Voluntary Carbon Trading: Key Risks and Mitigation Measures
The Voluntary Carbon Market (VCM) has been operational since the 2000s, alongside mandatory/regulated carbon market schemes such as the EU Emissions Trading Scheme and the US Regional Greenhouse Gas Initiative. The two largest VCM programs, Verra’s Verified Carbon Standard (VCS) and Gold Standard, have been in existence since 2006 and 2003 respectively. In this sense, VCM trading is nothing new. However, VCM has only really taken off in the past few years, with market growth rapidly accelerated by the adoption of the Paris Agreement in 2016 and, in its shadow, the Glasgow Climate Pact in 2021 and the proliferation of governments and companies making “net zero” carbon reduction commitments.
The rapid growth of VCM in recent years has made VCM trading much more common. Nevertheless, because the VCM is largely unregulated, unlike more established mandatory carbon markets, some commentators and participants still regard it as the “wild west” of the carbon trading industry.
In this article, we take a look at some of the major issues and opportunities currently facing VCM.
The legal nature of voluntary carbon credits
As with any asset or legal instrument, understanding the legal nature of Voluntary Carbon Credits (VCCs) is essential to assess and document how they can be traded and what risks there are for the parties to the transaction, including what interest to ownership can be claimed over them and what form of security can be taken over them. Their legal nature also impacts their regulatory treatment and the tax implications of trading and holding them.
Yet, there remains a great degree of uncertainty about the precise legal nature of VCCs, and VCM program providers largely circumvent this issue in their rules and standards. Since a VCC is a creature of contractual law (i.e. the construction of the VCM program under which it is issued) and is not an instrument created via an international legislative or treaty framework, its nature is determined by the law applicable to its creation. , possession and transfer. It is therefore determined by the national law or laws, taking into account the law applicable to the contractual framework in which the VCM program concerned operates and, possibly, the law applicable to any commercial documentation. This will differ between VCM programs and transactions, so there is no consistent answer to the question of the legal nature of VCCs.
Applying an English law analysis to the matter, the nature of a VCC would essentially be one of (i) a property right (in rem) or (ii) a personal right (in person). Personal rights are generally considered non-transferable because they are so closely linked to the relationship between the debtor and the creditor that a third party cannot demand that the debtor be liable to the third party in place of the creditor. On the other hand, a right in rem may be enforceable against the debtor by a third party if the legal procedures for the transfer of the creditor’s rights have been duly completed.
Commercial documentation governed by English law generally proceeds on the basis that CCVs are a form of intangible property (although this has not been determined with authority by the English courts), meaning that legal title may be held and transferred to another party. However, as an intangible property, this gives rise to complexities as to the security that can be taken on them. This is compounded by the need to consider the national law applicable to VCCs and the registry account in which they are held, for example, in the case of VCCs issued under the VCS, the law of the District of Columbia.
Industry efforts are underway to address the lack of consistency as to the legal nature of CCVs. However, until they materialize, it is important when negotiating and creating security interests in the CCVs to assess the impact of the applicable contractual law and the law applicable to the CCVs or the registry account.
Standardization of commercial documentation
For the same historical reasons as described above, unlike regulated carbon markets, there is no industry standard commercial documentation for CCVs. This is seen most clearly in “primary drawdown” business documentation, i.e. the first sale and purchase of CCVs from owners of carbon reduction projects, where the documentation tends to be specific to the VCM project and program. In such circumstances, the contractual documentation under which CCVs will typically be traded more closely resembles an emissions reduction purchase agreement (ERPA), rather than the industry documentation used to trade carbon allowances. carbon regulations such as EUAs, for example, the exchange documentation model developed by ISDA, IETA or EFET.
Even at the secondary trading stage, there is very little consistent trade literature in the market, although there are various forms that have their origins in the trade literature used for regulated carbon allowances, oil, metals, l electricity and other forms of raw materials or green certificates.
While there is no “magic” to documenting VCM trades, it is important to assess whether the form of contract used is appropriate to the facts of the transaction, the underlying carbon reduction project and to the applicable VCM program, in particular with respect to primary debit agreements. . This is perhaps less of a concern with secondary spot trading, but there are still significant risks/issues that deserve a bespoke write-up to allocate them appropriately, for example, the issue of corresponding adjustments to the Paris Agreement described below.
The lack of market standardization also presents opportunities; it is clear that sophisticated market participants have the opportunity to develop “buyer-friendly” and “seller-friendly” documentation, the scope of which is more limited when documenting transactions as part of the model documentation Of the industry.
However, there is clearly an appetite for more standardization in the market, and no doubt this would benefit many new market entrants looking to acquire CCVs to support ESG or net-zero objectives. Various industry groups (including IETA and ISDA) and working groups are currently developing a trade documentation model, which should eventually lead to greater standardization of the trade documentation approach in VCM.
Paris Agreement corresponding adjustments
The long-awaited settlement of Article 6 of the Paris Agreement was finally approved in November 2021 after intense negotiations during the United Nations Conference of the Parties on climate change in Glasgow (COP26), not to mention several years of preliminary talks.
The Article 6 resolution at COP26 was seen as critical to the success of the Paris Agreement; specifically, finalizing the Article 6 settlement meant firming up the accounting rules for “matching adjustments,” which would ultimately define the relationship between Paris Agreement government actions and the availability of carbon reductions for use in the VCM. In this respect, Article 6 was seen as both an opportunity and a threat to the VCM: the opportunity being to remove the lingering uncertainty about this relationship; the threat being that the corresponding adjustment rules could significantly reduce the ability of the VCM to operate alongside government climate mitigation actions, as codified in their Nationally Determined Contributions (NDCs).
The obligation to make corresponding adjustments with respect to international transfers of emission reductions has always been expected; however, it was unclear how far this would go. The result of COP26 was to extend the corresponding adjustment rules to cover emission reductions/removals that are claimed as carbon credits under a voluntary carbon market system once those credits are transferred to a private/public entity located in another country. In other words, carbon emissions covered by a country’s NDC actions cannot also be claimed as VCC under a VCM program and traded with a foreign entity, unless the government of that country confirms that it will make a corresponding adjustment to take those underlying carbon emissions out. of its NDC report.
The operators of the VCM program had to assess how to take this into account in their rules. Initially, the two main program providers – Verra and Gold Standard – indicated that they were going in two different directions. Verra took a position that the corresponding adjustment requirements would ultimately not affect whether CCVs could be issued, but rather what label/claim could be attached to them: an offset label (for compliant units to article 6) or an impact label (for units not conforming to article 6). 6 compliant units). Gold Standard initially indicated that it would take a more resolute stance of issuing CCVs only when it was demonstrated that corresponding adjustments had been made, if any. However, following a consultation, it appears that Gold Standard has softened its position, bringing it closer to Verra.
It remains to be seen how VCM will be impacted by all of this, but it seems likely that a two-tier market/pricing structure will develop: one for VCCs that comply with Article 6, and one for VCCs that don’t.