Mandatory and Voluntary Carbon Markets

Introduction

Climate change remains one of the greatest global challenges, requiring collective and innovative efforts to reduce greenhouse gas (GHG) emissions. Carbon markets, both mandatory and voluntary, have emerged as effective mechanisms for incentivizing emission reductions. Within these markets, the trading of carbon credits has become central to achieving net-zero commitments. 

Overview of Carbon Markets

Mandatory Carbon Markets (MCMs) 

Mandatory carbon markets, also known as compliance markets, are regulated systems designed to cap and reduce GHG emissions in sectors with significant environmental impacts, such as energy production, manufacturing, and aviation. 

Key features of MCMs include: 

• Cap-and-Trade Systems: Governments set a cap on emissions and issue allowances equal to the cap. Entities can trade these allowances to meet their compliance obligations. 

• Carbon Taxes: Some jurisdictions impose taxes on emissions as an alternative to cap-and-trade systems, incentivizing reductions by making emissions costly. 

Examples of MCMs: 

1. European Union Emissions Trading System (EU ETS): Established in 2005, this is the world’s largest and most successful cap-and-trade program.

1. Regional Programs in the U.S.: Initiatives like California’s Cap-and-Trade Program highlight regional leadership in the absence of federal mandates. 

Voluntary Carbon Markets (VCMs) 

VCMs operate independently of government regulations, offering flexibility to businesses and individuals to offset emissions through the purchase of Voluntary Carbon Credits (VCCs). 

VCMs are incentive-based markets that allow individuals and entities to purchase VCCs to compensate for any residual or unavoidable carbon emissions on a voluntary basis. Strategies to avoid, reduce and substitute greenhouse gases (GHG) must come before offsetting, but there are emissions being produced that are unavoidable due to a lack of current technology and cost. Each credit represents one ton of CO2 (or equivalent GHG) reduced or removed that has been independently verified.

There are two schemes available to offset carbon emissions. The first being a reduction scheme, which aims to cut emissions by improving existing processes. The second being removal projects that aim to absorb greenhouse gasses from the atmosphere.

Key benefits of VCMs include: 

• Flexibility: Unlike MCMs, participation is optional, allowing companies to align offsets with their sustainability strategies. 

• Support for Global South: Many VCCs are generated from projects in emerging economies, driving sustainable development and funding initiatives like reforestation and renewable energy. 
  

Purchasing and Retiring Voluntary Carbon Credits (VCCs)

Introduction 

• VCCS represent one metric ton of CO2 or its equivalent reduced or removed from the atmosphere through verified projects.

  VCCs can be purchased directly from suppliers in registries, such as Verra, American Carbon Registry, Gold Standard. Alternatively, VCCs can be purchased through brokers or exchanges such as CBL and ACX. Buyers include corporations, airlines, and governments with emissions-reduction goals.
• The holder of a VCC must “retire” the credits in order to claim their associated GHG reductions towards a GHG reduction goal. VCCs can also be retired on behalf of third parties. Retirement occurs according to a process specified by each carbon offset program’s registry. Once an VCC is retired, it cannot be transferred or used (meaning it is effectively taken out of circulation).

Legal Nature of VCCs

• The legal characterization of VCCs differs across jurisdictions. Pending the development of a global standard, the legal nature of VCCs is a jurisdiction-specific question which is currently answered by reference to national laws.
• VCCs are considered commodities within the meaning of Section 1a(9) of the Commodity Exchange Act, 7 U.S.C. Section 1a(9). Transactions in VCCs are subject to the jurisdiction of the U.S. Commodity Futures Trading Commission (CFTC). The main goal of the CFTC is to promote transparency and liquidity by standardizing VCC derivative contracts.
• The CFTC has defined a VCC as a tradeable intangible instrument that is issued by a carbon crediting program. VCCs are designed to represent real reductions or removals of greenhouse gas emissions from the atmosphere, which market participants can trade on the voluntary carbon market and use in efforts to offset greenhouse emissions to meet emissions reduction goals. 

Challenges

1. Quality Concerns: The lack of standardization in methodologies has led to skepticism about the effectiveness of certain VCCs. 
2. Double Counting: Ensuring that a single credit is not claimed multiple times.
3. Price Volatility: VCMs lack the price stability seen in regulated markets, complicating planning for both buyers and sellers.
4. Varying rules and methodologies: This in addition to numerous registries and exchanges can make it difficult to navigate trading platforms to purchase and retire credits.
5. Legislative, Regulatory, and Policy Changes: The legislative and regulatory landscape for VCCs remains unsettled, with potential changes that could affect their financial, accounting, and tax treatment. Regulators may manage supply and demand through new or existing powers or implement measures like price caps, additional taxes, or benefit-sharing obligations. Any such changes must be reflected in the transaction documents, requiring parties to agree on risk allocation for these uncertainties.
6. Interface with International Frameworks: The relationship between the VCC market and international frameworks, such as nationally determined contributions and Article 6 of the Paris Agreement, is still evolving.  Additionally, cooperative approaches for benefit-sharing and global emissions mitigation are under development. Parties must address these frameworks in their transaction documents as the market matures.
7. Diligence: Unlike compliance emission certificates (e.g., EU Emission Allowances), VCCs are not fully fungible. Their value depends on the underlying project’s type, jurisdiction, and quality. Parties should conduct thorough due diligence on the projects generating the VCCs being sold or purchased.
8. Tax Considerations: The tax treatment of VCCs remains uncertain and varies by jurisdiction. Parties should analyze potential tax liabilities, including withholding tax, sales tax, and any jurisdiction-specific implications related to VCC transactions.