Defining Quality in the VCM: Registries, Rating Agencies, and Independent Non-Profits

The quality crisis in the VCM

Throughout 2023, the carbon registries—arguably the cornerstone of the Voluntary Carbon Market (VCM)—have come under increasing pressure regarding the quality of their carbon credits. They've faced probing questions from the media on the robustness of their methodologies, standards, and crediting practices, with the UK newspaper The Guardian being particularly critical.

The VCM has spent the first half of this year establishing how to move forward in the wake of The Guardian’s exposé. Responses by industry have highlighted that while there are undoubtedly quality issues in the VCM, the estimate produced by the Guardian article claiming 94% of REDD+ credits (a preservation methodology used by registries) are worthless is inaccurate. Sylvera, one of the prominent rating agencies in the space, estimates that 31% of REDD credits are high quality, 44% are of medium quality, with 25% being effectively junk.

These extreme differences in estimates only underpin how elusive a clear definition of quality in the VCM is. While quality estimates vary, the fundamentals that underpin nature-based carbon markets–namely that trees capture and store carbon and their introduction or preservation has a host of co-benefits–are widely understood and accepted. The market needs a clear definition for high-quality carbon credits to create effective funding mechanisms that realize those fundamentals.     

In the current absence of a clear definition, buyers of carbon credits face uncertainties. Use of credits that are subsequently deemed to be of low quality in an organization’s climate strategy can be highly damaging, as the recent class-action lawsuit against Delta Airlines’ carbon neutrality claims underlines. Understandably, buyers seek greater transparency and assurance on the true value of the carbon projects they support and retire.

A few actors in the space are rising to the occasion. Rating agencies and independent non-profits such as the Integrity Council for the Voluntary Carbon Market (ICVCM) and the Voluntary Carbon Markets Integrity Initiative (VCMI) have recently gained prominence as registries aim to update their crediting practices and buyers look for reliable quality indicators. Their emergence represents a paradigm shift in the VCM, wherein quality assurance—a role previously held solely by the registries—is shifting to third parties.

The rise of rating agencies

The carbon rating agencies were all founded within the last three years and specialize in independent assessments of carbon projects that result in easy-to-digest ratings of their environmental impact. Examples include BeZero, Sylvera, and the recently launched Renoster. From a standing start, these agencies have quickly assumed an important role in the VCM; nearly two-thirds of respondents to the 2023 edition of Refinitiv’s annual carbon market survey said that agencies’ independent ratings were either ‘somewhat important’ or ‘very important’ in guiding organizations’ purchasing decisions.

Using various quality and risk assessment frameworks, these agencies evaluate projects along various criteria—including additionality, reliability of the project baseline, leakage, over-crediting, and permanence—to answer the same question: how much environmental impact does a project’s credit represent and what are its associated risks? 

While attempting to answer this question, agencies’ approaches and methods of communicating their findings differ. BeZero produces an alphabetic topline rating, similar to those found in debt markets, and prioritizes fungibility by employing a single methodology across all project types. Sylvera similarly produces an alphabetic topline rating but has different bespoke frameworks for different project types, sacrificing ratings fungibility for increased specificity. Renoster deviates from familiar topline ratings and produces a numerical score meant to represent the carbon sequestered per credit. The underlying composition of agencies' topline ratings and their methods for producing them also vary, although there is significant overlap in the criteria used to match those of accreditors and generally accepted in the VCM.

The resulting ratings are used by buy-side actors to make more informed decisions about which projects to support or invest in. Greater insights into the many risks that affect carbon projects—such as non-permanence risk, overcrediting risk, and delivery risk—will result in better risk management. The rating agencies’ thesis is that the resultant derisking of assets can be used to attract more investment into the VCM and catalyze growth.

That thesis is certainly sound; looking at other established markets such as debt markets indicates that agnostic third-party assessments of asset quality and risks are crucial for market stakeholders. However, the pricing data seem to show that, while the thesis may be sound, it is taking time to take hold: TIME found in June '23 that there is a low correlation of carbon prices and associated ratings, meaning the rating agencies’ outputs have yet to strongly inform pricing in the market. This is likely a result of the nascency of agencies’ efforts, lagging market adoption, and opaque trading processes.

Source: TIME CO2 Portfolios, "Carbon Pricing - Where the Market Currently Is and Where It Must Go", June 12th 2023

The agencies have indicated they have started seeing a correlation forming and we expect it to strengthen over the coming months and years. As of Feb '24, BeZero found that the premium for high quality credits has started to increase markedly over the past six months. While not conclusive, it is indicative of a relationship forming between quality and price.

The relationship between registries and rating agencies

The dynamics between carbon registries and carbon rating agencies are complex. While they share an ultimate goal—improving trust in the VCM to enable its growth—opinions differ on how closely the two should collaborate. Sylvera’s team explained to us that:

Registries may have been uncertain at first about the role carbon credit agencies would play, but have since recognized that ratings are complementary, offering objective evaluations that give buyers the confidence to buy credits and scale the market.

BeZero has also publicly advocated for a close partnership between registries and rating agencies and stated that its work is fundamentally complementary to that of a body such as Gold Standard. For his part, Hugh Salway (Head of Environmental Markets at Gold Standard) has stated that his organization welcomes rating agencies pointing out flaws in their systems, as this encourages improvement. 

Further highlighting the potential for collaboration, a registry interviewee who chose to remain anonymous gave the following prediction:

Rating agencies in the future could provide a valuable service to registries by serving as an early warning system for project rating downgrades. Even though registries have their own early warning systems, the systems and approaches used by registries and agencies across the market are likely to have different abilities and capacities. This diversification combined can provide greater permanence and quality enhancement opportunities for registries and the project developers they serve.

On the other hand, some argue that greater distance between accreditors and rating agencies is needed to ensure unbiased assessments of credits. They believe that close working relationships between the two could create conflicts of interest and compromise the integrity of the ratings. This perspective advocates for a clear separation between the standard-setting registries and the evaluative function of the ratings agencies. Renoster takes this stance and told us that:

Frankly, we observe that other rating agencies have very friendly connections with registries, to the point that they endorse one another and appear to be afraid to speak ill of the registries and methodologies that they're supposed to be watching. We don't regard this as a healthy situation for the carbon markets.

Clearly, finding the right balance between collaboration and independence involves some threading of the needle. BeZero’s team, however, highlights that a separation of functions can be maintained while working symbiotically:

Accreditors such as the registries set, enforce, and adapt the rules that form the foundation of carbon credit issuance. They are best placed to ensure higher standards of disclosure, adopt best practices, and leverage technological advances to boost minimum standards of quality. While accreditors are there to ensure compliance with rules and a level of reporting, however, they cannot guarantee quality; the accreditation process is necessarily binary. By comparison, rating agencies focus on carbon efficacy. Compliance with accreditation rules is a prerequisite for a BeZero Carbon Rating. Beyond that, the rating assesses what risks, imperfections, or information gaps may have become evident since a standard was created or a credit was issued.

Frameworks and standardization

The rating agencies are not alone in seeking to increase trust and transparency in the VCM. Frameworks are being developed by independent non-profits such as the ICVCM and VCMI that seek to standardize and harmonize practices according to rulebooks. The ICVCM, which grew out of Mark Carney’s Task Force on Scaling Voluntary Carbon Markets, styles itself as an independent governance body for the VCM and is responsible for the Core Carbon Principles (CCPs). 

The VCMI is focused more on demand-side integrity and produces guidelines on how corporates should use credits as part of their climate strategy. It recently released its Claims Code of Practice in late June, which provides companies with a rulebook on the credible use of high-quality carbon credits and associated climate claims. These bodies work closely together, coordinating launches and jointly defining best practice and credibility with regards to both the supply and demand sides of the market. 

The guidance documents produced by the ICVCM and VCMI are important touchstones for the rating agencies, which all welcome the initiatives and see the non-profits’ work as complementary to their own. While Sylvera is working with the latter to improve the use of credits on the demand side, it sees a greater crossover with the supply side focused work of the ICVCM:

ICVCM addresses supply-side integrity like we do at Sylvera, but takes a different approach to us as its assessments are at the standard and credit category level and ex-ante. Our assessments are done at the project level and ex-post. Therefore, taking the two assessments together gives buyers a comprehensive assessment of the credit they are looking to buy. We have collaborated extensively with ICVCM to support the development of their guidance and its application.

BeZero expressed that “calls to standardize disclosure rules and systems of reporting are uncontroversial” but raised concerns on whether that attempted standardization of quality and attempted maintenance of the ‘one credit equal to one tonne’ principle will cause blowback. They highlighted that the risks of standardization are two-fold:

First, and most seriously, opponents (let alone supporters) of financialising nature will continue to expose every and any chink, however big or small, in an approach that attempts to guarantee an outcome. If the CCPs tell everyone to trust the instrument because it delivers a tonne and it’s shown otherwise, it risks undermining buyer confidence once and for all.

Second, experience from flattening quality in the financial contract space incentivises actors to deliver the cheapest compliant credits. This has led to forward prices being below spot prices, which does not encourage liquidity to enter the market or hedging, both of which are necessities.

We have written more about standardization and difficulties with standardization in the contract space here

Similarly, Renoster state that they are “entirely supportive of all efforts to improve the carbon markets”, including the ICVCM and VCMI, and point to the fact that they “regularly cite the ICVCM’s core principles to defend our own findings and ratings”. However, they again highlight some potential issues relating to the way the actors in the VCM interrelate:

We view these frameworks positively; however, both of these were developed in close consultation with registries and project developers. Because of this, they are not pushing hard enough for the reforms that we need to see in this space.

While developed in consultation with the accreditors, registries have still expressed discontent with ICVCM output. For its part, Verra has at times been highly critical of the ICVCM, declaring in September 2022 that the Council is on the wrong track and in need of course correction:

Initial analyses of the draft CCPs and Assessment Framework suggest that few, if any, credits would pass the test, which will satisfy purists but do nothing to drive investment at the scale needed around the world to combat the climate crisis.

The strictness of emergent frameworks is also reflected on the demand side with the VCMI, which uses ICVCM quality standards as inputs for guidance on what credits corporates should use in their climate goals. Analysis done by Trove Research on 470 companies using carbon credits has found that only 3.8% of companies would meet the VCMI silver threshold, their lowest threshold. 

The emergence of these highly stringent frameworks on both the supply and demand sides of the market raises the question of how the VCM should integrate them. In our, and many others, view, the ideal balance lies in increasing the minimum threshold for quality by industry-wide standards, while still acknowledging that these assets will never be fully standardized and should be viewed along a risk spectrum. Non-profit, industry-wide initiatives are best suited for raising minimum standards, while a risk-adjusted view can only be provided by project-level analyses—analyses that rating agencies leveraging the latest technology are best suited to conduct. 

A march towards defining quality

It is true that the process of producing carbon credits has, in the first two decades of the VCM, been far too much of a black box. While its trust and transparency issues could be seen as teething troubles typical of a small market of novel assets, the emergence of rating agencies alongside initiatives such as the ICVCM and VCMI are signs of its growing maturity. Accordingly, Renoster see their role as:

… building ironclad cases for the excellent projects and naming and shaming those that fall short. This will result in a market shift towards quality, as project developers forgo their bag of tricks in favor of more conservative projects. Our hypothesis is that if the market knows that it's being watched, it will behave.

While integration of these ratings in pricing and market behavior is not yet ubiquitous, clear signals of adoption are emerging. BeZero notes that:

Since last year we have clearly seen a marked adoption and penetration of carbon ratings as a framework to think more fundamentally about project risks and carbon efficacy. Our client base has swollen, including many of the world’s largest banks, energy and commodity houses, and carbon credit marketplaces. Meanwhile, subscribers to the free rating service have risen tenfold … That tells us market players are now willing to use more risk analytics tools to assess quality, and not just rely on basic attributes such as accreditor, project type, or vintage.

For those that are new to the industry, finding consensus among these decentralized set of actors may seem chaotic. However, while establishing decentralized consensus requires more intensive orchestration relative to centralized decision-making, its output is more robust. This can be seen in systems of political governance, in the latest technological advancements, and in carbon markets. If we look at other decentralized systems, such as blockchains, the validators on a blockchain have to establish consensus on the validity of a transaction similar to how VCM actors have to achieve consensus on the definition of quality. For blockchains, the security and robustness of a blockchain is dependent on the diversity and decentralization of the validator set used to construct it. In the VCM, it is neither realistic nor desirable that a single entity obtain the power to define what quality is. Robust, multi-pronged quality assessments and approaches resulting from competition among different entities defining quality is critical. The march we see toward a unified definition of quality is being orchestrated by a decentralized system of actors, at times synchronously and at times chaotically, but the definition we are arriving at is an undoubtedly robust one.