The carbon credit market is rife with fraud allegations, and so far, strategies to combat this fraud have included many of the usual suspects, like government regulation and established standards. But as a group of partners from Womble Bond Dickinson explores, emerging blockchain technology could hold promise here.
Womble Bond Dickinson partners Jeffrey Whittle, Lisa Rushton, Paul Turner and Britt Biles co-authored this article.
The summer of 2023 is shaping up as one of the hottest recorded in many parts of the United States and the world, with scientists predicting that the warming trend will only continue — and even worsen. In light of this, ESG and energy transition are important touchstones in American boardrooms. Although most U.S. companies do not have mandatory restrictions placed on their carbon emissions (yet), public scrutiny and market pressures increasingly are pushing American companies to reduce their emissions to combat global warming.
Accordingly, U.S. companies looking for ways to reduce their carbon footprints — whether directly or indirectly — increasingly are buying, selling and trading carbon credits and offsets.
Carbon credits were created primarily to support cap-and-trade programs, which seek to use market-driven solutions to reduce greenhouse gas emissions. Under these programs, entities receive credits (or allowances) that authorize emissions up to a certain cap, which is periodically reduced. One carbon credit generally authorizes the emission of one ton of carbon dioxide or the equivalent in other greenhouse gases. Once a cap is established and allowances are awarded, entities may sell or trade their unused credits to other entities. This transactional component is intended to incentivize the reduction of greenhouse gas emissions in two ways:
- Entities that reduce their emissions below their caps can generate revenue by selling their extra carbon credits.
- Entities that do not reduce their emissions face increased operating costs because they must purchase extra carbon credits if their emissions exceed their caps.
Recently, companies have increasingly turned to the use of carbon offsets created through voluntary carbon markets (VCMs) as one way of attaining ambitious goals being set for reducing greenhouse gas emissions. VCMs involve new projects that reduce greenhouse gas emissions or remove carbon from the atmosphere, such as renewable energy facilities or reforestation. VCMs can generate revenue through saleable offsets that function similarly to credits, except they are not issued by the government as part of a cap-and-trade program issued allowances.
While some companies are capable of independently reducing emissions, many find they cannot eliminate their emissions, or even lessen them as quickly as needed. The challenge is especially tough for organizations seeking to achieve net-zero emissions.
Fraud in carbon credits
The use of carbon credits and offsets to help address climate change originated shortly after the 1997 Kyoto Protocol, which imposed binding greenhouse gas limits and reductions on its signatories. Because VCMs, in particular, do not have a unified or uniform integrated market for carbon and few companies that participate in these markets are under governmental mandates to reduce their carbon footprints, when unchecked, the risk of fraud, manipulation and abuse is significant in the VCMs. Indeed, earlier this year, the CEO of one of the leading assessment and certification companies for voluntary carbon credits, Verra, announced he would step down amid substantial allegations that the credits certified by his company did not provide the promised greenhouse gas reductions.
Additionally, there have been instances in which the same carbon credit or offset is sold and resold to multiple entities. When companies are voluntarily transacting in credits or offsets to reduce their carbon footprints, the risk of such double counting is increased because companies are less focused on the recordation and retirement of the credits.
Further, projects have claimed materially greater carbon reductions than, in fact, they are achieving or may claim circumstances and reductions that are not present (say, for example, by saving acreage of a rainforest that they claim would otherwise be destroyed, when there is no reasonably imminent danger of such deforestation). Such “non-additionality” occurs when climate benefits that would have occurred anyway improperly are attributed to a carbon credit or offset.
Fraud and market manipulation can create disclosure risks for market participants as well. For example, if a company relying on offsets makes representations about reductions that are found to be based on fraudulent information, it could face enforcement actions or derivative lawsuits as a result.
Here are some high-profile examples of alleged carbon credits fraud and abuse. While some of these cases are pending, they show that law enforcement and regulatory agencies around the world are taking an aggressive approach toward enforcement:
While no criminal charges or enforcement actions have been taken yet, serious questions are being raised about the Cordillera Azul National Park carbon credits project. The program is intended to protect tens of millions of trees in the Peruvian Andes, but many are now questioning whether the promised benefits of the program were exaggerated or misrepresented.
The Australian Securities and Investments Commission charged a man with operating an investment scheme that involved the sale of fake carbon credits. The scheme allegedly defrauded investors of more than AUD 7 million.
The U.S. attorney for the Southern District of New York extradited a defendant from Spain who was charged with wire fraud and money laundering relating to his role in a telemarketing scheme involving the fraudulent sale of purported “carbon credits” to victims in the UK. The alleged fraud involved, among other things, defendants’ creation of certificates and instruments purporting to be carbon credits and carbon offsets.
The Swiss Federal Office of Public Health ordered a company to stop selling carbon credits after it was found to be selling fake credits that did not represent actual emissions reductions. The company was fined and ordered to pay restitution to its customers.
The SEC charged a New York-based company and its founder with defrauding investors in a scheme involving the sale of fake carbon credits. The company claimed to be generating emissions reductions through the use of carbon capture technology, but the SEC alleged that the technology did not actually work.
The UK Serious Fraud Office arrested six men in connection with an alleged carbon credits fraud worth £38 million. The individuals were accused of creating and selling carbon credits that did not actually represent real emissions reductions.
California-based carbon trader indicted on multiple counts of wire fraud for a Ponzi scheme involving the creation and falsification of invoices and purchase agreements of carbon credits under the California pollution trading program.
Such market integrity concerns are stymying the potential of VCMs just as they are becoming strategically important to the energy sector and other companies seeking to reduce their carbon footprints. To wit, we are increasingly seeing agencies like the Commodity Futures Trading Commission (CFTC) take actions such as its issuance last month of a whistleblower alert asking the public for tips about fraud and manipulation in voluntary carbon markets — a “precursor” to bringing enforcement actions against market manipulators. And, just a few days later, CFTC announced the establishment of a new environmental fraud task force within its enforcement division to help investigate cases of fraud and misconduct in offset-related markets.
Strategies to help reduce carbon credits fraud
To address this ongoing problem, various organizations and initiatives have been established to promote transparency and accountability in the carbon credits market.
For example, the United Nations Framework Convention on Climate Change oversees the Clean Development Mechanism program, which aims to ensure that carbon credits are only issued for real, measurable and verifiable emissions reductions. Additionally, several third-party verification and certification schemes have been developed to provide independent validation of carbon credits and prevent fraud.
Some proposed solutions include:
- Carbon standards: A number of carbon standards have been developed to provide clear guidelines for measuring and verifying carbon offsets. These standards, such as the Verified Carbon Standard and the Gold Standard, require projects to demonstrate additionality, permanence and other criteria for ensuring the validity of carbon offsets.
- Independent verification: Third-party verification and certification schemes have been developed to provide independent validation of carbon offsets. These schemes, such as the Verified Carbon Unit program and the Climate, Community and Biodiversity Standards, require projects to undergo rigorous auditing and monitoring to ensure that they are delivering real emissions reductions.
- Regulatory oversight: Governments and regulatory bodies are increasingly becoming involved in the carbon credits market, with some countries introducing legislation to regulate carbon offsets. For example, the EU’s Emissions Trading System (ETS) requires that carbon offsets meet certain criteria, and the UK has introduced regulations governing the sale of carbon credits.
Enter the blockchain
An often-misunderstood technology shows great promise to help reduce fraud in this market: blockchain. By using a decentralized ledger system, blockchain technology can ensure the transparency and traceability of carbon offsets, making it more difficult to engage in fraudulent activities.
Here are some ways blockchain is being used in the carbon credits market:
- Immutable ledger: Blockchain creates an immutable ledger that records all transactions in a tamper-proof way. This means that once a transaction is recorded on the blockchain, it cannot be altered or deleted. This can help prevent fraudulent activities such as double counting or fake carbon credits from being introduced into the market.
- Transparency: Blockchain allows for greater transparency in the carbon credits market, as all transactions are visible to all participants in the network. This makes it easier to track the flow of carbon offsets and ensure that they are legitimate.
- Smart contracts: Blockchain technology also can facilitate the use of smart contracts (sales and licensing). Smart contracts are self-executing contracts that can automatically enforce the terms of a transaction. They can be used to automate the process of verifying carbon offset projects and issuing carbon credits, reducing the risk of human error or fraud.
- Verification: Blockchain can be used to verify the origin and quality of carbon credits. By storing information about the carbon offset project, including its location, methodology, and monitoring data, on the blockchain, stakeholders can verify that the carbon credits being traded are legitimate and represent real emissions reductions.
- Traceability: Blockchain can enable the traceability of carbon credits throughout the supply chain. This can help ensure that carbon credits are not double-counted or used to offset emissions that have already been offset by another party.
Overall, the use of blockchain technology in the carbon credits market has the potential to increase transparency, accountability and trust in the system, making it more difficult for fraud to occur.
There are a few companies that are already using blockchain technology in the carbon credits market to address fraud and improve transparency. Here are some examples:
- Veridium employs blockchain technology to track carbon offsets and ensure their legitimacy. The company’s platform, called the VERDE ledger, allows carbon offset projects to be registered and verified on the blockchain. The VERDE ledger also enables the creation and trading of carbon credits, providing greater transparency and traceability.
- ClimateTrade uses blockchain technology to certify and trade carbon credits. The platform’s blockchain-based registry allows users to track the ownership and history of carbon credits, making it more difficult for fraud to occur. ClimateTrade also uses smart contracts to automate the verification and issuance of carbon credits.
- Poseidon tracks carbon credits and enables individuals and organizations to offset their carbon footprint using blockchain. The company’s platform, called the OCEAN token, uses blockchain to verify the legitimacy of carbon credits and provide transparent reporting on the carbon offsetting process.
While the use of blockchain technology in the carbon credits market is still in its early stages, these examples demonstrate that some companies already are using blockchain technology to address fraud, increase transparency, and improve the security of their carbon transactions. Using blockchain technology for commercial contracts, in some instances, may be expensive and somewhat burdensome.
However, given the relatively young nature of the carbon markets, the intangible nature of the credits/offsets, the difficulty in having purchasers verify aspects of the underlying circumstances generating the credit/offset and the perceived history of fraud in the market, we expect that, as the market continues to evolve, U.S. companies participating in the voluntary carbon markets to further their ESG and energy transition goals may well find such costs warranted and may be able to manage these costs effectively to mitigate against these risks of fraud, manipulation and abuse.