This is the first part of a two-part series on the Regulation of the Voluntary Carbon Credit Market (VCM) in the EU.
The financial industry has long discovered the merits of the worldwide carbon market, sometimes described as the economist's solution to greenhouse gas emissions. While the EU legislator has agreed on further incentivising measures like a lower risk weight for exposures to the regulated EU Emissions Trading System (40%) in itsCRR review, particularly the VCM used to experience exponential growth, driven by the desire of companies to become sustainable and environmentally friendly.McKinsey predicts that by 2050, the VCM could grow by a factor of 100. However, regulatory approaches to the VCM are still in their infancy. While IOSCO is currently considering a broader regulatory approach by consulting on initial voluntary good practices for the integrity and orderly functioning of VCMs, the EU is focusing on enhancing transparency with disclosure and reporting requirements. In this part of the blog series, we explain (I) what carbon credits are and analyse the legal requirements currently applicable to them from both (II) a regulatory angle; and from (III) a transparency angle.
I. What are carbon credits and how are they traded?
The internationalIFRS S2 standards define carbon credits as emission units that are issued by a carbon crediting programme, that represent an emission reduction or removal of greenhouse gases, and that are uniquely serialised, issued, tracked and retired by means of an electronic registry. The European ESRS E1 standards, recently adopted by theEuropean Commission (the ESRS E1 Standards), are even more specific: According to these, one carbon credit represents one metric tonne of CO2e emission reduction or removal and is issued and verified according to recognised quality standards – although it remains unclear what these quality standards entail in detail (see III).
Unlike emission allowances, which are governed by theEU emissions trading system (ETS), carbon credits are – at least in the EEA – not issued by public bodies. The creation of a carbon credit rather requires the registration of a project (e.g., planting new trees) with a standard issuer, for which the standard issuer grants carbon credits to the project developer. These credits can be transferred to carbon credit buyers.
Carbon credits do not have to be traded in regulated marketplaces. However, similar to the market for shares or other financial instruments, the market for carbon credits comprises numerous players and intermediaries and, thus, can be a challenge to navigate. There are, amongst others, carbon credit brokers, traders, and marketplaces connecting buyers with credit issuers; carbon credit verifiers who certify the underlying projects’ adherence to certain standards; and carbon credit ratings agencies who assess carbon credits across several dimensions. Against this background, some institutionalised exchanges for carbon credits have emerged over the past years.
II. Regulatory requirements
Contrary to emission-reduction units (ERUs) and certified emission reductions (CERs), mentioned in the EU ETS Directive, carbon credits are not regarded as financial instruments under EU law – unless they are the underlying of derivative instruments. Thus, they neither trigger the initial licensing requirement with subsequent supervision typical for financial market regulation, nor the capital market or market abuse regulation requirements. However, as ERUs and CERs can no longer be exchanged for emission allowances, practical relevance of unregulated carbon credits is constantly increasing nowadays.
In this context, a strong regulatory framework could be crucial for the effective functioning of the voluntary carbon market – not least regarding the sensitive question of what qualifies as a high-quality offset. In December 2021, the International Swaps and Derivatives Association (ISDA) went ahead and published awhitepaper addressing the key legal issues in the UK, US, and Germany associated with the VCM. This paper outlines recommended actions to eliminate legal barriers in VCMs and emphasises the significance of standardised documentation to enhance certainty in voluntary carbon credit trading. In addition, it issuedVerified Carbon Credit Transactions Definitions, a booklet accompanied by template confirmations for carbon credit spot, forward and option transactions, that are designed to be incorporated into a confirmation for a physically settled spot, forward or option carbon credit transaction.
III. Transparency requirements
As regards transparency requirements, a distinction has to be made between the use of carbon credits to offset greenhouse gas (GHG) emissions and the trading of carbon credits.
In the context of GHG emissions offsetting, both the financial product-specific disclosure requirements under SFDR, as specified in the latestdraft Regulatory Technical Standard (RTS) on the review of principal adverse impacts (PAI) and financial product disclosures (SFDR Draft RTS, see ourblogpost), and the non-financial reporting requirements specified in ESRS E1 and the IFRS S2 standards now demand transparency on carbon credits. The approach of these three standards is largely aligned, with carbon credit disclosures primarily related to GHG emissions reduction targets.
In this context, it is essential to differentiate between gross GHG emissions reduction targets (reflecting planned changes in emissions within the entity’s value chain) and net greenhouse gas emissions targets (the entity’s targeted gross emissions minus planned offsetting efforts, including the use of carbon credits). The European SFDR Draft RTS and CSRD/ESRS regimes only refer to the former. But also within the IFRS S2 regime, carbon credits and avoided emissions must not be included in the calculation of gross GHG emissions reduction targets. Besides this substantial consistency, the regulations also set out different requirements:
SFDR Draft RTS
- In the information on “progress achieved towards the GHG emissions reduction target” for financial products that promote environmental or social characteristics or that have sustainable investment as their objective, carbon credits purchased and cancelled during the reference period covered by the periodic report must be stated.
- Recognising the potential contribution of carbon credits to climate change mitigation, the SFDR Draft RTS provide that within periodic reports, financial market participants are allowed to report volumes of carbon credits they have purchased and cancelled during the reporting period. However, the information should be provided in separate, detailed website disclosures. In these disclosures, the retired carbon credits should be disclosed in relation to only one single financial product to avoid double counting. Information regarding the quality of such carbon credits (the share of the carbon credits that have been certified by recognised quality standards for carbon credits as defined under Annex 2 of the ESRS E1 standard) should address concerns surrounding the environmental integrity of these carbon credits.
ESRS E1 Standard
- Where an undertaking has made public claims of GHG neutrality that involve the use of carbon credits, it shall explain, amongst others, the credibility and integrity of the carbon credits used, including by reference to recognised quality standards.
- Detailed information on “GHG removals and GHG mitigation projects financed through carbon credits” is supposed to provide an understanding of the undertaking’s actions to permanently remove or actively support the removal of GHG from the atmosphere as well as an understanding of the extent and quality of carbon credits the undertaking has purchased or intends to purchase from VCMs.
- Some disclosure requirements however, need further clarification, especially regarding the definition of “recognised quality standards", since the provided definition "quality standards for carbon credits that are verifiable by independent third parties, make requirements and project reports publicly available and at a minimum ensure additionality, permanence, avoidance of double counting and provide rules for calculation, monitoring, and verification of the project's GHG emissions and removals” still leaves the question of what actually constitutes “recognised quality standards” unanswered. This is particularly relevant for companies with net zero targets that should report on the "credibility and integrity of the carbon credits used".
IFRS S2 Standard
- The IFRS S2 standard requires information on carbon credits only within the context of net emissions targets, emphasising that this cannot obscure information about the business’s gross greenhouse gas emissions targets.
- Disclosure includes information on the reliance on carbon credits, third-party verification schemes, type of carbon credit, and the factors necessary for users to understand the credibility and integrity of planned carbon credit use.
The consistency in the key concepts of the main transparency frameworks will help to streamline the generally increased costs associated with sustainability disclosures and reporting. Within the EU regulatory framework, the SFDR Draft RTS even refer to the ESRS standards for the definition and calculations of information on carbon credits. However, it remains to be seen how the transparency requirements set out above interact with upcoming EU frameworks such as the Carbon Removal Certification Framework (CRCF) and the Green Claims Directive.
As regards the remaining problem of a lack of data, the SFDR Draft RTS suggest following the best effort principle to obtain information not readily available either directly from investee companies or by carrying out additional research, cooperating with third party data providers or external experts or making reasonable assumptions and indicating that such information is not available.
In connection with carbon credits trading, financial institutions are increasingly being asked to complete human rights due diligence questionnaires etc. as suppliers/vendors of these products, since their customers need this information to comply with their own legal obligations, such as the reporting requirements under the CSRD and SFDR set out above. In such cases, financial institutions may be required to answer questions of importance to their contractual partners and co-operate either because of explicit contractual agreements or general principles of the applicable civil law. It can be advisable to have an own human rights/ESG FAQ document at hand that can be provided as a standard response to information requests from different customers (instead of providing individual responses), giving them some comfort, or to have the questionnaires reviewed by legal counsel, to push back on questions that go beyond the information needs the customers might have.
In the next part of this series, Voluntary Carbon Credits: A regulatory grey area in the EU? (Part II), we assess the applicability of supply chain due diligence requirements for financial institutions (IV.) and considers the greenwashing risks that the public advertising of supposed CO2 neutrality achieved with carbon credits can entail and that is becoming increasingly apparent from recent court rulings (V.).
