Navigating the carbon offsets maze: emerging standards and regulation

The market for carbon offset credits has never been larger, and since the first reported carbon offsetting project in 1989,^[1] there has been an exponential increase in offsetting products entering the global offsets market. However, this has brought with it uncertainty around data reliability, verifiability of emissions avoidance or removal, and question marks around the integrity of the voluntary market itself. In short, before investing in any voluntary offsetting products, it is essential to examine the risks attached, the initiatives driving change in the market, and the direction the market is headed.

‘Carbon offset credits’ and ‘carbon credits’ are terms often used interchangeably when discussed in the context of the global market. There are, however, some fundamental differences between the two – a carbon credit refers to a certificate issued within an emissions trading scheme to allow you to emit a fixed amount of carbon. This is distinct from a carbon offset credit, which is a product, traded voluntarily, that is created in conjunction with a project either avoiding or removing carbon emissions. Specifically, avoidance projects are designed to reduce emissions compared to an accepted baseline scenario.^[2] Removal projects, on the other hand, are focused on the removal, or sequestration of carbon that has already been emitted. These are effectively technological or nature-based methods of capturing carbon from the atmosphere and storing it.

A period of rapid expansion and varying quality

When discussing the expansion of the global carbon market, it is best thought of as two distinct markets:

• Compliance markets – which are administered and regulated by national governments, or state regulators, and operated on a cap-and-trade system, such as the EU’s Emissions Trading System (ETS).
• The voluntary carbon market – which facilitates the buying and selling of both avoidance offsets and removal offsets on a market not subject to regulation or standardisation of metrics or trading rules.

While the ETS has presented its own issues (such that it is undergoing a number of significant changes as part of the EU Green Deal and the suite of legislation referred to as the ‘Fit for 55’ legislative package) the subject of focus for this article is the voluntary carbon market (VCM). The VCM was initially marketed towards environmentally conscious individuals seeking to account for their personal emissions. Now, however, with massive uptake from corporate entities seeking to bolster their net-zero targets, the VCM has grown into a global market worth approximately $1.3bn (2022).^[3]

Regulation has not kept pace with this growth, however, and there remains considerable scepticism around the quality of the VCM products on the market. This concern was compounded in January this year with the publication of the Guardian’s investigation into Verra Carbon Standard – one of the four main VCM credit registries. The Guardian’s report,^[4] which was the product of a nine-month investigation into Verra’s rainforest schemes, claimed that more than 90% of Verra’s rainforest offset credits are likely to be ‘phantom credits’ and do not represent genuine carbon reductions. Similar concerns were presented by the Commission Suisse pour la Loyauté, which regulates advertising in Switzerland, who found that claims made by FIFA in respect of the FIFA World Cup’s carbon neutrality could not be substantiated, and that it was “unclear whether [FIFA’s] offsetting measures comply with Swiss standards”.^[5]

What do you need to keep in mind for the current market

While Verra and FIFA offer cautionary tales for investors, there is clear ambition within the sector to restore confidence in VCM products. This has led to the development of global principles designed to assess, verify and standardise VCM credits. These principles provide a baseline of quality that allows companies to perform adequate due diligence when investing in the VCM.

The first set of global standards, designed for the aviation sector, were published in 2016 by the International Civil Aviation Organisation and were labelled the Carbon Offsetting and Reduction Scheme for International Aviation, or CORSIA. More recently, the Integrity Council for the Voluntary Carbon Market has developed the Core Carbon Principles (CCPs) and Assessment Framework with a view to establishing global standards for the wider VCM outside of the aviation industry. In addition to this, the Voluntary Carbon Market Integrity Initiative’s (VCMI) Claims Code of Practice (the code) has been developed with a common goal of providing certainty and credibility to the wider VCM, and regulating how companies communicate their offsetting use.

The CCPs are a set of ten principles that seek to establish the core tenets of high-integrity carbon offset credits. They are set out under the three headings of governance, emissions impact and sustainable development, and build on the requirements for validation, which were established by the CORSIA offset eligibility framework (the CORSIA framework). The CORSIA framework, while relating exclusively to the aviation sector, has been identified by the CCPs as a suitable initial benchmark against which VCM credits for the wider market can be assessed.

Carbon offset projects selling credits on the VCM can now apply for CCP assessment through the CCP assessment platform, which will confirm whether they meet the program criteria set out in the assessment framework. In order to become CCP certified, a project must first demonstrate, as an initial step, that it complies with the general eligibility requirements set out in the CORSIA framework. It then needs to establish that it is compliant with the distinct requirements of the CCP assessment framework.

VCMI’s code provides a different offering with a similar goal. The code establishes principles to be applied by companies when communicating that they have taken high-integrity climate mitigation action, which includes purchasing carbon offset credits beyond their value chain.^[6] Annex E of the code details the key principles governing the use of carbon offset credits, and in particular, why the ‘tonne-for-tonne’ approach,^[7] is the only one accepted by VCMI.

Most recently, on 28 November, VCMI published a number of supplementary documents to accompany the code. These documents included a Monitoring, Reporting and Assurance (MRA) Framework, a brand and associated mark for making ‘Carbon Integrity’ Claims, and a beta version of an additional claim, which covers scope 3 emissions. This new scope 3 emissions claim, which VCMI aims to finalise by Q3 2024, permits a company to make limited use of carbon credits to close the emissions gap between its scope 3 emissions reduction targets and its actual scope 3 emissions, while the company increases its internal decarbonisation efforts and investment.

Another factor to consider when devising a VCM investment strategy is the interaction between a company’s net-zero commitments and the use of offsetting. For example, if a company has committed to a target validated by the Science Based Targets initiative (SBTi), the opportunity to use offsetting to reach this net-zero commitment is significantly limited. The SBTi Corporate Net-Zero Standard (page 6) and SBTi Corporate Net-zero Standard Criteria (page 6, C12 and C13) state that only emission reductions within a company’s value chain count towards companies’ near- and long-term abatement targets.

Businesses cannot use any activities outside the value chain to meet their science-based targets, including any type of offsetting activity. In effect, this means that companies cannot seek to reach a net-zero position by utilising emissions reductions which occur ‘off-site’ through the purchase of offset credits. Instead, they must endeavour to achieve the emissions reduction within their own operations, or direct value chain, through their procurement or contracting strategies. The standard makes it clear that companies must reduce emissions by >90% before neutralising the final <10% of emissions with permanent removals.

Where is the market heading?

In addition to the emergence of global principles for the VCM, there has also been a shift in some jurisdictions towards the establishment of hybrid “regulated voluntary markets,” which segregate portions of the VCM and apply regulation and common standards to the offset credits traded in them. The emergence of the Japan GX League ETS (the GX League ETS), and the Australia Carbon Exchange^[8] have demonstrated a potential trajectory for a more stable and centralised VCM. While both are still in their nascent stages, they will offer market participants the opportunity to buy and sell offset credits on a voluntary basis, within the confines of a regulated market. This ensures that only high integrity credits are bought and sold.

The GX League ETS is designed to transition into a more conventional ETS market following its initial phase of operation (2023-2026), but voluntary participants^[9] in phase 1 will be subject to mandatory conditions, and the offset credits themselves will be subject to upper and lower price limits – ensuring stability and predictability. Further, the category of credits traded will be tightly regulated – only “J-credits”, or credits created under the Joint Crediting Mechanism are eligible to be traded.^[10] The central aim of this hybrid approach is that, while voluntary to participate, the markets are government-backed, and centralised, leading to much greater comfort from investors in the quality and price stability of the offset credits they are buying and selling.

It will also be interesting to see what impact the COP28 negotiations have on the overall direction of the market. One of the priorities of COP28 (which is taking place between 30 November to 12 December 2023) is the standardisation of the VCM through the carbon trading framework established under the Paris Agreement. This framework has been the subject of much negotiation since 2015, and has yet to be finalised. It is expected that the framework’s outstanding issues will feature heavily on the COP28 agenda, and any progress made in this regard will likely have wide-ranging implications for the structure of the global VCM.

Outside of the COP28 negotiations, there have been a number of recent developments within the market indicating a direction of travel towards VCM standardisation. On 4 December, the Board of the International Organization of Securities Commissions (IOSCO) published a Consultation Report outlining a proposed set of Good Practices to promote the integrity and orderly functioning of the VCM. Likewise, on the same date, the US Commodity Futures Trading Commission approved a proposed guidance and request for public comment regarding the listing for trading of voluntary carbon credit derivative contracts.

Conclusion

Depending on your perspective, voluntary carbon offsetting can represent a tangible and pragmatic path towards your business’s net-zero commitments, or a market offering only uncertainty, price volatility, and potential consumer backlash. The issues presented by the VCM in relation to offset integrity and price volatility are clearly factors for consideration when developing a path towards net-zero that incorporates carbon offsetting.

However, investors can take some comfort from the adoption of the CCPs and the Code, which provide a tenable basis upon which individual investments can be assessed. The emergence of hybrid regulated VCMs, which blur the line between voluntary and compliance trading will offer some insight into the stability provided by a state-backed pricing and standardisation. However, until these hybrid markets have been properly tested, careful scrutiny of voluntary offset characteristics, their respective validations or certifications, and the adoption of the approach set out in the CCPs and the code are vital to ensure the maximum offset return on investment is achieved.

For more information in relation to this topic, please contact Jill Shaw, ESG & Sustainability Lead or visit our ESG & Sustainability hub. With thanks to Luke McGivern for his assistance in the preparation of this article.

Date published: 6 December 2023