Carbon credits create a market for reducing greenhouse emissions by giving a monetary value to the cost of polluting the air. Emissions become an internal cost of doing business and are visible on the balance sheet alongside raw materials and other liabilities or assets.

By way of example, consider a business that owns a factory putting out 100,000 tonnes of greenhouse gas emissions in a year. Its government is an Annex I country that enacts a law to limit the emissions that the business can produce. So the factory is given a quota of say 80,000 tonnes per year. The factory either reduces its emissions to 80,000 tonnes or is required to purchase carbon credits to offset the excess.

After costing up alternatives the business may decide that it is uneconomical or infeasible to invest in new machinery for that year. Instead it may choose to buy carbon credits on the open market from organizations that have been approved as being able to sell legitimate carbon credits.

One seller might be a company that will offer to offset emissions through a project in the developing world, such as recovering methane from a swine farm to feed a power station that previously would use fossil fuel. So although the factory continues to emit gases, it would pay another group to reduce the equivalent of 20,000 tonnes of carbon dioxide emissions from the atmosphere for that year.
Another seller may have already invested in new low-emission machinery and have a surplus of allowances as a result. The factory could make up for its emissions by buying 20,000 tonnes of allowances from them. The cost of the seller's new machinery would be subsidized by the sale of allowances. Both the buyer and the seller would submit accounts for their emissions to prove that their allowances were met correctly.

Credits versus taxes
Credits were chosen by the signatories to the Kyoto Protocol as an alternative to Carbon taxes. A criticism of tax-raising schemes is that they are frequently not hypothecated, and so some or all of the taxation raised by a government may be applied inefficiently or not used to benefit the environment.

By treating emissions as a market commodity it becomes easier for business to understand and manage their activities, while economists and traders can attempt to predict future pricing using well understood market theories. Thus the main advantages of a tradable carbon credit over a carbon tax are:

The price is more likely to be perceived as fair by those paying it, as the cost of carbon is set by the market, and not by politicians. Investors in credits have more control over their own costs. The flexible mechanisms of the Kyoto Protocol ensure that all investment goes into genuine sustainable carbon reduction schemes, through its internationally-agreed validation process.