(Bloomberg) -- What, exactly, is a carbon credit?
That’s a question that decades after the first project was launched in Guatemala in 1988 still has some of the smartest legal minds scratching their heads.
In theory, a carbon credit is a certificate representing a one-ton drop in greenhouse gas emissions tied to projects such as a wind farm or a tree-planting scheme. They’re bought by companies to compensate for the pollution they produce somewhere else in the world.
But, when it comes to the laws that underpin financial markets, the answer to that question isn’t yet clear. Until it’s solved, banks and investors are unlikely to allocate anywhere near the billions of dollars that proponents expect to flow to carbon credits — contrary to the enthusiasm on show at Climate Week in New York this week.
“The vast majority of countries don’t currently have a clear answer to the question of what is a carbon credit, as a matter of law,” said Simon Puleston Jones, managing director of Emral Carbon, a brokerage and advisory firm, and former capital markets lawyer at law firm Simmons & Simmons. That “matters because if you’ve bought something from me and are suffering an economic loss, your loss might not be recoverable,” he said.
The World Bank and the International Institute for the Unification of Private Law (Unidroit), an intergovernmental organization, are working on a set of principles to help guide governments globally on the question.
The main deliberation focuses on whether a carbon credit is an asset, according to Belinda Ellington, a member of the Unidroit working group and former associate general counsel at Citigroup Inc. in London.
“Carbon credits don’t fit neatly into any jurisdiction’s current interpretation of the definition of an asset,” Ellington said. “If you’ve bought something that has no legal identity as an asset, the effect is you cannot be certain you own anything.”
In the UK, the Law Commission of England and Wales recently concluded that carbon credits “might” be considered digital assets, a new, third type of property. (The two other types of property under English law are tangible things in possession, like a pen or a house, and intangible things in action, like a contract.)
But for Puleston Jones, the commission’s failure to be decisive over a legal definition means “we’re no further down the line of understanding what a carbon credit is” and the matter will now be decided by the courts over decades. “It’s a wasted opportunity,” he said.
The collapse of Mt Gox, once the world’s biggest Bitcoin exchange, illustrates what’s at stake, Puleston Jones said. About a decade ago, the Japanese exchange was hacked and went bankrupt. Tokyo’s district court ruled Bitcoin wasn’t property in legal terms, meaning the people who lost Bitcoin had no rights to recover it, he said. Bitcoin creditors have been waiting 10 years to recover their assets in a distribution process that’s only recently kicked into action.
Like Bitcoin, the voluntary carbon market has been plagued by volatility. Having peaked in 2022, the market shrunk by almost a quarter last year to just $1 billion after a string of greenwashing scandals spooked buyers and cut demand.
Advocates see the market as a critical mechanism to help channel billions of dollars to projects that cut emissions in poorer countries, and to enable companies to compensate for pollution in their supply chains, which may be outside their direct control. From quality labels to new guidance on what claims companies buying offsets can make, efforts are underway to recover demand and help the market scale. The US and other governments have also thrown their support behind the market.
For lawyers, however, those efforts will be in vain unless the legal uncertainty is addressed.
“Currently, if you were to put a million dollars into the pre-purchase of verified carbon units, the net effect of that on your balance sheet is you’ve just got an unsecured million dollars out the door,” Ellington said. “Unsecured debt raises the costs of funding beyond the market tolerance.”
“It’s a big constraint for any bank,” said Chris Leeds, head of carbon markets development at Standard Chartered Plc. “As the market grows, we will need to see ways of effectively transferring risk and getting a better capital treatment otherwise it just doesn’t make sense financially.”
That hasn’t stopped Standard Chartered and other big banks from trying to establish a foothold in the market. JPMorgan Chase & Co., Bank of America Corp. and Barclays Plc have built out carbon trading and finance desks.
Citigroup is exploring how offsets could be used to reduce the risk of financing green projects in developing countries. Goldman Sachs Group Inc. has set up a fund that allows companies to invest in green projects and generate returns from offsets.
But ultimately, the goal remains scale, Puleston Jones said.
“We want carbon markets to become as tradable as equities markets or derivatives markets or debt markets or commodities markets,” he said. That requires “trust, certainty and integrity.”
Listen on Zero: How Carbon Offsets Went Wrong
©2024 Bloomberg L.P.
