Carbon offsetting: What businesses need to know
17th October 2022
Carbon offsets/carbon credits explained
Carbon offsetting is the use of ‘carbon offsets’, or ‘carbon credits’, to counterbalance greenhouse gas (GHG) emissions generated elsewhere. Organisations increasingly use carbon offsets as part of their sustainability and carbon reduction strategies.
A carbon credit is a tradable certificate (which should be certified by a regulatory or other competent independent body) representing the removal of one metric tonne of carbon dioxide (or equivalent amount of other GHG) from the atmosphere. Carbon credits can be used to claim emissions reduction. Once used it should be ‘retired’ and taken off the market so that it cannot be traded and re-used, to avoid double counting. Investment into carbon offsets can take place via regulated trading schemes, such as the UK Emissions Trading Scheme (ETS) [1], or within voluntary, unregulated offset markets. Within each, the purchase of a credit allows capital to flow into carbon avoidance, reduction and offsetting projects. These include, for example, tree planting; carbon capture, use and storage; renewable energy; regenerative farming; and methane capture from agricultural waste or landfill gas.
Carbon Hierarchy
Strategies to avoid, reduce and substitute greenhouse gases should come before carbon offsetting. However, once a business has avoided and reduced its carbon emissions as much as possible, it will need to offset its remaining emissions, to achieve carbon neutrality. This is referred to as the carbon hierarchy.
Voluntary carbon offset markets versus regulated emissions trading schemes
Carbon offset markets operate within both voluntary and mandatory (compliance) schemes:
- Voluntary markets function outside of compliance schemes (as carbon credits under voluntary schemes can’t be used to meet regulatory compliance obligations). This enables entities to purchase carbon offsets on a discretionary basis without the need for regulatory compliance. Credits can be used to support voluntary claims, such as the emission reduction pledges, targets and projects which make up companies’ Net Zero pathways.
- In compliance markets, participants buy credits that can be used to meet obligations to reduce emissions under international schemes such as member states’ commitments under the Paris Agreement, or national schemes such as the ETS.
As demand for compliance carbon credits is driven by regulatory obligations, their prices tend to be higher than offset credits traded on the voluntary market. It is estimated that a voluntary carbon offset market may be worth $50bn by 2030. However, as oversight of these markets is limited and fragmented, there are concerns that some credits may amount to little more than greenwashing. So, to legitimately lower overall global emissions, companies’ environmental integrity needs to be credible and verifiable.
A number of recent initiatives establish procedures and benchmarks to address these concerns [2]. The aims are to inject greater transparency into carbon offset use, and to ensure that carbon credit projects lead to a measurable reduction in global emissions.
Risks associated with carbon offsetting
The thinking behind carbon offsetting is laudable, but businesses should be alive to certain risks.
- Integrity and Quality
Banks and regulators have expressed growing concern about the integrity of offsets, as it can be difficult to verify the true nature of projects being funded [3].
Without systematic regulation, information gaps may exist in voluntary carbon markets. That can result in a lack of understanding of nuances in how projects work, their exact environmental impact, and the context in which they operate. This could cause financial and reputational damage for funders, companies investing in carbon credit and those not managing projects appropriately. It could, of course, also reduce progress on legitimate carbon removal.
- Additionality
Some carbon offsetting projects have been accused of not possessing ‘additionality’. That means they would have occurred as a carbon-reducing activity in any event [4]. The issue of additionality can call into question the utility of carbon offsetting at its root.
- Permanence
Many carbon offsetting projects revolve around capturing carbon biologically in natural habitats such as tree planting and peatland restoration. However, this only retains carbon for a period of time, whereas the burning of fossil fuels releases carbon from what is essentially a permanent carbon store. Efficacy assessments of certain carbon offsetting projects should therefore take into account the temporary biological capture of carbon versus its permanent release when burning fossil fuels.
Tree planting schemes often receive two other main criticisms: (1) Reforestation schemes have been known to plant fast-growing invasive species, reducing diversity and leading to monoculture plantations which can disrupt natural ecosystems. (2) Reforestation carbon offsets are forward-sold on the basis of the future carbon capture potential of a planted tree, not the offsets already made, which decreases the accuracy and undermines the validity of the offset credit promised.
Carbon credits and opportunities for business’ journey to Net Zero
- The need for ‘negative emissions’
Addressing emissions can be prohibitively expensive for some businesses. Other businesses cannot eliminate certain sources of emissions at all. (For example, the process of calcination in the production of cement at industrial scale is unavoidable and accounts for a large share of the cement sector’s carbon emissions.) Where these limitations result in an emissions reduction pathway that effectively requires ‘negative emissions, carbon offsetting can be the only workable mechanism through which some businesses can move towards Net Zero.
- Increased regulation
The international community made progress at COP26 towards bolstering the integrity of carbon offsetting with the Paris Rulebook, which implements mandates for carbon markets. When successfully implemented, those new rules and procedures should enable carbon credits to deliver on their potential to reduce global emissions, encourage companies to invest in these instruments as part of their Net Zero pathway, and provide important opportunities for investors to finance credit-generating projects.
Initiatives such as the Integrity Council for Voluntary Carbon Markets (IC-VCM) will also help carbon markets scale, without compromising carbon credit quality, through the development of the Core Carbon Principles (CCPs). The Voluntary Carbon Markets Integrity Initiative (VCMI), a multi-stakeholder platform whose goal is to improve governance on voluntary carbon markets by developing better guidance on the claims made about projects, will operate alongside the IC-VCM.
Introducing regulation into both compliance and voluntary carbon markets should help to define quality requirements and, in turn, to enhance the integrity of carbon offsets.
- Additional benefits
Voluntary carbon credits direct private funding to climate-action projects that would not otherwise become viable. These projects can have supplementary benefits that non-exhaustively include biodiversity protection, pollution prevention, public-health improvements, and job creation.
Carbon credits also encourage investment into the innovation required to lower the cost of novel climate technologies.
Scaled-up voluntary carbon markets could also facilitate the mobilisation of capital from the Global North to developing countries, where there is significant potential for economical, nature-positive, emissions-reducing projects.
How we can help businesses with carbon offsetting and Net Zero/ESG strategies
The growing demand for carbon offsetting calls for a market that is transparent, verifiable, and environmentally robust. Today’s market is fragmented and complex, but significant regulatory strides are being made to help organisations locate, and invest in, trustworthy sources of carbon credits.
Walker Morris is a multi-disciplinary commercial law firm, with specialist lawyers experienced in helping businesses achieve their Net Zero targets, as well as all other aspects of the ESG (environmental, social, governance) agenda. Our experts can provide advice in relation to ensuring compliance with the evolving carbon offsetting regulatory regime, and in respect of developing measurable adaptation strategies to further opportunities in the climate change arena.
Please contact Ben Sheppard, or any member of the Infrastructure & Energy, team for targeted, strategic advice on carbon offset markets and how to navigate existing and emerging regulation and initiatives, or for assistance with clean energy or carbon reduction projects.
[1] The ETS is a cap-and-trade system applicable to participants selected based on sector and carbon intensity. It caps the total level of greenhouse gas emissions, creating a carbon market with a carbon price signal to incentivise decarbonisation.
[2] Task Force on Scaling Voluntary Carbon Markets; UK Voluntary Carbon Markets Forum; Voluntary Carbon Markets Integrity Initiative; Integrity Council for Voluntary Carbon Markets; Agreement at COP26 on the Paris Rulebook
[3] For example, a study of forest offsets under California’s cap-and-trade programme found that almost 30 per cent of projects were credited with greater emission savings than they really achieved
[4] For example, recent research into the Clean Development Mechanism (which enabled carbon trading under the Kyoto Protocol) found most Indian wind farms financed with credits would likely have been built anyway
