Q2 | Torys QuarterlySpring 2023

Navigating risk as carbon markets mature


Building on the rapid growth of the carbon markets in 2022, expansion is expected to continue this year—not only in transaction volume, but also in the types of available carbon products in both the voluntary and compliance markets. Amid this growth, concerns persist regarding the integrity of certain carbon products, and as products proliferate and the market matures, participants in the carbon markets have a host of risks and considerations to keep in mind.

Carbon markets 101

  • What are carbon markets? The term “carbon markets” encompasses two main types of marketplaces where carbon products are traded: compliance markets and voluntary markets. Compliance markets are regulated markets established by law in a particular jurisdiction or internationally. In these markets, regulated entities must meet specified emissions limits, which they can satisfy by the purchase and retirement of eligible carbon products; their emissions reduction obligations drive the demand for these products. Examples of compliance markets include the Canada’s federal Output-Based Pricing System and Alberta’s Technology Innovation and Emissions Reduction Regulation. Compliance markets can also be linked together, allowing the trading of compliance products between them, as in California and Québec’s cap-and-trade systems under the Western Climate Initiative. In contrast, voluntary carbon markets (VCMs) are established by non-governmental authorities, which set standards for private actors to develop, buy and sell carbon products, ultimately to achieve voluntary emission reduction commitments (for example, to meet a net-zero commitment). Examples of VCM standards include the Verified Carbon Standard or the Gold Standard.
  • What products are traded on carbon markets? There are several types of products that can be traded in the carbon markets, including allowances and offsets. Carbon allowances are traded exclusively in compliance markets and represent a permission granted to the holder to emit a specific amount of greenhouse gases (i.e., one 1 tonne of carbon dioxide equivalent per allowance). In contrast, carbon offsets represent voluntary emission reductions, relative to business-as-usual, generated by a project in accordance with an approved methodology (typically, by removing carbon from the atmosphere or by avoiding emissions that would have been generated if the project had not occurred). Carbon offsets are traded on both voluntary and compliance markets. There are also other types of products specific to particular markets, including compliance credits created under low carbon fuel standards like Canada’s Clean Fuel Standard (CFS).
  • What types of transactions exist for carbon products? Trading of carbon products can occur through a variety of transaction structures. Frequently, they are traded through spot or forward transactions, either directly negotiated between buyer and seller or via an exchange or other trading platform. Increasingly, more sophisticated structures are being used as well, including carbon streaming transactions and trading in carbon product derivatives. Regardless of the transaction structure, any physical settlement of the trade occurs through the transfer of the product to the buyer on a public registry established either by a governmental or non-governmental authority (in the case of compliance markets and VCMs, respectively).

Continued growth of the carbon markets

The voluntary and compliance carbon markets continue their fast ascent. In 2021, the voluntary carbon market (VCM) reached a value of US$2 billion, which was about four times its value in 20201. Although global geopolitical and economic events slowed the pace of growth somewhat in 2022, the VCM will continue to grow in value, with one estimate suggesting a US$17 billion market by 20272.

In the compliance markets, the average price of carbon jumped much higher in 2022 compared to 2021 due to increasing carbon prices in the EU Emissions Trading System, Western Climate Initiative and other regulatory programs around the world. One estimate pegged the total value of the compliance markets at US$933 billion in 2022 compared to US$821 billion in 2021—a 14% increase3.

Along with rising value of these markets, we are seeing more compliance markets and VCMs enter the ecosystem. In the last 12 months in North America alone, a number of new compliance markets have been implemented, expanded or proposed (see notable examples below).

Examples of recent compliance markets and VCMs

  • Environment and Climate Change Canada has implemented the federal Clean Fuel Regulations (CFR), creating a market for compliance credits generated by qualifying lifecycle greenhouse gas (GHG) emissions reductions in the fuel supply chain.
  • Alberta has amended its Technology Innovation and Emission Reduction (TIER) regulation to enable offset project developers to convert serialized offset credits into “sequestration credits”, stackable credits that may be retired to meet compliance obligations under both the TIER and the federal CFR.
  • Ontario has launched its Clean Energy Credit registry for the creation, transfer and retirement of environmental attributes associated with the electricity production of qualifying clean energy resources in the province.
  • The U.S. Department of State, in partnership with the Rockefeller Foundation and the Bezos Earth Fund, unveiled in November 2022 a new global voluntary carbon trading market scheme that will generate carbon credits and make them available to private sector and government buyers.
  • Oregon state has implemented the Climate Protection Program, which sets a declining limit on GHG emissions for certain covered entities, starting in January 2022, with tradable instruments available for compliance.
  • Washington state has now implemented a Western Climate Initiative-modelled cap-and-trade system, and its first allowance auction on February 28, 2023 was fully subscribed.
  • The Carbon Offsetting and Reduction Scheme for International Aviation is in its initial pilot phase, running from 2021-2023.

Integrity concerns continue

Quality, validity and greenwashing

The growth of the carbon markets has kept the spotlight on the quality of the credits traded. In some cases, this has led to the invalidation of credits in compliance markets. For example, the California Air Resources Board recently invalidated 13,040 offset credits originally issued under its Compliance Offset Protocol for Livestock Projects4. The Climate Action Reserve also cancelled 1,027 offset credits in March 2022 from the 2021 vintage due to an error in the emission reduction calculations that was identified during a regulatory review by the California Air Resources Board5.

More generally, criticisms continue to be levied against the quality of credits. A recent study published in the journal Ecological Applications suggested that California’s improved forest management protocol overestimated the amount of sequestered carbon, leading to significant over-crediting at several project sites6. Allegations of system over-crediting have persisted in the market for several years7.

Critics of the use of carbon credits are increasingly lodging greenwashing allegations against the companies that retire them.

These criticisms are frequently levied against voluntary carbon market standards, especially given the pace at which the VCM has grown. Organizations, like the Integrity Council for the Voluntary Carbon Market (which was borne of the Taskforce on Scaling Voluntary Carbon Markets), are attempting to address these quality concerns as a prerequisite to mass scaling and standardization of quality markets8. On March 30, the Integrity Council published its core carbon principles (which outline the key attributes for high quality credits) and an assessment framework for determining which VCM programs will receive the Integrity Council’s approval9. Although these efforts have received some pushback10, Verra and the Gold Standard have welcomed the core carbon principles as establishing an important baseline for credit integrity.

More broadly, critics of the use of carbon credits are increasingly lodging greenwashing allegations against the companies that retire them, even where those credits have been validly issued and verified under well-recognized offset standards. Some of this criticism has focused on the additionality of carbon offsets, calling into question companies’ ability to support emissions reduction or net-zero claims based on their retirement of carbon offsets. For example, Greenpeace Canada submitted a formal complaint to the Competition Bureau in November 2021 alleging that Shell Canada’s Drive Carbon Neutral program violates the Competition Act by making materially false advertisements. In particular, Greenpeace Canada called into question the quality of the offset credits used by Shell Canada to offset the climate impacts of the fossil fuel products purchased by Shell Canada customers. Greenpeace Canada alleged that the underlying forest-based projects generating the offsets had shortcomings including issues of impermanence due to increased forest fires, pests and logging and a lack of additionality given that the lands in question were protected prior to implementation of the project11.

Other greenwashing allegations focus on potentially adverse impacts associated with offset projects. For example, an analysis published by The Guardian not only questioned the legitimacy of the emission reductions associated with the credits issued by Verra but also highlighted human rights concerns with the Alto Mayo flagship project registered with Verra (as well as with an underlying project)12. According to the analysis, the project has allegedly caused forced evictions of local residents and tension between residents and park authorities in the region13 14.

These criticisms create risk for purchasers of carbon credits that use or plan to use these credits to help them achieve voluntary net zero or other emission reduction commitments. They put those achievements into question even if the retired credits were validly issued.

Response to carbon market concerns

In response to these concerns, organizations, such as the Oxford Principles for Net Zero Aligned Carbon Offsetting, have recommended a shift to long-term carbon removal offsetting to meet net-zero goals, and even then, only after the organization has prioritized its own emissions reductions15. The Oxford Principles also recommend organizations transparently disclose the types of offsets they employ.

The International Sustainability Standards Board (ISSB) proposal for climate-related disclosures picks up on this recommendation16. Released in March 2022, the ISSB proposal aims to create a global baseline for climate-related disclosure standards. As drafted, it recommends extensive disclosure on a reporting entity’s use of carbon offsets, including information on how they are used in achieving emission reduction targets and the nature of the offsets (e.g., whether offsets are achieved through carbon removal or avoidance, whether any removal is nature- or technology-based), whether the offsets are subject to third-party verification and, if so, under what scheme or program.

The ISSB is working toward issuing final standards at the end of Q2 2023, with the first sustainability-related disclosures to be reported in 2025 in respect of annual reporting periods beginning on or after January 1, 2024. Although the UK government has confirmed its intention to adopt climate-related reporting standards in alignment with the final ISSB standards, Canadian and U.S. securities regulators have not made similar announcements to date, although the CSA and SEC’s proposals for climate-related disclosures are still under development (see our article “Climate change reporting: are you ready?” for more). And in Canada, OSFI has said it will consider updates to its final Climate Risk Management Guideline B-15 following the publication of the final ISSB standards17.

The EU has also issued a Proposal for a Directive of Green Claims that would require companies making carbon neutrality claims to disclose, as applicable, certain information about where they purchased carbon credits, whether those credits are removal or abatement credits and what methodologies were used to verify the integrity of those credits.

Carbon credit considerations

Given these trends, participants in the carbon markets—whether credit developers, compliance entities or market participants—should consider the following:

  • Whether the retirement of carbon credits will play a role in achieving an organization’s GHG emissions reduction targets and, if so, how the use of those credits will be prioritized among other emissions reduction strategies.
  • Whether carbon credits, or their originating project, can be diligenced prior to the purchase of those credits, not only for invalidation risks associated with the market or protocol in question, but also for potential greenwashing and other reputational risks. The level of diligence, where feasible, will depend in part on their proposed use.
  • Whether carbon credits being purchased have been independently verified by reputable verifiers and whether any additional verification can further reduce invalidation risk, such as in the California offset system.
  • Whether key risks associated with purchasing carbon products—including delivery, invalidation and change in law and program risks—are appropriately allocated in emissions reduction purchase agreements.
  • Where credits will be used in connection with a corporate net-zero or emissions reduction commitment, and how such usage will be tracked and recorded internally to support public reporting to the extent that this reporting becomes required or becomes a market expectation.
  • To the extent credit usage is being reported, how this reporting can be done transparently and accurately to minimize greenwashing concerns.

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

For permission to republish this or any other publication, contact Janelle Weed.

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