Fans of 'net zero' and 'cryptoassets' alike need to get to grips with developments in the markets for carbon credits, as recently explained in the
ISDA paper on the legal implications of voluntary carbon credits ("VCCs"). Voluntary emission reduction/removal schemes are those not mandated by law - so there's no fine or penalty system as there is for EU allowances trading scheme, for example. ISDA recommends that VCCs should be recognized as a form of (intangible) property in each jurisdiction, just as the
UK Jurisdiction Taskforce’s statement on the status of crypto assets and smart contracts provided
legal certainty under English law that cryptoassets are capable of being owned. Distributed ledger tech/blockchains also seem apt for
recording/tokenising/trading VCCs as their state/status may change often, and
that will be of interest to many stakeholders in different countries,
running different software/systems... but I appreciate that's a lot to take in/on!
What are VCCs?
VCCs are issued under certain non-statutory standards by, say, an industry body, to certify the reduction or removal of carbon dioxide from the atmosphere (one VCC means the relevant body has certified that one tonne of CO2 has been reduced or removed ("one tCO2e")). The VCC might be 'cancelled' or 'retired' and included in the accounts of the original project operator to meet its
own emissions reduction obligations or sold buyers who book them as a way of
neutralizing their own emissions. In the case of a sale, the revenues generated help fund either the original or subsequent reduction/removal project. A cancelled/retired VCC is removed from circulation, just like the carbon it represents. While not subject to a statutory regime, some VCCs may be recognized for
statutory compliance so the distinction between 'mandatory' and 'voluntary' credits is blurring. There remains a distinction between a VCC that qualifies for compliance in a mandatory scheme (making it a distinct legal instrument) and one
that can be swapped for a mandatory unit (merely
facilitating compliance with the scheme using the mandatory units, but at least 'recognized).
Challenges
Quality/Standardisation: concerns over 'greenwashing' mean the quality of the underlying
project affects the quality of the VCC. Buyers focus on the project methodology used to generate the VCCs
and the impact of projects. Standardization is therefore challenging.
Double Counting: It's critical to avoid the benefit of the carbon reduction corresponding to the VCC being claimed more than once (e.g. a
VCC sold to a third party for offsetting also being used to avoid the obligation to purchase carbon credits; or where different schemes cover the same activity (renewable energy
certificate and carbon offset).
Pricing: a lack of reliable, transparent price discovery means buyers have little comfort they are paying the right price and
sellers may struggle to fund projects.
Article 6 of the Paris Agreement/COP26:
this aims to establish a new international carbon market, whereby countries set their own contributions through the trading of emissions reductions (internationally transferred mitigation outcomes ("ITMOs")). Countries could purchase emissions reductions from others who've already met their target. There are rules on ITMO transfers;
the potential to link emissions trading schemes; a process for trading carbon credits from emissions-reduction
projects; a framework for cooperation with inactive countries (e.g. through development aid). The implications for
VCC markets will be clearer after the rules are further developed (e.g. whether VCCs should be treated as ITMOs) but this complexity will likely reduce the
supply of VCCs, ease of transacting and liquidity in the near term.
Fragmentation:
The fragmented nature of the VCC markets by geography and different schemes, registries,
carbon standards, methodologies, and VCCs themselves hampers standardization and the development of an effective, liquid market.
Legal Treatment: the legal nature of VCCs differs in that they can
be viewed as intangible property in one jurisdiction but a 'bundle of
contractual rights' in another. That means different rules for how VCCs can be created, traded and retired; how
security is taken and enforced; and how VCCs would be treated on insolvency. In theory, there are several potential
different jurisdictions whose laws could apply to a VCC: the jurisdiction of the register in which the VCCs are recorded; the jurisdiction of incorporation of the registrar; the governing law of the carbon standard rules and/or registry rules; and/or the law of the location of the project from which the VCCs are generated.
Steps could be
taken in national legislation and international treaty to resolve differences. Distributed ledger technology (DLT) could record VCCs in the
ledger where digital assets are considered intangible property. For instance, in the context of the EU Emissions Trading regime, the
German Emissions Trading Act (TEHG) provides that if EUAs are registered in
a person’s account, the account is deemed to be correct and that person has legal title to the
EUAs; and the EU Registry Regulation provides for legal ownership of allowances and the finality of transactions.
Importantly, the legal status of a VCC as an asset in itself is distinct from
the legal treatment of a transaction in relation to that VCC, so an instrument used as the basis for a transaction relating to a VCCs could be subject to financial regulation (e.g. a listed future, an OTC forward or option or a unit in a collective investment scheme), even if the underlying VCCs themselves are not considered regulated financial instruments.
Fungibility: to aid the development of a liquid market, VCCs should be interchangeable for the purposes of
satisfying transfer obligations between traders. This is not a feature of the asset itself but the context. Banknotes are fungible to satisfy payment obligations, but are not fungible for tracing purposes (each note is serialized). A unique serial number does not preclude a VCC
from being fungible, so the issue is whether and why the market will treat different VCCs as interchangeable for the purposes of settlement/delivery [this raises interesting questions as to whether/when non-fungible tokens (NFTs) might actually be 'non-fungible'...]. Fungibility of VCCs depends on:
- Commonality of unit of measurement: each VCC corresponds with one tCO2e reduced
or removed;
- market acceptance of common standards for vetting the approval and verification of VCC-producing projects, at least by an agreed approach to segmenting the market as a whole;
- Adherence to generalised carbon standards and registry rules, as opposed to only specific registry rules. interoperable registers;
- Locating registers in jurisdictions that provide clarity over the legal treatment of VCCs;
- Targeted legislative amendments in jurisdictions where elements of the VCC lifecycle are dependent on a local statutory regime (e.g. what rights do traders, non-debtor counterparties or the holders of securities have against each other or intermediaries acting for either participant in the event of insolvency in a particular jurisdiction).
Conclusion:
ISDA recommends that VCCs should be recognized as a form of (intangible) property in each jurisdiction, just as the UK Jurisdiction Taskforce’s statement on the status of crypto assets and smart contracts provided
legal certainty under English law that cryptoassets are capable of being owned.
Distributed ledger tech/blockchains also seem apt for
recording/tokenising/trading VCCs as their state/status may change often, and
that will be of interest to many stakeholders in different countries,
running different software/systems...
That's an awful lot to take in/on!
