Voluntary carbon markets (VCMs) allow for carbon emissions to be offset through a range of mitigation projects. The amount of carbon offset is converted into a financial instrument, a 'carbon credit'. Carbon credits have become a key tool for firms and individuals seeking to reduce their carbon emissions impact, a clear imperative, driven by global and local/national net zero targets, increased regulation, public policy and investor awareness.
Market integrity risks in VCMs
There are four important links in the VCM value chain. Originators perform the action that reduces or removes carbon in the atmosphere, for example by reforesting an area of land. The amount of carbon affected is then converted to a credit, which is stored at a repository. Brokers and exchanges interface between repositories and consumers, dealing in both the original credit, and derivative financial instruments. Consumers, either firms or individuals, complete the value chain.
Risks to market integrity can emerge at all stages of the value chain, yet VCMs currently fall outside the remit of EU and UK financial regulators.
The greatest risk is that the scientific claims behind a credit do not hold up to scrutiny. The bodies that claim to verify carbon credits are usually voluntary and are not currently recognised for UK financial compensation scheme purposes. And, even if the carbon-related aims can be substantiated, there may be other impacts, for example preventing indigenous peoples 'access to ancestral land, that would not otherwise meet firms' due diligence or consumer expectations.
For credits that are traded on an exchange, the non-standardised nature of carbon credit contracts can cause problems. Contracts may contain bespoke terms which are contentious in the event of a dispute. These issues are compounded by the fact that market-facing pre- and post-contractual disclosures are generally of a lower quality than for other types of financial instruments.
In addition, the exchange and brokerage landscape has yet to consolidate and is not yet operating at scale, which may be a barrier to entry for potential market participants. Ultimately, this can lead to uncompetitive market pricing and cause liquidity issues in the market.
Once a carbon credit has been used to offset against a consumer's carbon emissions, it should be retired to reflect the fact that its benefit has been used up. However, there is no clear mechanism for ensuring that a credit sold shouldn't already have been retired.
The FCA has also warned that scammers are targeting retail investors as the market for sustainability-related instruments grows.
It shouldn't be a surprise then, that firms and consumers using VCMs are exposed to significant reputational risks.
IOSCO's recent consultation report provides a host of recommendations to regulators to improve integrity issues within VCMs. Some of these can be implemented without full supervision of firms, such as improving investor education, clarifying the regulatory treatment of carbon-related exposures and using national or legislative carbon-related targets to direct VCM behaviour. For jurisdictions which do fully supervise VCMs, governance expectations, market surveillance and verification methodologies are also addressed.
Although VCMs do not currently fall within EU and UK regulators' remits, focus is growing. The UK Government is expected to consult in 2024 on developing high-integrity VCMs. Reflecting other regulatory initiatives, including transition plan disclosure requirements and the proposed UK Sustainability Disclosure Standards, both of which may drive an uptick in VCM users, this consultation is likely to include actions to improve confidence in the markets and reduce reputational risks.
In the EU, direct action on VCMs has been slow. Nonetheless, a range of regulatory requirements, including the Corporate Sustainability Reporting Directive (CSRD) and the Sustainable Finance Disclosure Regulation (SFDR) have given firms an incentive to engage in markets that are high quality. While the development of the EU Carbon Border Adjustment Mechanism (CBAM) is likely to have an impact on the pricing of VCMs, it has otherwise been for the market itself to fill the gap and define the standard of 'high quality'.
Market-based initiatives emerge
Emerging market-based initiatives include the 10 Core Carbon Principles for originators and registries, published by independent governance body the Integrity Council for the Voluntary Carbon Markets (ICVCM). The Core Carbon Principles define a baseline of good practice for the governance, transparency and verification of VCMs and the products traded. A set of emissions impact principles establish baseline criteria for high-quality credits, to ensure that they offer quantifiable and sustainable carbon offsets and that external impacts on other ESG issues, such as social safeguards, are maintained.
At COP26, it was announced that the Voluntary Carbon Markets Integrity Initiative (VCMI) would be established, to help firms understand how to manage and disclose their engagement in the carbon markets. A code of practice for carbon-related claims has now been published. The Claims Code sets out the steps that firms can take to make verifiable disclosures over their use of carbon credits. In parallel with measures to improve the integrity of VCM functioning, the Code can help firms reduce their reputational risk.
Actions for firms
For VCM's to become increasingly more successful and move further into the mainstream there is need for increased levels of transparency in the underlying information and products and projects. Firms that already participate in VCMs will need to engaged with all the emerging initiatives and industry best practice described above. Firms that are not yet active in this space may find that expected net zero transition requirements make VCM trading a useful part of their future strategy. Firms should seek to understand the end-to-end lifecycle of their traded credits and make sure that due diligence provides them with the necessary transparency to support a firm's risk appetite. As the UK and EU landscape for VCMs evolves, all firms will need to ensure that that they have the necessary governance structures and frameworks to support them with managing existing and future risks around VCM products.
How KPMG can help
KPMG in the UK can help firms to build and adapt quality risk frameworks and governance structures to manage the risks and opportunities of participating in VCMs. We also offer due diligence and assurance services that provide valuable independent opinions to support components of the VCM value chain.