Carbon Offsetting Schemes – a risky business?

United Kingdom

Carbon off-setting schemes involve the generation of pending issuance units (PIUs) which are essentially a promise of a carbon credit in the future, sold as a climate benefit. PIUs can be purchased from landowners participating in restoration projects registered under the Woodland Carbon Code or the Peatland Code (the Codes). It is a way of forward purchasing units of carbon (representing 1 tonne of carbon dioxide each) which are intended to mature over the term of the relevant restoration project. The aim of such a purchase is that the PIUs eventually become verified carbon units which can then be used to offset future UK-based emissions. This CMS Law-Now explores the legal risks arising for investors from the purchase of PIUs.

What are PIUs?

PIUs are effectively a “promise to deliver” a carbon unit at a point in the future as a result of a successful restoration project involving woodland or peatland. For PIUs to be sold, the restoration project must meet the requirements of the Codes which provide the framework for peatland and woodland restoration projects to be validated, assessed and verified. PIUs are sold by the landowner, with the income generated by the sale of the PIU being used to fund the restoration of woodland or peatland. Each carbon unit represents one tonne of carbon dioxide equivalent removed from the atmosphere.

The projects sequester carbon through restoration of peatland or growth of trees over a period of up to 100 years. Once the carbon sequestration has been evidenced and verified, the PIUs effectively mature and become “verified carbon units”. The verification process involves approval by a body approved and appointed by the Codes’ Executive Board. Once verified, the carbon units can be used to offset an organisation’s carbon emissions or can be sold. Carbon units which are offset are ‘retired’ and cannot be used again.

PIUs are intended to cover a set period or vintage which may be the length of the restoration project or a phase of it. Under the Woodland Code the first issue (on validation of the project) is for 5 years and thereafter for 10 year periods. The guidance for the Peatland Code permits the sale of PIUs at commencement of the project and suggests that their vintage could be up to 30 years or more.

Projects registered under the Codes can be high risk for purchasers of PIUs as there is no mechanism which is guaranteed to protect the initial investment. The Codes have been designed to facilitate the restoration of peatland and woodland by raising funds for that purpose. While the Codes do have built in protections for investors there are no guarantees that the carbon credits will be verified and therefore realised, so great care is required when considering the purchase of PIUs.

PIUs – Areas of Risk

There are two main areas of risk: (i) ‘Failure of Anticipated Carbon Sequestration’ and (ii) ‘The Length of the Projects and Long-term Ownership’.

(i) Failure of Anticipated Carbon Sequestration

PIUs can only become carbon credits if the restoration project is successful. They do not become carbon credits until the project is verified as having sequestered a specific amount of carbon. Consequently, the purchaser is reliant on the project being successfully progressed and completed so that the PIUs are verified and available to off-set carbon emissions. The risk in investing PIUs is that some or all of the PIUs do not become verified, that so they are rendered worthless and the investment is lost.

Inadequate management of the project is likely to lead to the projected carbon sequestration being less than expected or non-existent. Besides poor performance by the project developer, a project could fail due to natural factors such as drought or fire. In this situation an amount of the PIUs ‘purchased’ may not reach verification stage and instead they will become worthless. There is no mechanism under the Codes whereby the purchaser is automatically refunded their initial outlay in these circumstances. The income from the sale of PIUs will have been spent on the ineffective restoration and so the investment is lost.

The Codes require that a Restoration Management Plan (RMP) is put in place for each project. The Codes’ guidance states that the RMP should contain a mechanism for managing the peatland/woodland and include the objectives, activities, a chronological plan and a statement of who will deliver the restoration. If a developer follows the relevant Code and the RMP, then the chance of failure is reduced but not eliminated.

Prior to achieving validation, projects are surveyed and thoroughly assessed by validation bodies, who are approved and appointed by the Codes’ Executive Boards. Once validated, the projects are regularly assessed and monitored to ensure that restoration and management is in accordance with the RMP and the monitoring plan. If by year 5 of the project term the predicted improvements have not been achieved, then remedial action must be undertaken.

There is however no mechanism under the Codes whereby purchasers of PIUs are reimbursed should the project fail. The Guidance recommends that when proposed projects are assessed, risks are identified and mitigation is built into minimise the risks. The Guidance also recommends that compensatory emissions reductions are provided for should the restoration fail. However, these are only recommendations.

(ii) The Length of the Projects and Long-term Ownership

The purchase of PIUs is a personal contract with the landowner (or the party generating the PIUs) at the beginning of the restoration project. Full payment for the carbon credits which may ultimately be generated is made at the beginning of the long-term project. The payment is made to the entity or person who undertakes to carry out the restoration project in accordance with the Codes. Many years will pass before the carbon credits are verified. No interest (or any other sum) is payable to the purchaser of the PIUs during the restoration phase.

Restoration projects under the Codes are long term projects - at least 30 years for peatland projects and much longer for woodland projects. There will always be a risk that during the project term the landowner will become insolvent, die or want to sell the land upon which the project is based. Similarly, where a tenant is responsible for the management of the peatland or woodland there is a risk that the tenant will become insolvent, assign their interest in the lease or terminate the lease.

There is currently no way of binding the successors of landowners or tenants to take on the obligations in the RMP as the RMP is personal to the parties who entered into it. The RMP is not registered against the landowner’s title and so does not create a real right which runs with the land. Therefore, there is a risk that if the RMP is not implemented that the PIUs will not be verified and they will become worthless.

Next Steps

The protection of investors is not the priority of the Codes and the in-built protections are insufficient. The risks to investors can be mitigated to an extent. With knowledge of all relevant risks and available mitigating actions, businesses can make a measured decision on whether the purchase of PIUs is an appropriate way of achieving net zero. Great care is required in structuring the legal agreements associated with purchase of PIUs. If we can assist you with this do get in touch.

Article co-authored Sokratis Androutos, Trainee Solicitor at CMS.