools share the same idea of putting a price on carbon.

One of the most common tools is the creation of carbon credit markets. A carbon credit is a generic term for any tradable certificate or permit representing the right to emit one ton of carbon or carbon dioxide equivalent. The carbon credit “cap and trade” mechanism used today is very similar to the methodology used for the U.S. Acid Rain Program, which was an emission trading program launched in 1990 aimed at reducing sulfur dioxide and nitrogen oxide levels. In essence, a regulator establishes a cap on the overall emissions of a group and then distributes emission allowances to the separate participants, up to the cap limit.

If a company’s carbon emissions fall below its assigned amount, then that company can sell their surplus of carbon credits to other organizations that may have exceeded their respective limit. Cap and trade schemes allow companies to buy and sell “credits” for many types of pollutants, such as acid rain, but the market for carbon credits is by far the biggest.

In 2007, the size of the global carbon credit market was approximately $60 billion, with over 23 million metric tons of carbon dioxide traded in the U.S. alone. Today, carbon credits are relatively cheap, but carbon markets will become even more important in coming years. Louis Redshaw, head of the environmental markets at Barclays Capital, predicts that “Carbon will be the world’s biggest commodity market, and it could become the world’s biggest market overall.”

The Intergovernmental Panel on Climate Change (IPCC) first noted that a tradable permit system is one policy instrument that has been shown environmentally effective in the industrial sector. The carbon credit mechanism was formalized in the Kyoto Protocol, an international agreement between more than 190 countries whose aim was to address the issue of climate change. Under the Kyoto Protocol, each country is issued an Assigned Amount Unit (AAU) of carbon credits, and they are entered into the country’s national registry, which is validated by the United Nations Framework Convention on Climate Change.

Countries who ratified the Kyoto Protocol set quotas for the emissions of local businesses and organizations, thus establishing a carbon market through a cap and trade scheme. The Kyoto mechanism has been used most notably in Europe, where the European Union Emission Trading Scheme (EU ETS) was established in 2005. The EU ETS is the largest emission trading scheme in the world. It employs a basic cap and trade model where the ETS imposes annual targets for carbon dioxide emissions on each EU country. The major carbon emitters in each country are then given national allowances that they can sell or purchase depending on their need.

The United States, however, did not ratify the Kyoto Protocol and there is no national cap on carbon emissions at this point in the U.S. Consequently, there is no mandatory cap and trade scheme in the U.S. for carbon credits. Nevertheless, carbon markets have still developed in the U.S. due to voluntary commitments from corporations to cap their emissions. The Chicago Climate Exchange (CCX) is a U.S. GHG-trading platform where members make a voluntary, but binding commitment to meet annual reduction targets. The members who reduce GHG emissions below their targets can profit from the surplus. In addition, several states have discussed carbon cap and trade programs, and California recently announced that they would in fact start a cap and trade program for carbon credits in 2012. More commitments like these and the possibility of a national cap in the near future will increase the robustness of the U.S. market for carbon credits.

Although cap and trade is the traditional route for reducing carbon emissions, “carbon offsets” are increasing in popularity. A carbon offset firm acts as a middleman by estimating the emission levels of a company and then providing opportunities to invest in carbon-reducing projects across the world. By investing in these carbon-reducing projects, a company can receive carbon offsets for the carbon emissions that its investments are removing from the atmosphere.

Carbon credits and carbon offsets are not the only financial mechanism for discouraging pollution; another common policy tool in the U.S. is the use of Renewable Energy Certificates (RECs). RECs are present in U.S. states that have adopted Renewable Portfolio Standards, which require local utilities to obtain a certain percentage of their electricity from renewable sources. RECs are also tradable commodities, but they represent the environmental attributes coming from the generation of one-megawatt hour of electricity by a renewable energy source. In general, RECs have much higher values than carbon credits, and solar RECs (SRECs) in particular tend to have very high values. Whereas carbon credits trade in the range of 0.30-$3.50, SRECs generally trade from 200-$650 per credit.

Today, carbon markets are still in their infancy in the U.S., but carbon credits, carbon offsets, and renewable energy credits represent great potential for reducing pollution and protecting the environment through economical, market-based approaches.