Article

Trust, but Verify: The Recipe for A Global Carbon Credit Trading System

Published Date
Jul 14 2022
Industries which cannot easily decarbonize would love to be able to claim reductions in net greenhouse gas (GHG) emissions by “offsetting”—creating or buying carbon credits. For carbon credit offsetting to truly have a role in decarbonization, there needs to be a robust and widely internationally accepted verification mechanism which takes account of the holistic impact of offsetting activities and a market in which to bring the various industry players together. In this article, our experienced team outlines some key initiatives in developing a global carbon credit trading system.

Through offsetting, activities in one sector which reduce, absorb or avoid the release of GHGs can be matched with GHG emissions elsewhere. The measurable GHG emissions from one set of activities can be balanced against measurable “credits” from GHG reduction in another set of activities. This may involve, for instance, the removal of existing carbon in the atmosphere, or the avoidance of emissions that would otherwise be released. By this method, the level of the net GHG emissions may be claimed to be reduced for the business which emits carbon.

This technique is particularly useful to industries (energy producers reliant on fossil fuel products and fertilizer, cement and metals producers, among others) that cannot feasibly make the radical technical changes needed to directly decarbonize their business models or operations, at least in the short term.

The creation of carbon or credits, is of interest to GHG emitters and financial traders alike. In a simplistic example, carbon credits arising from investment in a project to plant sustainable forests could be applied to GHG emissions from a cement producer that finds it commercially unattractive to implement costly steps to lower the GHG emissions within its production processes. The producer’s demand for carbon credits creates an economic incentive to plant forests and putting aside potential social and environmental factors and assuming consistency in methodology, the position from a net GHG perspective is ostensibly no different than if the producer had changed its operations. However, it is less costly and less disruptive to existing business operations.

Trust: The Problem with Carbon Credit Trading

A major barrier to the adoption of carbon credit offsetting is how to verify in a meaningful, robust and internationally credible manner that the purported carbon reductions of an offsetting project are:

  • Genuine;
  • Accurately measured;
  • Not subject to double counting by multiple jurisdictions or regulatory systems;
  • Permanent; and
  • Sustainable—including not creating or increasing non-GHG related social and environmental problems.

Without guarantees in this regard there are just measurable emissions without countervailing measurable reductions.

Therefore, for carbon credit offsetting to truly have a role in decarbonization there needs to be a robust and widely internationally accepted verification mechanism which takes account of the holistic impact of offsetting activities and a market in which to bring the various industry players together.

If:

  • Public opinion can accept that GHG emission reduction projects will prolong for now but genuinely mitigate the use of fossil fuels and emissions-intensive industrial process; and
  • Global stakeholders—the general population, policymakers, industry, finance providers and markets—can have confidence in the strength of the pipeline of robust and credible carbon credits from genuine GHG emission reductions projects, then carbon credit projects can accelerate the drive towards net zero and help us get there less expensively in all dimensions.

Mandatory carbon credit markets exist for certain industries and governments which have agreed to be legally bound by emission limits. These include the EU Emissions Trading System (EU ETS) and the U.K.’s post-Brexit national emissions trading scheme.

There are also voluntary carbon markets. These involve public and private entities choosing to trade carbon credits under rules they agree amongst each other. The establishment of a voluntary carbon market regime is one goal under the Paris Agreement on Climate Change (“Paris Agreement”). The Paris Agreement is an international treaty which came into force in November 2016, obliging its signatories to adhere to certain actions in a bid to limit global warming to below 2 degrees Celsius in comparison to pre-industrial levels. Article 6 provides for voluntary bilateral emissions reduction trading among signatory countries and envisions a global carbon market overseen by a UN supervisory body.

In parallel, a number of regimes exist or are under development for voluntary carbon trading among private companies, including by the Integrity Council for Voluntary Carbon Markets (“Integrity Counsel”) and the Abu Dhabi Global Market (ADGM).

However, no scheme has yet gained widespread acceptance, nor clarity on how the different voluntary carbon markets will interact.

Without a coherent scheme by which markets are interconnected based on common qualifications, rules and procedures, it is unsurprising that public opinion continues to retain (at best) a level of ambivalence and skepticism toward the whole concept of carbon credit offsetting, and that large-scale investments in carbon offsetting projects are not taking off.

We outline below some key initiatives to shift this dynamic.

The Solution: Getting to an Internationally Recognized Voluntary Carbon Credit Trading Scheme

No carbon market is going to gain sufficient traction unless global regulators take more action in convening governments and relevant global stakeholders for an international regulatory scheme for defining, verifying, measuring auditing, using, acquiring and disposing of carbon credits.

While, as noted, the creation of such a scheme is envisioned in the Paris Agreement, the momentum for its actual creation is somewhat lagging. If regulators prove unwilling or unable to take on this role, private sector groups such as the Integrity Council could take up the reins, although questions over the authority and independence of any private sector body will be raised by public stakeholders or competing private market participants.

Candidates for an oversight role include the Financial Stability Board and the United Nations Framework Convention on Climate Change’s (UNFCCC) own secretariat. Other international regulatory bodies may also provide expertise on appropriate standards, for example the newly established International Sustainability Standards Board (a limb of the not-for-profit IFRS Foundation with responsibility for setting IFRS Sustainability Disclosure Standards).

The international regulatory scheme must be consistent with the carbon credits market proposed under the Paris Agreement. It could leverage one of the existing voluntary carbon trading exchanges or systems which are already under development. Cohesion between voluntary schemes, and adherence to a set of high standards robustly enforced by an international body, should then enable buy-in from and adoption by market participants.

Any such scheme, or schemes, must involve, as a minimum, the following:

Science-based Criteria and Assessment for the CO2 Reduction Value of Credits

Carbon credit criteria must be objective and sufficiently transparent to be comprehensible to a wide audience and hence must be designed to minimize the potential for manipulation of the system.

This should encourage environmental, social and governance (ESG) interest groups to recognize and endorse the system.

This endorsement will, in our view, be crucial for any system to be effective and to overcome ambivalence within public opinion that currently challenges carbon credit offsetting activities.

GHG reduction-related credits under the Paris Agreement have the potential to satisfy these requirements. Article 6.2 provides for the trading among nation signatories of credits for projects that remove GHGs or reduce carbon emissions, known as internationally transferred mitigation outcomes (ITMOs). Guidance has been published on the application of Article 6.2 which includes some objective criteria for measuring ITMOs. Japan and Switzerland have established projects for the purchase and sale of these carbon credits. However, negotiations between countries on Article 6.2 trading agreements are lengthy, meaning uptake of the trading of carbon credits scheme has so far been limited.

Article 6.4 permits countries to trade carbon credits, which will be accredited by a UN Supervisory Body made up of 12 members from the parties to the Paris Agreement. The Supervisory Body will be responsible for establishing methodologies for qualifying Article 6.4 activities as well as the registration of activities and accreditation of operational entities. However, the members of the Supervisory Body are yet to be agreed and methodologies for measuring emissions reductions yet to be produced, meaning actual carbon credit trading is likely still some years away.

A complication exists in the overlap between the existing Clean Development Mechanism (CDM) and Article 6.4 carbon credits. The CDM was a comparable scheme to Article 6.4 established under the Kyoto Protocol, a predecessor international treaty to the Paris Agreement. Concerns have been raised about the CDM, including the quality of the emission reductions approved under it. It is expected that the CDM will be absorbed into the carbon credit trading scheme now covered by the Paris Agreement. However, projects registered under the CDM will be permitted to transition to the Paris Agreement system and to use their existing methodologies until as late as December 31, 2025. This leads to a risk of uneven standards that may dilute the credibility of the Paris Agreement’s carbon credit trading scheme.

Other voluntary carbon credit initiatives are developing methodologies for assessing the emissions reduction value of carbon credits. The Taskforce on Scaling Voluntary Carbon Markets (“Taskforce”), for example, which involves well respected members of the finance and climate communities, established the Integrity Council through a multi-stakeholder process with the aim to develop Core Carbon Principles (CCPs) for this market. The CCPs and a related assessment framework are under discussion, with a consultation on the CCPs due to be launched in July 2022.

Concerns have been raised that the Taskforce may have prioritized scaling up the carbon market over guaranteeing quality. It remains to be seen whether the proposed CCPs are rigorous enough to engender the confidence of global stakeholders.

At present, it is unclear how CCPs will interact with the Articles 6.2 and 6.4 carbon credit trading schemes under the Paris Agreement. The Taskforce has said that once the rules implementing Article 6 become clear, its trading market should comply with the Article 6 rules, but that further work would need to be done to “determine how to proceed”. To date, there has been no agreement on the interaction between Article 6 and the Taskforce’s proposed market. Some commentators have raised concerns that, unless the voluntary credits meet standards equivalent to Article 6.3 requirements, they will be considered lower quality. Others have questioned whether there will be sufficient political will to create the high-quality markets for which the Taskforce is aiming.

Into this space, the ADGM announced in March 2022 its intention to become the first regulator globally to develop a framework to support carbon as a commodity. It aims to create a regulated carbon trading exchange and carbon clearing house in Abu Dhabi, called the AirCarbon Exchange (ACX). This offers market participants the prospect of an exchange on which carbon credits can be traded and financed in the same way as more conventional commodities. ADGM’s proposals suggest that ACX would be established as a Recognized Investment Exchange, regulated by ADGM and recognized by the Financial Conduct Authority on which distributed ledger technology would be used to create digital tokens for specific carbon credits which could then be spot traded, and in the longer term, scope for carbon credit futures to be traded.

Global Registry and Initial and Ongoing Processes for the Verification of Carbon Credits

There should be a central registration system to guarantee the legitimacy of carbon credits and to verify that those carbon credits are, and continue to be, eligible for the system.

The schemes established under Article 6 of the Paris Agreement and proposed by the Taskforce each envisage international databases or registries tracking details of carbon credit trading transactions. In the case of Article 6, a database recording information on ITMOs submitted by participating countries will be implemented and scrutinized by the UNFCCC secretariat. It will feed into a centralized accounting and reporting platform. Article 6 also foresees that countries will maintain their own domestic registries, although an international registry will be available for countries that do not have access to their own system. A separate registry will exist for Article 6.4 credits, also administered by the UNFCCC secretariat under the supervision of the UN Supervisory Body (which is based in Germany). The Article 6.4 registry is expected to take some time to develop.

Details of the Taskforce’s proposed registry are yet to be confirmed. There needs to be a way of achieving synchronicity between the Article 6 trading scheme and other voluntary carbon credit trading scheme registries in order to avoid double counting (discussed in further detail below).

It is unclear where the registries of voluntary carbon credit trading schemes like that of the Taskforce would be maintained. Any country with a credible position on climate change and sufficient diplomatic capital would be a good candidate, including most Western jurisdictions, or even special economic zones/semi-autonomous regions with robust climate ambitions, such as ADGM or NEOM in Saudi Arabia.

Registries should, however, be internationally neutral. This requires a trustworthy international body to maintain them. Once again, an offshoot of the FSB or a UN body could provide a solution. If properly administered, international schemes are likely to attract global cooperation due to the financial benefits available, particularly for companies in hard to decarbonize sectors as discussed above.

Initial and ongoing verification processes exist within the Paris Agreement’s proposed carbon credit trading schemes. Participants in Article 6.2 trading schemes must submit an initial report on their ITMO metrics followed by annual updates on changes to the information provided in those reports. Initial and annual reports are subject to verification by a technical expert. Entities wishing to participate in Article 6.4 trading schemes must submit an activity design which should be approved by the national member state, then independently assessed for compliance with the Paris Agreement rules by a “designated operational entity” and finally a request submitted for registration to the UN Supervisory Body. The UN Supervisory Body has the final say over registration as an Article 6.4 activity or project. Ongoing monitoring of emission reductions achieved by the activity or project will be conducted by the public or private entities participating in the activity, in line with UN Supervisory Body requirements.

The Taskforce and Integrity Council have declared their intentions to bring integrity and high standards to global carbon credit trading markets. However, details of verification mechanisms have not yet been confirmed—though may be published in the Integrity Council’s consultation, which again is expected to launch in July 2022.

Common International Standards for Accepting Carbon Credits and their Legal Status

“Double counting” is a particular concern in carbon credit trading markets. There is a risk, for example, that a market participant sells carbon credits for a given project to an emitter in another country, while also claiming the benefit of the carbon credits within its own jurisdiction.

To mitigate this risk, it is vital that common international standards for accepting carbon credits are agreed.

The Paris Agreement has its own internal system of “corresponding adjustments” designed to guard against the risk of double counting. Broadly, the adjustments work by ensuring that when a country sells carbon credits, it makes a corresponding adjustment to deduct those credits from meeting its own “nationally determined contributions” (NDC) targets (i.e., the individual climate change targets submitted by the signatories to the Paris Agreement). This would ensure that the carbon credits cannot be used by both the selling and purchasing country. However, criticisms have been levied at the Article 6 mechanism and the ongoing potential for double counting, in part due to the way averages may be used in some cases to calculate corresponding adjustments over an NDC calculation period.

Further, private companies may well be participants in some, but not all, possible voluntary carbon credit trading schemes. This again raises the prospect of double counting. A properly regulated and synchronized system of voluntary carbon credit trading could help manage this problem, ensuring that market participants operate in accordance with a set of internationally agreed and administered global standards.

Giving participants comfort as to how carbon credits are characterized legally and ensuring that any transactions in carbon credit credits are legally enforceable is also vital to the success of this market.

The International Swaps and Derivatives Association (ISDA) recently published a paper on the legal implications of voluntary carbon credit trading markets, identifying uncertainties and proposed actions that could be taken to increase legal certainty.

Firstly, certainty in the market would be enhanced if it was confirmed whether carbon credits should be treated as “property,” rather than as a bundle of contractual rights. If carbon credits were treated as property, this would mean that existing property laws, such as those concerning the transfer of property and conflicts of laws, would apply to carbon credits. It is likely that carbon credits would be treated as property as a matter of English law, but there is as yet no authoritative case law on this matter.

Additionally, in most jurisdictions, carbon credits are not subject to financial services regulation, absent regulatory intervention (such as ADGM has proposed). Regulators may consider it prudent to clarify whether carbon credits fall outside of the financial services perimeter or, if deemed appropriate, to bring carbon credits within scope of existing or new financial services regulation.

Like ISDA, we would encourage the publication of legal statements, legislative amendments and regulatory guidance to clarify the treatment of voluntary carbon credits, including by global legal standard setters such as UNCITRAL and UNIDROIT. In addition, we support the creation and adoption of standardized documentation, which, as ISDA notes, will support the ability to issue clean legal opinions for the secondary carbon credit trading market.

Content Disclaimer
This content was originally published by Shearman & Sterling before the A&O Shearman merger