Carbon Credits and Voluntary Carbon Markets: Client FAQs

A carbon credit is an acknowledgment of a metric tonne of carbon that has either avoided release into our atmosphere or has been removed from our atmosphere. The holder of a carbon credit is permitted to emit that same amount of carbon. Individuals and companies can buy or sell carbon credits on carbon markets – mandatory or voluntary – to compensate for unavoidable carbon emissions.

Carbon credits are independently certified, verified and issued by governments or boards, and are traded like any other commodity. 

Purchasers of voluntary carbon credits ("VCCs") vary widely, and can include private companies, non-governmental organisations, governmental bodies and individuals. There are a number of reasons to invest in VCCs, but VCCs are particularly useful for "hard-to-abate" sectors.

Broadly, hard-to-abate emissions are emissions that are either prohibitively costly or impossible to reduce with technology that is currently available. Typically, hard-to-abate sectors are split between heavy industry (e.g. cement, steel, and chemicals manufacture) and heavy-duty transport (e.g. trucking, shipping, and aviation). Together, these sectors contribute to approximately 30% of global emissions, which is expected to double under projected business-as-usual scenarios.

For businesses in these sectors, investing in VCCs is an opportunity to reduce their carbon emissions, facilitating compliance by businesses with carbon footprint targets and limiting carbon liabilities.

Businesses purchase VCCs for a variety of reasons. One is that VCCs are traded as a means of meeting climate transition plans or ESG targets. With an increasing number of non-regulated entities adopting net-zero commitments, VCC trading is seen by businesses as a less capital-intensive means of reducing their carbon footprints, as compared with retrofitting or investment in renewable energy.

Another reason is for investment purposes. VCCs correspond to the avoidance or removal of carbon (of which there is no limit), meaning there is no finite cap on the number of VCCs which could be issued. However, the availability of VCCs (and the subsequent price) is impacted by supply and demand pressures. Because the pricing of VCCs is affected by market forces, this means credits can be acquired for investment purposes. In addition to potential investment returns, investors in VCCs may be further attracted by knowing their investment will contribute to the development of carbon-negative projects.

We are also seeing businesses trade VCC derivatives, where the VCCs are the reference assets underlying the contracts. Such derivatives can be used for speculative trading or for hedging purposes to mitigate against future carbon credit price fluctuations, or for speculative trading. For example, the electric carmaker Tesla has earned billions of dollars from carbon trading with $1.79 billion attributed to carbon credit sales in 2024 alone.

VCCs can also be used to in an effort to increase the value of another product in the eyes of environmentally-conscious consumers. We have advised a client seeking to tie fuel they sold to a set quantity of carbon credits, allowing them to advertise its greener credentials and charge an associated "greenium" to customers when compared against their regular fuel offering.

The requirement for companies to adopt carbon offsetting measures is at the forefront of the corporate agenda. For the UK economy to meet its net zero target by 2050, the shift in energy sources will need to accelerate at a historic-record rate. This is where VCMs come in.

VCCs acquired or traded on VCMs allow businesses to work towards their own net zero goals. By trading VCCs, businesses can offset their own emissions while providing funding for projects which create VCCs, such as investing in carbon capture projects. Analysts predict that, if used correctly, VCMs could double global emissions reductions whilst also cutting costs by 20 per cent. VCMs are also an area for growth. While the global value of VCMs were estimated to be worth about $2 billion in 2021, forecasts predict the sector could be worth between $10 to $40 billion by 2030.

What makes VCMs attractive to companies is that carbon trading enables businesses to reduce their emissions immediately. This contrasts with other methods of offsetting like retrofitting, sequestration or investing in sustainable energy – all of which take time before companies can see an impact. Purchasing and trading carbon credits is also significantly less capital-intensive for companies. VCMs also present an alternative method of reaching ESG goals for companies and sectors which would otherwise struggle to meet the carbon footprint targets, such as businesses in 'hard to abate' sectors.

The absence of a centralised market or standardised guidelines for VCMs means there is regulatory uncertainty surrounding the future rules and regulations for voluntary carbon trading. The expansion of carbon markets has led to concerns regarding the functioning of the market, including the pricing transparency of VCCs. Unlike in MCMs, VCCs are not certified or verified by one official body, but instead by various registers operating in each VCM.

Regulators are now turning their attention to VCMs in response to calls from industry bodies to improve market practices. In September 2024, US regulators adopted the first federal guidelines requiring exchanges independently to verify carbon offset derivatives.  Many EU countries have proposed similar measures to improve the integrity and functioning of carbon markets, and the UK government recently announced its intention to push ahead with consultations aimed at improving the practices of VCMs. Notably, carbon credit markets were a key topic at the COP29 UN Climate Conference in November 2024, where Article 6 of the Paris Agreement was adopted. It is hoped that international standards in relation to the global carbon market, adopted in line with Article 6.4 of the Paris Agreement, will improve confidence in carbon markets.

To date, regulatory uncertainty and a lack of a universal framework for the operation of VCMs has been one of the biggest challenges for investors to navigate. The relatively novel regulatory landscape means companies will need to remain adaptable amidst changes to rules regarding VCCs. We are monitoring developments in this space. 

As with any expenditure or investment by businesses, the tax treatment of holding, retiring and disposing of VCCs will be a key consideration for businesses looking to become involved in this area.  Much like any other asset, the tax treatment will depend on a number of factors including the way in which VCCs are acquired and the use that the business puts them to, e.g. whether they would be retired in order to meet the business's net zero target or sold on.

Under new rules introduced by HMRC this year, the sale of VCCs can be classed as a 'taxable supply' for VAT purposes. This enables businesses which generate VCCs to recover their input tax from generating the credits upon subsequent sale to the market. The move towards clarifying the tax position on VCCs has been prompted by the growth of the market and the increasing use of secondary instruments in carbon trading. It is worth noting that certain types of VCC (such as those which have not been verified independently) will remain outside the scope of VAT.

The treatment of VCCs for other types of tax remains unclear. However, having been involved in various projects in relation to VCCs, including the development and launch of the LSEG derivatives exchange for funds invested in VCCs, we are ideally placed to advise on the tax position.