Understanding compliance and voluntary carbon markets: A guide for sustainability leaders

An introduction to compliance and voluntary carbon markets

Carbon markets are systems where people – usually organisations – can buy and sell carbon credits. A carbon credit is a certificate that represents one tonne of carbon dioxide equivalent.

Today when discussing carbon markets, we do so in two main categories: compliance carbon markets and the voluntary carbon market.
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Compliance carbon markets

These systems are created based on national, regional and/or international policies or regulations.

In compliance-based carbon markets, governments or regulatory bodies set limits on the total amount of greenhouse gas (GHG) emissions that certain industries or businesses can emit. These schemes are usually called emission trading schemes (ETSs).

Emissions trading schemes typically fall into two main categories: cap-and-trade schemes and baseline-and-credit schemes.
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• Under cap-and-trade schemes (such as the European Union ETS) a hard cap is set on the total volume of GHG by all emitters captured in the scheme. Within this cap, companies buy or receive emissions allowances which they can trade between themselves, or the market, as needed. The cap is reduced over time.
  
  The allowances (or carbon credits) under the EU-ETS are known as the European Union Allowance (EUA).
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• Under baseline-and-credit schemes (such as Australia’s Safeguard Mechanism legislation) high-emitting companies identified by the government must keep their emission below their individual government-set baselines. Baseline-and-credit schemes also set an aggregate cap on emissions, and this is how individual baselines are then set.
  
  If a company emits less than its baseline, it may be able to create carbon credits it can then sell to other regulated entities. In the Australian example these are called Safeguard Mechanism Credits (SMCs).
  
  If a company emits more than its baseline, it must purchase additional carbon credits of the relevant scheme. In Australia, this can be from other safeguard mechanism entities (in the form of SMCs) or from projects that deliver carbon removal or avoidance and have been accredited to produce Australian Carbon Credit Units (ACCUs*).
  
  *ACCUs are one of the few compliance carbon credits that may also be used for voluntary purposes, adding additional complexity to the supply/demand balance of the market.
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Voluntary carbon market

As more and more organisations and individuals want to help repair the climate, they’re looking to offset emissions they can’t reduce, or to invest in nature because it is the right thing to do – and not because they are legally required to do so.

This is driving the ongoing growth in the international voluntary carbon market.

The voluntary carbon market is a system, and its associated schemes or standards, that enables the buying and selling of carbon credits on a voluntary basis. Carbon credits are created by carbon projects which are initiatives designed to avoid emissions or to remove carbon from the atmosphere.

To help manage the growing number of carbon projects, and the carbon credits they produce, a number of voluntary certification and accreditation bodies have been created.

These include standards and registries that govern the issuance of carbon credits units by certified projects, such as the Verified Carbon Standard, the Gold Standard and the Clean Development Mechanism.

These standards can also apply to be endorsed by the International Carbon Reduction and Offset Alliance (ICROA) as a signal of good governance, open access and robust validation and verification of carbon projects.

It is difficult to precisely calculate the size of the market, however most analysts agree that it will only grow in size and importance. By one estimate the voluntary carbon market reached approximately US$2billion in 2021, four times its 2020 value.  It is expected to reach US$10 - $40 billion by 2030.

As such, regulatory bodies and verification agencies are accelerating their efforts to continuously improve the integrity and liquidity of the market.  A recent example of this is the Integrity Council for the Voluntary Carbon Market’s (ICVCM) release of a global benchmark for carbon credit quality (called the Core Carbon Principles).

These critically important frameworks are welcomed by both buy and sell side market participants, and they will continue to grow and evolve in line with the market.

The creation of carbon credits in the voluntary carbon market

While compliance carbon credit units are controlled by government policy (i.e. it determines emissions caps or baselines set, and how compliance credits are created), there is a growing number of carbon credits created and traded on the voluntary carbon market.

Let’s take a look at the different types of carbon projects and credits in the voluntary carbon market, and how they are created.

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Different types of carbon projects and credits in the voluntary carbon market

Carbon credits in the voluntary carbon market are broadly classified as carbon avoidance credits and carbon removal credits, delivered through either nature-based projects or technology-based projects. Please see the table below.

Nature-based carbon removal projects often attract a price premium because they are often viewed as higher impact, both in terms of greenhouse emissions and other forms of nature repair, such as biodiversity. We discuss this in more detail further in the guide.

How projects are created in the voluntary carbon market

Carbon projects and the carbon credits they produce are created by carbon project developers.

In nature-based projects, project developers can be the landowners, but most often they are organisations that coordinate the project on behalf of landowners and/or local communities.

In technology-based projects they are usually organisations that invest in building the infrastructure or technology that will deliver the carbon avoidance or removal, or that partner with local communities.  

Project developers structure the project, determine the best standard for accreditation, and coordinate the process of accreditation and creation of carbon credits.

While each project is different in terms of impact, budget and crediting period, the lifecycle of a carbon unit on the voluntary carbon market usually looks like this:
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*Please note that the steps below - particularly steps 1 and 2 - have been simplified to provide a high-level introduction only.
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1. Project design and validation *
   The first decision a carbon project developer makes is on the type and scope of the project. This may be based on the developer’s specific skillset, the needs of the community they are representing or the commercial opportunity.
   
   This initial step includes selecting a suitable carbon credit accreditation scheme and submitting the project design for validation under the scheme.
   
   For example, a reforestation project may have the option to be accredited by the Verified Carbon Standard (VCS) initiative or the Gold Standard. If the project is in Australia, the developer may be eligible to have the project accredited by the Clean Energy Regulator and produce ACCUs, which can be bought for compliance or voluntary purposes.
   
   Each standard has its own set of methodologies, rules and requirements for project validation and verification. Another factor to consider is the demand for carbon units of different types and accreditations. Demand can vary quite significantly between unit types and therefore attract different prices.
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2. Project creation and verification *
   Once the organisation that governs the chosen standard validates the project design and the expected emissions reductions or removals, the project is then implemented.
   
   When complete, the verification process of assessing project impact begins. This assessment is managed by the standard organisation once the project has been implemented, and then periodically throughout the life of the project.
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3. Issuance of carbon credits
   Once the project is validated, created and verified, the regulatory body behind each standard will start issuing carbon credits to the project developer.
   
   To use the examples from above, the VCS standard issues Verified Carbon Units (VCUs), the Gold Standard issues Certified Emissions Reductions (GS CERs) and Verified Emissions Reductions (GS VERs), and the Australian Clean Energy Regulator issues Australian Carbon Credit Units (ACCUs).
   
   These credits are then available for purchase by organisations looking to offset excess emissions, invest in nature repair, or (in the case of ACCUs) to also meet regulatory obligations.
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4. Purchase of carbon credits
   The standards organisations operate registries to track all credits issued, transferred and retired in the voluntary carbon market.
   
   Organisations can purchase carbon credits through several different channels, including directly from the project developers, through consultants or brokers or through marketplaces and exchanges. We discuss this in more detail in the next section.
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5. Using (or retiring) carbon credits
   Carbon credits purchased by an organisation can then be used to support its climate goals.
   
   In the voluntary carbon market this may be to offset excess, hard-to-reduce emissions or as a means of financially supporting nature repair while emission reduction efforts are still underway.
   
   Any carbon units used to make these claims are surrendered or ‘retired’, ensuring that they cannot be used in the future by other organisations.

How to find carbon credits that meet your values and sustainability goals

Selecting the right carbon projects is a critical process for corporate sustainability teams. The team needs to ensure that the investment is having a positive impact, that it's meeting the expectations of customers, investors and other stakeholders, and that it's done in a way that maintains trust and credibility.

The stakes are high at a time of growing urgency for meaningful climate action, and when public awareness and scrutiny of carbon projects is at an all-time high. Here are some key things to consider.
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Ensure alignment with your strategy

It is important that the carbon procurement process is aligned to the objectives of your overall net zero strategy and the values of your organisation.

If you're not sure where to start, or need assistance in a process that's already underway, a consultant that understands the corporate decarbonisation journey and carbon markets can help you:

• Define and document your net zero strategy,
• prioritise your emission reduction initiatives,
• formulate your short and long-term carbon procurement plan, and
• manage the selection, due diligence and purchase of aligned carbon credits.

Part of the initial strategy process is the selection of the right certification or accreditation framework to help guide your climate journey. Organisations such as the Science Based Target initiative (SBTi) or Climate Active often provide guidance on preferred carbon credit types.

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Understand carbon project specifications

Corporate focus on project quality sends powerful demand signals to the market.  As such, transparency into carbon project specifications is also evolving quickly, helping to make the selection process a little easier.

When carbon credits are created, project developers are obliged to provide details about the plan and output of these projects, as well as monitoring reports that compare actual impacts against predicted impacts.    

Carbon project developers will also typically publish the following data about each project. These can be used as markers of quality that, together, help guide the due diligence process.
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• Accreditation
  Accreditation for carbon credits is managed by independent standards organisations. Each project developer must choose the standard that best meets their project specification and business plan. The most recognised standard bodies in the voluntary carbon market include the Verified Carbon Standard (VCS) and the Gold Standard.
  
  Projects verified and validated under well-known and recognised standards such as the VCS or Gold Standard usually attract a price premium.
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• Project type
  There are two main types of carbon projects, carbon avoidance and carbon removal projects.
  
  Carbon avoidance projects aim to reduce emission by preventing them from being released in the first place. While carbon removal projects focus on removing GHG that have already been emitted. More on that in the table above.
  
  Carbon credits from projects that remove carbon from the air are often considered to have a higher impact that those that simply avoid emissions. This however is only one of the indicators of project quality, and both types of credits have an important role to play.
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• Project method
  ‍Carbon projects can be created around a variety of different methods. This includes nature-based methods (such as reforestation, afforestation, ecosystem repair or savanna burning) and technology-based methods (such as solar farms or direct air carbon capture). More on that in Table 1 above.
  
  A project method that is getting a lot of attention currently is the protection or restoration of marine or coastal ecosystems (dubbed ‘blue carbon’). These ecosystems include seagrass, mangroves and saltmarshes, and can store more carbon per area than land-based forests.
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• Co-benefits
  A growing number of projects are focused on delivering additional positive impact, beyond the removal or avoidance of carbon emissions. These outcomes are called co-benefits, such as positive social, economic or biodiversity impact.
  
  Co-benefits are usually defined in terms of the 17 United Nations Sustainable Development Goals. Examples include creating employment, education and training opportunities for people local communities, ensuring clean water and sanitation, and/or promoting gender equality.
  
  Organisations are increasingly choosing to support projects with very specific co-benefits that are closely aligned with their brand values and priorities. As such, projects with co-benefits often attract a price premium.
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• Location
  Climate change is a global problem which requires a global solution. Projects that operate in less developed countries, are often able to create a bigger impact for the local community by creating employment, education and training opportunities for people working in these areas.
  
  Some organisations choose to support projects in certain locations in line with their business priorities and values.
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• Crediting period (vintage years)
  The vintage of a carbon credit refers to the year that it was issued. Carbon credits with older vintages sometimes raise some concerns amongst buyers. An older vintage could indicate the project originally had difficulty selling its credits.
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• Independent quality signals (rating agencies)
  Rating agencies have emerged to help provide market intelligence on the voluntary carbon market. Their role is to help buyers conduct due diligence on their carbon credit purchases and to help grow trust in the market. Each rating agencies uses its own methods to assess projects and issue project ratings.
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As discussed earlier, carbon markets exist in both compliance and voluntary schemes. Compliance carbon markets are created and regulated by mandatory carbon reduction regimes in certain countries, whereas the voluntary carbon market enables companies to purchase carbon credits on a voluntary basis.

In certain cases, non-regulated entities may buy compliance market credits to meet their voluntary sustainability goals. An example of this is the Australian Carbon Credit Unit (ACCU) which can be traded both on the compliance and voluntary carbon market.   

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Did you know?

There are tools available today that let you find and filter on the project detail to help make project selection easier. It makes sense if these tools are integrated into a broader climate management system so you can manage your net zero program in one place.

Different ways of buying carbon credits in compliance and voluntary carbon markets

The purchase of carbon credits for both compliance and voluntary purposes usually takes place in the primary or secondary market.  

Put simply, the primary market or direct investment refers to the purchase of credits directly from the project that creates them.

The secondary market, on the other hand, refers to the trade of credits between buyers and sellers after their initial sale in the primary market. These may be excess units that an organisation holds, or units that were originally purchased as an investment vehicle.

Let’s take a look a closer look at the main ways to purchase carbon credits:
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• Directly from a project developer (primary market)
  Buyers can purchase carbon credits directly from projects that generate them, such as renewable energy projects, forestry projects, or other carbon removal or avoidance initiatives. Doing so enables you to get closer to the source (you may even be able to visit the project!) but it is not necessarily more cost effective as individual, once-off, purchasers often lack economies of scale. Also, focusing on one project developer can be limiting if your goal is to compare a wide range of options.
  
  There is however more than one way to buy carbon credits directly from a project, with many organisations now exploring long-term carbon offtake agreements. Similar to a Power Purchase Agreement (PPA), in a carbon offtake agreement the buyer agrees to purchase a set volume of credits, at set price points for several years into the future. This is usually done with the help of a consultant who can help explore, structure and negotiate the deal mechanics.
  
  You can read more about the different methods of carbon procurement - including a handy reference table - in this article.
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• Through a deal facilitator, a consultant or a broker
  Carbon market experts can facilitate transactions between buyers and sellers of carbon credits. The right partner will have a wide network of global clients and can help you find suitable carbon credits that meet your requirements. They can facilitate deals in the primary and secondary market – from project developers, exchanges or over-the-counter. They can also provide advice on market trends, pricing, and credit quality and advise on the best contracting options, including long-term carbon offtake agreements. If they already transact a large volume of carbon credits, the right partner can often obtain preferential pricing. They then usually charge a small fee on the wholesale market value of the carbon credit purchase.
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• Over-the-counter (OTC)
  In an OTC transaction, carbon credits are traded directly between buyers and sellers without the mechanics of a formal exchange. You can go to a secondary carbon credit seller directly if you can identify them, and this can provide more flexibility around contract terms and pricing. It may however be less transparent, and more difficult and time consuming to find a suitable counterparty. This is where a specialist carbon consultant, that understands the market and has extensive connections, can help.
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• Carbon exchange
  A carbon exchange operates in a similar fashion to a stock exchange but in the purchase, clearing and settlement of carbon credit units. The identities of buyers and sellers are usually unknown. Trading on an exchange is usually limited to wholesale / institutional clients and not accessible for most corporates due to licencing, and restrictive or onerous memberships.  It also doesn’t allow for bespoke product preferences like the OTC market does, as exchanges generally only transact in base homogenised units.
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• Online platforms and retailers
  There are several online platforms and retailers that offer carbon credits for sale to individuals and businesses. These platforms select a range of credits to feature on their platform and often sell them through bundled packages which include a fee for their service. This can a user-friendly way to purchase carbon credits, but it does come at a price premium compared to accessing the wholesale market, and the choice of carbon credits is often limited.

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The role of carbon markets in the net zero journey

The science could not be clearer. Our planet needs us to take bold and decisive action and the urgency is building.

This must start with deep and meaningful emissions reductions, but the time is here to leverage all tools at our disposal. This includes investment in our natural assets and in technology-based solutions that help us remove and avoid emissions.

Carbon markets can help us do this. They enable international collaboration, support corporate net zero commitments, and help funds flow to communities that are among the most affected by climate change.

As we move forward in the fight against climate change, carbon markets will continue to evolve and adapt to the changing landscape, driving further innovation and collaboration among businesses, governments, and individuals.

By understanding the nuances of carbon markets and their essential role in achieving our climate goals, we can all contribute to building a more sustainable and resilient future.
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Are you read to take the next step on your net zero journey?

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We help corporate sustainability teams, carbon & clean energy project developers, and wholesale & industrial clients, take decisive action to net zero. Get in touch with our team to see how we can help.