Carbon credits: a new frontier for Luxembourg fund managers

Carbon credits are rapidly gaining recognition as a compelling new asset class for fund investors, driven by growing global commitments to combat climate change and reduce greenhouse gas (GHG) emissions. As governments and corporations intensify their decarbonization strategies, carbon markets have become essential financial mechanisms. These markets enable the trading of emission permits, offering investors both positive environmental impact and potential financial returns. 

For fund managers, especially in Luxembourg’s vibrant investment landscape, carbon credits represent a unique opportunity to align portfolios with sustainability goals while tapping into a rapidly expanding market.

Why carbon credits gain traction

A dual market structure: The carbon credit market facilitates the buying and selling of permits that allow holders to emit a specific amount of carbon dioxide or equivalent GHGs. These markets are broadly divided into two categories: compliance and voluntary. Compliance markets, such as the European Union Emissions Trading System (EU ETS), are government-regulated frameworks where companies must adhere to legally binding emission caps. In contrast, voluntary carbon markets (VCMs) operate without regulatory obligation, allowing companies and individuals to purchase carbon credits to offset their emissions voluntarily.

Flexibility and innovation: While compliance markets dominate in size and regulatory rigor, voluntary markets are evolving rapidly, driven by increasing corporate demand for flexible, innovative approaches to sustainability. The VCM’s adaptability enables a diverse range of projects – from nature-based solutions like reforestation to advanced carbon removal technologies – to generate credits. This flexibility fosters innovation but also requires careful scrutiny to ensure credibility and impact. 

Growing investor interest: Carbon funds focusing on the voluntary market are gaining traction as they offer opportunities to support emerging climate solutions and engage with a broader set of stakeholders.  Increasingly, these strategies are seen as complementary to natural capital and forestry funds, given their shared focus on climate change mitigation, biodiversity preservation, and long-term sustainability. Blending carbon credits with natural capital exposures enables investors to build diversified portfolios that capture both financial returns and environmental co-benefits. This trend is reinforced by the recent rise of new natural capital funds in the US and Europe, underscoring the growing institutional appetite for investments that deliver measurable impact alongside returns.

Navigating the complexities of carbon funds in Luxembourg

Despite the attractive opportunities, launching a carbon fund in Luxembourg presents unique challenges due to the specificities of this emerging asset class combined with the broad spectrum of Luxembourg’s investment fund toolbox and the variety of accounting frameworks available.

Choosing the right fund regime and structure

Luxembourg offers a variety of fund structures, including the Reserved Alternative Investment Fund (RAIF), Specialized Investment Fund (SIF), and the other lightly regulated Limited Partnership (SCSp). While the RAIF is popular due to its flexibility and relatively streamlined authorization process, it may not always be the best fit depending on the investors’ profile, marketing strategy, or specific objectives of the carbon fund. In some cases, a more traditional SIF or even a non-fund vehicle might be more appropriate. The geographic location of the underlying carbon projects can also influence the fund structuring decision, as different jurisdictions may present specific regulatory, legal, or tax considerations that impact investor protection and operational efficiency. Managers must evaluate these options early in the design phase to avoid regulatory or operational mismatches later.  Taking the example of setting up the carbon credit fund as a RAIF, the promoter of the fund has the option to determine the accounting principles within the prospectus. Whereas most RAIFs present their investments at fair value, it is also possible to apply a cost model, realizing gains only upon realization.

Valuation hurdles

Under the AIFM Law, if the valuation function is not outsourced to an independent external valuer, the Commission de Surveillance du Secteur Financier (CSSF) must closely examine the procedures implemented at the AIFM level. Given the complexity and illiquid nature of carbon credit, most fund managers currently prefer to keep this function in-house. However, because valuation methodologies for this asset class are still evolving and vary significantly across managers, it is not uncommon for the CSSF to request a report from the réviseur d’entreprises agréé before granting authorization for the fund. This process can add time and cost to fund launches, requiring managers to prepare a robust policy and supporting documentation to justify their approach.

Accounting frameworks and operational considerations

Luxembourg’s investment vehicles benefit from a broad range of accounting frameworks. A regulated fund (RAIF or SIF) would allow IFRS or Luxembourg GAAP, whereas an SCSp under the AIFM Law allows for additional reporting frameworks. The novelty of carbon credits means that not all accounting standards are ideally suited to their unique characteristics. Their illiquidity and bespoke nature can make fair value measurement challenging, and inconsistent accounting treatments across funds can complicate investor reporting. 

Selecting the right framework: fund managers must carefully select an accounting framework that balances compliance, transparency, and operational efficiency. 

Engaging with carbon market experts is essential to develop sound policies and ensure that financial statements accurately capture the fund’s exposures and associated risks.

Finding the right partners

Finding fiduciaries and depositaries familiar with the regulatory nuances of carbon credits can be challenging. These service providers play a vital role in safeguarding assets and ensuring regulatory compliance, so their expertise in this emerging asset class is essential. A lack of understanding can lead to delays, increased costs, or operational risks, underscoring the importance of early engagement and education with key service providers.

2025: What’s next for carbon funds in Luxembourg?

As carbon credits gain traction and have the potential to transition from niche instruments to mainstream investment assets, Luxembourg fund managers have a timely opportunity to lead in this evolving space. The growing demand for sustainable investment solutions and the increasing sophistication of carbon markets make carbon funds an attractive proposition for investors seeking both impact and returns.

However, the path to successfully launching and managing a carbon fund is not without challenges. The complexity of valuation, the need to choose the right fund structure, the careful selection of accounting frameworks, and the importance of knowledgeable service providers all require thorough planning and expertise. By addressing these factors proactively, Luxembourg fund managers can design innovative, compliant, and efficient carbon funds that meet investor expectations and regulatory standards.

In doing so, they will not only contribute to global climate goals but also position themselves at the forefront of a transformative asset class with significant growth potential. For those willing to navigate the complexities, carbon credits offer a compelling new frontier in sustainable finance, one that combines financial innovation with meaningful environmental impact.