Carbon credits conundrum: What’s left for countries hosting carbon projects as VCMs develop?

As efforts to develop Article 6-compliant carbon markets step up and voluntary carbon market activities develop, host countries are becoming increasingly concerned about the impact that international carbon projects may have on their future.

While concerns differ from country to country, governments are interested in securing fair compensation for local communities involved in voluntary carbon projects, retain some of the value generated by the international sale of carbon credits, and – most importantly – keep enough of the carbon credits produced on their soil to be able to meet their Nationally Determined Contributions, the goals set by the Paris Agreement.

The Paris Agreement allows governments to reach their NDCs via different tools including compliance markets, carbon taxes, and – under Article 6 – the retirement of carbon credits produced domestically or purchased on the international market.

Countries that are hosting carbon project activities worry that if too many carbon credits produced on domestic soil either as part of the VCM or the Article 6 sovereign carbon market are sold abroad, not enough may be left for local governments to reach their own NDC targets.

These concerns have already prompted host countries such as Papua New Guinea, Indonesia and Honduras to introduce moratoriums on carbon activities. Observers say more countries may follow.

"We are entering a new phase of carbon markets," said Hugh Salway, head of markets at project certifier Gold Standard. "More governments may take steps that affect the voluntary market in the next months, some of which may present opportunities for investors and some may come with risks."

Papua New Guinea put a halt on all new voluntary carbon forestry projects in March. Indonesia followed suit in April with a temporary halt on some carbon activities, including non-nature-based ones, saying it intended to align all activities taking place on its soil with national policies. In June, Honduras also introduced a moratorium on all nature-based voluntary carbon projects.

Honduras Deputy Environment Minister Michael Stufkens told S&P Global Commodity Insights their government needed to tackle the risks and conflicts associated with the recent escalation in the sale of forest carbon credits in the national territory "at unfair and obscure prices."

He also highlighted the need to have "a clear panorama of our national carbon stock" to implement the countrys' NDCs, as well as "a defined legal framework" to avoid opening to voluntary carbon markets in a counterproductive way. The moratorium would be lifted once the Honduran government completes its strategy and regulation of the sector.

Retain emission reductions

"Host countries are trying to figure out what is the best strategy to reach their NDCs," said Kevin Conrad, executive director at the Coalition of Rainforest Nations, an NGO.

"Which policies, regulation they should put in place, how would they get the private sector collaboration in achieving the state's NDCs," Conrad said. He added that countries are currently evaluating how quickly sovereign markets will take shape and if the existing voluntary carbon markets should be ignored, regulated or abandoned."

Forestry activities developed by international players and used for offsetting foreign emission, for example, could utilize all the soil available, especially in countries as small as Papua New Guinea, and leave no room for local players or the government to produce carbon credits.

This would require the host country to buy credits from elsewhere, possibly at a great deal of public expense, if not indebtedness. Overselling is also a big risk for host countries that have yet to implement national registries.

The problem is particularly strong for REDD+ credits, issued by projects aimed to avoid deforestation, says Ben Rattenbury, Head of Policy at intelligence platform Sylvera.

"In many countries REDD+ credits can be issued only after the landowner has released its carbon rights to the company developing the project," Rattenbury said.

This creates a potential conflict between landowners that are keen to set up partnerships with international developers and make money out of them, and the local government that is suddenly deprived of emission reductions production potential

"In this scenario, tensions between the interest of land owners (typically private organisations) and governments could arise," Rattenbury said.

Coordination among stakeholders

Reaching NDCs will be an effort that each country party to the Paris deal will make in coordination with the domestic players active in those industry sectors in most need of decarbonization. It will be up to the government to request these private players to reduce their emissions and give them the possibility to resort to carbon credits to do so.

Therefore, according to Andrea Bonzanni, international policy director at at International Emissions Trading Association, the moratoriums seen over the past months may have also been triggered by the need of host governments to coordinate with their internal stakeholders on which activities to undertake to decarbonize their respective countries.

"Governments are starting to assess the role of markets in meeting their NDCs and the interactions between domestic instruments, the voluntary carbon market, and Article 6," Bonzanni said, adding that "they may select some industry sectors, impose an obligation on emitters, and offer the possibility to compensate through the use of carbon credits."

Possible solution

For Sylvera's Rattenbury, host countries' concerns are triggered by little visibility on the potential impact of VCM activities on their NDCs goals.

This little visibility derives from lack of clarity around the use of Corresponding Adjustment for VCM credits claimed by corporates against their emissions.

The problem could be unlocked in two ways, said Rattenbury. It could be solved by ruling out the need of a CA for corporate buyers. This would allow host government to use all the voluntary carbon credits produced on their territory to meet their NDCs, even when the same credits are used by international companies to offset their emissions.

Or, Rattenbury added, carbon markets stakeholders could agree globally that corporate buyers do need to obtain a Corresponding Adjustment from the host government, meaning that the carbon credits used by corporates will not be used by the governments against its NDCs. In this case, however, rules that allow host countries to retain part of the emission reductions created by private developers on their soil may be required.

"For example, out of a sum of credits purchased by a buyer, a proportion of the emission reductions could remain with the host government to be claimed against its NDCs," Rattenbury suggested.

The share of proceeds and overall mitigation of global emissions rules already contained in Article 6 are already setting a precedent for a similar solution, the VP Policy said.

Retaining cash

Beyond the need to secure capacity to meet the NDC goals, host countries are also considering the need to ensure fair conditions for local communities and to retain some of the value generated by the international sale of VCM credits. It is also unclear whether there are taxes in place on VCM activities, to ensure that some of the profits made by international developers are shared locally.

"VCM activities are not leaving any profit to host countries," Conrad said. "All profit is taken offshore."

Also, while Article 6 allows the host country to develop the revenue share model, in the VCM it all happens between project developers and private landowners without transparency, where project developers try to retain as much profit as they can, Conrad said.

According to Gold Standard's Salway, this will be a balancing act for host countries, which will have to consider the benefits of introducing levies on market activities and the need to maintain attractiveness towards investors.

Facing the risk

While the list of countries introducing moratoriums seem destined to increase, VCM traders are trying to protect their respective portfolios.

"Some clients are anticipating the risk of countries wanting to keep credits at home, and not allow their export," a Europe-based carbon trader said. "Buyers need to figure how to diversify the geography of their portfolios."

Government interventions are feared to trigger reduction in supply of credits available internationally, as well as prices of credits linked to local markets, the same source said.

Another trader, also Europe-based, noted that while geography was already an important factor in the diversification of trader's portfolios, the Indonesia's moratorium had made it even more relevant.

As carbon markets appear to be entering a now bumpy period after the constantly bullish curve seen in 2021, new hedging tools will be needed to help market player navigate the uncertainty ahead.