De-risking carbon markets: Managing legal uncertainty in the treatment of carbon credits
28 April 2025
April 2025
Herzog Authors: Dr. Ruth Dagan, Partner and Head of the Environment and Climate Change practice at Herzog Fox & Neeman, and Co-Chair of the IETA Legal Working Group; and Dana Gilon, Associate in the firm’s Environment and Climate Change practice, focusing on environmental, climate, ESG, and carbon market matters.
Legal due diligence on carbon credits requires verifying ownership rights, transfer mechanisms, security interests, and insolvency treatment across all relevant jurisdictions. The UNIDROIT project is developing harmonized principles for the private law treatment of verified carbon credits (VCCs), addressing the legal fragmentation that currently creates commercial risk for investors, off-takers, and financiers in the voluntary carbon market.
We are excited to share a new report co-authored by Herzog Fox & Neeman’s Environment and Climate Change practice and BeZero Carbon, exploring one of the biggest barriers to growth in the voluntary carbon market: the legal uncertainty surrounding the private law treatment of verified carbon credits.
As equity and debt financing increasingly support advance market commitments, confidence in the legal treatment of VCCs becomes essential. Yet today’s fragmented legal landscape introduces commercial and operational risks that hinder market growth.
Amid the legal fragmentation and the post-issuance risks associated with it, robust risk management of foundational project elements becomes increasingly critical to build confidence, ensure stability, and unlock the full potential of carbon markets.
Our report highlights:
- Why legal clarity on ownership, transfer, security and insolvency treatment is fundamental for commercial transactions involving VCCs.
- How the UNIDROIT Project and other legal initiatives are advancing legal harmonization—and what challenges remain.
- How advance market participants such as investors, off-takers and financiers are likely to manage post-issuance legal risk.
- Why pre-issuance risk management tools—like ratings and insurance— play a central role in bolstering market integrity.
- What lies ahead for market participants navigating legal uncertainty.
Executive Summary
Carbon credit markets are a vital tool for climate investment. However, uncertainty and lack of clarity around the legal treatment of verified carbon credits (VCCs) under private law have had a hindering effect on the growth of the voluntary carbon market (VCM). This uncertainty complicates commercial transactions, particularly as market appetite grows for pre-issuance VCCs and as credits are increasingly integrated into compliance schemes.
Certainty on the legal treatment of VCCs under private law is paramount to the market’s ability to scale to the necessary size to deliver climate action. Efforts by several leading international organisations have begun to address this legal gap, but a broad global consensus would further benefit the market. The International Institute for the Unification of Private Law (UNIDROIT) Project represents the most comprehensive initiative to date, aiming to develop international legal principles that clarify core legal aspects of commercial transactions in VCCs, such as ownership, transfer, and insolvency treatment of VCCs. However, even after its expected completion in 2026 and implementation in national jurisdictions, variations in the legal rules across jurisdictions will persist, maintaining legal fragmentation.
The legal risks occurring in the pre-issuance phase of a VCC’s lifecycle can have material legal effects post-issuance. While VCCs become legally recognised assets upon issuance, purchasers may encounter post-issuance scenarios of default such as revocation of issued VCCs due to invalidation, reversals, or defective title. The risk of discovering that the domestic regime does not afford sufficient legal protections to bona fide purchasers, security interest-holders or creditors in insolvency can have a deterring effect on market transactions. To manage such legal risks, investors, off-takers, and financiers will seek to verify the domestic legal rules applicable to VCCs, before reaching a final agreement. However, realistically, it will be impossible to fully predict and account for the legal consequences of these various scenarios, given the legal fragmentation which is expected to persist.
Carbon ratings and insurance can help market participants both understand the risk of adverse outcomes and enable proper risk management of foundational project elements. As the carbon market evolves, advance market participants are expected to make more intentional legal choices and to seek to minimise the risk of those choices being challenged or litigated. They will likely turn to performance risk tools like carbon credit ratings and insurance to manage ongoing uncertainty. While these tools do not directly address legal uncertainties during the post-issuance phase, they can help to identify and manage exposure to project-specific risks providing a degree of assurance in transactions where legal safeguards remain unclear. Ratings offer an independent assessment of the risk of a credit delivering its promise of avoiding or removing one tonne of CO2e. Using ratings as part of their due diligence process enables investors and off-takers to better understand the risk of facing an adverse outcome in relation to their expected future credits. Insurance can offer financial protections against the unique risks inherent to carbon projects, such as non-delivery, government interventions, credit invalidation and reversal risks.
Governments should seek greater international alignment on the legal nature of VCCs and the market should look to integrate risk-based tools to support market credibility. As VCCs continue to serve voluntary and compliance markets, integrating risk-based tools into market architecture can support investor confidence and market integrity. Despite progress toward legal harmonisation, ongoing variance will necessitate robust risk management strategies.
The legal treatment of carbon credits under private law in recent domestic and international initiatives
The conversation around the legal nature and treatment of carbon credits has intensified over the past several years across both international platforms and domestic jurisdictions. Prominent international organisations such as the International Swaps and Derivatives Association (ISDA) and the International Organization of Securities Commissions (IOSCO) have published several relevant reports, while multiple domestic legislative bodies, including the Legal High Committee for Financial Markets of Paris (HCJP), the United Kingdom Law Commission (UK Law Commission) and the United States Commodity Futures Trading Commission (CFTC), have issued guidelines and recommendations for future action. A summary of each adopted position can be found in Tables 1 and 2.
Table 1. The approach of selected international institutions to the legal treatment of VCCs.
| Institution | Publications | Recommendations |
|---|---|---|
| International Swaps and Derivatives Association (ISDA) | ISDA published two reports that provide an overview of the legal treatment of VCCs across different jurisdictions, focusing on the uncertainty surrounding the matter in local laws. This uncertainty is perceived as a barrier to solving the complex issues surrounding VCCs, including creation, purchase, sale, and retirement, as well as questions relating to securities and insolvency. | ISDA recommends that VCCs be viewed as a form of property, as viewing them as a bundle of contractual rights may give rise to further complications.
ISDA acknowledges that progress in developing rules will be slow and recommends that national and international efforts occur in parallel; otherwise, delays will threaten to prolong uncertainty. Their work references the UNIDROIT Project. |
| International Organisation of Securities Commissions (IOSCO) | In a recent report, IOSCO identified the implications of the legal treatment of VCCs on the rights that a holder may assert over them, including for security interests, their treatment for tax and accounting purposes and their treatment upon insolvency. | IOSCO sets out its best practices for VCM actors, which acknowledges the use of carbon credit ratings and the need for legal certainty. It recommends providing jurisdictional certainty on the legal treatment of VCCs, subject to consistency with domestic mandates and processes. However, it does not offer a specific recommendation for how regulators should define VCCs. IOSCO recognises the work of UNIDROIT in providing certainty on these issues. |
Table 2. The approach of selected national governments to the legal treatment of VCCs
| Institution | Position | Recommendations |
|---|---|---|
| Legal High Committee for Financial Markets of Paris (HCJP) | A report published by HCJP identifies the complexity of establishing a legal regime for the VCM because of its cross-border nature, the differences in substantive rules between jurisdictions, and the absence of a common international legal regime. Locally, the report distinguishes between the legal nature of EU allowances, which it deems clear and well-defined under French law, and that of VCCs, which remains undefined and uncertain. | The HCJP concludes that VCCs should be recognised as intangible assets under French law, as such classification corresponds to their economic and operational nature. Any other classification would introduce inconsistencies and risk undermining the legal certainty of the VCM.
Based on this classification, the report views registration in a registry account as constituting a presumption of ownership. Further, it states that VCCs can be the subject of security rights but cannot be considered eligible assets for financial collateral under French law. In relation to the cases of reversal or revocation of VCCs, the HCJP has yet to reach a consensus, referring to the work of UNIDROIT on these matters. |
| UK Law Commission | The Commission published a draft bill and a supplemental report on digital assets as personal property, stating that its recommendations may also apply to VCCs.
The report found that such assets do not easily fit into existing categories of personal property under UK law, namely “things in possession” or “things in action”. |
The Commission proposes recognising a new type of personal property, “third category property”, which reflects the unique characteristics of these types of assets. By recognising a new and separate category of personal property, the draft bill confirms that the two traditional categories of property are not exhaustive, allowing assets which fall outside these categories to be considered property under UK law.
The Commission does not conclude that every type of VCC will necessarily be considered an object of personal property rights but rather stipulates that the UK courts should decide on these boundaries as a matter of common law. |
| The US Commodities and Futures Trading Commission (CFTC) | The CFTC published guidance regarding the listing of VCC derivatives to support transparency, liquidity, and market integrity in the VCC derivatives markets and ultimately drive standardisation and efficient capital allocation to scale the cash market for high-integrity VCCs.
The guidance also acknowledges that standardisation mechanisms for VCCs are still being developed. |
The CFTC approaches VCCs as a tradable intangible instrument or an intangible commodity, which can underline a derivative contract.
The guidance outlines certain commodity characteristics of VCCs that have been broadly identified across both mandatory and voluntary carbon markets. These include transparency, additionality, permanence, risk of reversal, and robust quantification. Designated contract markets (DCMs) will consider these characteristics upon selection of crediting programs from which eligible VCCs may be delivered at the settlement of a VCC derivative contract. |
Significant interest in the legal treatment of VCCs has become prevalent amongst carbon market participants and experts, as demonstrated by a comprehensive report jointly authored by GenZero and Allen & Gledhill LLP in 2024. This report has stressed the need for certainty concerning the legal character of VCCs; it uses Singapore as a case study and analyses relevant legal principles and case law applicable in Singapore, ultimately recommending that VCCs should be classified as intangible property under Singapore law. With its analysis and recommendations, the report illustrates how each domestic jurisdiction would approach the treatment of VCCs as reflective of its own specific private law principles and unique attributes.
Another leading body of work regarding the PACM registry can be found in two recent publications by IETA. In January 2025, IETA published a position paper focusing on the relationship between accounts to be held in the PACM registry established under Article 6.4 of the Paris Agreement and the ownership of PACM credits in the accounts. IETA argues that the PACM registry should confirm ownership of account holders, such that the transfer of units in the PACM registry will constitute the transfer of ownership of the transferred units from the holder of the previous account to the new account holder. This approach recognises that such units can be the subject of proprietary rights. IETA also refers to the work of UNIDROIT concerning other subtleties of the legal nature of units under the PACM framework. A draft submission published by IETA in March 2025 in response to calls for input published by the PACM SBM further acknowledges that PACM units can be the subject of security rights alongside proprietary rights.
These initiatives give rise to two central aspects of the conversation developing around the legal nature and treatment of VCCs:
One key aspect is the consensus on the need for certainty on the private law treatment of VCCs in relation to core issues such as proprietary rights, transfer of title, security rights, insolvency, and more. These issues are potentially affected from the legal perspective by scenarios such as reversal, revocation, and third-party claims on title to VCCs.
The other key aspect is the ensuing recognition that even once such certainty is internationally achieved, variances in the legal treatment of VCCs across domestic jurisdictions will remain and will inevitably continue to affect commercial transactions and financial investments in VCCs.
Following these dynamics, the project undertaken by UNIDROIT has become the leading initiative on the determination of internationally applicable recommendations for the adoption of private law rules on the treatment of VCCs internationally and within domestic legal regimes.
The UNIDROIT Project on the legal nature of VCCs
The UNIDROIT Project is an important and inequivalent effort to fill a substantial void in the global discussion around carbon credits, an effort endorsed by leading national and international organisations and expected to have immense influence on carbon market activity. It is intended to become the foundation for the development of legal rules on the treatment of VCCs in business activities across the globe. The following section explains the UNIDROIT Project and the proposed principles in detail.
Following the approval of the UNIDROIT Project by the UNIDROIT General Assembly in December 2022, based on a proposal submitted by ISDA, the UNIDROIT Working Group on the Legal Nature of VCCs (the Working Group) was established in May 2023. The Working Group is tasked with drafting an international law instrument on the legal nature and other private law aspects of VCCs. To date, the Working Group has held five sessions out of eight planned sessions and has published Draft Principles on the Legal Nature of VCCs (the Principles), accompanied by an issues paper. The UNIDROIT Project is slated to be completed in early 2026, with the adoption of the Principles by the UNIDROIT Governing Council.
Purpose and scope of the UNIDROIT Project
The objective of the UNIDROIT Project is to provide guidance on a range of private law issues relating to VCCs (including, but not limited to, issuance, ownership, and transfer), thereby reducing legal uncertainty that legislators and market participants may encounter in the context of transactions in VCCs, and fostering global uniformity and certainty in the private law treatment of VCCs. The Principles are intended as uniform guidelines for the alignment of domestic legal regimes.
As the VCM grows, UNIDROIT expects that enhancing legal certainty will facilitate transactions in VCCs and support the development of a well-functioning market that could play a central role in combating climate change while simultaneously increasing capital flow to emerging markets in developing countries.
The Principles are intended to apply universally to all domestic jurisdictions, irrespective of their legal approaches, i.e. both the common law and civil law regimes. They are applicable to VCCs, which are described as “credits issued post independent verification that an emission reduction or removal has occurred as a result of a specific project activity”, which may be used under voluntary markets, under PACM established by Article 6.4 of the Paris Agreement, under sectoral compliance markets such as CORSIA, and under jurisdictional tax markets which permit partial offset through the use of eligible VCCs.
Only private law aspects of VCCs are covered by the Principles, with a particular focus on property law, namely, when are VCCs the object of dispositions and acquisitions, and when can rights in VCCs be asserted against third parties?
Regarding matters within the scope of the Principles, UNIDROIT states that the Principles will take precedence, once adopted and implemented, over national laws in case of a conflict. At the same time, UNIDROIT expressly excludes various aspects of private law from the scope of the Principles, including matters relating to intellectual property and consumer protection, as well as certain matters of property law and contract law. These range from issues relating to the proprietary right over a VCC, transfer, and valid creation of a security right in a VCC (subject to some exceptions where the Principles provide specific rules on these matters), to issues relating to relationships between contracting parties or with third parties. The matters expressly excluded from the scope of the Principles are left to be covered by the national law in each domestic jurisdiction without any recommendations or guidance by UNIDROIT relating to the structure or content of the national law that should apply to them, hence leaving domestic law on these matters unaffected by the Principles.
The UNIDROIT Principles
To fulfil the purpose of the UNIDROIT Project, a format of recommended principles accompanied by explanatory commentary was chosen. A summary of these Principles can be found in Table 3 below. The summary is based on the latest draft published in March 2025 in preparation for the Working Group’s fifth session, as certain matters, and in some cases entire Principles, are still under deliberation.
Table 3. Summary of the proposed UNIDROIT Principles, as of March 2025
| Principles | Meaning |
|---|---|
| General Principles | The Principles stipulate that a VCC can be the subject of proprietary rights. This classification is based on certain attributes of VCCs, namely that it is individuated (by a unique identifier), it can be controlled (by a specific registry account holder), it is rivalrous (as it can only be used by one person at a time) and it can be transferred between accounts. Classifying a VCC as property is deemed necessary by the Working Group to attract the scale of the investment needed to make VCCs a vehicle for raising climate finance.
No specific requirements are prescribed for the acquisition of a proprietary right in a given VCC, which shall be determined on a jurisdiction-specific basis based on the property law in each jurisdiction. In this way, UNIDROIT considers the important role of domestic regulators, such as the UK Law Commission, in further developing and defining the legal treatment of VCCs in their respective jurisdictions. |
| Creation of a VCC | A VCC comes into existence when a VCC registry records that it has been credited to an account.
As to whether a person has proprietary rights in a VCC after the moment it comes into existence (for example, in case of transfer), the question is left to be addressed by local law, subject to the requirements regarding transfer discussed below. |
| Transfer of a VCC | The Working Group recognises that the ability of market participants to easily transfer VCCs and obtain proprietary rights over them upon a transfer is essential to a well-functioning VCM. The Principles stipulate that a transfer can include no greater proprietary rights than those the transferor has in a VCC and that the transferee acquires all the proprietary rights that the transferor had or had the power to transfer.
In addition, the establishment of an innocent acquisition rule is suggested to enhance legal certainty and benefit the market. Under this rule, a buyer who acquires a VCC without notice that the seller did not own the VCC can nonetheless obtain proprietary rights. |
| Cancellation of a VCC | The Principles determine that a VCC can be cancelled as a result of reversal, revocation, or retirement, in which case the VCC ceases to be the subject of proprietary rights.
The consequences of cancellation in error are left to be addressed by local law. |
| Reversal of a VCC | A VCC can be cancelled for reversal when it no longer meets the definition of a VCC, and the cancellation comes into effect when a VCC registry makes an entry indicating as such. Though cancellation for reversal would result in the VCC ceasing to be the subject of proprietary rights, the cancellation does not affect any rights that a VCC may carry against third parties. For example, a VCC holder’s contractual right against a validation and verification body or other specific parties will nonetheless be preserved. Circumstances that give rise to cancellation for reversal should result in a pro-rata cancellation of VCCs among all registered holders. |
| Revocation of a VCC | A VCC can be cancelled for revocation if it is demonstrated that it never met the definition of a VCC, in which case it is considered void from the outset and as never having existed as the subject of proprietary rights. As in the case of reversal, cancellation for revocation does not affect any rights that a VCC may carry against third parties, such as a transferable contractual right against specific parties. |
| Retirement of a VCC | Once a registered holder has instructed the VCC registry to retire a VCC, it must cancel the VCC and make an entry indicating its cancellation. |
| VCC Registry | The definition of a VCC registry is kept broad to apply to most, if not all, VCC registries. The duties of the registry operator towards a registered holder are listed, including, but not limited to, compliance with the registry rules, allocation of a unique identifier, keeping adequate records and compliance with instructions by the registered holder. The Principles also address the relationship between the registry operator and the VCC registered in the registry it operates, stating that the registry operator has no proprietary rights in a VCC, that a VCC cannot be used for the satisfaction of claims of creditors of the registry operator, and that a VCC does not form part of the registry operator’s assets in case of insolvency. |
| Custody | The Principles establish the relationship between a custodian, its client, the VCC it maintains for its client, and, in appropriate cases, a sub-custodian. Similarly to the case of a registry operator, a VCC is not available to creditors of the custodian and does not form part of the custodian’s assets in case of insolvency.
The custodian’s duties towards its client include safeguarding the VCCs, maintaining them securely and effectively, acquiring VCCs promptly if necessary, and keeping clients’ VCCs separate from the custodian’s own account. A VCC maintained by a custodian may be the subject of the security rights of the custodian, such as in cases where the client separately owes the custodian fees or the custodian provides a loan to the client to acquire the VCC. In the case of custodian insolvency, the VCC must be transferred from the custodian’s account. The Principles also include instructions for cases where an insolvent custodian fails to maintain sufficient VCCs for its clients. The Principles also suggest an innocent client rule adapted from the innocent acquisition rule relating to the transfer of VCCs and tailored to the case of acquiring VCCs through a custodian. |
| Secured Transactions | Security rights are not defined in the Principles, as the law relating to secured transactions can differ considerably between jurisdictions. According to the Principles, a VCC can be the subject of security rights, and a VCC subject to a security right granted to a third party may be maintained by a custodian. Matters relating to the creation, making effective against third parties, priority, and enforcement of a security right in a VCC are governed by national law.
The Principles list the ways in which a security right in a VCC can come into effect against third parties, also accepting methods of third-party effectiveness under national law but prioritising the methods presented in the Principle. |
| Insolvency | The Principle on the effect of insolvency on proprietary rights in VCCs was adopted from the UNIDROIT Principles on Digital Assets and Private Law and has yet to be developed as a principle suitable for VCCs. The Principle is expected to address different cases of insolvency beyond the insolvency of a custodian, including insolvency of a person with a proprietary right in a VCC who may or may not have granted a creditor a security right in a VCC as collateral, insolvency of the project proponent that is still or no longer the holder of the VCC, or insolvency of the VCC registry. The applicable treatment in these cases of insolvency is closely linked to the legal nature of VCCs. |
What are the implications of UNIDROIT’s work?
The Principles are essential to enhancing legal certainty
As identified by the initiatives discussed above, UNIDROIT’s development of global uniform standards is a significant and essential step in enhancing legal certainty and uniformity concerning the legal treatment of VCCs under private law. Legal certainty and uniformity are projected to enhance the integrity of the market and, therefore, contribute to the development of robust, efficient, and scalable carbon markets.
Specifically, by offering a solution to one of the central vulnerabilities identified in IOSCO’s consultation report and increasing the integrity and efficiency of the VCM, the UNIDROIT Principles can promote IOSCO’s expressed efforts on a global scale, alongside IOSCO’s proposed set of good practices.
Navigating the remaining roadblocks to legal certainty
While UNIDROIT acknowledges the need for certainty and global harmonisation of legal rules relating to commercial transactions in VCCs, it is evident from the challenges reflected in the work done thus far that the road to such certainty and harmonisation is lengthy and complex. Furthermore, even once the implementation of UNIDROIT’s recommendations is well underway, considerable variations and ambiguities will remain in how domestic jurisdictions approach private law issues relating to VCCs, simply due to the significant differences between national private law regimes. UNIDROIT acknowledges such variations and expressly leaves many of the significant legal queries raised in its work to be determined based on domestic legal rules in each jurisdiction, as discussed above.
It is, therefore, apparent that complete uniformity and certainty would not be achieved, as explicitly stated by UNIDROIT, and that remaining variances and uncertainties in the legal treatment of VCCs across domestic jurisdictions will inevitably continue to affect commercial transactions and financial investments in VCCs for the long-term.
Given this reality, the question arises: how will progress in defining the legal rules governing VCCs, alongside the remaining variations and uncertainties in domestic rules governing private law, affect the demand side of the market? More so, how will it affect the appetite for advance market commitments in the form of project investment and offtake agreements, as well as their respective financing structures and terms?
The interconnection between the pre-issuance and post-issuance phases of a VCC’s lifecycle
The conversation around the legal nature and legal treatment of carbon credits under private law intentionally focuses on VCCs—which are verified, post-issuance units. However, this conversation directly and inevitably affects the pre-issuance phase of a carbon project’s development and the considerations of advance market participants such as investors, off-takers, and financiers while structuring transactions and evaluating associated risk.
It must be recognised that a fundamental interconnection exists between the pre-issuance and post-issuance phases of a VCC’s lifecycle, which can have material legal effects. Under the various initiatives discussed above, it is upon issuance that VCCs become legally recognised assets and are subject to proprietary rights. However, purchasers of VCCs may subsequently encounter scenarios of default such as delivery of invalid tonnes resulting in revocation of issued VCCs, reversal events affecting issued VCCs, or discovery of defective title held by the project developer in the underlying project and assets. 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 hinder the appetite towards advance market commitments and thus on overall market growth.
The intrinsic connection between the pre-issuance and post-issuance phases of a VCC lifecycle increases the need for clear and uniform legal rules on the treatment of VCCs in various commercial and transactional scenarios. In the quest to minimise the risk of exposure to unfavourable results in potential legal disputes, investors, off-takers, and financiers will seek to verify the domestic legal rules applicable to the treatment of VCCs in the various relevant jurisdictions. 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 pertaining to the legal treatment of VCCs, even once the UNIDROIT Project has been completed. This legal risk will inevitably play a role in the transactional considerations of prospective investors, off-takers, and financiers of carbon projects.
On a practical level, upon determining whether the jurisdiction in question is aligned, either partially or fully, with UNIDROIT’s recommended principles, the primary concern for potential investors and buyers would be to what extent their contractual rights and interests are legally protected within the jurisdiction in question, in such events as reversal and revocation of VCCs, as well as instances of a legal challenge to the title in the project producing the VCCs, or the title in the VCCs themselves (such as in the case of competing security interests or insolvency). Each of these scenarios materialises after the VCCs have been fully approved and issued. However, as discussed above, these scenarios can retroactively undercut the validity of such units and the entire set of legal rights originally perceived to be attached to the VCCs under the advance market commitment.
As a result, in jurisdictions found to be non-aligned or merely partially aligned with the UNIDROIT Principles, investors, buyers, and financiers can be expected to require additional measures to protect their contractual rights or balance their contractual risk. Such measures can take the form of a change in the choice of the contract’s governing law and the requirement for additional contractual guarantees. These measures can also take the form of 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.
The role of ratings and insurance where transactional legal protections are lacking
While risk-based tools are not designed to directly address legal uncertainties, they can be leveraged as additional safeguards by market participants to balance the legal risk that can develop at the post-issuance stage. Pre-issuance ratings, for example, already include consideration of specific legal risk as part of the project execution risk assessment. For example, the project developer’s legal right to implement the project and commercialise the resulting carbon credits. Ratings and insurance can be used to decrease the probability of legally risky scenarios developing post-issuance, which would necessitate deliberation on applicable domestic laws in events such as reversal and revocation, as well as potential discussions on legal protections afforded to secured lenders.
Ratings help to independently assess 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. To mitigate risks associated with early-stage project development, off-takers and investors increasingly incorporate project ratings into their agreements, such as linking the price paid for credits or the quantity of credits purchased to a higher-level rating.
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. Investors increasingly require insurance as a mandatory condition precedent to funding agreements with project developers. This ensures that key project performance risks are addressed before financial commitments are made or disbursed.
Figure 4. Mapping risks across the lifetime of the project and the credits issued.
Furthermore, there is increased impetus for institutions and governments to incorporate risk-based tools into the design of carbon markets. Governments should consider the integration of risk-management tools to support investor confidence and market integrity. This is particularly relevant where VCCs are integrated into compliance markets. 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 differing sectors, standards and regions. They also provide a third party risk metric that can be used to align incentives between transacting counterparties. Insurance offers a distinct risk management mechanism, enabling 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 in both voluntary and compliance markets.
Further considerations must be made in cases with carbon market integration
National regulatory carbon pricing schemes allowing offsetting with VCCs and national policy on Article 6 could affect advance market commitments and their contractual provisions. Once a VCC unit enters a regulatory carbon regime, it is subject to a set of pre-determined legal rules, which may differ from when it exists strictly within the VCM.
In this context, it is our view that further consideration should be given to the significance of the integration trend discussed above within the conversation around the legal treatment of VCCs. While UNIDROIT’s Principles recognise that certain compliance schemes permit the use of certain VCCs for compliance purposes, UNIDROIT currently does not address how its Principles interact with pre-determined legal rules governing certain compliance schemes. Potential misalignments in this regard could restrict a buyer’s ability to use VCCs to service their compliance obligations and, in turn, slow the integration trend as a whole.
As discussed above, the integration of VCCs into compliance schemes is increasing globally, with a projected future impact on the EU. Therefore, a discussion regarding the legal treatment of VCCs and the implementation of the UNIDROIT Principles in this regard would be incomplete without considering potential integration scenarios between the VCM and compliance markets.
Conclusion
As the carbon credit market evolves, market participants are expected to make more intentional legal choices and to seek to minimise the risk of those choices being challenged or litigated in the first place. As a result, proper risk management of foundational project elements becomes increasingly critical to market confidence, stability, and growth.
The adoption of risk management measures targeting the fundamental elements of carbon project development, such as using ratings to identify risks to projects and insurance products to manage those risks, can strengthen the confidence of advance market participants in the pre-issuance phase. By identifying and managing performance-related risk, these tools offer a degree of assurance despite ongoing legal uncertainty post-issuance.
It is our hope that the UNIDROIT Project will encourage the swift development of clear and predictable domestic rules on the legal treatment of VCCs while recognising that legal variance will remain and continue to characterise this aspect of the market into the future. Within the existing landscape, carbon market investors, off-takers, and financiers can effectively manage transactional risks by carefully considering the legal landscape applicable to their future VCCs and utilising ratings and insurance measures as an integral part of their advance market commitment risk-management strategy.
We invite further discussion on the role of domestic and international legal rules governing VCCs in the development and growth of carbon markets in general.
Download Full Report >> click here
Related Carbon Market Insights:
• Unlocking Carbon Market Demand: How Safe Harbors Can Protect Corporations from Greenwashing Risk
• Dr. Ruth Dagan Appointed Co-Chair of IETA Legal Working Group
