The European Union (“EU”) is coming closer to adopting mandatory rules for companies that use carbon credits.
- First, the European Parliament and Council are considering for adoption a Commission for a Regulation on a Carbon Removal Certification Framework (“CRCF Regulation Proposal”).
- Second, the European Commission (“Commission”) is in the process of adopting standards (the so-called “ESRS”) for the EU’s mandatory ESG reporting regime—the Corporate Sustainability Reporting Directive (“CSRD”)—that will also cover disclosures on companies’ use of carbon credits (including as emission offsets) and their quality.
These two regulatory initiatives are closely tied to each other. In effect, the draft ESRS that the Commission is considering for adoption require subject entities to disclose GHG removals and GHG mitigation projects financed through carbon credits.
The EU’s aim of regulating carbon credits coincides with its push for carbon neutrality by 2050, and a related significant proliferation of companies publicly committing to achieve “net-zero” emissions by mid-century, which has triggered an uptick in strategic purchases of carbon credits in the voluntary carbon market (“VCM”). The CRCF Regulation Proposal and the upcoming ESRS will help to expand sustainable and verified carbon removals and encourage investment in technological innovation.
Companies turning to the VCM to reach their net zero goals, and others active in the generation, trading, and use of carbon credits, will want to follow these initiatives closely. Opportunities remain for companies to express views that may shape the final contours of these regulations.
We discuss these developments and opportunities for public comment below.
Regulation for a Carbon Removal Certification Framework
The European Parliament and Council are currently considering for adoption the CRCF Regulation Proposal that the Commission presented in late November 2022. The Proposal contains rules to monitor, report and verify the authenticity of carbon removals taking place inside the EU/EEA. In effect, the proposed scheme is only intended to operate for carbon removals that take place in the EU/EEA.
The CRCF Regulation is based on four quality criteria (carrying the “QU.A.L.ITY” moniker):
- Additionality and baselines,
- Long-term storage, and
These criteria guide the requirements of the CRCF Regulation Proposal. In particular, to ensure the transparency and credibility of the certification process, the CRCF Regulation Proposal:
- sets out quantification, additionality, and long-term storage requirements that products must meet to be certified;
- requires that certification methodologies comply with these requirements, and provides the Commission with powers to establish the methodologies; and
- requires companies to subject their certification to independent third-party verification through a certification scheme.
Thus, the CRCF Regulation Proposal would require carbon credit project developers and potential users to conduct their own assessment of the carbon removal in accordance with the “QU.A.L.ITY” principles and the methodologies prepared by the Commission and then submit that assessment for independent verification through a certification scheme.
The CRCF Regulation Proposal requires certification schemes to be recognized by the Commission. All service providers of certification schemes must submit annual records of their activities to the Commission, and communicate any attempted fraud they identify. Moreover, certification schemes may only use accredited third-party certification bodies to verify project developers’ and users’ carbon removal assessments. These certification bodies may only be accredited by national accreditation bodies in the EU Member States. Hence, the CRCF Regulation Proposal creates a system of accreditation similar to that of notified bodies under the EU product rules.
At this stage, it is not yet clear how carbon offsets created through carbon removal projects applying the methodologies and certificate schemes set forth under the CRCF Regulation Proposal may serve as an alternative mechanism to meet the EU’s GHG emissions reduction targets. According to the Commission’s explanatory memorandum on the CRCF Regulation Proposal, part of the revenues of the European Union’s Emissions Trading System (“EU-ETS”) are directed to the Innovation Fund, which helps businesses invest in innovative clean technology – including carbon removals. The CRCF Regulation Proposal fits within that push towards investing in innovation. However, it appears that carbon removals under the CRCF Regulation Proposal would not be tradable or serve a purpose under the EU-ETS.
In addition, the EU’s regulatory efforts on carbon removals are clearly linked to global developments. Notably, in their January 2023 meeting, the International Sustainability Standards Board (“ISSB”) confirmed that the proposed Climate-related Disclosures (“Draft S2”) would require companies to disclose the intended use of carbon credits, disaggregating the net emissions targets and intended use of carbon credits from the company’s gross emission reduction targets. The ISSB is one of two standard setting boards of the International Financial Reporting Standards Foundation (“IFRS”) and is responsible for developing IFRS’ sustainability disclosure standards. These standards are intended to act as a global baseline to ensure companies accurately and transparently report on their ESG activities. The Draft S2 would require a company to disclose the number of carbon offsets necessary to reach the company’s net zero goals, including certain factors required for users to understand the credibility and integrity of the offsets intended to be used by the entity. A carbon removal activity’s compliance with the CRCF Regulation Proposal (once adopted) would likely be an important marker of credibility and integrity.
Interaction with the EU’s Mandatory Carbon Credit Reporting Regime for Companies under CSRD
The draft ESRS standards that that the Commission is currently considering also include ESRS E1 on Climate Change (“ESRS E1”), which proposes a set of mandatory climate disclosures for many companies. The ESRS E1 contains two principal disclosure requirements for companies with respect to their GHG removals and GHG mitigation projects that are financed through carbon credits:
- First, companies must disclose GHG removals and storage from their own operations and their upstream and downstream value chain, and report the underlying calculation assumptions and methodologies; and
- Second, and most important for carbon credits and the VCM, companies must disclose the amount of GHG emission reductions or removals (in metric tonnes of CO2eq) from climate change mitigation projects that financed through any purchase of carbon credits.
In addition, the ESRS E1 also requires that:
- Companies relying on carbon credits for achieving any net-zero targets explain the credibility and integrity of the carbon credits used, and whether and how its claims of GHG neutrality neither impede nor reduce the achievement of its GHG emission reduction targets;
- Companies consider recognized quality standards for preparing information on carbon credits, verifiable by independent third parties, to make public reports, and to provide rules for calculation, monitoring, and verification of the project’s GHG emissions;
- Companies disclose information on carbon credits with a breakdown of the following items (see AG 66 for the tabular format in which companies are suggested to present information on carbon credits):
- the share (percentage volume) of reduction projects and removal projects;
- the share (percentage volume) of each recognized quality standard;
- the share (percentage volume) issued from projects in the EU; and
- the share (percentage volume) that qualifies as a corresponding adjustment under Article 6 of the Paris Agreement;
- Companies apply consensus methods on accounting for GHG removals as soon as they are available;
- If applicable, companies report the total amount of carbon credits it plans to cancel in the future based on existing contractual agreements (e.g., non-retired credits in registry accounts); and
- Carbon removals not undermine the efforts on GHG emission reductions (ESRS E1 suggests that approximately 90-95% of GHG emission reductions should come from a company’s own business emission reductions).
It is yet to be seen specifically how the ESRS E1-7 disclosures will interplay with the EU’s CRCF Regulation Proposal. The draft ESRS E-1 does not reference the CRCF Regulation Proposal, but it requires companies to “apply consensus methods on accounting for GHG removals as soon as they are available.” This fits with the Commission’s purpose for the regulation of the certification of carbon removals—namely to increase transparency, credibility, and integrity around companies’ actions to permanently remove GHG from the atmosphere.
The Commission is set to adopt the draft ESRS as delegated acts by mid-2023. On November 23, 2022, EFRAG sent its draft ESRS to the Commission. Once adopted, the European Parliament and Council have two months to present any objections. Thereafter, the ESRS will be the mandatory standards according to which companies must report a wide variety of ESG impacts (see here for more details).
It may take up to 18 months until both the Parliament and Council reach an agreed text and the CRCF Regulation Proposal is finally adopted by the European Parliament. Even thereafter, the EU’s certification framework will only be fully operational once the Commission has adopted the first certification methodology and recognised the first certification scheme.
The Commission’s proposed draft of the CRCF Regulation Proposal is currently open to a public consultation until March 7, 2023, and companies may submit comments through the Commission’s “Have Your Say” website.