Advocates say carbon credits are ready for prime time. Lawyers say they need a legal definition to become an asset as tradable as stocks and bonds.
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.
The carbon credit market is facing a major hurdle: the lack of a clear legal definition for what exactly a carbon credit is. Despite its potential to help fund critical climate initiatives and reduce emissions, legal uncertainties are preventing banks and investors from fully committing to the market.
A carbon credit is meant to represent a reduction of one ton of greenhouse gas emissions, often linked to projects like renewable energy or reforestation. Companies purchase these credits to offset their own emissions. However, without a standardized legal framework defining carbon credits as assets, financial institutions remain hesitant to invest billions into the market.
Legal status
“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.)
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.
“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.”
While big banks like Standard Chartered, JPMorgan, and Goldman Sachs are actively exploring ways to engage with carbon markets, they remain cautious. The market itself has experienced volatility, shrinking by 25% in 2023 after greenwashing scandals dented demand.
Despite the growing importance of carbon markets as a tool for addressing global emissions, their future hinges on resolving these legal uncertainties and establishing trust, integrity, and certainty within the financial system. Without these, carbon credits will struggle to become as widely tradable and reliable as stocks, bonds, or other commodities.
Source: Bloomberg
