What is carbon finance?

Carbon finance is a financial mechanism used to develop projects that reduce greenhouse gas emissions or increase carbon sinks.

The core principle: the emissions reduction itself is the asset. For instance, a loan to build a wind farm is green lending. It becomes carbon finance only when the emissions reductions are measured, verified, and monetised.

Carbon finance and carbon credits

Carbon finance includes carbon credits and investments in climate projects that avoid, reduce, or remove carbon from the atmosphere. Funding is typically directed towards projects in emerging and developing economies, where abatement costs are lower and conventional project finance is harder to access.  

What the provider of capital receives varies. An investor in a project takes a financial return. A company buying the credits receives the mitigation outcome and the right to report it. In both cases the payment is tied to a verified tonne.

In the voluntary carbon market, the capital comes principally from corporate buyers, carbon funds, and intermediaries rather than from states.

How does carbon finance work?

Carbon finance works by assigning a monetary value to mitigation activities. Companies or governments invest in projects that reduce or remove emissions, and the resulting credits are sold to generate the revenue that funds the project.

Each carbon credit represents one tonne of CO₂ equivalent that has been avoided, reduced, or removed from the atmosphere. These credits are issued by independently certified climate projects, registered with international standards such as the Gold Standard or the Verified Carbon Standard (VCS).

The central question in carbon finance is timing. Mitigation has to be delivered and verified before a credit exists, but most projects need capital long before that.  

The forms carbon finance takes are distinguished mainly by when the capital arrives relative to issuance, and who carries the risk in the meantime:

• Spot purchase: The buyer purchases credits that have already been issued and are held in a registry account. This is the most common way credits change hands. The revenue sustains existing projects and makes comparable ones viable in future.
• Forward offtake agreement (ERPA): The buyer contracts to purchase future credits at an agreed price ahead of issuance. The revenue certainty this provides can support financing from other sources.
• Prepayment: The buyer pays some or all of the price in advance of delivery. For many project types this is necessary rather than optional, because substantial capital is required before any mitigation can be verified.
• Equity and project finance: Investors fund the project entity directly and take a share of credit revenue.

The appropriate form depends on the project, its stage of development, and the buyer's objectives.

The four forms of carbon finance differ primarily in timing and risk allocation. Spot purchases are lowest risk; prepayment and equity carry the highest, but enable projects that would otherwise never get off the ground.

Carbon finance: step by step

The basic flow from capital commitment to credit retirement:

1. Capital is committed. A developer secures finance, whether from a buyer's prepayment or offtake commitment, from investors, or against expected credit revenue.
2. A climate project reduces or removes emissions (e.g. renewable energy, forest protection, improved cookstoves).
3. The emissions reductions are measured, verified, and certified by an independent third party.
4. Carbon credits/VERs are issued and recorded in a public registry.
5. A company purchases and retires the credit, demonstrating its financial contribution to climate action.

Why does carbon finance matter?

Carbon finance plays a critical role in closing the global climate funding gap. According to the IPCC, limiting warming to 1.5°C requires rapid and large-scale investment in emissions reductions that is far beyond what public budgets alone can deliver.  

Carbon finance matters because it:

• Creates revenue where none otherwise exists. A protected forest sells nothing, and an avoided methane emission has no customer. Carbon finance is what allows these activities to be funded at all.
• Mobilises private capital for climate projects in regions where conventional finance is hardest to access.
• Enables immediate climate action by funding projects that deliver measurable impact today.
• Supports sustainable development. Many carbon-financed projects deliver co-benefits such as clean water, biodiversity protection, and improved livelihoods.

Carbon finance and additionality

A foundational principle of carbon finance is additionality: a climate project qualifies for carbon credit issuance only if it would not have taken place without the revenue from carbon finance.  

This ensures that the emission reductions represent a genuine, additional benefit to the climate and not something that would have happened anyway.

Additionality is assessed against a baseline scenario, meaning what would most plausibly have occurred without that revenue, considering whether the activity is viable on its own economics, whether it goes beyond what regulation already requires, and whether it is already standard practice in its sector and geography. The assessment takes place when the project is validated, before any credits are issued.

Carbon finance vs. climate finance

While the terms are sometimes used interchangeably, there is a distinction. Carbon finance is a subset of climate finance, focused exclusively on market-based approaches tied to a verified tonne.

Carbon finance specifically refers to capital tied to a verified tonne: it is deployed against, and repaid by, measurable emission reductions or removals.

Climate finance is a broader term covering all financial flows directed toward climate mitigation and adaptation, including government grants, green bonds, and development aid.

Under the UN climate framework, climate financerefers principally to the resources that developed country Parties have committed to provide to developing country Parties for mitigation and adaptation, under Article 9 of the Paris Agreement. Carbon finance is not part of that commitment, and transfers of mitigation outcomes between countries fall under Article 6 instead.

Carbon finance vs. carbon pricing

Carbon pricing, through carbon taxes or emissions trading systems such as the EU Emissions Trading System, or ETS, establishes what it costs to emit. It is a policy instrument rather than a flow of capital into projects: a carbon tax generates public revenue, and an emissions trading system allocates allowances that permit emissions rather than financing reductions.

Carbon pricing therefore sits upstream of carbon finance. Where the two meet in practice is inside the company. Companies use a carbon price, whether a regulatory one or an internal shadow price, to size the budget they then direct towards verified mitigation. Carbon finance is what happens when that budget is deployed.

There are two market types:

• Compliance markets: Regulated by governments (e.g. the ETS), where companies must hold allowances for their emissions.
• Voluntary Carbon Market (VCM): Where companies and individuals voluntarily purchase carbon credits to finance mitigation outside their own value chain.

The role of carbon finance in achieving net zero

For companies on the path to net zero, carbon finance is the mechanism that funds verified mitigation elsewhere, alongside a company's own decarbonisation.  

By financing certified climate projects, companies address their ongoing emissions while contributing to global climate goals beyond their own value chain.

Leading frameworks such as the SBTi Corporate Net-Zero Standard now require that companies invest in climate projects outside their value chain as part of a comprehensive climate strategy (alongside ambitious internal emission reductions).

Carbon finance also operates between states. Article 6 of the Paris Agreement establishes crediting mechanisms at government level, under Article 6.2 and Article 6.4.

Learn how ClimatePartner helps companies navigate carbon markets.