The role of international arbitration in voluntary carbon market disputes

Introduction

Voluntary carbon markets (VCMs) could play a major role in the energy transition by helping difficult-to decarbonize industries meet their net-zero ambitions through investing in carbon credits. However, as a relatively new, rapidly expanding and largely unregulated market, there is the risk of disputes arising across the VCM value chain as the industry tackles issues of carbon accounting consistency and integrity, evolving regulation and competing interests between public and private sector participants.

What are VCMs?

Carbon credits or offsets are transferable instruments certified by internationally recognized independent registries. Each credit is verified as representing a reduction of one metric tonne of CO2 emissions or the equivalent amount of other greenhouse gases (GHGs). VCMs allow carbon emitters to buy carbon credits or carbon offsets from projects that remove or reduce GHG emissions, and then use those credits or offsets to compensate for their own emissions.

Who are the key market players?

Sellers of carbon credits are typically the developers or owners of projects involving the conservation or planting of forests, clean cooking projects or the replacement of fossil fuel with renewable energy generation. Once a project has been developed, the developer applies to the applicable independent registry or standards body whose role is to examine the project and information supplied, and issue carbon credits based on their estimate of the project’s greenhouse gas reductions and then act as a registry to store and process credits over the project’s lifecycle.

Initial buyers of carbon credits may be brokers, retailers or institutional investors who wish to profit by reselling the offset in the secondary market. Alternatively it may be brought by an “end user,” who will take credit for the GHG reduction the offset represents by using or “retiring” it with the registry so that it cannot be used again. These end users are often large corporates in high emitting industries seeking to achieve net-zero.

What types of disputes will be arbitrated?

In the context of international arbitration, VCM disputes are likely to fall into two categories:

1. Disputes between commercial parties
   
   As with other commercial disputes, international arbitration will be an attractive dispute resolution mechanism for commercial entities operating in VCMs to include in their contracts. The issues arising in VCMs are specialized and relatively new, which invite the appointment of arbitrators with relevant market and technical expertise. The majority of cases will also be cross-jurisdictional, meaning that international arbitration will be the preferred choice for enforcement purposes due to the wide reach of the New York Convention. 
2. Investor-state disputes
   
   In the absence of any contractual arrangement, investors in international carbon projects will need to rely on investment treaties to bring claims against a State or State-owned entity. The dispute resolution mechanism in the majority of these treaties will be International Centre for Settlement of Investment Disputes (ICSID) arbitration. 

Value disputes

We see the potential for arbitration to play a particular role in disputes relating to credit “value.” The standards bodies responsible for issuing carbon credits and offsets are largely unregulated. There is also a lack of consensus in carbon accounting due to the existence of multiple voluntary programs, the absence of standardized rules or documentation, and mixed views on what, in fact, makes a quality carbon credit. Disputes can therefore arise as to the “value” of a carbon credit, misselling and “carbon fraud.

For example, the value of a carbon credit will depend on its “additionality.” Introduced in Article 6 of the Paris Agreement, this concept qualifies GHG reductions as “additional” if those reductions would not have occurred “but for” the offset project. The less likely it is that a project would have been pursued even without the prospect of the sale of carbon offset credits, the lower the quality of the credit. Assessing “additionality” is complex and highly technical, with a range of different environmental, societal and political factors requiring assessment.

Projects aimed at reducing deforestation in one area, for example by preventing agricultural activities, could lead to an increase in those activities elsewhere (known as “displacement”), which may also affect a carbon credit’s true “value.”

In 2023, an investigative report alleged that at least 90 percent of rainforest offset credits verified by Verra, a world-leading forest carbon offset certifier, do not represent “real” emissions reductions. The report alleged that only a handful of Verra’s rainforest projects showed evidence of deforestation reductions and that the threat to forests had been overstated for Verra projects. Similar criticisms have been made in relation to other standard bodies and carbon projects in recent years and these stories are making international headlines.

Regardless of whether these criticisms are valid, questions over the level of emissions reductions represented by carbon credits or offsets issued by a standard body will have an onward impact on their value in the market. Until there is an internationally recognized standard method for carbon accounting, there will be market uncertainty and in turn, litigation risk. There is the risk of claims by initial and/or final purchasers against project developers or owners arising out of the diminution in value of those credits or offsets, for example, for breach of contract, misrepresentation or fraud.

Like other “commodities,” carbon credits can be sold via long term offtake agreements. These will often take the form of forward purchase agreements with the seller and purchaser contracting for carbon credits that are yet to be produced. When dealing in such an uncertain market, there is potential for significant fluctuations in the value of the carbon credits between the point of sale and the point of delivery. Pricing disputes, particularly if the contract includes a price review mechanism, may arise.

Disputes may also arise if there are delays in the issuance of carbon credits due to delays with project development and/or verification by the relevant standards bodies (over whom a project developer may have very little control/influence in terms of the timeline for verification).

Investor-state claims

As VCMs continue to grow, states may seek to bring in regulations which affect investors in international VCM projects. We have already seen the ICSID case of Koch Industries v Canada which concerned a claim of over US$30 million arising from the withdrawal of Ontario’s “Cap and Trade” program. The program had allowed market participants to buy and sell emission allowances and was linked with equivalent programs in California and Québec, allowing for cross-border trading. The case was dismissed on jurisdictional grounds but highlights the potential for further investor-state arbitrations, including in VCMs.

Litigation risk in VCMs should not be overstated – the industry remains in its infancy and as it matures, it should evolve to meet some of the challenges it currently faces. For participants in the VCMs, selecting arbitration for the resolution of disputes offers technical expertise, independence and international enforcement.

With thanks to Lamar Mukundi