ESG. Net zero. Carbon sequestration. In 2023, all of these terms will continue to be widely referenced in mainstream media publications, corporate governance and shareholder materials, and regulatory filings and issuances. Although the terms are technically unrelated, at their core they reflect a growing social consciousness, both in the United States and abroad, concerning carbon dioxide (CO2) presence in the atmosphere and the impact of individual and corporate actions on greenhouse gas (GHG) emissions.
Corporate documents or individuals that make reference to environmental, social, and governance (ESG) investing criteria, achieving net-zero goals, or pursuing sequestration initiatives often do so with specific, targeted actions in mind designed to achieve certain benchmarks. Of course, that raises a threshold question of how an entity or individual can achieve reduced GHG goals or demonstrate net-zero operations. In response to growing public and internal entity demands to address climate change, corporate entities and individuals are seeking to reduce carbon footprints through the generation or purchase of environmental attributes. However, regulatory exposure and the potential for enforcement oversight raise practical concerns and considerations for the entities—both purchasers and sellers—that transact in these products.
Environmental Attributes
The purchase and sale of environmental attributes is an established concept in the energy industry, with environmental attribute provisions having long been embedded in energy generation offtake agreements. However, environmental attributes include more than just those created by virtue of the development and operation of a renewable generating facility.
Most recently, corporations have sought to minimize the impact of their carbon footprints through the purchase and sale of a different product: carbon offsets. As described below, purchasers and sellers of carbon offsets must be mindful of potential regulatory exposure for the transaction—in particular US regulatory oversight over instances of fraudulent and manipulative conduct.
Carbon Offsets
In order to be an effective means of demonstrating that it reflects the actual reduction of carbon emissions, a carbon offset must successfully represent 1 tonne of CO2 emissions that are permanently removed from the atmosphere. In other words, the holder of the carbon offset must have confidence that the offset commodity it has purchased can be verified to result from a project that actually removed or offset carbon emissions from the atmosphere permanently that would not otherwise have been removed but for said project.
Entities that purchase carbon offsets for purposes of demonstrating compliance with net-zero initiatives or reduced carbon footprints must, therefore, be assured that a carbon offset adheres to a generally accepted principle that it is verifiable, permanent, additional, and otherwise unclaimed.
To date, achieving this assurance has historically proven difficult. Purchasers and holders of offsets proceed along a caveat emptor, or buyer beware, pathway, and must take care to consider and address several germane issues associated with the offset purchase and retirement transaction, including variability in standards and the absence of any uniform standard, questions of permanence in many carbon offset generating projects, and the challenges with confirming additionality.
Potential Regulatory Oversight
Due to growing concerns over the quality of carbon offsets and market fragmentation noted above, the offsets market has a significant risk of fraud. The Commodity Futures Trading Commission (CFTC) has expressed interest in how it might impose a regulatory regime over bilateral purchases and sales of carbon offsets. Most recently, Commissioner Romero addressed the CFTC’s role in a February 10 keynote address to the FIA and SIFMA Asset Management Derivatives Forum.
In her remarks, Commissioner Romero expressed her view that products traded in the voluntary carbon market that do not reflect their representations related to carbon reductions could amount to greenwashing. In her view, and arguably the view of the CFTC as a whole, greenwashing is one type of fraud that would fall within the prohibited purview of the Commodity Exchange Act and Rule 180.1 and/or Rule 180.2 of the CFTC’s regulations.
And, to be sure, although the CFTC has exclusive jurisdiction over derivatives markets (which are distinct from physical carbon offset transactions), the CFTC’s long-established antifraud authority encompasses both the derivatives markets and the spot market (thereby bringing carbon offset transactions within the CFTC’s oversight authority).
Types of Fraud
What types of carbon offset transactions might constitute fraud? In the view of the International Organization of Securities Commissions, as relayed by Commissioner Romero:
- There is a risk of fraudulent selling of carbon credits that do not exist or do not belong to the seller.
- Different methodologies to quantify the carbon being avoided or reduced pose risks for greenwashing.
- Conflicts of interests between traders and investors could lead to traders manipulating carbon credit prices by issuing buy/sell recommendations to their customers, while doing the opposite with their own credits.
- The risk of unclear and misleading communications around buyers’ use of carbon credits could result in greenwashing.
Looking Forward
At bottom, this regulatory exposure and potential for enforcement oversight raises practical concerns and considerations for entities transacting in carbon offsets—both purchasers and sellers. By way of limited example, parties should ensure they have carefully considered the representations, warranties, indemnification provisions, and title provisions in commercial purchase and sale contracts. It is imperative that internal compliance and legal counsel involved in carbon offset transactions be familiar with, or consult with individuals who are familiar with, CFTC oversight and evolving market trends in this space. This is particularly important for transacting parties that have not historically transacted in commodity markets subject to CFTC oversight and, therefore, are potentially unfamiliar with the regulator.
In short, as we move through 2023 and beyond, the regulation of carbon offsets is certainly on the horizon. Holders and purchasers of carbon offsets should consider two overarching items as they participate in the carbon offset market: (1) the potential for federal regulation of offset purchases and sales and (2) contractual protection in offset purchase and sale agreements that addresses the key risks and issues, including those mentioned above.