This article examines: 

1. Legal, regulatory and investor pressure to meet carbon reduction goals; and
2. how certain companies are subject to mandatory participation in ETS and how non-ETS companies can access the voluntary carbon market. 

It also explains how participation in the voluntary market is likely to be impacted by the implementation of Article 6 of the Paris Accord (on which substantial agreement was reached at COP26 in Glasgow); and how the costs of carbon insetting, carbon offsetting and ETS allowances may converge such that net zero costs become a major cost consideration for boards.

In short, meeting carbon reduction goals will cease to be primarily a public relations exercise and will increasingly be a matter which will impact every aspect of the company’s operations.  It should be a key component of an ESG strategy.

Legal, regulatory and investor pressure to meet net zero commitments

Section 172(1)(e) of the UK Companies Act 2006, requires a director to have regard (amongst other matters) to the impact of the company’s operations on the community and the environment.

Meanwhile section 414C of the Companies Act provides that a strategic report for a financial year of a company must include a statement which describes how the directors have had regard to this requirement.

Additional pressure is applied to listed companies from the regulatory disclosures they are required to make on their net zero commitments and due to pressure from investors to have ambitious targets and meet them.  By way of example.

• In the UK, from 1 January 2021, the FCA Listing Rules required UK incorporated and overseas commercial companies with a premium listing to state in their annual financial report whether they have made disclosures consistent with the recommendations of the Taskforce on Climate related Financial Disclosures (TCFD) or explain if they have not done so.  In December 2021, the FCA extended these requirements to in-scope standard listed companies for accounting periods beginning on or after 1 January 2022.  This helps to assess UK listed companies on their net zero commitments.
• In the EU, the Non-Financial Reporting Directive (NFRD) lays down the rules on disclosure of non-financial and diversity information by certain large companies and non-EU groups with EU operations meeting the relevant thresholds, including environmental matters.  On 21 April 2021, the Commission adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD) which would amend the existing reporting requirements of the NFRD and extend the scope to all large companies and all companies listed on regulated markets (except listed micro-enterprises).  This will require the audit (initially on a limited assurance basis) of reported information and introduces more detailed reporting requirements, and a requirement to report according to mandatory EU sustainability reporting standards. 
• The SEC is developing a mandatory climate risk disclosure proposal for publication by the end of March 2022 – see here.
• Many asset managers are signatories to the Principles of Responsible Investment (the “PRI”), a network of international investors working together to put the PRI into practice.  Altogether, there are currently 3826 signatories (which includes not just asset managers but also banks and advisers) details of which can be found here.  
• Non-PRI signatory asset managers are also including ESG priorities in their own investment model.  For example, Blackrock’s updated engagement priorities for 2022 continue to ask that companies disclose a net zero-aligned business plan that is consistent with their business model and sector. Blackrock also encourages companies to: (1) demonstrate that their plans are resilient under likely decarbonization pathways, and the global aspiration to limit warming to 1.5°C; and (2) disclose how considerations related to having a reliable energy supply and just transition affect their plans. 
• As recently reported in the Guardian, Make My Money Matter campaigning group, urged ministers to follow up the UK’s legal commitment to reach net zero emissions by 2050 by making it mandatory for pension schemes to align their portfolios with the UK’s net zero target.
• In September 2021, the World Economic Forum announced that over 50 multinational companies had begun including the Stakeholder Capitalism ESG reporting metrics in their mainstream materials, including annual reports and sustainability reports.  These guidelines were published in 2020 in conjunction with the big four accounting firms to create non-financial reporting standards against which major corporations can report.

In addition banks are now assessing climate risks of their customers, which could affect the cost and availability of finance.  Plus, the EU is creating a common classification system for sustainable economic activities, or an “EU taxonomy” to encourage finance into these activities.  Somewhat controversially nuclear and natural gas are currently included, although the European Parliament may attempt to exclude these energy sources from being termed as sustainable as reported here in the FT.  The UK and other international jurisdictions are also introducing taxonomy regulations to have similar effect.

Finally, funds which market themselves as ‘sustainable’ are themselves under pressure to select investee companies which will meet sustainability criteria.  As this recent article in the FT reports, Morningstar recently removed more than 1,000 funds from its list “including many that listed ESG criteria to self-classify as promoting environmental and/or social characteristics” under Article 8 section of the Sustainable Finance Disclosure Regulation.  

The pressure on companies to do more and report on what they are doing will only increase.

How can (or must) companies participate in the carbon market or ETS schemes?

ETS schemes

Companies in heavy emitting industries (such as power, oil refineries, steel, mining & materials, paper & packaging, chemicals and aviation) will, in many jurisdictions, be subject to emission trading schemes (ETS).  These cap-and-trade systems, set a cap on greenhouse gas (GHG) emissions that declines annually to achieve the climate goals of its jurisdiction or members. 

Carbon allowances equal to the emissions cap are then either freely allocated or auctioned to emitting entities who may then trade these allowances between them (i.e. those who have undershot their cap have a surplus to sell to those that have not). The supply and demand for these allowances establishes a market price.  

Companies subject to ETS schemes will well understand these requirements and we therefore do not examine this market in detail.  However, how allowance prices have risen should be noted by non-ETS companies because this price might be regarded as a proxy for how high voluntary carbon credits prices could go.  EU ETS prices have doubled over the past year to nearly €100 per tonne of carbon dioxide equivalent (CO2e) – having been priced at just €5 per tonne before 2015.

The voluntary market

Outside ETS markets, companies who wish to buy carbon credits can participate in the voluntary market. 

Increasingly companies can calculate the internal cost of abating carbon emissions generated in the ordinary course of business.  If the cost of purchasing carbon credits is cheaper than reducing a company’s carbon footprint, there is a financial incentive to buy carbon credits, aka voluntary carbon units (VCUs).   However, it is quite possible that the cost of offsets may in time be similar to the cost of insetting or even rise to the level of EU ETS allowances.  Nature based carbon offset VCUs are trading at around $15 per tonne of CO2e, an almost threefold increase over the last 12 months.

This market is forecasted to grow exponentially by a number of commentators and a McKinsey study explains why see here.  For the reasons explained below, not all VCUs are created equal and companies need to understand why if they are to meet valid ESG targets.

Some argue that buying VCUs is cheating or greenwashing – see this article in the Guardian.  However, not all VCU’s are equivalent and in our opinion, this Guardian article is overly critical of the voluntary carbon market and fails to differentiate between different types of VCUs.  

• Where there has been a ‘corresponding adjustment’ (which ensures no double-counting), the VCU has a net carbon benefit and are becoming known as ‘offset claims’ compared to those that do not which are increasingly known as ‘impact claims’.   
• Also nature based carbon offset projects can have a significant impact on reversing deforestation and providing alternative employment opportunities for indigenous peoples who engage in illegal logging or deforestation out of economic necessity.  These bring a strong social as well an environmental dimension to net zero goals.
• Finally, carbon removal offset claims are those which actually remove carbon emitted (e.g. carbon capture using technology).  These will likely command the highest price of all as rather than mitigating or reducing carbon they actually eliminate carbon emitted by human activity.  A TED talk by Microsoft’s Chief Environmental Officer explains Microsoft’s ambitious plan to approach net zero and the global challenge to develop carbon markets which price VCUs properly.

As a result, a divergence is developing between the price of VCU’s which comprise impact claims, offset claims and removals.  Gold Standard – one of the leading accreditors of VCU’s – will now differentiate between impact and offset VCU’s and this divergence is resulting in a price differential.  

Well-informed or ethical buyers of VCU’s may choose only to acquire VCU’s which comprise offset claims.  In part, this divergence is a result of the agreement at Glasgow’s COP26 on how the trading mechanism of the Paris Accord will be implemented – see below.

Even then, there is increasing encouragement only to use VCU’s where companies have maximised the use of insetting.    For example, the Science Based Targets initiative (SBTi) (a partnership between CDP, the United Nations Global Compact, World Resources Institute (WRI) and the World Wide Fund for Nature (WWF)) is developing the Net-Zero Standard to provide business leaders with “a common, robust, and science-based understanding of net-zero”.  

One of the aims of SBTi is try and ensure that for most companies with net-zero targets, 90% of action is insetting or similar so that offsetting is not used to avoid taking necessary steps to mitigate climate change.  

Article 6 of the Paris Accord and the likely impact on the voluntary carbon market

In 2015, the Paris Accord was signed by 95% of the world’s emitting countries.  To achieve the objectives of the Paris Accord, countries have committed to Nationally Determined Contributions (“NDCs”) that align over time with the agreement’s ultimate goal of holding global average temperature increases to 2°C above pre-industrial levels, while also pursuing efforts towards limiting the temperature increase even further to 1.5°C. 

In November 2021, COP 26 in Glasgow decided to increase its targets every 5 years to ensure its target of a 45% reduction in 2010 level emissions was met by 2030.  At COP 26, 100 countries covenanted to halt Deforestation by 2030. Via the San Jose Declaration, most countries covenanted to not allow pre 2020 carbon credits to be used as mitigation (thus undoing most of the damage caused by “zombie “ credits which arose in the Clean Development Mechanism (“CDM”) created at the time of the Kyoto Protocol). COP 26 itself prohibited the use of pre-2013 carbon credits. 

In other words, not only are new offset VCUs becoming more expensive (because they are in fact lowering carbon emissions rather than double counting them) but also older carbon credits are being retired from use and/or considered sub-standard VCUs.

Article 6.4 of COP 26 is the trading mechanism of the Paris Accord that was finally agreed at Glasgow. It opens the door for qualifying carbon credits to be admitted as mitigation for emissions. It is now under discussion for the  6.4 qualifying emission reductions (“A6.4ERs”) to be used as mitigating credits in the ETS schemes of the EU, UK, US, China, Switzerland, Australia and NZ .  If this happens, it  will create large scale demand for these A6.4ERs, cause a supply shortage and the price effect is only capped by the EU ETS price (which currently at nearly €100/tonne).

As a result, the market for VCUs will likely fracture into a series of sub-markets which will command very different prices.  

So what should companies be doing?

First and foremost, companies need to understand their carbon footprint, their plans to reduce it and how it will be disclosed, audited and scrutinised by investors and regulatory bodies.  They should also be carefully assessing how to reduce and offset their carbon footprint and understand the cost of doing so.  Major emitters will be subject to ETS caps and increasingly expected to use carbon capture to abate emissions entirely.  This will drive up the cost of energy from non-renewable energy sources.

Companies need to understand how the carbon market works and the significant changes which are taking place which will impact pricing of VCUs depending on their quality and whether they may in future qualify as A6.4ERs.

In most cases, companies will need to participate in the voluntary carbon market to reach net zero in addition to taking steps to reduce their carbon footprint.  However, as is made clear above, not all VCUs are the same.  Buying cheap sub-quality VCUs could result in negative PR if it looks like companies are cheating on their carbon reduction targets.  It could even be as toxic as falling foul of modern slavery legislation in the supply chain.  Standards of accounting for carbon abatement will get increasingly exacting.

To access the voluntary carbon market, we recommend companies explore genuine partnerships with carbon offset projects which have been accredited to meet higher standards rather than just look for the lowest cost approach in the market.  This way, companies can build lasting relationships with local communities preserving rainforests or engaging in reforestation (nature based carbon capture).  In particular, companies can enter into a direct VCU offtake contract with a carbon offset or carbon capture project.  These direct offset contracts can secure a supply of VCUs, help mitigate against market fluctuations and, most importantly of all, ensure that the carbon project meets the standards required by the company and investors.  

The importance for companies to understand this development in the business environment cannot be overstated.  

Published – 24/02/22