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The Opportunities and Risks of Carbon Credits

Globally, companies are increasingly taking on the challenge of achieving net-zero carbon emissions. This is often achieved by way of a regulatory push and sometimes voluntarily. Carbon credits will be one of the key components of the net-zero toolbox that allow companies to offset emissions they have not yet cut. The market for carbon credits is expected to increase significantly in the near future.

There are risks and opportunities related to carbon credits. If carbon credit projects are appropriately run, credits will lower overall emissions. If carbon credits are created in developing countries, they may aid in other sustainable development goals.

Carbon credits can bring about these positive results only if the integrity of the credits is ensured. Regulation of the carbon market is insufficient and fragmented, so there exist legitimate concerns that some carbon credit exchange may amount to little beyond greenwashing.

For these reasons, the international community took important actions during the Glasgow Climate Change Conference in 2021 to improve the quality of carbon credits. They introduced new regulations on procedures and benchmarks for credits (e.g., on government approvals, methods for monitoring emission reductions Monitoring, reports, as well as verification). These rules are designed to ensure that carbon credit projects genuinely result in measurable reductions in global emissions, and also to improve transparency in the process. Given the scope and complexity of the issue the rules are intricate and difficult to comprehend in the real world.

The new rules don’t necessarily apply to the entire spectrum in carbon markets. National regulators as well as private credit certifying bodies are currently deciding on how to incorporate the new rules into their respective work with a window of opportunity for all stakeholders to play an impact on how the rules are implemented. Early signs suggest the new rules will reshape public and private standards this year, increasing their integrity and, over time, reducing fragmentation. If successful these rules will allow carbon credits to deliver on their potential to cut global carbon emissions, encourage businesses to invest in these instruments as part their net-zero path and will provide significant opportunities to investors to fund credit-generating projects.

The Article 6 in the Paris Agreement sets out the essential mandate for carbon markets. They allow nations to fulfill their international climate obligations (nationally defined contribution or NDC) by purchasing carbon credits. The big development in Glasgow was the much-anticipated agreement regarding the known as the “Paris Rulebook,” which aims to fulfill this obligation. Below, we introduce carbon markets as well as”the” Paris Rulebook, and their interplay.

Carbon markets in a nutshell. Carbon credits are awarded as a part of an initiative in an “host” country in order to cut or eliminate emissions. Each credit gives the owner the right to emit a particular amount of carbon, usually the equivalent of one ton. Credits are bought from a corporation or country that is in compliance or voluntary markets.

In compliance markets, companies buy credits that can be used to meet their obligations to reduce emissions as part of (i) international programs (e.g., by countries to achieve their NDC in the Paris Agreement or by airline operators to offset their emissions under CO2 offset schemes such as the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA)) or (ii) national schemes (e.g. or by corporations to limit their liability under a national emission trading scheme (ETS) or a carbon tax). Every regulator decides on the extent carbon credits may be used in order to meet legal requirements and conditions for obtaining credits.
In the voluntary carbon market (VCM), companies purchase carbon credits to support non-binding claims (e.g., voluntary net-zero pledges, that are known as “offset claims” or to demonstrate their support for projects to reduce emissions, that is known as “impact assertions”). Presently, there’s no unified international regulation or standard for the quality of carbon credits that are able to be used for the VCM.

The Paris Rulebook in a nutshell. In a nutshell, the Paris Rulebook develops two approaches for the international transfer of carbon credits. The first is the Cooperative Approach (Art 6.2) applies when countries trade carbon credits between them or, as per some guidelines, when a host country permits another country or company to make use of credits, even if it does not have a contract with another country. As an example of using the Cooperative Approach, Switzerland and Peru reached an agreement allowing Switzerland to finance credit-generating projects in Peru in exchange to carbon credits Switzerland can use to reach its 2030 NDC goal. The second is the Sustainable Development Mechanism (SDM) (Art 6.4) creates an international system to approve credit-generating initiatives, typically run through private investment.

Each approach is governed by for each one, Paris Rulebook sets out substantive and procedural requirements to protect the authenticity of credits — credits that contribute meaningfully to reducing overall global emissions.

What are the essential conditions of the Paris Rulebook?

(1) The credit cannot be double-counted Carbon credits can be counted once. The host country can formally agree not to use this credit in order to reach its own NDC and instead let the credit be used for other reasons to reduce carbon emissions (e.g., by another country to meet their NDC and by a company in another country). In such a case the credit won’t be considered by the host country and the other country or company.

(2) Additionality: A credit-generating project must result in reductions or eliminations of emissions which wouldn’t have happened without the anticipated income stream from the sale of credits that the project generates. This guarantees that a project has the potential to have an additional — impact on lowering emissions in the country of its host, irrespective of who actually is using the credit. It is the SDM Approach (Art 6.4) provides more details on how to determine the amount of reductions in emissions.

What are the key difference between these two approaches to the Paris Rulebook?

(1) International approval: In accordance with the Cooperative Approach (Art 6.2) the credit-generating program is run under the authority of the host country , but without the endorsement of an international body to supervise. While there isn’t an international body, the parties must meet detailed reporting and transparency requirements, which are subject to the approval of independent technical experts who can issue (nonbinding) advisory public statements. However, under the SDM Approach (Art 6.4), there are extra layers of oversight: A project must be approved by the country hosting it and a newly-created international supervisory body, which is based on the recommendations of an independent verification body.

(2) Levies on mandatory use: Under the SDM Approach (Art 6.4), mandatory levies of 77% are assessed on carbon credits. These levies are intended to aid in climate adaptation to the needs of developing countries (5 percent of them contribute to the United Nations Framework Convention on Climate Change Adaptation Fund) and to guarantee the additionality of (2 percent are cancelled). Levies on mandatory levies are not required pursuant to the Cooperative Approach (Art 6.2) However, they are “strongly recommended.”

The new rules grant the host nation a crucial role in credit-generating projects. They are able to decide (i) what standards are applicable (the Cooperative Approach, SDM Approach, or an approach which isn’t part of the Paris Rulebook) and (ii) whether carbon credits are used to meet its specific NDC or not. How these choices are made will determine the significance and the possible uses for the carbon credit resulting.
The effect on carbon markets is the result of Paris Rulebook on carbon markets. While it is true that the Paris Rulebook provides only limited direct regulation of carbon markets it is expected to have an impact on market regulation and improve the integrity of credits , both in voluntary and compliance markets. In fact, even though a number of aspects in the Paris Rulebook are still to be clarified, steps are being made to boost standards for carbon credits in line with it. In addition, the most prominent private credit-certifying bodies, like Gold Standard and Verra, are currently strengthening their standards in light of the Paris Rulebook.

The effect from the Paris Rulebook on carbon markets. Even though there is no direct regulation of carbon markets, the Paris Rulebook provides only limited direct regulation of carbon markets, it’s anticipated to have a significant effect on market regulation, increasing the credibility of credits both in compliance and voluntary markets. Although a variety of the provisions included in the Paris Rulebook are still to be clarified, steps are being made to boost standards for carbon credits accordance with. Notably, some of the top private credit-certifying organizations like Gold Standard and Verra, are working on upgrading their standards to reflect the requirements that of Paris Rulebook.

In the VCM there aren’t unifying international rules for the credit quality. This could be changing. Private initiatives are developing guidelines to improve the integrity of credit (e.g., the Voluntary Carbon Markets Integrity Initiative) with the first guidelines expected in April. In the meantime, the Paris Rulebook requirements on double-counting as well as additionality and transparency are likely to influence the guidelines. As time goes on, certain national regulators may also be able to regulate credit used for voluntary purposes, for example, defining quality requirements for the credits are used by a business to satisfy net-zero commitments.

On compliance markets national regulators sometimes allow a company to make use of credits to fulfill some or all obligation under the carbon tax , also known as an ETS. Regulators could make the eligibility requirements more stringent according to the Paris Rulebook. Other countries with a carbon tax or ETS may be more inclined to allow the utilization of credits with high-quality which meet requirements of the Paris Rulebook requirements. While the CORSIA scheme for offsetting emissions from international aviation already has strict guidelines for high-quality carbon credits, some countries may further enhance the standards.

The Paris Rulebook is also expected to affect pricing. Credits that conform to the Rulebook will be more secure and are likely to qualify to be used in greater markets. Therefore, they can be expected to receive an increase in price.

Potential and risk for participants. It is clear that this time of rapid-changing market and regulatory dynamics provides significant opportunities and risks for all participants. It is important to note:

Companies have the option to buy carbon credits that are of high-quality to achieve their zero-net-zero pledges (either optional or perhaps mandatory). The increased scrutiny of the authenticity of carbon credits both by consumers and regulators underpins the necessity of choosing the correct carbon credit “product.”
Investors and developers of projects have the opportunity to invest in, and develop projects of high-quality, but there are some concerns about what market and regulatory aspects will play out (including, e.g., pricing dynamics as well as the stability and liquidity of the market as it expands).
Regulators now must further develop in order to apply the Paris Rulebook and decide whether they want to modify the eligibility criteria for their own domestic ETS and carbon tax systems. Internationally, regulators must consider the impact of the rules on schemes like CORSIA and whether to subject different industries (e.g. the shipping industry) to similar schemes.
Host countries may seize on the possibility of receiving additional financial support for projects that reduce carbon by carefully assessing which carbon credit approach to pursue to reduce emissions and encourage sustainable development.

We’re ready to assist people in navigating this confusing world. This can include, for example providing clients with advice on the risks and opportunities in financing their own emissions-reducing projects through the generation and sale of carbon credits; buying carbon credits that offset emissions and help them reach their net-zero objectives; future-proofing carbon credit investments in light of the fast-changing regulations; and working with governments to maximize the benefits and reduce the risks of participating in the carbon market.