Recent Developments in the Voluntary Carbon Market: Key Implications

At a glance:

• The voluntary carbon market (VCM) enables companies to offset their carbon emissions using carbon credits, and facilitates investment in projects that positively contribute to mitigating climate change.
• A carbon credit represents one ton of carbon dioxide either removed from the atmosphere or prevented from being emitted. Carbon emitters can then offset their emissions by purchasing a commensurate number of credits, although VCM usage is designed to be limited to “unavoidable” emissions.
• Engagement with the VCM is necessary for companies seeking to set net-zero targets under frameworks such as the Science Based Targets Initiative (SBTi), although in that case only carbon removal credits qualify.
• Carbon credits differ from carbon allowances (such as the EU Emissions Trading System, or ETS) purchased in mandatory compliance markets. VCM credits are used primarily to offset emissions, whereas an allowance purchased in compliance markets counts toward the holder's green house gas (GHG) emissions.
• The VCM is decentralised and currently largely unregulated. A mosaic of third parties provide issuance standards, verification and rating services in their absence.
• The growth of the VCM market is currently constrained by headwinds, primarily resulting from undermined trust in the authenticity of the credits themselves. The VCM market has been criticised as inadequately transparent, and it is difficult for prospective buyers to establish the credibility of the underlying projects (e.g. where credits issued do not reflect the offsets claimed).
• New reporting standards, such as the European Sustainability Reporting Standard (ESRS), require companies to report on the use of carbon credits and how they factor into their decarbonisation strategies. Other initiatives, such as the EU´s new Carbon Border Adjustment Mechanism (CBAM) and the UN´s Nationally Determined Contributions (NDC´s) (for use by nation-states), refer to VCM usage. The EU is also working on a new Carbon Removal Certification program.
• This year has seen further advancements in the VCM, including the emergence of regulatory frameworks, and increased focus on project credibility. These developments are key to understanding the direction that the VCM is heading.

This article is relevant for chief sustainability officers, chief financial officers, investors and companies with net zero goals, and others participating or thinking of participating in the VCM. Stakeholders working with innovation either inside corporates or start-ups providing VCM solutions and those involved in VCM projects will also find this article useful.

This article provides an overview of how the VCM operates, outlines the current state of the market and headwinds it faces as well as setting out key recent developments.

How the VCM operates

A carbon credit can be generated by an activity or project that either results in emission reduction or emission removal.

Emission reduction credits represent a reduction or avoidance of GHG emissions in various ways, such as replacing a planned fossil fuel power plant with renewable energy sources, or switching to clean cookstoves. Emission removal credits are offsets generated by projects that remove carbon dioxide directly from the atmosphere, such as biological carbon sequestration or direct air capture with geological storage.

Carbon credits are not standardised financial instruments - differing according to the underlying project type and the verification standard issuing the credits (e.g. the Integrity Council’s “Core Carbon Principles”), when the credits were issued (aka the “vintage”) and whether emissions are reduced or removed.

Currently, there is a variety of verification standards, with each applying its a distinct methodology to their generation and issuance. Once a project has been verified, carbon credits can be issued by a standard body and entered in a registry. The two largest registries are Verra and Gold Standard although new smaller ones are emerging that apply universal standards such as ISO14064-2 and involve the use of blockchain for transparency reasons. Registries:

• Give each carbon credit a special number so they are easily tracked, preventing double counting and promoting transparency in the carbon market.
• Partner with third-party groups to ensure validation and verification, so that carbon credits are genuine, effective and meet set standards.
• Maintain databases that track the issuance, transfer, and retirement of carbon credits, providing a clear and easily accessible record of transactions.
• Facilitate transactions through enabling efficient and secure transactions between buyers and sellers, ensuring a smooth transfer of carbon credits between parties.

For a carbon credit to be considered high-quality and transparent, it needs to be validated and verified by validation / verification bodies (VVBs) – which are qualified, third-party auditors. By validating the carbon credit, the VVB assesses whether the underlying project meets all necessary criteria from the methodology applicable to that project. Verification ensures that the outcomes claimed by the project have been achieved, and that these outcomes have been quantified according to the requirements of the standard.

The supply of carbon credits comes from three main sources: international crediting mechanisms (such as the Paris Agreement), domestic crediting mechanisms set up by governments (such as the California Compliance Offset Program), and independent standards managed by non-governmental entities (like Verra and Gold Standard).

Demand for carbon credits primarily comes from companies aiming to meet emission reduction commitments, and nation-states seeking to help meet their domestic emission reduction commitments. Results-based climate finance also influences demand, where governments or international organizations purchase credits to promote climate action.¹ By purchasing credits from “innovative” projects or those with a greater degree of impact, purchasers can encourage continued innovation in the types of projects and higher quality verification standards in the industry.

Differences between the projects creating the carbon credits and the verification processes used can lead to variability in the perceived value and quality of carbon credits. For example, credits from internationally recognised mechanisms might command higher prices than those from lesser-known independent standards.

Like any market, the price of carbon credits is influenced by supply and demand. During 2022, prices for exchange traded credits fell (with nature-based credits experiencing the greatest drop, from approximately $16 USD to $5 USD) as demand slowed. This was possibly due to public criticism facing these types of credits.² Currently, around 45% of carbon credit supply arises from renewable energy activities.³ As the cost of renewables decreases, and these projects become increasingly economically attractive without the extra revenue offered through carbon crediting, a shift toward nature-based credits covering emissions removals and reductions from agriculture, forestry and land use activities is expected.

Stakeholders within the market are increasingly demanding more rigorous verification standards and underlying projects with more tangible impacts. This has led to a premium on carbon credits underlied by emissions removal projects over reduction projects. As the market matures, it will be crucial for project developers, verifiers, and buyers to work collaboratively, ensuring that carbon credits not only have environmental integrity but also deliver on broader sustainability goals.

Current state of the market

As of 2022, total issuance of carbon credits totaled approximately $1.3 billion USD, and it is projected to grow 40% by 2023 (to $1.9 billion USD)⁴. VCM expansion is being driven by increased demand for credits as more companies adopt corporate climate targets and look to finance climate action. Owing in part to a lack of standardisation, carbon credits are largely traded over the counter (OTC) off of exchanges.

However, VCM growth currently faces several headwinds. Primarily, there is a perceived Iack of market transparency and project credibility. Transparency is a crucial element in the VCM, as it allows purchasers to ensure credits are based on real activities creating verifiable and measurable impact. A lack of transparency amplifies project credibility concerns, as firms are unable to distinguish low-quality credits from those that are high-quality. As such, increasing transparency and the standardisation of carbon credit verification could result in a stronger, integrated market and create a level playing field. With common standards, buyers would have more confidence in comparing and evaluating carbon credits from various sources.

The continuing growth of the VCM is attracting new technologies and innovation with traceability and quantification platforms. For example, the application of blockchain technology to the VCM may be useful in providing auditable, traceable, and reproducible records that document the emissions process and lifecycle of carbon credits.

Carbon insetting, an emerging and complementary practice to carbon offsetting, focuses on integrating carbon reduction initiatives within a company's direct operations and supply chain. Instead of purchasing carbon credits from third-parties for projects that are unrelated to the purchaser, companies invest in carbon reduction or removal projects along their own land. An example of this could be switching from fossil-based fuel sources to renewable energy sources or planting trees on land owned by the company.

Key developments

Recently, there have been several developments in the VCM aiming to improve the integrity of the market through implementing common frameworks and the standardisation of carbon credit verification:

COP28 Presidency, GFANZ and VCMI commitment: On 19 September 2023, the COP28 Presidency, the Glasgow Financial Alliance for Net Zero (GFANZ), and the Voluntary Carbon Markets Integrity Initiative (VCMI) hosted a high-level round table to promote high-integrity demand in voluntary carbon markets. The discussion emphasised the vital role of high-integrity VCMs in the net zero transition, the need for a comprehensive integrity framework for VCMs, and the importance of clear demand signals from COP28.

Agreement on Article 6 of the Paris Agreement: The rules on Article 6 finalised at COP26 in 2021 establish a framework for countries to voluntarily collaborate in achieving their emission reduction targets and adaptation goals through the Article 6.4 Mechanism, and International Transferred Mitigation Outcomes (ITMOs). These provisions aim to facilitate international carbon trading through allowing transfer of mitigation outcomes between countries, ensuring environmental integrity, and promoting cost-effective climate action, while preventing double counting of emission reductions and supporting sustainable development.

SBTi launches consultation on Beyond Value Chain Mitigation (BVCM): SBTi is a leading framework for setting corporate net-zero targets in line with climate science. In 2023, the SBTi initiated an open consultation on its BVCM Guidance Paper. Beyond value chain mitigation refers to mitigation actions or investments made outside of a company's value chain, for example, purchasing carbon credits. The paper aims to provide companies with clear benchmarks for credibility and set best practices for transparency in their ‘beyond value chain’ mitigation efforts. By setting clear standards and providing guidance, the SBTi paper will assist the corporate sector in ensuring efforts are both credible and transparent, thereby improving trust in the VCM.

EU Carbon Removal Certification: Introduced in November 2022, this voluntary framework sets rules for the independent verification of carbon removals, as well as rules to recognise verification schemes that can be used to demonstrate compliance with the EU framework. As the framework only recognises activities that remove carbon, reduction credits are unable to be certified under this framework. The proposal is currently being considered by the European Parliament and the Council of the European Union with trilogue negotiations expected to start in Q4 2023.

The Integrity Council for the Voluntary Carbon Markets and the Voluntary Carbon Markets Integrity Initiative: Announced in June 2023 a joint commitment to provide a coordinated set of standards throughout 2023 aimed at establishing an integrated market integrity framework for high-quality, transparent, credible, and accountable carbon credits. This framework will provide for both carbon removal credits and carbon reduction credits, which is a key difference when compared to the EU Carbon Removal Certification. This is also likely to have implications on how registries operate and what carbon credit attributes are shown among registries.

International Carbon Reduction and Offsetting Accreditation (ICROA): The ICROA is an accreditation program run by the International Emissions Trading Association (IETA), which aims to improve the VCM. In March 2023, ICROA launched a remodelled Accreditation Programme to better meet the integrity demands and evolution of the VCM. The refreshed Accreditation Programme will introduce new and simplified Accreditation application procedures and replaces the Executive Committee with an Accreditation Committee which will represent the views of the accredited organisations.

Key considerations for firms

Carbon credits serve as a tool for companies aiming to apply science-based targets to achieve net-zero status. However, the use of carbon credits should be viewed only as a complementary element within an overall decarbonisation strategy. Companies involved in the VCM should prioritise emission-reduction efforts first and use high-quality carbon credits in relation to emissions that cannot otherwise be avoided, not as a substitute for emissions reductions. The EU´s new European Sustainability Reporting Standards (ESRS) requires companies to report on the role carbon credits play in their decarbonisation strategy and maintain transparency by disclosing the types of credits they purchase, what standards are being used and whether they have been verified by an accredited third-party.

When looking to purchase carbon credits, purchasers should have in place a strategy that defines how carbon credits fit within their overall climate targets and how they can be integrated as part of the business. Key aspects to note include discrepancies between different credit types due to the impact of a project, and whether credits have been reliably verified as having offset the claimed amount of carbon. This requires credible, permanent, additional, and verified carbon credits from projects that adhere to reputable monitoring, reporting, and verification frameworks. Companies should be transparent about their use of carbon credits and communicate how they fit into their strategy for achieving climate targets, which means also identifying actions taken to address their own carbon emissions. The steps outlined below provide guidance on the actions that a company should take before purchasing carbon credits:

• Set clear objectives – Define your company’s sustainability goals and objectives. Determine how the use of carbon credits aligns with your brand, and fits into your brand positioning and overall strategy. At the same time, consider the value chain and ecosystem of partners and how carbon credits can contribute to achieving your emissions reduction targets or net-zero strategy.
• Assess emissions – Conduct a thorough assessment of your company’s carbon emissions (scopes 1-3) to identify areas where reduction efforts might be challenging. This will help determine the quantity of emissions required to be offset.
• Choose verification standards (Registry) – Consider reputable standards that have established methodologies and rigorous criteria for evaluating and certifying carbon projects. Look to diversify your portfolio based on geography, nature vs. technology and consider investing in “pending” credits.
• Identify high-quality carbon projects – Projects should align with your company’s values and objectives. Look for projects that generate high-quality offsets and ensure they meet the criteria set by your chosen verification standard. Also consider other benefits from carbon projects, such as in terms of biodiversity and/or social aspects.
• Due Diligence – Conduct due diligence on the carbon projects you are considering. Review project documentation, methodologies, and third-party verification reports. Ensure that the projects have been independently evaluated and verified by an accredited verification and validation body (VVB) according to a high-quality standard.

Conclusion

The VCM holds immense potential to drive climate action and facilitate the transition towards a net-zero future. Its ability to provide companies with a mechanism to offset unavoidable emissions is pivotal, especially due to the urgency of achieving their carbon reduction goals. By investing in projects that align with their values and their brand, companies can not only contribute to climate change mitigation but also drive positive social change through financing projects.

However, the VCM is not without its challenges. The market’s current state characterised by issues of transparency, project credibility and varying standards underscores the need for innovation. Addressing these challenges is not only a functional necessity as purchasing credits also holds strategic importance. A robust and transparent VCM can instil confidence among stakeholders and ensure that their engagement in the market is not only about offsetting emissions but making a tangible difference.

Recent developments offer promising pathways to enhance the VCM's effectiveness. By embracing transparency, adhering to robust standards, and prioritising emission reduction efforts, companies can navigate the evolving landscape of the VCM and contribute to a sustainable future.

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References

¹World Bank (2023). State and Trends of Carbon Pricing 2023. The World Bank https://openknowledge.worldbank.org/handle/10986/39796

²World Bank (2023). State and Trends of Carbon Pricing 2023. The World Bank https://openknowledge.worldbank.org/handle/10986/39796

³ World Bank (2023). State and Trends of Carbon Pricing 2023. The World Bank https://openknowledge.worldbank.org/handle/10986/39796

⁴ Trove Reseach – Voluntary carbon market 2022 in review webinar