Caveat Emptor: The Use and Abuse of Carbon Credits

The last several years have seen a material increase in the use of carbon credits and offsets by companies as part of broader global efforts to address climate change and reduce carbon emissions. That trend will, in all likelihood, exponentially increase over the next decade. The use of carbon credits, however, is by no means a risk-free proposition. The rules remain highly uncertain and subject to frequent modification. A patchwork of opportunistic bad actors, including, in some instances, organized criminal groups, has flocked to the space. And more recently, regulators, media, civil society organizations and courts have been rightfully cracking down on the false and misleading use of credits with dubious contributions to emissions removals or reductions. Yet, despite the obvious headwinds, carbon credits can still play an important role in future efforts to manage global climate-related impacts and goals particularly considering recent efforts by standard setters and regulators (for example, in the EU, the UK, Canada and the U.S.) to actively try to address the related concerns. As this process unfolds, companies that choose to acquire carbon credits need to be especially vigilant and actively manage the related risk factors, taking proactive steps to ensure the integrity of the credits and their use.

The Potential Benefits of Carbon Credits

The terminology around carbon “credits” and “offsets” is confusing. They are somewhat ill-defined concepts and often used interchangeably despite potential differences. Generally, they can refer to formal credits generated from mandatory carbon-reduction schemes (such as cap-and-trade regimes in the EU, Australia, New Zealand, South Korea, California and Quebec) or to credits or offsets generated voluntarily under specific frameworks and standards and registered with a carbon registry. Trade in these voluntary carbon credits, with each credit being equivalent to one metric ton of carbon dioxide equivalent (CO2e), emerged with the 1997 United Nations (UN) Kyoto Protocol to facilitate and enable carbon removal and/or reduction projects. Market mechanisms were sought to incentivize and promote projects that would not have occurred in the absence of some form of compensatory mechanism for developers. Proponents have argued that, without such compensatory credits or mechanisms, there are minimal incentives for market-led carbon reduction and removal projects—even those with clear and distinct atmospheric carbon removals like carbon capture technologies.

From a buyer’s perspective, voluntary credits can be particularly helpful in facilitating efforts to promote climate action and neutralize residual carbon emissions where direct emissions reductions would prove too costly and difficult. Consistent with that view, 48% of survey respondents agree that carbon credits are an effective solution for fighting climate change.

Given the perceived utility of voluntary carbon credits by many companies and financial institutions, it is not surprising that demand has increased significantly in recent years. Most respondents (60%) to our survey have either already purchased some form of carbon offsets (28%) or are considering purchasing them in the future (32%).

And the use of credits is only expected to grow in coming years for three interrelated reasons. First, evolving global regulatory disclosure requirements around greenhouse gas (GHG) emissions, especially in the U.S., the EU, the UK, Canada and Australia, means that corporate emissions—which have largely gone unmeasured or hidden from public scrutiny until recently—are now being made public. Second, the increasing use and integration of overall environmental, social and governance (ESG) factors, including emissions data, into investment decision-making means corporate management is increasingly attuned to their relative performance and reputation on emissions factors vis-à-vis competitive benchmarks. Third, companies are increasingly embracing detailed energy transition plans to reduce their carbon emissions and impact, including direct actions to lower climate emissions reductions and other intermediate means (such as climate credits) to “neutralize” residual emissions.

There’s No Free Lunch: Carbon Credits Are Not Risk-free

However, despite the many potential benefits and merits of carbon credits, the current uncertainty, lack of definitive guidance and regulation around accounting mechanisms and the patchwork of organizations involved means companies should proceed with caution.

Companies should be especially mindful of three related risk factors related to carbon credits: third-party and jurisdictional issues; project accounting and impacts; and disclosure and communications risks.

Third-party and Jurisdictional Risks

First, the opacity and complexity of carbon credit markets has resulted in numerous opportunistic and dubious third parties flocking to the industry. That includes organized criminal groups, corrupt politicians and a slew of other potential bad actors. Companies that purchase carbon credits should vet and screen the widest possible swath of individuals and organizations associated with carbon credit offerings and projects to the fullest extent practicable. Most respondents to our survey appear to understand the necessity, with 82% agreeing they already do or will conduct due diligence to ensure carbon credits are purchased from a legal entity.

However, screening should go way beyond direct intermediaries, at least until regulation catches up with market practice and clear best practices and reputable intermediaries and institutions emerge who can be relied upon in this space. At least for now, screening and basic diligence should include reasonably attainable counterparties throughout the carbon credit value chain. That includes, for example, conducting diligence on the carbon registries themselves. Recent high-profile investigations, for example, have raised concerns around some of the more reputable carbon registries in the market. Companies need to watch the watchers to avoid getting caught up in headlines around improper credit usage or schemes.

Companies should also assess the broader ecosystem of project developers and any associated parties, including, but not limited to, identifiable landowners. The geographic locations of these projects often involve jurisdictions with limitations around transparency, rule of law, sovereign oversight capacity and, in some cases, are subject to high levels of public corruption. That creates perfect conditions for the use of carbon credit projects by organized criminal operations, including for bribery, money laundering and financial obfuscation schemes (for example, via opaque land registries and hidden beneficial ownership structures). Relatedly, companies should also better understand the nuances of jurisdictional risks and developments as evolving geopolitical or domestic political issues will likely impact some of these credits and result in their nullification. The Zimbabwe Government’s recent takeover of the local carbon trading market is a prime example of how sovereign risk can materially impact project viability.

Project Accounting and Impact Risk

A further and frequently misunderstood risk factor concerns the underlying project accounting and determination of actual impacts on carbon emissions. Carbon credit projects are not created equal. In addition to having different credit-generating processes and mechanisms—including nature restoration, forestry, REDD+, energy efficiency, non-CO2 gases, fuel switching and/or renewable energy—they also involve varying demand profiles and command different purchase price levels. Companies need to ensure that these projects address climate change by legitimately removing, reducing or avoiding emissions. That, after all, is the whole purpose of the credit regime. Fortunately, 80% of our survey respondents agree or strongly agree that they at least plan to take steps to verify that the purchased carbon credits are appropriately addressing climate change.

Until more regulation and clearly defined best practices and standards emerge, companies will need to rely on their own subject matter experts and/or credible and competent third parties to understand and scrutinize developers’ claims about how emissions are reduced or removed as well as the mechanisms through which that reduction or removal occurred or will occur. That’s especially true under current conditions, where the credit ecosystem and landscape continue to evolve in real time. Carbon credit accounting, for example, is based on the foundational concept of “additionality”. As discussed earlier, at a theoretical level, additionality basically means that a credit project must demonstrate that it reduces or removes carbon from the atmosphere and would not have happened without the credits. That involves assessing and quantifying the underlying tons of CO2e reduced or removed over a distinct period and, therefore, determining the permanence of the reductions and removals. In addition to having the right technical competence and expertise, determination of issues around additionality, quantification and permanence involves a degree of judgement and discretion.

Adding to the complexity, numerous potential standards, frameworks, principles, protocols (most importantly the Greenhouse Gas Protocol’s project-level accounting) and other related technical issues have emerged to assist and provide methodological rigor around measuring, validating and verifying these components. These rules and standards are filtered through an ecosystem of registries and third-party organizations. While a “race to the top” around standards and methodologies should assist in theory, in practice there is still a lot of learning-by-doing involving a limited number of qualified subject matter experts, creating confusion and uncertainty in the market.

The confluence of technical, legal, regulatory and reputational issues surrounding carbon credit project accounting and development means that, until better regulatory oversight and bright-line standards emerge, companies will need to engage the right internal subject matter experts and knowledgeable third-party providers to assist with assessing the integrity of the underlying credits and the processes involved.

Disclosure and Communication Risk

Lastly, even for clearly legitimate carbon credits, there are important risks around their use. Companies must zealously commit to transparency and clarity in any related disclosures and communications with stakeholders about their climate programs and how carbon credits are being used. In particular, companies must ensure their climate-related and emissions reduction disclosures and communications do not risk misleading stakeholders, including investors, about their own climate-related performance, goals and targets, especially as it pertains to the use of credits in achieving carbon neutrality and any science-based net-zero targets.

Transparency and integrity around climate-related disclosures and communications starts with companies ensuring that their own emissions calculations and disclosures around GHG Scope 1, 2 and 3 emissions are aligned with existing best practices under the GHG Protocol and related quality-control standards and ensure that any assumptions, uncertainties, limitations and risks are duly disclosed.

Despite the apparent confidence that a minority of firms have around their GHG calculations, most still struggle with data collection and are unfamiliar with the relevant standards and protocols and the underlying accounting calculations and mechanics. For example, while valuable as part of an overall emissions management program, carbon credits should never be used to directly reduce Scope 1, 2 or 3 emissions calculations and, relatedly, should not be used in calculating science-based climate targets (around net-zero calculations, for example). The most widely adopted and credible standard setter, the Science Based Targets initiative (SBTi), for example, makes it abundantly clear that credits should only be used to “neutralize” the impact of residual emissions after any targets have been achieved. Most importantly, companies must ensure that narratives and disclosures around emissions targets and carbon credits accurately portray exactly how they are being used, including their limitations. In the current environment, which is hyper focused on greenwashing, even a modicum of misleading information or exaggeration on climate issues can raise major reputation and legal risks. As with all other ESG factors, zealous and rigorous transparency and integrity around disclosures and communications is of paramount importance. “Sunlight is the best disinfectant,” as Supreme Court Justice Louis Brandeis once famously quipped over a century ago.

Proceed, but with Caution

Given all the uncertainties involved, companies may choose to refrain from voluntary carbon credits markets altogether. However, when used in the right way, carbon credits can arguably play a critical role in broader efforts to address climate change, including around neutrality goals and going beyond SBTi targets. In addition, better methodological guidance and standards from academic institutions and civil society organizations continue to evolve and advance in real time and carbon credit registries are making concerted efforts to address issues with the underlying project accounting and developments. Moreover, a cottage industry of solutions providers and standard setters is emerging to address many of the integrity-related issues raised above. Lastly, a slew of new regulatory standards and oversight mechanisms are set to transform climate-related and emissions disclosures and practices in the near future. In the meantime, and as this process unfolds, companies that choose to use carbon credits should look to their subject matter experts and service providers to navigate the uncertain terrain.

References
https://www.theguardian.com/environment/2023/jan/18/revealed-forest-carbon-offsets-biggest-provider-worthless-verra-aoe
https://www.bloomberg.com/news/articles/2023-05-16/zimbabwe-plans-takeover-of-carbon-credit-trade-voids-past-deals