Global carbon markets: setting the standard

January 2023

Raul Rosales explains why the new global landscape offers new opportunities but also demands new standards.

As we reflect on the 27th United Nations Climate Change Conference (COP27), few can doubt the importance of financial accounting in carbon markets.

Developments in recent weeks alone include the U.S. unveiling a new voluntary carbon trading scheme, and the International Organization of Securities Commissions (IOSCO) proposing efforts to make scrutiny around carbon trading more robust. This new voluntary carbon market can help to provide some of the funding required for the energy transition whilst decarbonization in emerging markets, but faces the challenge of the integrity of carbon offsets and transparency.

Global carbon markets are evolving with innovative business models in the exchanges of Singapore and London, as well as market infrastructure initiatives, e.g. Carbonplace, providing trustworthy regulated market infrastructure. Nevertheless, we need to address the absence of financial accounting for carbon offsets, and currently, there is neither a specific financial accounting definition for these offsets nor clear, complete regulation on how to account for them.

It’s no surprise that such weight has been placed on the role of standard-setting in and around carbon markets – after all, in 2021 global carbon markets grew to a record €760 billion ($851 billion). And it was this time last year, at COP26 in Glasgow, that the IFRS Foundation, in its unveiling of the new International Sustainability Standards Board (ISSB), drove carbon accounting well and truly into the limelight. This has been a great step forward, but this is all focused on disclosure and reporting and the industry needs clear rules on how to reflect the trading of carbon credits in their financial statements.

One year on, and with financial accounting standards – particularly those concerning carbon credits – widely accepted as being crucial to address transparency and scaling up carbon markets towards a net zero target by 2050, there is an opportunity for the International Accounting Standard Board (IASB) to retake the ‘Emissions Trading Schemes Project’ to amplify the definition of financial instruments for carbon offsets and to set up specific standards for this novel investment asset class. This project will be pivotal in achieving transparency in financial accounting practices, and ultimately in achieving transparency and integrity in global carbon markets.

These are some of the findings of a recent report, co-authored by myself alongside María Angeles Peláez, Global Head of Accounting & Regulatory Reporting at Spanish bank BBVA.
This report is based on the current accounting regulation under IFRS, and brings insights from the industry, banks, asset managers and senior policymakers, on an important topic that regulators seem reluctant to address.

This policy report also provides insights from the nascent carbon markets in China, with thoughtful insights from Grace Hui, former Head of Green and Sustainable Finance at HKEX. China is playing a key role in carbon markets across APAC, and we all want to secure transparency which requires international standards for financial accounting. Otherwise, the risk of arbitrary local rules and regimes threats the market and its opportunities.

With a bourgeoning global carbon market and new investable assets making the need for revised financial accounting regulations more pressing in the fight against climate change, the report reflects an awareness of the rapidly changing climate investment landscape and offers several concrete recommendations to policymakers and industry professionals in achieving a state of much-needed openness in accounting practices.

The need for new standards in financial accounting for ‘certified carbon offset credits’ (i.e., carbon offsets, as transferable and tradable financial instruments based on IFRS definitions) is all the more important, with carbon offsets remaining misunderstood as financial instruments, creating barriers to standard setting in this space.

The opportunity exists for policymakers and regulators to lead this change in capital markets for carbon finance – and there are avenues to set up specific standards for carbon offsets, to revisit the definition of ‘financial instruments’ under IAS 32 as financial assets, and finally to include them among the financial instruments at ‘fair value criteria’ as defined in IFRS 13 as a separate reported line item in both the balance sheet and within the income statement.

In this context, rather than being classified as intangible assets or inventories, or leaving it to the judgement of local accounting regulators, carbon offsets which show the right degree of integrity should be considered investable assets used as part of a bank’s offering to corporate clients for ‘offsetting’ and ‘hedging’ purposes, and again, highlighting the need of international standards and avoid regulatory accounting and financial accounting arbitrage which doesn’t help.

In addition, the current lack of clarity about carbon markets’ financial accounting has implications for banks in their role as intermediaries in the global emissions trading system (ETS) through the Fundamental Review of the Trading Book (FRTB) which implies higher capital charges for carbon trading under the standardised approach to market risk.

As already mentioned, although the IFRS Foundation has made a significant effort to set up the ISSB, and the work that the ISSB currently does to issue new guidelines in the space of sustainability is of great value, there is still a need for this project to be prioritised to develop global sustainable standards, which should be upheld by the IASB, being well-suited to address the two main benefits of improved carbon offset financial accounting: more accurate standards for new financial products, and synergies with recent sustainability disclosure projects.

A year ago, in Glasgow, the creation of the International Sustainability Standard Board (ISSB) marked a major step towards transparency. One year later, and with the backdrop of a bourgeoning global carbon market, the need to provide funding for the accelerated energy transition in developed and emerging countries, need an urgent response from the international regulatory bodies. Only through comprehensive, the right understanding and definitions, and wide-reaching standards in financial accounting for carbon offsets will we ensure that, amongst such change, transparency remains.

• Raul Rosales is a Senior Executive Fellow at Imperial College Business School’s Centre for Climate Change Finance and Investment