Key strategies for managing legal uncertainty in carbon markets

The voluntary carbon market (VCM) has faced significant challenges in recent years, including the lack of clarity and uniformity in the private law treatment of verified carbon credits (VCCs). As investor and off-taker interest in pre-issuance VCCs rises, so does the need for legal certainty in commercial transactions in VCCs. The evident trend of VCCs increasingly being integrated into compliance carbon schemes further reinforces this need for legal certainty. 

The road to harmonisation

Various initiatives, such as the Integrity Council for the Voluntary Carbon Market (ICVCM) and the Voluntary Carbon Market Integrity Initiative (VCMI), alongside government efforts and private sector innovations such as ratings and insurance, have been implemented to increase credibility and transparency across the supply and demand sides of the market. However, the fragmented legal environment and lack of clear legal rules for carbon credits under private law continue to constrain the market's growth and its ability to deliver true climate action. 

Prominent institutions and regulators, including the International Organization of Securities Commissions (IOSCO, Report on Voluntary Carbon Markets), the International Swaps and Derivatives Association (ISDA, Report on Legal Implications of Voluntary Carbon Credits, Report on Legal Nature of Voluntary Carbon Credits), the UK Law Commission (Report on Digital Assets as Personal Property), and the Legal High Committee for Financial Markets of Paris (HCJP, Report on the legal and regulatory aspects of voluntary carbon credits), have begun to address this topic, with growing consensus on the need for certainty on this aspect of the market. 

The legal uncertainty is here to stay 

To date, the most comprehensive on-going effort to deliver such certainty is the International Institute for the Unification of Private Law (UNIDROIT) Project. It aims to establish international legal principles for VCCs under private law that clarify core legal aspects of commercial transactions in VCCs, such as ownership, transfer of title, security rights, and insolvency. 

Many market participants agree that if designed correctly this newly defined legal infrastructure could result in the necessary market scaling and deliver increased climate action on the ground, we must acknowledge, as explicitly stated by UNIDROIT, that even once the UNDROIT Project is complete in early 2026 and then implemented and transposed into domestic legislation, variations of legal rules across jurisdictions will persist, and will continue to present challenges to commercial transactions and financial investments in VCCs. 

The implications of post-issuance risk for pre-issuance considerations

A fundamental interconnection exists between the pre-issuance and post-issuance phases of a VCC's lifecycle, which can have material legal effects on the considerations of Advance Market participants such as investors, off-takers, and financiers while structuring transactions and evaluating associated risk. 

Under the various initiatives listed above, it is upon issuance that VCCs become legally recognised assets and are subject to proprietary rights. Yet, purchasers of VCCs may subsequently encounter default scenarios such as delivery of invalid tonnes resulting in revocation of issued VCCs, reversal events affecting issued VCCs, or discovery of defective titles held by the project developer in the underlying project and assets. 

In the quest to minimise the risk of exposure to unfavourable results in potential legal disputes (for example in the case of competing security interests or insolvency), investors, off-takers, and financiers will seek to verify the domestic legal rules applicable to the treatment of VCCs within the various relevant jurisdictions, in order to evaluate to what extent their contractual rights and interests are legally protected. In such eventualities, the risk of discovering that the applicable domestic rules do not afford sufficient legal protections to bona fide purchasers, security interest-holders or creditors in insolvency, can have a hindering effect on market growth. 

However, realistically, it will be impossible to fully predict and account for the legal consequences of these various scenarios, given the persisting non-uniformity and uncertainty across domestic jurisdictions on rules about the legal treatment of VCCs, even after the completion of the UNIDROIT Project. 

The role of ratings and insurance as transactional risk management tools

As the carbon market evolves, Advance Market participants are expected to make more intentional legal choices and implement measures to minimise the risk of those choices being challenged or litigated. Such measures can include, for example, a change in the choice of the contract’s governing law and the requirement for additional contractual guarantees or a more robust pre-contractual due diligence process on the project and its legally risky attributes, supported by ongoing oversight by a ratings agency or underlying insurance coverage over the contract’s term.

Tools such as carbon credit ratings and insurance offer a degree of assurance despite ongoing legal uncertainty in the post-issuance phase, by identifying and managing performance-related risk, which encapsulates the performance of the credit against its commitment to remove or avoid one tonne of CO2e. While not designed to resolve legal fragmentation across jurisdictions, carbon credit ratings and insurance provide useful safeguards that can help market participants both understand the risk of adverse outcomes and enable proper risk management of foundational project elements.

Ratings provide an independent assessment of the likelihood that a credit will avoid or remove one tonne of CO2e, enabling market participants to understand the underlying risks to a carbon project. Insurance is another independent risk management tool, offering financial protection against the risks inherent in carbon projects, such as non-delivery, government interventions, credit invalidation and reversal risks. Together, these tools support market participants in making informed decisions, even in the face of legal ambiguity.

Designing carbon markets as integration advances

There is increased impetus for institutions and governments to incorporate risk-based tools into the design of carbon markets. This is particularly relevant where VCCs are integrated into compliance schemes such as carbon taxes or cap-and-trade systems. Ratings can act as a fungible risk metric across all VCCs, whether used for voluntary or compliance purposes, enabling market participants to compare and contrast credits from different sectors, standards and regions. Insurance enables market participants to transfer their financial exposure to specified risks to third-party insurers. As regulators and policymakers work to strengthen market integrity, integrating risk-based tools such as ratings and insurance can further enhance confidence and stability for any VCC investment decision.

Preparing for the road ahead 

The development of clear and predictable legal frameworks for VCCs remains essential to the growth of global carbon markets. The UNIDROIT Project contributes to this objective by encouraging harmonised approaches across jurisdictions, while acknowledging that legal variation and uncertainty will continue to shape the market landscape.

Further consideration should also be given to potential integration scenarios between the VCM and compliance markets within the discussion regarding the legal treatment of VCCs, particularly in relation to the interaction between emerging legal frameworks from the UNIDROIT initiative and existing rules governing compliance schemes. Any misalignments could affect the pace and structure of market integration.

Ultimately, carbon market investors, off-takers and financiers can better manage transactional risks by carefully assessing the legal landscape of their future VCCs and incorporating tools like ratings and insurance measures into their  Advance Market commitment risk-management strategy. A joint report by Herzog Law and BeZero Carbon offers an in-depth analysis of these legal and market dynamics, providing guidance for strategic decision-making in a rapidly evolving carbon market.

Explore carbon credit purchases, total emissions, and climate targets of thousands of companies on Data Hub™ — the first platform designed to help sustainability providers generate sales leads!"

illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.