Author: Aurelia Britsch
The outlook for voluntary credit markets looks positive over the long-term, but this year, they are facing a credibility test, says Aurelia Britsch, Senior Director, Head of Climate Research, Sustainable Fitch.
Voluntary carbon markets (VCMs) are likely to grow significantly in the coming years, in both volume and value terms. VCMs exist alongside a growing number of mandatory carbon markets in such areas as the EU, the UK, China and some US states. VCMs allow carbon emitters to offset their ‘unavoidable’ emissions by purchasing carbon credits created by projects aiming to remove greenhouse gasses (GHGs) from the atmosphere through forestry, land use and carbon storage, or reduce emissions from energy and industry. They remain an important part of climate finance, compensating for residual emissions from hard-to-abate sectors via carbon removals. They also incentivise investment in emissions-reductions technologies. Additionally, nature-based solutions (NBS) also allow to protect nature and biodiversity, at a time when investors are increasingly focusing on them.
In spite of this relatively rosy longer-term outlook, VCMs are facing a credibility test in 2023. The quality of many, perhaps most, carbon credits have been called into question, with a notable increase in criticism from both the media and industry participants over issues such as lack of quality control or additionality and leakage. The multiplication of standards, marketplaces and new services around VCMs are adding confusion to an already opaque market, which could erode confidence in those markets until best practices are well established.
Meanwhile, a key trend of 2023 and beyond is the detailed examination from investors and regulators of carbon accounting practices, net zero claims, and credible transition plans, and increased efforts from authorities to tackle greenwashing. Deeper scrutiny from developed market authorities on greenwashing means regulators will look more closely into offsetting practices and green marketing claims, which have proliferated in recent years. This has been particularly the case among consumer products, which have often used vague concepts, such as ‘carbon neutral’, ‘climate neutral’ or ‘100% CO2 compensated’, in their promotions.
As a result, corporations may remain cautious over offsetting in the near term. Companies that wish to make credible efforts towards their net zero commitments are likely to reconsider or reduce their reliance on offsets and will need to focus to a greater extent on actual emission reduction within their operations and supply chains. This is likely to require larger investment than buying offsets. Those that continue to rely on low priced offsets risk a reputational backlash, and potential litigation as regulators increase their efforts to stymie greenwashing in 2023.
The unregulated nature of VCMs hinder greater take-up of them, as it compromises their credibility and use case for buyers. As such, state- or industry-imposed governance will probably rise for VCMs. Some progress was made at COP 27 over Article 6, which aims to set up a UN-administered system of carbon trading between countries and companies. However, some key questions remain on how this will affect VCMs.
Meanwhile, attempts to establish standards are making slow but steady progress, and should standardise VCMs and give them credibility in the long run. The two main emerging carbon market governance initiatives are the Voluntary Carbon Markets Integrity Initiative (VCMI), created to guide the credible use of offsets on the demand-buyer side; and the Integrity Council for the Voluntary Carbon Market (ICVCM) on the supply side, to ensure the integrity of the projects.
In the longer term, demand for carbon credits is likely to rise significantly, driven by the multiplication of companies’ net zero targets and the actual implementation of transition plans to reduce emissions. To be sure, a credible transition plan will require first and foremost to reduce absolute emissions, and to rely on carbon credits to offset residual emissions only.
Although there is no established limit on how much a company could rely on offsets versus actual emission reduction, the Science Based Targets initiative (SBTi), which approves corporate net zero targets, said offsets could only be used to compensate for a small portion of residual emissions that cannot be eliminated in the long term. As a result, while the reliance of individual companies on offsets may be capped, the sheer number of companies that will need to offset part of their emissions mean carbon credit demand will be strong in the long term.
Value wise, voluntary carbon credit prices are likely to rise significantly in the coming decades, along with compulsory market prices. Nature-based credits (which can entail emission avoidance or removal), carbon removal credits (an afforestation project, or a carbon capture and storage project via direct air capture for example), and credits with co-benefits will attract higher prices. Those attributes sometimes overlap, for example, in the case of some afforestation projects, which are NBS removing carbon from the atmosphere and sometimes contribute to local communities. Newer vintage credits will also gain more attention, as they tend to better follow best practice standards than older vintage credits. This is likely to increase the investment needed by corporates to offset their residual emissions.
Aurelia Britsch is Senior Director, Head of Climate Research, Sustainable Fitch