The Voluntary Carbon Market: A Beginner’s Guide.

26 Apr

We recently invested in Stabiliti, a company involved in voluntary carbon offsetting for the payment industry, and we needed to ramp up our knowledge in this field quickly. Here, we are sharing what we learned.

The voluntary carbon market (VCM) is a market-based mechanism to reduce greenhouse gas emissions.
The voluntary carbon market operates through a hierarchy of actors and processes. Standards define project protocols that Developers follow. Validation and Verification confirm project integrity, leading to Credit issuance. Brokers and Traders act as intermediaries, facilitating credit sales to End buyers. Transactions result in Offsets, allowing buyers to neutralize their emissions.

Unlike regulations like carbon taxes or cap-and-trade systems, the VCM is voluntary. Organizations decide to participate in it because shareholders, customers, or employees expect them to reduce their climate impact, and it is seen as one tool for doing so.

Corporations working to decarbonize their activities may decide to compensate for unavoidable emissions by financing projects that do the opposite of emitting. These are known as carbon projects, and they either avoid the release of carbon or remove it from the air. Developers of carbon projects issue carbon credits. They can release as many credits as the tons of carbon avoided or removed by their Project. One carbon credit, once retired, can offset one ton of greenhouse gases emitted by a company or organization.

types of carbon projects

Renewable energy, Industrial gas capture, Energy efficiency, Forestry initiatives, Clean water, Regenerative agriculture, Wind power, Biogas, Oil recycling, Solar power, and Water filters.

Still, they all need to sell carbon credits. To finance their operations, some projects harness the ability of trees, the ocean, or the soil to store carbon. Others use technology to remove carbon from the air. Before issuing credits, these activities need to be certified by a standard. Standards are separate organizations, often nonprofit, that verify that carbon projects are removing or avoiding carbon emissions and respect the core principles of carbon finance. The job of linking supply and demand is done by intermediaries like traders, brokers, or exchanges.

This is an example of a partnership for carbon removal projects.

Current Regulatory Framework

As shaped by the rules under Article 6 of the Paris Agreement, the voluntary carbon market distinguishes between two types of mechanisms: Article 6.2 and Article 6.4. Article 6.2 pertains to bilateral or multilateral trade agreements of emissions reductions between countries, resulting in Internationally Transferred Mitigation Outcomes (ITMOs). This mechanism allows for trading these outcomes, which can be quantified in various ways, including carbon dioxide equivalent or renewable energy metrics.

On the other hand, Article 6.4 establishes a global carbon market overseen by a Supervisory Body under the United Nations Framework Convention on Climate Change (UNFCCC). This mechanism involves project developers registering their emission reduction projects with the Supervisory Body and, upon approval, issuing UN-recognized credits, known as A6.4ERs. Countries, corporations, and individuals can acquire these credits to count towards climate action commitments.

One of the principal concerns addressed in these mechanisms is the avoidance of double counting. Corresponding adjustments are required for all authorized carbon credits to ensure that when one country sells them, they deduct them from their greenhouse gas inventory, allowing the purchasing country (or entity) to add them to theirs, promoting transparency and environmental integrity. However, voluntary credits purchased by private companies fall outside this official system, and thus, there is a risk that they may still allow for double counting.

The rules also consider the Clean Development Mechanism (CDM) from the Kyoto Protocol, allowing CDM projects to transition to the Article 6.4 mechanism, albeit under stringent conditions and timelines.

As for the implications for the voluntary carbon market, projects that aim to register under Article 6.4 must comply with its rules, and all credits authorized by countries must be accounted for. However, the framework lacks clarity on the potential issuance of credits that are not permitted and thus not accounted for, which could result in greenwashing by companies making offset claims based on these "non-authorized" units.

Moreover, the rules under Article 6 encourage a move from simple offsetting towards an approach that includes a component of overall mitigation of global emissions. For instance, a small percentage of A6.4ERs will be canceled outright to ensure some emissions reductions benefit the atmosphere directly, and some credits will be allocated to the Adaptation Fund to finance climate adaptation initiatives.

The UNFCCC Supervisory Body has been finalizing the regulations underpinning Article 6.4, including activity cycle procedures, standards for projects, and validation and verification standards. They are also focused on ensuring the protection of social and environmental rights through safeguards, such as the Appeals and Grievances Procedure and the Sustainable Development Tool. These are subject to public consultation to gather stakeholder input. In addition, they are developing guidelines and methodologies for carbon emissions removal activities.

The information provided comes from an extensive review of the rules outlined by the UNFCCC, Carbon Market Watch, and other related sources, which discuss the developments and negotiations leading up to and following COP26 and COP28 (unfccc) (Carbon Market Watch).

Regulation outlook

The voluntary carbon market is increasingly shaped by formal and informal regulatory developments. Key among these is the work of the Integrity Council for the Voluntary Carbon Market (ICVCM), which focuses on establishing Core Carbon Principles (CCPs) to enhance transparency and market efficiency. These principles are set to be issued and are expected to significantly influence the market by improving the matching of buyers and sellers of carbon credits, addressing the increasing demand due to evolving climate-related regulations.

On a broader scale, financial and listed firms in the UK are required to report their net-zero transition strategies from 2023, a move likely to be mirrored by the EU's proposed Corporate Sustainability Reporting Directive (CSRD), mandating nearly 50,000 firms to disclose their transition plans from 2024. This increased regulatory scrutiny extends to the International Sustainability Standards Board's (ISSB) proposal for all firms to publish net-zero transition plans and the U.S. Securities and Exchange Commission's (SEC) proposals for climate-risk disclosures, including disclosures on carbon offsets.

The CFTC has shown interest in possibly establishing a broader regulatory framework for the voluntary carbon markets, including spot markets, to support informed decision-making and financial integrity. The SEC has also proposed rules requiring mandatory disclosures related to internal carbon pricing and using carbon offsets and renewable energy credits (RECs).

Legislation like the Inflation Reduction Act (IRA) in the U.S. aims to significantly reduce carbon emissions and incentivize carbon capture and storage technologies, potentially increasing the supply of carbon credits in the voluntary market.

Considering these developments, entities engaged in the voluntary carbon market should be vigilant about evolving legal and regulatory standards, which may influence market participation and carbon credits and offsets as part of emissions reduction strategies (KPMG) (Cleary Gottlieb).

How can companies calculate the carbon offset of their products?

Companies can calculate the carbon offset of their products by following a multi-step process:

Life Cycle Assessment (LCA): Conduct an LCA to quantify the emissions associated with all stages of the product's life cycle, from raw material extraction through manufacturing, transportation, use, and disposal.
Emissions Factors: Use recognized emissions factors for each activity or process involved in the product's life cycle. Governmental agencies or environmental organizations often provide these factors.
Data Collection: Collect data on energy use, materials used, transportation distances, waste generated, and other relevant activities associated with the product.
Carbon Footprint Calculation: Apply emissions factors to the collected data to calculate the total greenhouse gas (GHG) emissions. This is typically measured in metric tons of carbon dioxide equivalent (CO2e).
Offset Projects: Identify and invest in carbon offset projects that reduce, remove, or avoid GHG emissions equivalent to the product's carbon footprint. These projects could include renewable energy, reforestation, or energy efficiency initiatives.
Third-Party Verification: To ensure credibility, have the carbon footprint and offset calculations verified by a third-party organization that specializes in carbon accounting.
Continuous Monitoring and Reporting: Regularly monitor and report on the product's carbon footprint and the performance of the offset projects to ensure that they continue to match the emissions.
Transparency: Communicate to stakeholders and consumers about the methodology used, the nature of the offset projects, and their impact on the product's carbon footprint.

Using these steps, companies can accurately calculate and offset the emissions associated with their products. It's crucial to follow recognized standards and guidelines, such as those from the Greenhouse Gas Protocol or ISO, to ensure that the calculations are robust and internationally accepted.

How do market participants agree on the right price for credits?

The pricing of voluntary carbon credits is influenced by a complex array of factors that reflect the specifics of the projects generating the credits and broader market dynamics. These factors include the standard issuing of credits, project methodology or type, vintage, project location, additional co-benefits beyond carbon reduction, nature of the project (nature-based or engineered), and whether the project is jurisdictional or project-based. Credits from projects that remove carbon from the atmosphere are typically valued higher than those that avoid emissions.

Market participants rely on assessments and ratings provided by various entities to determine the value of credits. Rating agencies and recent news about specific projects can also influence prices, as can the presence of certain features like sustainability co-benefits, which can command higher prices. In addition to these factors, the actual trading of credits, which includes bids, offers, and completed transactions for eligible credits, informs the market price. Transparency in reporting these trades is essential for buyers and sellers to make informed decisions.

In general, carbon credits from well-established standards like Verra or Gold Standard and projects that are independently verified to be effective and sustainable are sought after and may therefore command higher prices in the market. Additionally, credits from newer engineered carbon removal projects tend to be priced higher than those from nature-based projects due to their novelty and the current cost curves.

Project developers must navigate a multi-step process involving project registration, emission reduction verification, and carbon credit issuance to bring their credits to the market. On the other hand, buyers should begin by quantifying their carbon emissions and then select credits based on this footprint and their budget, considering the types of projects and their benefits that align with their values and goals.

It's important to note that while carbon credits play a critical role in reducing greenhouse gas emissions by incentivizing investment in carbon reduction projects, they should not be viewed as a substitute for direct emission reduction efforts through energy efficiency, renewable energy, and sustainable practices. Instead, they are a complementary tool within a broader strategy to combat climate change (Thallo) (carboncreditcapital) (spglobal).

What are the problems with the Voluntary Carbon Market?

The voluntary carbon market, despite its potential for positive impact, faces several significant challenges:

Double Counting: There's a risk that more than one party claims carbon offsetting without standardized accounting protocols. This issue highlights the need for standardized nested accounting and protocols for interoperability across different jurisdictions and scales (Frontiers in).
Market Failures and Inefficiencies: Carbon markets are critiqued for potential market distortions, with some believing that without mandated compliance markets, voluntary markets might not be sufficient to drive the necessary action against GHG emissions. Real-world market dynamics often lead to excess supply and price distortions, which can affect the effectiveness of compliance markets (Frontiers in).
Monitoring, Reporting, and Verifying: The process for validating VCM projects is resource-intensive and complex, often leading to significant costs that can deter project development. However, technological advances such as satellite imagery and artificial intelligence may help reduce these costs and improve the verifiability of projects (Frontiers in).
Additionality and Baselines: Ensuring that carbon offset projects provide additional environmental benefits compared to what would have occurred without the project is a critical but complex aspect. Dynamic baselines that account for natural fluctuations are essential to measure a project's impact (Frontiers in) accurately.
Permanence: There are concerns about the long-term sequestration of carbon, commonly referred to as "permanence." Voluntary markets need to ensure that carbon stocks are maintained for the long term, typically 30-100 years, but the practicalities of guaranteeing this permanence can be challenging (Frontiers in).
Stakeholder Inclusion and Inequity: Projects can inadvertently disenfranchise local communities or create economic incentives that don't align with local needs. Standards now offer certifications to encourage stakeholder inclusion, but ensuring these are integrated and effective remains an ongoing process (Frontiers in).
Project Efficacy: Many nature-based carbon offset projects need to meet strict sustainability criteria, and the emission reductions they promise are often based on vague predictions or inflated baselines that overestimate their impact (Euronews).
Community Conflicts: Some projects can lead to community displacement or conflict, especially if local populations must be adequately involved or promised community benefits do not materialize (Euronews).

Is local carbon offsetting a better option?

Local carbon offsetting can offer several advantages:

Enhanced Transparency: Local projects may provide greater visibility into the actual impact of the offsetting efforts. This can foster trust among stakeholders, as the offsetting results are more observable and tangible.
Community Benefits: Local offset projects can benefit the community by creating jobs, improving local environmental conditions, and contributing to local sustainability goals.
Reduction in Leakage: Focusing on local offsets can reduce "leakage"—the phenomenon where emissions reduction in one area inadvertently causes an increase in another.
Cultural Alignment and Stakeholder Engagement: Local projects can be more culturally aligned with the community, ensuring better engagement and support from local stakeholders, leading to more successful and sustainable projects.
Lower Costs: Transport and implementation costs may be lower for local projects. Additionally, local offsetting can be integrated more seamlessly into local business operations and sustainability strategies.
Educational Value: Local projects can serve as educational tools for the community, raising awareness about carbon emissions and climate change mitigation strategies.
Regulatory Alignment: Local offset projects may be better aligned with local regulations, policies, and sustainability goals, ensuring compliance and support from local authorities.

However, there are also challenges and limitations to local carbon offsetting:

Scale: Local projects may offer a different scale of emission reductions than some larger international projects.
Diversity of Options: Local markets may have fewer projects to choose from, limiting the types of offsets available.
Economies of Scale: Larger international projects might benefit from economies of scale that can make them more cost-effective per unit of carbon reduced or sequestered.
Risk Diversification: International offsetting allows for diversification of projects across different regions and ecosystems, which can spread risk and enhance resilience.

Whether local carbon offsetting is better depends on the offsetter's specific goals, values, and circumstances. A mix of local and international carbon offsetting projects can often be beneficial to balance the benefits and address the limitations of each approach.

Can blockchain and smart contracts solve these market challenges?

Blockchain and smart contracts can potentially address some of the challenges in the voluntary carbon market:

Transparency and Traceability: Blockchain technology can create a transparent and immutable record of carbon credits and transactions, allowing buyers to trace each credit's origin and life cycle. This ensures that each credit is only sold and retired once, thus addressing double counting issues.
Automated Verification: Smart contracts can automatically verify the fulfillment of certain conditions, such as the actual sequestration of carbon before a credit is issued. This can help ensure that projects meet stated goals and compliance standards.
Standardization and Interoperability: Blockchain platforms can help standardize data across different projects and standards, making integrating and comparing projects easier. This can facilitate market interoperability and more straightforward aggregation of offsets.
Reduction of Fraud: The decentralized and tamper-proof nature of blockchain can help reduce fraud by providing a secure platform for issuing, trading, and retiring carbon credits.
Streamlined Transactions: Smart contracts can streamline transactions by automatically executing trades when predefined conditions are met, which can reduce administrative costs and time.
Liquidity and Market Access: Blockchain can potentially increase market liquidity by providing a platform accessible to a broader range of investors and project developers.
Enhanced Reporting: Blockchain's ledger can facilitate real-time reporting and monitoring, which could improve the credibility of carbon offset projects.
Risk Management: Smart contracts can hold funds in escrow and only release them upon successful project verification, managing buyers' risk and ensuring funds are used appropriately.
Permanence and Additionality: Blockchain can be used to ensure that carbon offset projects are permanent and additional by maintaining a time-stamped and publicly accessible record of project activities and impacts.
Cost Reduction: Automating various processes like issuance, trading, and retirement of credits can reduce the costs associated with market participation, potentially allowing smaller projects to enter the market.
Tokenization of Carbon Credits: Carbon credits can be tokenized on a blockchain, splitting them into smaller units and increasing accessibility for smaller buyers and sellers.

While blockchain and smart contracts offer promising solutions to improve the voluntary carbon market's efficiency and integrity, their implementation must be done thoughtfully. It's essential to ensure that the technology complements existing systems, aligns with regulatory standards, and is accessible to all market participants. Additionally, the energy consumption associated with blockchain technology must be considered, especially given the environmental focus of carbon markets.

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