Can voluntary carbon markets be fixed?

Companies that have announced climate targets (for instance: becoming “net zero” by 2050) represent a market capitalization of over $20 trillion. Almost all of them will rely on carbon offsets purchased on the voluntary carbon market (VCM) to reach their target. And yet, despite the obvious importance of the VCM, there are virtually no academic studies that analyze in-depth its functioning.

In our working paper, we fill this gap.

The process of creating a carbon offset starts with a project developer setting up an emission reduction project. For example, the project developer might plant a number of trees that will remove 100 tonnes of CO2 from the atmosphere. At this point, the project developer will select a Verification and Validation body (VVB) to audit the project and a standard setter to certify the offsets. In our example, the VVB would ensure that the trees have been really planted, while the standard setter would certify that the entire project has been carried out in a way that meets its standards.  Therefore, there are two actors – standard setters and VVBs – assessing the quality of carbon offsets.

The fundamental problem, however, is that the project developer, the standard setter, as well as the VVB, each have incentives to overstate offset claims (hereinafter, “to inflate offsets”). The project developers can clearly increase its profits if it has more offsets to sell. Similarly, standard setters can profit from offset inflation, as their fee depends on the amount of offsets certified: VVBs are hired and paid by project developers and must be accredited by standard setters, thus they also have incentives to facilitate offset inflation.

Most of the demand of the VCM comes from corporations that have a self-interest in purchasing cheap and inflated offsets.

If offset buyers were interested in purchasing only offsets that correspond to true reductions of CO₂, then reputational sanctions might prevent market players from inflating offsets. But most of the demand of the VCM comes from corporations that have a self-interest in purchasing cheap and inflated offsets. Cheap and inflated offsets allow corporations to reach their climate target at a lower cost. And, given that their end-consumers are unable to assess the quality of the offsets they purchase, the expected reputational sanctions that corporations face for relying on inflated offsets are extremely low. Further, carbon offsets certified by the leading standard setters increasingly provide regulatory benefits. For instance, in several countries’ corporations purchasing carbon offsets certified by the leading standard setters can pay lower taxes. Obviously, these companies have incentives to purchase as many offsets at as little cost as possible to cut their tax bill. Thus, offset buyers have no interest in punishing standard setters, VVBs and project developers that inflate offsets.

Do these pervasive market failures imply that we should throw away the baby with the bathwater? We argue that the answer to this question is no.

The Intergovernmental Panel on Climate Change has acknowledged that projects aimed at removing carbon dioxide from the atmosphere are necessary to reach the goal set in the Paris Agreement and the VCM can mobilize the capital needed to develop such projects. Moreover, the VCM can potentially help develop countries to build more resilient and greener economies.  For these reasons, we develop a list of dos and don’ts for policymakers who want to help the VCM fulfilling its potential (Table 1).

To begin with, we argue that policymakers should not implement ex-ante regulation or impose ex-post liability on standard setters and VVBs that inflate offsets. Given the extreme complexity of the market, policymakers and courts are unlikely to have enough information to be able to implement either of these solutions in an effective manner. Most importantly, we argue that policymakers should avoid that certification from leading standard setters are associated with regulatory benefits, as this further displaces the reputational mechanisms that should limit rating inflation. 

Instead, we argue that any attempt to improve the functioning of the VCM should simultaneously achieve three things: i) increase the transparency of the market, ii) provide agents that possess the relevant information with the necessary and sufficient incentives to identify low-quality offsets, and iii) strengthen reputational sanctions for inaccurate certifications. In the last part of the article, we propose a policy that simultaneously achieves these three goals.

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By Luca Enriques (University of Oxford & ECGI), Vittoria Battocletti (Bocconi University) & Alessandro Romano (Bocconi University)

If you would like to read further articles in the 'Governance and Climate Change' series, click here

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