A key landmark in Carbon Credit transactions 5 min read
How can you measure carbon trading if you can't define a carbon credit? Absent a definition, you can't write a contract, benchmark industry standards or truly create a functioning carbon-trading market globally.
That's why last week's release of the ISDA Verified Carbon Credit Transactions Definitions represents an important advancement for global carbon credit markets as it offers a foundational platform to build consistency of documentation.
In this Insight, we examine and summarise the key features of the ISDA VCC Definitions and explain how they will impact the carbon credit market and its participants.
- On 13 December 2022, the International Swap and Derivatives Association Inc (ISDA) published the 2022 ISDA Verified Carbon Credit Transactions Definitions (the VCC Definitions) which provide standard definitions and confirmation templates for spot, forward and option transactions in verified carbon credits (VCCs) under the ISDA Master Agreement.
- The VCC Definitions have been published to provide some industry standardisation for, and help facilitate, secondary market trading of VCCs.
- VCC markets will play an important part in the energy transition, and publication of the VCC Definitions is an important step towards building the liquidity of these markets in Australia and globally.
Users of derivatives, carbon credit and energy transition project teams, legal counsel and compliance.
Publication of the VCC Definitions represents an important step forward for global carbon credit markets.
In a series of whitepapers published in 2021 and this year, ISDA considered the role of derivatives in relation to carbon markets. These papers:
- highlighted the importance of derivatives to both mandatory and voluntary carbon markets, particularly in relation to secondary trading (ie subsequent trading of emission allowances and credits after their initial distribution to parties who either directly generate them or purchase them from an emission reduction project); and
- raised the importance to market participants of standardised documentation for secondary market trading of carbon credits.
The latter point in particular has been a focus of discussions amongst industry participants this year.
The publication of the VCC Definitions represents a key milestone in achieving this as they (including the confirmation templates) offer a foundational platform to build consistency of documentation. Similar initiatives have been undertaken by other industry bodies. The International Emissions Trading Association (IETA) has developed documentation that spans primary and secondary over-the-counter emission markets. A few months ago IETA published a framework agreement for secondary market transactions in verified carbon credits.
This means market participants whose trades are covered by both IETA documents and ISDA documents will have a choice as to which ones to use. Different commercial and legal circumstances will drive that choice differently. The good news for participants is that:
- ISDA worked closely with IETA in preparing the VCC Definitions so that there is alignment of the two sets of documents on their central provisions and principles to the extent possible; and
- the publication of the VCC Definitions give participants the choice of plugging in to ISDA's existing legal and contractual frameworks for derivatives more generally.
The VCC Definitions are a collection of definitions for terms related to physically settled spot, forward and option transactions in 'Verified Carbon Credits' or 'VCCs'.
A 'Verified Carbon Credit' is a unit measured in tCO2e, representing some form of greenhouse emission reduction, which has a unique serial number and is quantified, verified and issued into a registry account operated pursuant to a carbon standard. This carbon standard can be mandatory or voluntary, domestic or international.
The VCC Definitions also include template confirmations for spot, forward and option transactions in VCCs.
Essentially, the VCC Definitions seek to provide a documentary platform which will have the flexibility to support trading of VCCs across various jurisdictions, standards and registries.
With this goal in mind, the VCC Definitions (which are drafted by our colleagues at Linklaters) are crafted broadly and generically. They also contain a number of elections which allow parties to tailor the terms to their individual preferences. This means they are set up to cater for a wide range of scenarios and can:
- be used in trade confirmations irrespective of the governing law applicable to that trade and can be used in markets and by market participants in any region globally;
- cover VCCs issued under different carbon standards and kept under different registries; and
- be used as a set of standardised terms in the market or to document bespoke transactions reflecting the elections of parties in individual trades.
The key concepts in the VCC Definitions are:
- two alternative methods of settlement:
- physical delivery of VCCs into the receiving party's registry account; and
- an option for the delivering party to retire a VCC on behalf of the receiving party;
- an option for netting of VCC delivery obligations;
- VCC Disruption Events—these are used to address certain scenarios where there is a failure to deliver or receive VCCs. Instead of allowing them to automatically trigger Events of Default or Termination Events, the consequences are softened:
- VCC Settlement Disruption Event: where an event beyond the control of a party makes it impossible or impracticable for it to deliver or receive VCCs, the relevant obligations are effectively deferred after the event no longer applies or the longstop date is reached. On the longstop date it becomes an Illegality under the 2002 ISDA Master Agreement (or an Additional Termination Event under the 1992 ISDA Master Agreement);
- failure to deliver: there is a built-in remedy period for delivery obligations which may be specified by the parties (or, if none is specified, is set at two Delivery Business Days). After that period expires, the receiving party may terminate the transaction and require payment of the Receiving Party's Early Termination Value as determined by the receiving party. Parties may elect for this to be payable only by the delivering party; and
- failure to receive: conversely, if the receiving party fails to take steps to allow delivery to its registry account, a similar remedy period applies. On its expiry the delivering party may terminate the transaction and require payment of the Delivering Party's Early Termination Value as determined by the delivering party. Parties may elect for this to be payable only by the receiving party;
- provisions relating to registry requirements; and
- VCC specifications, including definitions for specific carbon standards, registries and VCC types.
Please get in touch with the Allens expert team to learn more about how we can assist with your carbon credit transaction project or any other questions in relation to derivatives more generally.