Over the coming years, trillions of dollars of investment will be needed to fund the projects, infrastructure and technology required to transition to a more sustainable economy. Financial markets will be critically important in helping to ensure that capital gets to where it’s needed, and we think the development of voluntary carbon markets is one of the ways this can be achieved. That’s why we published new standard documentation for the trading of verified carbon credits (VCCs) at the end of last year.
For companies that may struggle to reduce their carbon emissions organically, a voluntary carbon market offers a viable way to reduce net emissions and support green initiatives. By buying VCCs, firms can meet their sustainability objectives while also funding projects that reduce or capture carbon, thereby boosting the flow of capital to those essential initiatives.
For this market to work effectively, however, a robust legal and regulatory framework is needed. In December 2021, ISDA published a whitepaper that explored the key legal issues associated with this market in the UK, US and Germany, and we supplemented this last year with a paper focused on France, Japan and Singapore. Those papers set out recommended steps to remove legal obstacles in voluntary carbon markets and highlighted the importance of standardized documentation as a means of creating greater certainty when trading VCCs.
The 2022 ISDA Verified Carbon Credit Transactions Definitions and related template confirmations for spot, forward and options contracts were published in December as part of a broad ISDA effort to develop robust legal and risk management standards for markets related to environmental, social and governance (ESG) activities.
Importantly, the definitions have been designed with the ability to support trading across carbon standards and registries, avoiding the need for multiple idiosyncratic documents. Just like our documentation for other asset classes, there is great benefit in having a single set of definitions and templates because it allows users to trade carbon credits more easily and on a global basis – in turn, enabling the market to scale. Despite standardizing key terms, users can still tailor their trades – for example, by specifying certain VCCs for delivery or choosing to accept a wide pool of credits, ensuring maximum flexibility.
Of course, robust legal documentation isn’t the only prerequisite for this market to work effectively. Market participants also need certainty that the projects they are supporting when they buy VCCs have a genuine and verifiable impact on carbon reduction. The Integrity Council for the Voluntary Carbon Market has developed a set of core carbon principles that should go a long way to achieving this. The principles, which are due to be finalized this quarter, establish a number of tests to protect the integrity of this market – for example, funded initiatives would need to be transparent about their activities and the resulting carbon reduction would need to be permanent, with any risk of reversal fully compensated.
We recognize VCCs are not the only channel available to firms to meet their sustainability objectives and support the green transition. There are a range of other financial instruments that have a valuable role to play, including sustainability-linked derivatives (SLDs), which embed a sustainability-linked cashflow in a derivative structure and use key performance indicators to monitor compliance with ESG targets. Last year, we carried out a survey to determine how firms are engaging in this nascent market and how trades are being documented. Based on the findings, we plan to develop standardized terms and clauses to document SLDs, which will help to build greater efficiency into the trading of this product.
The drive to net zero is now approaching a crunch period. We’ve seen a real mindset change in recent years and ambitious commitments from governments and businesses around the world to work together to tackle the challenge. By developing an effective legal framework for products such as VCCs and SLDs, we can help firms to safely scale up their participation in these increasingly important markets.
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