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Carbon credits – what are they and what they mean for investors

Do carbon credits fit into the race to net zero? Here’s a closer look at what they are and how to tell which companies are using them correctly.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Laura Hoy
ESG Analyst

Published on 30 November 2022

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

A growing focus on slowing climate change has led to a wave of commitments to net zero among the world’s largest companies. But a mass reduction in emissions is more complicated than it sounds.

Just because a company has committed to net zero, that doesn’t mean they won’t be polluting. In fact, for many companies, it’s business as usual. Most will continue to rely on fossil fuels to power their organisations. So to get to net zero, they use something called carbon offsetting.

As we continue to walk the path toward an energy transition, these so-called carbon credits have become a topic of much debate. Here’s a closer look at what carbon credits are and how companies can use them properly.

To learn more about investing responsibly, including how net zero might impact your portfolio, visit our Responsible Investment page.

How to invest responsibly

What are carbon credits?

Companies that want to cut down their emissions but are unable to wean off fossil fuels can buy offsets called carbon credits. The credits are actually investments in schemes designed to help reduce emissions. This can be anything from a project that replaces fossil-fuel energy with renewable energy, to one that removes emissions from the atmosphere, like forestry development or carbon capture programmes.

The theory is these types of investments will allow polluting companies time to bring down their emissions, while at the same time bolstering necessary projects that reduce greenhouse gasses. It will be impossible to eliminate emissions completely, so there needs to be a balance between reducing emissions and reducing projects.

On paper, the idea makes sense. But in practice, it can be more complicated.

Why offsetting can be off-putting

Critics say offsetting opens the door for greenwashing – this is where a company's green credentials are exaggerated in order to avoid public criticism.

Carbon credits aren’t all that expensive. It costs less than £3 to offset one tonne of carbon dioxide. That makes it possible to maintain business as usual, while paying for offsets.

Achieving net zero in this way doesn’t necessarily drive real change, the companies themselves should also be working to reduce their own emissions directly.

It will be a long time before clean energy becomes a meaningful part of the energy mix. In the meantime, reducing our impact is a key way to slow climate change. These small, measured changes need to start now and overreliance on carbon offsets could discourage this.

Carbon credits are designed to be somewhat of a straight swap, but making sure the system works is a tangled process. For one, there's a question of whether the emissions are actually offset. Sometimes offsetting projects simply shift carbon production from one area to another. There's also a risk that nature-based projects aren't maintained and protected beyond the immediate future.

Not to mention that all carbon credits aren’t created equally. There’s some debate over what constitutes as a high-quality offset. Apart from being linked to a successful project, there are other issues to consider like how even clean energy projects have some impact on biodiversity and human rights.

The road ahead for carbon credits

In order to implement carbon credits successfully, transparency and regulation is needed. The current rules that determine which types of projects can yield credits are fragmented, and alignment has been a slow process.

Some say a central regulator is needed to oversee inter-global credit trades. Others are reluctant to give up autonomy over the process.

However, one thing is certain – credits on their own aren’t enough to support the net-zero transition. A direct reduction in emissions is needed along-side a scheme of high-quality offsets.

It’s not always easy to parse out a company’s path to net zero, but it has tended to be outlined somewhere in their annual report. Lots of companies also release a full sustainability report each year as well.

Another good resource is the Science Based Targets Initiative (STBI). This organisation vets companies’ emission reduction goals to make sure they’re in line with the Paris Agreement’s goal to limit global warming to 1.5 degrees Celsius above pre-industrial levels.

If a company’s sustainability goals have been approved by STBI, carbon credits aren’t a main feature. All reductions are direct reductions from the company itself and offsets are only considered when bringing emissions down further than the goals.

Case study – PepsiCo

Food and beverage giant PepsiCo is one company that’s keeping carbon credits out of its target to help reduce emissions from its operations and supply chain by 75% by 2030 compared to a base year of 2015.

The group’s also aiming to reduce indirect emissions, like those that come from using its products, by 40% over the same time frame. To do that, the group’s focused on how it can directly bring down its own impact.

Pepsi’s made a lot of important changes to its business in order to make progress on its goal. The group’s US operations are now powered by 100% renewable electricity. This shift toward renewables has been the driving force behind a 25% reduction in the company’s greenhouse gas emissions.

Notably, this doesn’t necessarily mean Pepsi’s lights are all powered by solar panels. Pepsi has been building new wind and solar farms at its plants and distribution centres, which will fulfil some of its energy needs.

For the rest, the group relies on Power Purchase Agreements (PPAs) and Renewable Energy Certificates (RECs). PPAs are investments in developing renewable energy projects. They offer companies like Pepsi renewable energy ‘credit’ in exchange for financing a developing project. RECs are renewable energy credits from existing wind or solar farms. These investments differ from carbon credits because rather than offsetting emissions, they’re used to “buy” the renewable power needed to keep their operations running even if it isn’t available through the existing grid.

For companies like Pepsi that rely on the energy grid, this is their only way to shift to renewables at present. These investments should help increase the proportion of renewable energy in the global mix by giving providers the financing they need to push the technology forward. This should allow Pepsi’s operations to be powered directly by renewable energy someday.

Pepsi isn’t just doing this out of the goodness of its heart. There are business risks that come alongside rising temperatures that Pepsi is mindful of.

The group has already had to stop production at some of its plants from time-to-time because temperatures have exceeded limits for the machinery.

Temperatures that are too high also make it more difficult to grow things like corn and potatoes, needed to make many of the group’s products. These outcomes are estimated to cost Pepsi $1-$1.2bn over the course of ten years.

The bottom line

Carbon credits are a feature in the journey toward net zero, but they shouldn’t be the only feature.

It’s important to fully understand a company’s net zero pledge to assess the risks properly. Over-reliance on carbon offsets leaves that company heavily exposed as rules regarding emissions reductions tighten.

For now, adhering to a 1.5-degree climate scenario is voluntary. But the introduction of a carbon tax or stricter emissions rules could change that. If - or when - this happens, companies that aren’t already aligning with this benchmark could find it difficult to make sudden, sharp changes and could find themselves in a precarious position. With that in mind, it’s important to understand how companies are manoeuvring to fit into a more climate-conscious future as part of the investment analysis process.

Investing in clean energy – is there opportunity ahead?

This article isn’t personal advice, if you’re not sure if an investment is right for you, seek advice. All investments can fall as well as rise in value, so you could get back less than you invest.

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