How can Carbon Offsets Play a Role in Carbon Market Compliance?

Can carbon offsets play a role in India’s compliance carbon market?
What India can learn from the EU, Korea, and New Zealand about integrating carbon offsets into compliance markets

Christi Kesh, Aparna Sharma

07 March 2025

In the global effort to tackle climate change and curb greenhouse gas emissions, what role can carbon offsets play in India’s compliance carbon market? Globally, offsets have emerged as a widely used tool for individuals, corporations, and governments to reduce their carbon footprints through project-based emission reduction. The United Nations Framework Convention on Climate Change (UNFCCC) defines offsets as “a climate action that enables individuals and organizations to compensate for the emissions they cannot avoid, by supporting projects that reduce emissions somewhere else.” While offsets are commonly utilised in voluntary carbon markets, they can also be integrated into compliance market frameworks, offering flexibility and easing the transition for hard-to-abate sectors in India that will be obligated to reduce emissions under the Carbon Credit Trading Scheme (CCTS).

India's CCTS, introduced in December 2023, marks a significant milestone in establishing a compliance carbon market set to launch in 2026. The Bureau of Energy Efficiency (BEE), under the Ministry of Power, is spearheading this initiative by crafting policies for both compliance and voluntary mechanisms. To build a robust CCTS, it is crucial for BEE to evaluate and expand the carbon credit portfolio available to obligated entities (OEs) to meet their targets. The inclusion of a limited percentage of offsets in the compliance mechanism is under consideration, as they can provide flexibility and liquidity to obligated entities in hard-to-abate sectors, depending on the stringency of emission reduction targets.

Integrating offsets into the carbon credit trading scheme

Offsets can serve multiple roles in strengthening India's compliance carbon market. Their integration must be carefully designed to ensure effectiveness while preventing potential pitfalls.

Transition support for OEs: Offsets can provide OEs with a transition period to adjust to new regulations while preparing for direct emission reductions. Their usefulness depends on the rigour of the targets. If targets are lenient, offsets may offer little added value. However, if targets are stringent, they can provide the necessary flexibility, especially for hard-to-abate sectors.
Market liquidity and price influence: Offsets can enhance market liquidity while also influencing allowance prices. A high supply of offsets, for instance, could exert downward pressure on allowance prices. To prevent unintended consequences, such as prolonged price suppression, a phased approach to offset use can be implemented.
Expanding emissions reduction impact: An increased demand for offsets can drive the development of more emission reduction projects across sectors, broadening the impact of India’s climate action efforts.

Lessons from Global Emissions Trading Systems (ETS)

India can refine its approach to compliance carbon markets by drawing insights from countries with established ETS frameworks:

Importance of offset regulation – Korean ETS: Initially, Korean entities were permitted to meet up to 10 per cent of their compliance obligations using offset credits. This aimed to support the country’s Paris 2030 commitments, utilise surplus Clean Development Mechanism (CDM) credits, and improve market liquidity. However, due to legal challenges and market volatility, the limit was later reduced to 5 per cent. The Korean ETS highlights the importance of stringent oversight and regulation of offset credits to maintain market confidence.
Prioritising direct reductions – EU ETS: The EU initially incorporated international credits from CDM projects to diversify emissions reduction options. However, following the 2008 financial crisis and a subsequent drop in demand for credits, they significantly restricted the use of CDM credits. The EU thus recognised the importance of direct emissions reductions over excessive reliance on offsets.
Ensuring market stability – New Zealand ETS: As a small country with relatively steep abatement costs, offsets provided a cost-effective emissions reduction pathway. Initially benefitting from CDM offset credits, New Zealand faced price crashes due to demand volatility post-2008, similar to the EU. Consequently, it disallowed international offsets in 2015 unless they met high environmental integrity standards to ensure real and additional reductions from offsets.

Considerations for India’s compliance mechanisms

India can draw valuable lessons from these international experiences.

Leverage CDM experience: Both Korea and India have extensive experience with CDM projects and well-functioning voluntary markets, which could help entities meet compliance obligations early in the process.
Adopt a phased approach: Learning from the EU and Korea, India can mitigate risks related to uncertain demand and carbon pricing for offset credits by initially allowing higher offset limits for flexibility and gradually reducing them to balance market stability and encourage direct emissions reductions.
Ensure environmental integrity: New Zealand’s experience demonstrates the importance of carefully determining the source and type of permitted offsets. These offsets could come from the Indian Carbon Market’s voluntary mechanisms or secondary private markets.

A strategic, well-regulated approach can help India maximise the benefits of the inclusion of offsets while mitigating potential challenges.

Impact of target stringency on offsets

An important factor in introducing offsets into compliance mechanisms is the stringency of targets set for OEs. These impacts will vary under different target scenarios:

Lenient Targets: If targets are easy to achieve, OEs may meet or exceed them without needing offsets, resulting in surplus credits, as seen in the Perform, Achieve, and Trade (PAT) scheme.
Moderate Stringency: Even with moderately stringent targets, OEs might still fulfil their obligations without relying on offsets, potentially leading to credit surpluses. In this case, offsets can still provide flexibility for the hard-to-abate OEs.
High Stringency: When targets are highly stringent, offsets can add more value, particularly in hard-to-abate sectors where direct emissions reductions are difficult. They can help industries gradually adapt to the compliance mechanism.

The need for robust oversight

India’s CCTS compliance mechanism should establish rigorous monitoring, reporting, and verification systems. These are essential for ensuring the accuracy and legitimacy of emissions reductions achieved through offsets. Additionally, mechanisms like stability reserves can help regulate allowance supply and promote market stability. This is vital to establish a relationship between offsets and allowances, preventing issues such as a collapse in allowance prices from an unchecked influx of offsets into the compliance mechanism.

The BEE is assessing how to integrate offsets into the compliance market while maintaining market stability. While offsets can promote liquidity and flexibility, their use should be limited to ensure that direct emissions reductions remain the primary goal. By setting appropriate offset quotas, India can also regulate overall market dynamics effectively. Drawing from global experiences, India has the opportunity to design a compliance mechanism that advances both its climate goals and sustainable development priorities.

Christi Kesh is a Research Analyst and Aparna Sharma is Programme Lead at the Council on Energy, Environment and Water (CEEW). This piece was supported by additional research by Sawan Oberai. Share your comments with [email protected].

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