In depth

The rise of offsets and carbon markets

Carbon markets — which have arisen from the trade in carbon offsets — have been in existence for more than 20 years, and having advised on the earliest transactions, funds and drafting market reference contracts from their inception, we have seen them experience both growth and challenges. The first phase of carbon markets was triggered by the adoption of the Kyoto Protocol in 1997 — which put in place a framework for the international trade in project based offsets. We are now seeing a second phase, which has begun in response to the universal emissions reduction or limitation commitments of the Paris Agreement, and complementary commitments from the private sector to reduce their own emissions, often relying on offsets. The development of voluntary carbon markets — an important aspect of the transition to net zero — brings both opportunities and risks for private sector engagement. It is estimated that the market for carbon credits will scale significantly by 2030 and may be worth over USD 50 billion by 2050, a significant opportunity. But it will be critical to ensure the integrity of the carbon credits transacted in order to avoid or reduce the risks that come with such a large market. This will require infrastructure (contracts, registries, exchanges) that will support streamlined trading and improved liquidity, and governance and reporting frameworks that provide greater market transparency.

Growth of carbon markets

Carbon markets are developing in various jurisdictions at the global, regional, national, sub-national and voluntary levels, and are at differing levels of maturity. They also fall into two categories: “mandatory” markets where governments set requirements that compel certain entities to participate, and which often include a “cap” on the allowable amount of emissions, requiring those that exceed those limits to offset them through use of credits; and “voluntary” markets, which include trading to support the corporate commitments mentioned above. Article 6 of the Paris Agreement establishes a framework for parties to voluntarily cooperate to implement their Nationally Determined Contributions (NDCs) and pursue higher ambition. Among the key issues at COP26 will be whether parties can finalize detailed guidance and rules for Article 6 that would build upon the market frameworks developed under the Kyoto Protocol and lay the ground for a truly international system of carbon trading. Even in the absence of such a system, we are seeing strong growth in voluntary markets, and innovative types of offsets projects, including forests, mangroves, oceans, soils, and other methods. Some of these projects deliver what are known as “co-benefits”, meaning they may also support environmental, social and cultural benefits such as biodiversity, education and employment of local communities (particularly in disadvantaged areas), protection of indigenous land and culture as well as forest conservation and restoration of ecosystems such as rivers and streams. There is increasing interest in projects that deliver offsets alongside the UN’s Sustainable Development Goal outcomes. Over the past 15 years or so, several “standards” have been developed to verify carbon credits for use in the voluntary carbon market, for example, the Gold Standard and Verra’s Verified Carbon Standard. Given the importance of offsets to climate action, Mark Carney (UN Special Envoy for Climate Action and Finance. Advisor to UK Prime Minister Boris Johnson) also launched the Taskforce on Scaling Voluntary Carbon Markets as part of COP26. This initiative aligns with another key effort, known as the Champions Race to Zero.

Considerations for carbon market participants

Companies looking to participate in carbon markets and to offset greenhouse gas emissions will need to consider the best mode of engagement for their business and risk appetite.

This may include decisions about forward or “spot” purchases of offset units, engaging directly with projects or through intermediaries such as brokers and exchanges and even whether to invest directly in projects or project development companies. In each case, companies will need to undertake due diligence to understand and mitigate transaction risks (e.g., project, counterparty, market, legal and reputational risks).