The international bid for legal certainty on carbon credits: taking China’s example to the UN

The joint meeting in early 2024 convened experts from various countries in related fields to prepare a draft UNCITRAL/UNIDROIT study on the legal nature of voluntary carbon credits (Research Report). This covers the legal nature, ownership, issuance, transfer, secured transaction, insolvency and other aspects of carbon credits to fully reflect the views of all parties and member States. It is applicable to different international trade scenarios. A revised Research Report is planned for submission to the 57th session of the UNCITRAL Conference in New York, United States of America, in June 2024.

The legal nature of carbon credits – and how it affects trading and finance

In practice, most countries, including China, have not yet clarified the legal nature of VCCs, and there is no international guidance on the determination of the legal nature of VCCs.

The legal nature of VCCs has a direct impact on carbon trading and carbon finance in a number of ways, including:

how carbon credits are acquired and sold
what rights carbon credit owners can assert against them
how to dispose of carbon credits associated with market participants in the event of their insolvency, and
the tax and accounting rules that apply to carbon credits.

Current international academic views include that carbon credits are:

a combination of a series of contractual rights (based on agreements between parties; can be bought, sold and transferred like any other contractual asset)
intangible assets (valuable rights that can be owned and transferred, but without a physical form like tangible assets)
the fruits of real estate (derived from the ownership or use of land or property; treated as a form of property right), and
digital assets (exist in a digital form and can be stored, accessed and transferred electronically).

Most of these views are held by experts in the common law system, including university professors in the UK and Europe, representatives of British and American law firms and representatives of major international organisations.

Some countries have clarified the legal nature of VCCs, but the laws are markedly different. For example:

Australian law clarifies that the Australian Carbon Credit Unit is personal property that can be passed on through assignment, will and legal succession.
The US Commodity Futures Trading Commission (CFTC) has recently defined carbon credits as intangible commodities.
In Argentina certified emission reductions (CERs) issued under the CDM mechanism are considered a security

In Peru they are defined as intangible movable property. The significant differences between various jurisdictions, and between common law and civil law systems, make it difficult to form a unified determination of the legal nature of VCCs. The types of VCCs themselves are diverse.

With the promotion of various international organisations and other entities, third-party platforms such as Verra and Gold Standard may also stipulate the legal nature of carbon credits issued and managed by them in the future.

It is still useful to have an international discussion on the legal nature of VCCs, to help market participants understand their rights and responsibilities in voluntary carbon markets and manage risks more effectively. It is also helpful to provide a theoretical basis for legislators and regulators in different countries to develop more forward-looking regulations and policies.

Having clarity on the legal nature of carbon credits is crucial for creating a stable and predictable business environment in the carbon market.

Does the existence of VCCs depend on third-party platforms that issue and register them?

Most international mainstream VCCs are issued by third-party platforms. Forum participants had a lively discussion on what happens if a third-party platform ceases to exist due to bankruptcy or other reasons. Will it affect the VCCs existing in the accounts opened by holders on the platform?

This relies on the legal nature of VCCs.

If they are contract-based claims, their existence will be more dependent on the platform that operates the VCCs account. If a third-party platform ceases to exist, things will become complicated - the holder of VCCs will not automatically obtain ownership, and the relevant rights and interests may be included in the bankruptcy estate of the third-party platform for liquidation and distribution.
If they are considered property rights, then the existence of VCCs, as independent objects, does not depend on the platform that operates the accounts of VCCs holders. Even if the third-party platform goes bankrupt, the holder still has the rights to the VCCs held in their accounts and has the right to demand the delivery of the VCCs.

Even if VCCs exist independently of third-party platforms based on the nature of property rights, there are still two issues:

1. Whether VCCs still have economic value in the absence of third-party platforms

The market's recognition of VCCs is not only affected by internal factors such as the quality, traceability and market transparency of VCCs, but also by external factors such as the regulatory framework of carbon markets in various countries and the attention of the international community to carbon emission reduction. Since there are many factors that affect the economic value of VCCs, including not only legal factors but also market supply and demand relations, policy factors and technical factors, all factors should be comprehensively considered when judging the economic value of VCCs.

2. The need for an independent and stable mechanism to take ‘custody’, reduce risk and maintain trust

Third-party platforms play an important role in the carbon market, including the formulation, issuance, registration and trading of standards.

Since the carbon credits applied for and issued by project owners according to their standards are often registered in the accounts opened on the platform, the non-existence of the platform may involve many aspects such as the archiving, management and trading of VCCs. To protect the rights and interests of investors and VCC holders, it is necessary to consider the model of financial market infrastructure and establish an independent and stable custody mechanism. This can ensure the transparent, safe and traceable management of VCCs, help maintain market trust and avoid the potential risks faced by investors due to platform bankruptcy.

What are the benefits of financing if carbon credits are ‘real rights’ (that is, akin to )?

Under the civil law system there are potential institutional advantages if carbon credits are considered as having the nature of property rights. The more specific term used is ‘in rem’ – a Latin expression meaning there are rights or interest in a property without others involved.

1. Clearer rights and lower risks

Carbon credits are relatively independent from the third-party platform's own credit to a certain extent, if they have the status of a movable property through possession. This brings higher certainty for financing transactions, helping to avoid potential legal disputes, improving the predictability of financing transactions and providing a safer trading environment for investors and creditors.

2. Easier verification and transfer of ownership

The ownership of intangible movable and immovable property is usually established on a registration basis. This registration system makes it easier to verify and transfer the ownership of carbon credits, simplifies the financing transaction process and improves the efficiency of the transaction.

3. Better security for banks – and therefore more willingness to lend

At the same time, because property rights are more easily defined and enforceable in law, treating carbon credits as property rights also provides financial institutions with more reliable guarantees. Banks and financial institutions are often more willing to accept property rights as security because they provide clearer legal protection to borrowers and reduce potential risks.

How the current practice in China is bringing protection for creditors via ‘dual’ registration

At present, China has a lot of financing practices based on carbon allowances and carbon credits. In the transactions we have been involved in, financial institutions have provided financing to small and micro enterprises that hold carbon emission rights with carbon allowances or carbon credits as collateral.

Local registration. Many local pilot carbon emission allowance exchanges have been piloted, providing a relatively complete function of registering and freezing carbon emission allowances in carbon accounts.
Unified registration. In addition to registering the guarantee on the local pilot exchange, many financial institutions will also register the carbon emission allowance security on the unified registration and publicity system for movable asset financing. In the absence of clear guidance from laws and regulations, this dual registration arrangement provides maximum protection for creditors.

Judicial support for ‘property’ status

China’s Supreme People's Court (SPC) has also given a relatively clear and positive view on the issue of judicial certainty. In February 2023, the SPC issued Opinions on Providing Judicial Services for Actively and Steadily Promoting Carbon Peak and Carbon Neutrality by Fully, Accurately and Comprehensively Implementing the New Development Concept. This clearly upholds the validity of carbon asset security contracts and supports compensation for the pledgee in priority for the registered pledged carbon assets. These opinions reflect the judicial attitude of treating carbon allowances and carbon credits as property rights similar to those that can be set up as guarantees, which is of great significance for stabilizing market expectations.

Are carbon credits fungible – that is, ‘things’ that are interchangeable like cash?

The discussion about the fungibility of carbon credits is also about whether one carbon credit unit can replace another carbon credit unit to achieve the same function in a given situation. This asks whether carbon credits can be regarded as a kind of ‘indefinite thing’ in law - assets like gold and currency are among examples. If the ‘indefinite thing’ is accidentally lost before delivery, due to its interchangeability, the obligor can still fulfill the delivery obligation by delivering the same kind of thing.

How fungibility would simplify processes – and cut costs

Considering carbon credits as ‘fungible’ interchangeable assets would have a positive effect on carbon credit trading in terms of improving the liquidity of carbon credits, simplifying the transaction process and reducing transaction costs.

As a case study: take the example of a carbon asset security scenario in financing. According to the UNCITRAL Model Law on Secured Transactions, after the loss of the security right the secured creditor who obtains security possession needs to return the collateral to the security provider. China’s Civil Code has similar requirements for the pledgee. If the carbon credit is considered a fungible asset, it will provide greater flexibility for the transaction participants – the secured creditor can return other carbon credits of equivalent value when the security right is extinguished, rather than just a specific carbon credit. This not only simplifies the operational process, but also reduces the transaction costs incurred by all parties for the return of specific carbon credits.

Is there a way to ensure carbon credits are fungible?

The fungibility of carbon credits is influenced by a variety of factors.

Contractual terms – similarity. If voluntary carbon market trading participants use the same contractual terms when trading different types of carbon credits, then these carbon credits may be considered interchangeable.
Interoperability of platforms. When the issued carbon credits issued according to specific issuance standards need to be revoked due to accounting errors or other reasons, the account holder can only offset them by giving up the corresponding number of carbon credits issued under the same issuance standard. Whether the carbon credits are interchangeable is related to whether the third-party issuance and registration platforms are interoperable.
Underlying offsetting project and end-use. Carbon credits can be considered interchangeable in certain contexts because of the degree of uniformity in the way carbon credits are measured. Each carbon credit unit corresponds to the reduction or removal of one tonne of greenhouse gases from the atmosphere. However, given the different standards for issuing different types of carbon credits, market participants often do not treat different types of carbon credits as fungible.

Therefore, when discussing the realization of carbon credit interchangeability, it is necessary to consider the coordinated development of market standards, contract specifications and technology interoperability, and strive to promote the carbon market to provide greater liquidity and reduce transaction costs.

Chinese courts haven’t had to consider the issue – but that is changing (and international discussions may affect decisions)

There are some trading cases that are underway in China relating to overseas carbon credits. This means parties trading carbon credits will start to focus on whether the legal nature of carbon credits by various third-party entities will have an impact on the judgment of Chinese courts.

Chinese courts aren’t usually concerned with the legal nature of credits…

There are no relevant precedents on disputes arising from international carbon credit trading, based on our public searches. In practice, Chinese courts focus more on the analysis of facts than abstract legal reasoning - including combing through relevant evidence and applying legal provisions when making judgments and reasoning. Therefore, when the case does not touch on special circumstances such as the bankruptcy of the parties, and in the absence of clear provisions on the legal nature of carbon credits in China's laws and regulations, the court may not necessarily and does not need to discuss in depth the determination of the legal nature of carbon credits by a third party. In fact, for many disputes related to carbon credits, the focus of the controversy does not need to delve into the nature of the disputed subject matter but remains on the level of contractual disputes concerning the terms and performance of the transaction contract itself.

…except in the case of bankruptcy (and other special circumstances)

However, the legal nature of carbon credits is likely to play an important role in judicial discussions in some special types of disputes. For example, cases where the legal nature of the subject matter must be used as the basis for judgment due to the bankruptcy of a party or other special circumstances. In the absence of clear regulations in China, international discussions on the legal nature of carbon credits will also serve as a reference for Chinese courts' judgments. But the final decisions will depend on a variety of factors including the domestic legal framework, regulations and the specific circumstances of the case. In such cases, a thorough argument on the legal nature of carbon credits, in order to clarify the relevant legal relationships, can help provide the courts with a more accurate basis for judgment.

The advances of China's CCER system compared with overseas carbon credit systems

In the international carbon credit market, different countries and regions have formulated different regulations and standards, resulting in differences in the legal nature of carbon credits. China has shown a certain degree of advancement in the institutional construction, financing practice and supervision of national certified emission reductions (CCER).

Benefits of separate registration and trading institutions: China’s model

China's CCER system adopts a model of separate registration and trading institutions. The clear division of responsibilities allows the two institutions to be relatively independent, which:

helps to prevent potential conflicts of interest
reduces the possibility of possible misoperation or information tampering, and
improves the transparency and fairness of the CCER trading market.

Benefits of centralised and unified trading

Under this framework, China has adopted a centralised and unified trading method. This has many advantages compared with voluntary emission reduction mechanisms such as Verra, which mainly rely on over-the-counter agreements for voluntary CER trading.

Regulatory efficiency. Centralised and unified trading provides regulators with a more convenient and efficient means to monitor market activity and trading behavior in a more timely manner. This helps to detect and correct market anomalies in a timely manner, which can reduce the cost of regulatory enforcement.
Improved risk monitoring. Centralised and unified trading enables regulators to monitor market risks more accurately, including but not limited to transaction size, price fluctuations and market manipulation.

Benefits of strong national supervision

China's registration and trading institutions are operated and managed by the National Center of Climate Change Strategy and International Cooperation (Strategy Center; a public not-for-profit institution directly under the Ministry of Ecology and Environment) and the Beijing Green Exchange, respectively. As a subsidiary of the Beijing Equity Exchange, the Green Exchange is a comprehensive environmental rights trading institution approved by the Beijing Municipal People's Government.

Administrative measures clarify the functions and responsibilities of the two, acting as a unified national registry and trading institution for voluntary greenhouse gas emission reduction (in full, titled the Administrative Measures for Voluntary Greenhouse Gas Emission Reduction Trading (Trial)).

Compared with other for-profit third-party platforms, China's registration and trading institutions are subject to stronger supervision, undertake more public functions and have clearer and more neutral boundaries of rights and responsibilities. This helps to increase the transparency of the CCER trading system, reduce potential misconduct and increase the confidence of market participants. In addition, strict supervision will help promote the implementation of effective risk management and supervision by relevant registration and trading institutions, reduce the possibility of platform bankruptcy, and better protect the rights and interests of trading participants.

The joint meeting also discussed whether the monetisation model of third-party platforms such as Verra charging fees to VCC project developers is sufficiently neutral.

Benefits of consistent standards and certification

Institutions engaged in CCER certification in China need approval by the Certification and Accreditation Administration of the People's Republic of China. In contrast:

most of the rules for accredited or designated certification bodies developed by carbon credit platforms operated by third parties are autonomous
most countries have no mandatory regulatory provisions.

On the one hand, the autonomy-level regulations may lead to a lack of consistency and standardisation, which increases the uncertainty and complexity of the transaction and increases the possibility of disputes between project owners and certification bodies.

On the other hand, different carbon credit platforms may have different certification body rules, which makes project parties and investors face additional adaptation costs and risks when trading across platforms.

China's mandatory regulation of CCER certification and accreditation:

will help make up for the possible inconsistencies and lack of standards in the various rules of the carbon credit market
improve the unified standards and credibility of certification bodies, and
are conducive to the standardised development of the market and the protection of investors' rights and interests.

Conclusion

As carbon markets experts at KWM in China, we have a responsibility to let the world know more about the development status of China's carbon market, and share our insights on the uniqueness and benefits of China's carbon market system.

The joint meeting in Vienna was attended by a total of 45 delegates, including university professors and representatives from common law countries. Eight were from international organisations, including the International Swaps and Derivatives Association (ISDA), the International Organization of Securities Commissions (IOSCO), the United Nations Framework Convention on Climate Change (UNFCCC) and the World Bank. There were two representatives from China, which showed the importance that UNCITRAL attached to China's voice.

The discussion of the legal nature of carbon credits must integrate the views and practices of the civil law system, without being dominated by voices from the common law system.

The exchanges and cooperation at the joint meeting brought opportunities to:

actively share China's experience and achievements in the construction of the carbon market
publicise China's policies and measures in response to climate change
promote the international community's awareness and understanding of China's carbon market.

This will help countries better understand China's carbon market and development trends, promote the development and cooperation of the global carbon market, and jointly address the challenge of climate change.

Want to know more about carbon markets in China, or globally? See related insights and visit our Carbon page.

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