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For one thing, we can’t go back in time and try to fix things. For another, unfortunately there are some activities that we simply have to keep on doing, and, despite (or perhaps due to) technological progress, those activities pollute.

The whole point of carbon credits is to apply a cost to the emission of carbon. Up until now we have been getting a free ride, pollution-wise. Economics 101 tells us that, by making the emission of carbon cost something, we inhibit emitting activities. Obviously, it’s in the interests of the polluters to make that cost of carbon as low as possible and this is where carbon credit schemes get interesting.

Before I talk about how carbon credit schemes are valued it’s worth mentioning the alternative – a flat carbon tax. A carbon tax, as is promoted by a number of authorities, would set a fixed price per tonne for emitted carbon. That money would, by-and-large, go into general tax revenue for the government and would certainly work to stifle activities that cause the direct emission of carbon into the air. The problem with flat tax is it doesn’t reward innovation on the part of low-carbon technologies, and the fixed price is unlikely to represent the most optimal cost for reducing emissions. It’s all cap, no trade. The other alternative that has been proposed, mostly by governments that lean towards climate-scepticism, is a carbon trading scheme with no fixed reduction targets. This won’t work either as there is no inherent requirement for firms to buy credits at all. It’s all trade, no cap.

Cap and trade schemes work like this: A fixed, high penalty rate is applied to emissions that exceed a certain stated target and firms are free to buy qualifying credits on the open market to bring their balance below the target level. The price of carbon on the open market will vary from scheme to scheme but is guaranteed to be lower than the penalty rate. Hence an upper bound is set for the price of carbon and classical market efficiencies force the real price of carbon emissions as low as possible. This is the model recognised by the Kyoto protocol and was the recommended model put forward to the Australian Government’s carbon trading task-force in mid 2007.

There are a few details that relate to the government wishing to protect certain industries from an economic king-hit that give these schemes local colour. You may have heard the term ‘grandfathering’ of credits. This is just a weird way of saying that the government in some cases simply gives a parcel of credits to favoured industries to help them meet their targets. Recall the old saying that what the government giveth, the government taketh away. Well this reverses that neatly. In Europe the various EU countries were given free- reign to allocate carbon permits to their pet industries with very few limitations and, shock horror, they basically pissed away their entire trading scheme. We saw the price of the European Trading Scheme credits peak, wobble and then collapse when the data became public, all because of this over-allocation of credits. Something given has no value. A more sophisticated approach to allocating credits is to auction a limited supply. This then forces invited industries to take a bet on what the real cost of their emissions will be and provides a significant disincentive for over-allocation.

Still with me? Over time, the targets (the amounts of carbon you are freely allowed to emit) are pushed lower. This allows your business to gradually make the necessary structural and behavioural changes needed to reduce emissions. In the meantime technical innovation and business acumen on the part of those firms creating carbon credits should also bring the cost of emissions reduction down. This is a win for business and the planet, but only if the targets are aggressive enough, the penalties high enough and the timetable urgent enough.

Next issue, I’ll discuss the different types of carbon credits and how your money actually goes to reducing atmospheric carbon.

Dave Sag is the CEO of Carbon Planet, a global carbon emissions company. Carbon Planet consults on all things carbon, ranging from conducting formal carbon emissions audits and ghg life-cycle analysis, to comprehensive carbon matchmaking and helping projects generate their own carbon credits. Carbon Planet builds emissions calculators and retails carbon credits to the general public and business alike.