Everyone Wants to Buy Carbon Credits – Here’s What You Should Know

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A. Introduction

The voluntary carbon market (VCM) is undergoing a much-needed overhaul as we work towards building a robust, high integrity VCM to facilitate the widely anticipated surge in demand for quality carbon offsetting. This is naturally driving more participants to enter the VCM, bringing with them new products, platforms and solutions that augment and challenge convention.

Although the basic utility of voluntary carbon credits (VCCs) and the importance of quality are relatively well understood and may easily be researched, VCCs can be surprisingly complex instruments. This commentary is intended as a high-level buyer’s guide to alert buyers to some of the complexities of VCCs so that they may consider the practical and legal implications relative to their intended use of VCCs.

B. What do VCCs do?

VCCs represent a certification that the holder[1] either directly or indirectly has avoided, reduced or removed from the atmosphere a specified quantity (usually one metric ton per VCC) of carbon dioxide equivalent (tCO2e) in line with relevant rules and requirements.[2] Its market value primarily derives from its quality.

The VCM essentially comprises buyers who voluntarily purchase VCCs either as a tool to neutralize or compensate some of their own emissions or as an investment. VCCs are typically issued by self-regulated organizations (e.g. Verra, The Gold Standard and emerging registry solutions) (Registries) according to proprietary standards and methodologies approved by the applicable Registry which govern project verification and VCC issuance.

C. VCC Buyers Beware

1. No global standard on quality

There is currently no global standard for the assessment of VCC quality resulting in inconsistent benchmarking of high quality VCCs. This means buyers must navigate different Registry standards and determine for themselves what constitutes “high quality”. It is too often a challenge for buyers to find high quality VCCs at transparent pricing.

The absence of global standards on quality is therefore a major pain point that continues to inhibit the scaling of the VCM. Addressing the problem is central to the objectives of the Integrity Council for the Voluntary Carbon Market (Integrity Council), which is developing the core carbon principles (known as CCPs) as a framework to “provide a credible, rigorous, and readily accessible means of identifying high quality carbon credits that create real, additional and verifiable climate impact with high environmental and social integrity”[3]. Assuming widespread adoption, the CCPs will provide an important framework which will then need to be implemented by Registries.

It is however important to note that the standards for VCC quality would evolve as “the views on additionality, permanence, and leakage evolve, considering advances in science, technology, and market views on appropriate crediting baselines”[4].

The assessment of the potential co-benefits of VCCs (beyond emissions reductions) through appropriate measurement, reporting and verification processes particularly with the different benchmarks adds another layer of complexity.

2. Elusive legal nature of VCCs

The Taskforce on Scaling Voluntary Carbon Markets (TSVCM) noted that the legal nature of VCCs is highly fragmented across methodology types, standards and jurisdictions. This statement quite neatly highlights why determining the precise legal nature of VCCs can be complex – and this is just in respect of VCCs in their original form issued on-Registry.

As we look to scale the VCM, classifying the precise legal nature of VCCs is becoming increasingly important for buyers, as well as for project owners and other participants:

a. Relevant jurisdictions

There will typically be a number of relevant jurisdictions. Projects that generate VCCs can be located just about anywhere in the world. In most cases this will be a different jurisdiction to the issuing Registry (whose methodology, standards and terms of use apply), the VCC buyer, and the jurisdiction in which the carbon dioxide the VCC buyer wishes to offset was emitted. For example, rights (including to environmental claims) in respect of a wind farm project and the relevant project documents, approvals and title interests would be governed by the applicable laws (which could mean state as well as national laws) of the jurisdiction in which the project is situated; the project owner’s contractual arrangements with the applicable Registry for the purposes of project approval may be subject to the laws of a neutral jurisdiction; and the terms of use in respect of the issued VCCs will be subject to the governing law of the jurisdiction preferred by the Registry.

Where a buyer is a listed company or regulated entity, the jurisdiction in which it is listed or licensed may also be a relevant jurisdiction. Buyers should be mindful that the direction of travel of ESG regulations suggests (and we are of the view that this is inevitable), that listed companies and regulated entities will be required to disclose the VCCs that they retire to offset emissions (including details of the projects generating those VCCs). In other words, regulators will accept only VCCs of a certain quality as a tool to verify the stated emissions reductions. Buyers therefore need to be alert to the critical importance of quality in respect of the VCCs they are acquiring and take appropriate measures to manage quality control and avoid the pitfalls – which include reputational and legal risk – of getting it wrong.

b. Characterizing VCCs

The legal nature of a particular VCC will depend on who’s asking, and how that VCC is characterized according to the laws of the relevant jurisdiction.

How the law of a relevant jurisdiction characterizes, or is likely to characterize, a VCC will depend on numerous factors, including whether it has a common law or civil law system. In the absence of international convention or a common approach across jurisdictions, it is quite possible that different relevant jurisdictions will characterize the same VCC differently and this presents a challenge to the development of a robust, interconnected VCM. The TSVCM and Integrity Council identify this as a priority issue that needs to be addressed.

The precise legal nature of a VCC will be of fundamental relevance in transactions where VCCs are to be used in connection with a financing. The type of security that may be taken over a VCC and the process for taking effective security, will depend on the legal nature of that VCC and the legal regime in the relevant jurisdiction. The most relevant jurisdiction for the purposes of taking and perfecting a security interest will likely be the jurisdiction of the Registry account in which the VCCs are credited, which should be discernable easily enough. Buyers of conventional or digital VCCs may need to consider other approaches, such as custody or escrow arrangements, to deliver an effective solution.

The legal nature of VCCs and the structure through which they are acquired and traded may also impact the tax treatment of those VCCs in the relevant jurisdictions. 

c. Non-fungibility of VCCs

Although VCCs purport to achieve the same outcome (i.e. to enable the retiring party to claim a stated quantity of emissions offset), VCCs issued under different Registries are not fungible. Neither are VCCs issued under the same Registry in respect of different projects, or VCCs from the same project unless they are of the same vintage. Buyers may select VCCs based on the nature of the carbon offset, the type of project generating the VCCs, their vintage, the location in which the project generating the VCCs is located etc., and any of these factors may affect the quality and extent of carbon mitigation or sequestration. Non-fungible VCCs, therefore, cannot be assumed to be the same legal thing, even in the same jurisdiction. The legal nature of a VCC needs to be considered on a case-by-case basis.

3. VCCs and virtual assets

As carbon market participants continue to innovate and develop tech solutions to improve quality and functionality, as well as reduce friction and inefficiencies, to advance the growth of a robust VCM, we expect VCCs will increasingly be issued in a digital format utilizing DLT and other technologies. High integrity VCCs can essentially be minted, on an automated basis on or off-Registry, from the project performance data. In other words, the VCC will be the actual data that evidences the greenhouse gas reduction or removal. We consider this to be a necessary and inevitable evolution but note that in some jurisdictions a digital VCC may be a virtual asset, and this could lead to unwanted consequences for market participants in jurisdictions where such virtual assets are regulated. It would be counterintuitive if a digital VCC is treated as a regulated product when a paper equivalent is not.

4. VCCs and securities regulations

Generally speaking, we would expect that VCCs in their original form and issued in accordance with a respected Registry would not fall under a typical definition of securities. For those who accept, as we do, that a robust VCM will need to accommodate a wide range of VCC buyers and risk appetites, the widely anticipated huge surge in demand for VCCs means a corresponding surge in demand for VCC-related investment products seems inevitable. Investors in VCCs should consider whether a VCC-related investment product has been packaged or sold in a manner that renders it a regulated financial instrument (which may include investment schemes, funds, derivatives, futures) in that jurisdiction even though the underlying VCCs are not regulated.

Determining the precise legal nature of a VCC will be an important consideration prior to the listing or offering of those VCCs or VCC-related investment products and derivatives.

5. Complex contractual matrix

As commented above, the lifecycle of a typical VCC issued in accordance with a respected Registry already involves numerous parties and contractual relationships covering a number of relevant jurisdictions and applicable laws. The emergence of new VCC marketplaces, exchanges, trading platforms and distribution channels, will add further complexity to this contractual matrix. Understanding this matrix can help a buyer manage risk. Buyers should also understand all applicable trading or handling fees.

6. Be clear what you are buying

An on-Registry buyer who receives the purchased inventory deposited into its own Registry account is almost certainly buying full title to those VCCs – i.e. the legal and beneficial interest in those relevant jurisdictions that make the distinction. A buyer who chooses to buy or hold its inventory through an intermediary (e.g. via an omnibus-type account arrangement), may or may not hold legal title to the purchased inventory. Given the relationship between title and enforcement, buyers should read and understand the applicable terms of use and any arrangements with intermediaries.

Registries do not give, and typically will expressly exclude in their terms of use, any guarantee of title to the purchased VCCs. If any issues arise, for example relating to project performance verification or if there are problems with the VCCs themselves, the VCCs can be canceled and all legal and beneficial title to the cancelled VCCs will be extinguished. This will usually be a reasonable position where the Registry simply provides a registry service and is not a party to the trade but may start to feel less reasonable where title fails due to errors made at the project approval stage in respect of the environmental benefits. Buyers may want to manage this risk.  

Buyers of VCC-related investment products, derivatives and digital VCCs may not be buying VCCs at all. A forward interest, economic interest or option is not the same thing as title to a VCC. It is important that buyers are clear about what they are buying. It is worth noting where the underlying VCCs were issued on-Registry, the applicable terms of use may prohibit the creation of digital or subsidiary interests or investment products of VCCs without the consent of the Registry.   

7. Regulated voluntary markets

By most definitions the VCM is an unregulated market. Buyers should be mindful that some jurisdictions have partially regulated the voluntary market within their jurisdictions, such as prohibiting or requiring consent from relevant authorities for the export of domestically originated VCCs. Conversely, in some jurisdictions the absence of regulatory clarity means there is uncertainty about whether domestically originated VCCs may be sold or retired offshore. Buyers need to understand the applicable regulatory environment and manage risks accordingly.  

***

We are of the view that there is no pathway to net zero carbon without a robust, functioning, and interconnected VCM to channel capital towards emissions reduction and removal projects. This cannot happen soon enough but will inevitably take time. In the meantime, carbon market participants can all contribute to this outcome by only buying or dealing in high quality VCCs.  

A printable version of this piece can be downloaded here:


[1] References to the “holder” of a VCC are loose references to the person to whose account the relevant VCC is credited from time to time in the register constituting the VCC.

[2] https://www.isda.org/a/38ngE/Legal-Implications-of-Voluntary-Carbon-Credits.pdf

[3] Core Carbon Principles, Assessment Framework and Assessment Procedure Draft for public consultation (The Integrity Council for the Voluntary Carbon Market, July 2022).

[4] TSVCM Final Report (January 2021).

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