A carbon credit is a term used for any tradable certificate or permit that represents the right to emit one tonne of carbon dioxide or other greenhouse gas. In the carbon finance market, carbon credits are issued to reduce carbon emission.

Kyoto protocol established carbon credit market mechanism, where advanced countries were given emission reduction targets, known as assigned amounts unit. The countries then set quotas for different industries. Companies were given quota for carbon emission by complying with an allowance of credit units. These carbon units are tradable. A company can go for clean energy and less carbon-intensive practices to comply with the cap.

The World Bank report on ‘the future of carbon markets for climate change mitigation’ 2019 state that under the Kyoto protocol, countries aim to achieve their target of reducing carbon emissions. For that, they are participating in carbon markets under ‘flexible mechanism’ approach that facilitates the voluntary transfer of low-cost emissions allowances or carbon credits. In order to comply with the cap, they can offset their emission by financing a carbon-reducing project called carbon offset.

Two key approaches are used which enable countries to acquire GHG reduction credits. The first tool is a clean development mechanism (CDM), which allow a country to sponsor a GHG reduction project in a developing country where the cost of reducing GHG is lower. Joint implementation (JI) is another tool, that allows a country to set a green project in another developed country.

Countries can also go for emission trading (ET), where carbon credits are traded in international carbon markets.

Carbon credits aim to allow the market to carry their commercial activities along with low emissions and less carbon-intensive approaches as compared to that scenario when no cost incurred on carbon emissions. The GHG mitigation projects generate credits to finance carbon reduction schemes and sustainable development programs.