How will IOSCO guardrails affect the carbon markets?

The International Organization of Securities Commissions (‘IOSCO’) has published two papers that propose regulatory changes to carbon-related markets: a consultation report on Compliance Carbon Markets (‘CCMs’) and a discussion paper on Voluntary Carbon Markets (‘VCMs’). The proposals are intended to solve issues associated with both markets, including greenwashing, criminal activity such as fraud and market abuse, and a lack of market integrity.

IOSCO published both papers at the United Nations Climate Change Conference (COP27) and has sought comments on the proposals by 10 February 2023.

Carbon-related markets are intended to “reduce GHG emissions by establishing a price on the GHG emissions”.[1]

There are two main types of markets.

First, CCMs, also known as Emission Trading Schemes, involve carbon permits that are issued by government organisations which cap a company, or an industry’s carbon usage. A credit amounts to one tonne of CO2. If a company reduces emissions below their allocation, they can sell credits on secondary markets, and, conversely, if a company emits beyond their cap, they can purchase credits.

The second type of market is a VCM, which involves credits issued on a project basis as opposed to an allowance basis. Environmentally positive projects, those that remove greenhouse gas emissions, are assigned credits for every tonne of CO2 removed from the atmosphere. Standard bodies, such as Verra and Gold Standard, certify the legitimacy of a project and operate registries housing these credits.

Companies are issued credits on primary markets - for those that conduct environmentally positive work - and can trade these credits on secondary markets - for companies seeking to offset carbon emissions they produce in their business. Both markets intend to provide a financial incentive to lower GHG emissions.

VCMs are largely unregulated with no governing body, centralised trading platform or agreed methodology for what constitutes a carbon credit. CCMs are more developed but lack the sophistication of established commodity markets.

IOSCO has sought to address these concerns by introducing “guardrails” to regulate both markets. It argues that market growth requires regulation to ameliorate current and potential issues.

Issues

There are a host of issues surrounding the operation of carbon markets, which are raised in both papers, and which the proposals seek to address. At a high level, the issues are rooted in the following:

1. Compliance Carbon Markets:

1. Conduct - including conflicts of interest between market participants.
2. Lack of transparency, oversight and monitoring of trades.
3. Fraud, insider trading and price manipulation.

2. Voluntary Carbon Markets:

1. Project level - concerns over the environmental integrity of carbon credits, where accreditation systems are fragmented, with no central system or definition of a “high quality carbon credit”.[2]
2. Trading Environment – concerns over the sophistication and functioning of both primary and secondary markets.
3. Communication Over Use – concerns around greenwashing, and companies purchasing and trading credits that are invalid or obtained by corruption.

Carbon Compliance Markets

The report for CCMs advises national authorities on how to regulate allowance-based markets. There are currently 29 compliance markets globally, including the European Union, the United Kingdom, New Zealand, and Canada. The value of globally traded permits grew to $851 billion as of January 2022, an increase of 164% from the previous year.[3]

IOSCO’s 12 recommendations deal with the primary market, market integrity, and market transparency and structure.

Recommendations 1-5 relate to the primary market, suggesting that authorities should pursue auctions as opposed to free allocations when considering how to allocate allowances, as this will improve price formation, and active participation as a result. In addition, auctions should be frequent and any intervention by national authorities should strictly follow rule-based mechanisms.

Recommendations 6-8 deal with market integrity. This includes legal certainty over the nature of allowances, including whether they are within the remit of financial regulators. It also recommends that authorities require strict market reporting in order to reduce systemic risk, enhance trade information transparency and mitigate against market abuse.

Finally, recommendations 9-12 deal with the transparency and structure of the market. The report relies on existing commodity markets and recommends robustly regulated infrastructure, such as trading venues and auction platforms, as well as standardized contracts and the requirement to set clear rules for the functioning of secondary trading markets.

Voluntary Carbon Markets

VCMs are not as established as CCMs, with most jurisdictions failing to have government or regulatory oversight frameworks. However, significant growth is predicted from a current $1 billion valuation, to $50 billion by 2030. IOSCO proposes 11 key considerations.

The first proposal promotes open access in trading markets, which it is hoped will lead to a centralized trading platform where regulation would have greater impact. Currently, VCMs are fractured and de-centralized with each standard body holding their own registry. For example, Verra has its own carbon credit registry, but “looked forward to working with IOSCO on its proposals” to build a global system.[4] The advantages to a centralized system are clear as it will create transparency and improve the integrity of carbon credits.

The second and third considerations address market integrity specifically. They focus on achieving VCMs that are not open to “fraud, manipulation, or disruption”.[5] The paper places emphasis on Interpol’s 2013 report into criminal activity in carbon markets, where it found carbon-related markets to be a target for fraud, money laundering and market abuse.[6] In addition, the fourth consideration is to make data publicly available, which IOSCO claims will promote transparency, improve trading competition, and market efficiency.

The proposals also address the integrity of the carbon credit. This includes standardization for the accreditation of each credit. IOSCO has sought to deal with these inconsistencies by promoting a standard methodology for a carbon credit, which will in turn improve environmental credibility. For example, current methodology for a deforestation project differs from a carbon-capture project.

Greater cohesion between carbon-related markets is proposed as well as strict rules surrounding the financial integrity of participants and transactions. IOSCO proposes that procedures should be put in place to achieve financial integrity which is “the centrepiece of any market”.[7] The paper also deals with legal certainty. It raises questions over the categorisation of carbon market products and signposts potential jurisdiction issues. For example, how will a jurisdiction deal with international stakeholders. It also raises the question of how in an event of bankruptcy a carbon credit will be treated.

The final considerations propose a robust governance framework and propose to ameliorate conflicts of interest that could potentially occur between market participants. The paper finally suggests the establishment of a governing body. Alongside the considerations, 12 toolkits have been published that suggest practicalities for participants to consider.

Conclusion

In their current form, proposals for both papers are an outline of the issues facing carbon markets and lack detail on substantive measures to ensure effective regulation. The purpose of both discussion papers is reflective of its title - a discussion - where IOSCO has sought the input of relevant market participants and regulators.

IOSCO has proposed to work closely with the Integrity Council for the Voluntary Carbon Market (IC-VCM), an organisation which aimed to try and implement core carbon principles for certifying carbon credits by the end of 2022. However, doubt has been cast over their principles, which included re-certifying all existing carbon credits, an “impossible” policy according Verra.

Whilst it is not clear how carbon-related markets will evolve, IOSCO’s appetite for regulation to aid market growth in both CCMs and VCMs is clear. If the proposals take shape, business entities and national authorities will face significant change in how carbon markets operate and are regulated. As carbon markets play an important role in providing a financial incentive for companies to achieve net zero emission targets, it will be necessary to continue keeping a close eye on regulatory developments in these markets.