Deconstructing the Legal Nature of Voluntary Carbon Credits

Voluntary carbon credits (VCCs) have emerged as a critical tool in the global fight against climate change. These credits, which represent one ton of carbon dioxide (or equivalent greenhouse gases) reduced or removed from the atmosphere, are traded on the voluntary carbon market (VCM) to help companies and individuals offset their emissions. However, the legal nature of VCCs remains a complex and evolving issue, with significant implications for their use, transfer, and regulation. This article explores the key factors impacting the legal nature of VCCs, the trade-offs involved, and the challenges of defining their legal status in a way that supports the growth and integrity of the VCM.

What Are Voluntary Carbon Credits?

Voluntary carbon credits are generated through climate mitigation projects, such as reforestation, renewable energy initiatives, or carbon capture and storage. These projects are verified by independent third-party organizations, such as Verra or Gold Standard, to ensure they meet specific environmental and social criteria. Once verified, the credits are issued, recorded in digital registries, and made available for purchase in voluntary carbon markets.

Unlike compliance carbon markets (CCMs), which are regulated by governments and involve mandatory emission reduction targets, the VCM operates on a voluntary basis. Companies and individuals buy VCCs to offset their emissions, meet sustainability goals, or make public statements about their commitment to climate action. However, the voluntary nature of these markets also introduces challenges, particularly around the legal definition and treatment of VCCs.

The Legal Nature of Voluntary Carbon Credits

The legal nature of VCCs is a central issue in their use and regulation. Currently, there is no global consensus on how VCCs should be classified under private law. Different jurisdictions treat them in various ways, leading to uncertainty and fragmentation in the market.

Bundle of Contractual Rights: Some jurisdictions consider VCCs as contractual rights arising from agreements between project developers, verification bodies, and buyers.

Intangible Property: Other jurisdictions view VCCs as intangible assets, similar to intellectual property or financial instruments. This classification would allow VCCs to be traded, transferred, and used as collateral more easily, but it requires clear legal frameworks to define and enforce these rights.

Digital Assets: Given that VCCs exist in digital form, some suggest they could be classified as a new category of digital assets. This approach aligns with the growing use of blockchain technology in carbon markets but raises questions about how to regulate and secure these assets.

Each of these characterizations has trade-offs. Treating VCCs as intangible property or digital assets could enhance market liquidity and facilitate their use in structured finance transactions. However, it also requires significant legal and regulatory development to ensure clarity and enforceability. On the other hand, treating VCCs as contractual rights may be simpler but limits their functionality and market potential.

Challenges in Defining the Legal Nature of VCCs

Defining the legal nature of VCCs is not just an academic exercise—it has real-world implications for their use and regulation. Some of the key challenges include:

Ownership and Transfer: Uncertainty about who owns VCCs and when ownership transfers can complicate transactions. For example, if a project developer goes bankrupt, it may be unclear whether the VCCs they generated can still be used or traded.

Secured Transactions: VCCs are increasingly used as collateral for financing climate projects. However, without clear legal frameworks, lenders may be hesitant to accept VCCs as security, limiting their utility in structured finance.

Cross-Border Trade: The lifecycle of VCCs often involves multiple jurisdictions, from project development to verification, issuance, and trading. Determining the applicable law and jurisdiction for disputes is a complex issue that requires harmonized principles.

Insolvency and Disputes: The treatment of VCCs in insolvency proceedings and dispute resolution mechanisms is another area of uncertainty. For example, if a registry holding VCCs goes bankrupt, it is unclear whether the credits would survive the insolvency.

The Role of International Collaboration

Given the global nature of carbon markets, international collaboration is essential to address these challenges. Organizations like UNIDROIT and UNCITRAL are working together to develop principles and guidelines for the legal treatment of VCCs. Their efforts aim to harmonize legal frameworks across jurisdictions, reduce uncertainty, and support the growth of voluntary carbon markets.

One key initiative is the UNCITRAL/UNIDROIT Joint Study, which explores the legal nature of VCCs and provides recommendations for addressing legal uncertainties in their cross-border trade. The study emphasizes the need for clear definitions, standardized registries, and harmonized principles for ownership, transfer, and secured transactions.

Balancing Trade-offs and Considering Impact

Balancing the trade-offs involved in defining the legal nature of VCCs requires careful consideration of their impact on market participants, including project developers, buyers, and regulators. For example:

Market Liquidity vs. Legal Certainty: Treating VCCs as intangible property or digital assets could enhance market liquidity but requires significant legal development to ensure certainty and enforceability.

Flexibility vs. Regulation: While voluntary markets thrive on flexibility, increased regulation may be necessary to address integrity concerns and ensure the credibility of VCCs.

Global Harmonization vs. Local Contexts: Harmonized principles can reduce fragmentation and support cross-border trade, but they must also respect the unique legal and regulatory contexts of different jurisdictions.

Ultimately, the goal is to create a legal framework that supports the growth and integrity of voluntary carbon markets while addressing the needs and concerns of all stakeholders.

Characterization of VCCs in the US

In the United States, a VCC is treated as a tradeable intangible property. There is no overarching federal regulation that addresses the legal nature of VCCs. However, VCCs are considered commodities within the meaning of the Commodity Exchange Act which means they 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.

Definition of a VCC

The CFTC defines a VCC as follows:

“A VCC is 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. One VCC typically represents greenhouse gas emissions reduced by, or removed from, the atmosphere equivalent to one metric ton of carbon dioxide.

Like other carbon credits, VCCs are commodities traded in both spot and derivatives markets. VCs are available for sale and trading in spot voluntary carbon markets, over the counter, and on spot trading platforms. In the spot market, market participants such as project developers can trade credits with a wide range of other market participants such as end users and intermediaries such as brokers. In the derivatives markets, market participants may trade derivatives such as VCC futures, and such derivatives may provide reference prices for spot and other derivative trades.”

Carbon credits, such as VCCs, are encompassed in the definition of “commodity” in Section 1a(9) of the Commodity Exchange Act, 7 U.S.C. Section 1a(9) (see words highlighted in bold below):

The term “commodity” means wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice, and all other goods and articles, except onions […], and all services, rights, and interests […] in which contracts for future delivery are presently or in the future dealt in.

Transactions in VCCs

Characterization of a VCC itself is distinct from the characterization of a transaction in VCCs, including from a regulatory perspective. The status of an asset is a separate consideration from the status of a transaction in that asset.

An important factor in determining the regulatory characterization of a transaction is the timing of settlement. Longer settlement times may in certain circumstances be a factor indicating that the transaction is a regulated instrument (such as a derivative), even if the underlying asset is not.

In the U.S., Title VII of the Dodd-Frank Act provides the CFTC with regulatory authority over non-security-based swaps, the Securities and Exchange Commission has regulatory authority over security-based swaps, and the two agencies have joint authority over mixed swaps.

VCCs as non-security-based swaps

If VCCs are traded as the underlying commodity component of a derivatives transaction, then it is likely to be deemed a non-security-based swap. If that is the case, then there are various levels of oversight depending on whether it is traded on a designated contract market (DCM) or is executed bilaterally between eligible contract participants. Futures contracts traded on a DCM are subject to DCM oversight such as trade practice surveillance and enforcement actions. In contrast, bilateral derivatives may potentially be subject to the CFTC's trading clearing and reporting regulations, as well as mandatory margin rules.

In broad terms, commodity derivatives transactions can be separated into two major categories:

• over-the-counter (OTC) commodity derivatives transactions; and
• exchange-traded commodity derivatives

OTC commodity-derivatives transactions are bilateral transactions between parties that are intended to meet each party’s specific risk and financial management strategies. These transactions allow the parties to negotiate the exact terms of an agreement and are characteristic of VCM transactions. OTC commodity derivatives transactions are especially useful to commodity producers (such as CDR suppliers), because they allow producers to hedge all or some of their expected production further into the future than may be practical with exchange-traded commodity derivatives transactions. This allows the parties to structure a hedge that is highly correlated to the volatility of their market and their business model.

By contrast, exchange-traded commodity derivatives transactions are standardized one-size-fits-all transactions that require the parties to implement hedging strategies based on a narrow range of contract terms.

Physically settled commodity derivatives transactions

Both OTC and exchange-traded commodity derivatives can be either cash-settled or physically settled.

Physically settled commodity derivatives transactions involve the actual purchase and sale of physical commodities (VCCs) at an agreed later date. The contract must specify that the underlying commodity is to be sold on a specified date in the future for a fixed price. These contracts are also referred to as commodity forward contracts. They require the actual delivery of a specified quantity of a particular commodity (VCC) on a specified date. The parties may negotiate and customize all aspects of an OTC commodity derivatives transaction. This gives them control over the structure of the hedging transaction, the exact quantity of the commodity to be hedged, and the remedies available to the parties in the event of a default.

The future acquisition of VCCs on the VCM is usually physically settled commodity derivatives transactions. By contrast, cash-settled derivatives transactions result only in payment obligations between the parties and do not involve the purchase or sale of the underlying commodity.

General mandate of the CFTC

Although the CFTC lacks direct authority to regulate the voluntary carbon market (VCM), it can use its powers over the exchanges regulated by the CFTC to impose certain standards indirectly. The CFTC has been working to establish standards for the VCM, despite its limited legal authority. By requiring exchanges to conduct due diligence on crediting programs and verification providers, the CFTC is adding a layer of accountability to the VCM.

Some VCC futures contracts, which allow for physical delivery of these credits at settlement, are actively traded on CFTC-regulated exchanges (such as DCMs). The prices of these contracts are tied to the spot price of VCCs that meet specific criteria.

On September 19, 2024, the CFTC published its Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts (Final Guidance) to CFTC-regulated exchanges responding to common concerns and public comments about the quality of the VCM. It outlines several factors DCMs must consider when designing and listing VCC derivative products. However, it does not require exchanges to verify the quality of the underlying VCCs themselves. Instead, the Final Guidance sets out expectations for how exchanges should assess whether third-party verification and crediting programs meet the CFTC’s core principles for listing futures contracts.

Key points from the Final Guidance

The Final Guidance emphasizes several factors that CFTC-regulated exchanges should consider when complying with the Commodity Exchange Act and CFTC regulations, particularly regarding VCCs:

1. Transparency: Exchanges should clearly disclose which crediting programs and project types support the VCC derivatives. It is important that VCCs accurately represent the greenhouse gas reductions or removals they claim to.
2. Additionality: Although the CFTC deliberately did not define "additionality", it recognized it as a key characteristic of high-quality Exchanges should ensure that the crediting programs assess additionality effectively.
3. Permanence and Risk of Reversal: The CFTC advises exchanges to consider whether the crediting program has safeguards to prevent the reversal of carbon reductions (g., through a buffer reserve).
4. Robust Quantification: Credit programs must use conservative and transparent methods to quantify greenhouse gas reductions for VCC derivatives, and exchanges need to adopt limits on speculative positions.
5. Governance: The governance structure of the crediting program should ensure transparency, independence, and accountability. Exchanges should evaluate the decision-making and risk-management procedures of these programs.
6. Tracking: Exchanges should ensure that crediting programs have systems in place to track the creation, transfer, and retirement of VCCs, ensuring each credit represents a unique and verified emissions reduction.
7. Prevention of Double-Counting: Exchanges need to ensure that credits are not double-
8. Third-Party Validation and Monitoring: Exchanges should ensure that third-party validation and monitoring systems are in place for VCCs, with robust procedures to verify compliance with quality standards.

The CFTC emphasizes that exchanges must monitor their VCC derivatives’ terms and conditions, ensuring they align with these factors through compliance and enforcement practices.

Conclusion

The legal nature of voluntary carbon credits is a complex and evolving issue with significant implications for their use, transfer, and regulation. While there is no one-size-fits-all solution, international collaboration and harmonized principles can help address the challenges and trade-offs involved. By clarifying the legal status of VCCs, we can unlock their full potential as a tool for climate action and support the transition to a low-carbon economy.

As the voluntary carbon market continues to grow, it is essential to consider the impact of legal decisions on market participants and the broader goal of reducing global emissions. With the right legal frameworks in place, VCCs can play a vital role in achieving our climate goals and creating a more sustainable future.