Carbon markets see promise and peril from COP26
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Carbon markets see promise and peril from COP26

By Mark Nicholls 30 Sep 2021 (Last Updated September 30th, 2021 09:38)

Agreement on carbon trading rules at COP26 could help climate finance flow to developing countries – but strict carbon accounting risks bringing the market to a halt.

Carbon markets see promise and peril from COP26

Carbon traders and developing country governments alike are looking to the COP26 climate talks for resolution on Article 6 – the provision of the Paris Agreement that governs the trading of emissions between countries. Such trading, some argue, could enable deeper emissions cuts, dramatically cut the cost of the low-carbon transition and help finance flow to the Global South. Others urge caution, arguing for a watertight accounting regime that will ensure its environmental integrity, but which traders fear will freeze activity.

The stakes are high. “I don’t think net zero is possible without Article 6,” says David Hone, chief climate advisor at oil major Shell. He argues that many countries will find it extremely expensive – or even technically impossible – to unilaterally eliminate or sequester all emissions from their economies by 2050.

“There are a lot of countries with enormous sink capacity, both geological and natural, and there are going to be lots of countries with industrial capacity that just cannot get to zero,” he says. “Net-zero emissions will need this matching between sinks and sources, and that will cross borders.”

The value of emissions trading lies in the economic efficiency that can flow from connecting those who can reduce emissions cheaply with those who face high costs. One study, from the International Emissions Trading Association (IETA) and the University of Maryland, estimates that Article 6 could reduce the cost of meeting the Paris Agreement’s mitigation goals by more than half, or around $250bn a year, by 2030.

Were governments to reinvest these savings in additional emissions-reduction measures, they could increase abatement by 50%, or five gigatonnes a year by 2030 – equivalent to the entire emissions of the US in 2016 – at no extra cost.

“Article 6 holds the potential for countries to aspire to greater ambition,” argues Dirk Forrister, chief executive of IETA. It could “unleash capital flows” to support the emission-reduction policies, targets and goals set out in the Nationally Determined Contributions (NDCs). These are the voluntary pledges countries have submitted under the Paris Agreement, many of which are contingent on international climate finance.

Following in Kyoto’s footsteps

Market mechanisms were an integral part of the Kyoto Protocol, the forerunner to the Paris Agreement. The Protocol was negotiated in 1997 and imposed emissions targets on rich countries from 2008 to, in theory, 2020.

The Kyoto Protocol successfully tapped into the power of markets to drive enormous investment in climate mitigation. Through its Clean Development Mechanism (CDM) in particular, entrepreneurs scoured the developing world for opportunities to invest in projects that, by reducing greenhouse gas emissions, earned carbon credits for sale to rich-world emitters. The Protocol’s international trading rules, meanwhile, allowed governments to buy and sell emissions allowances among one another.

The Paris Agreement’s Article 6 involves similar provisions. It lets governments “pursue voluntary cooperation” to reduce emissions. Under article 6.2, these can generate “internationally transferable mitigation outcomes”, which count towards the national emissions reduction goals of the governments that buy them.

Article 6.4 envisages the creation of a mechanism, for use by both public and private sector organisations, to “incentivise and facilitate… the mitigation of greenhouse gas emissions”. Article 6.4 would be supervised by a body set up by the UN Framework Convention on Climate Change, like the CDM is.

However, six years after the Paris climate talks, that mechanism and the broader Article 6 rules have not been finalised, held up by wrangling between governments over a range of issues. While the COP26 talks in Glasgow are expected to finally result in an agreement, the outcome risks disappointing carbon trading advocates.

Wrangling over the rules

Article 6 was to have been finalised at the Katowice climate talks in 2018, but an agreement proved impossible even a year later, at the last round of pre-Covid, in-person negotiations in Madrid in December 2019, in spite of a well-elaborated text. Several issues remain unresolved.

One is whether to allow projects registered under the CDM to continue to operate and generate carbon credits under the new Paris mechanisms – as well as whether credits generated by those projects before 2020 are admissible towards Paris goals. Many governments argue this would dangerously water them down. They also note the CDM was bedevilled by controversy, with questions raised over the real climate benefit provided by many of the projects.

Allowing CDM credits into the Paris system would reduce costs in the near term, says Forrister, but make it much harder and more expensive to hit medium-term targets. “We are operating with a limited atmospheric carbon budget,” he says. “You want to do the honourable thing in terms of the investors involved, but at the same time, it has to be limited, otherwise it becomes economically irrational.”

He believes there is a compromise within reach that would allow some CDM project types to qualify under Article 6.2. Equally, the limited carry-over of some pre-2020 CDM credits is likely to be allowed. The CORSIA emissions trading system for aviation allows the use of CDM credits generated between 2016 and 2020 only, he notes.

A second key issue centres on the “use of proceeds” provision in Article 6.6. As with the CDM, the UN will tax transactions, with the revenues intended to cover administration of the mechanisms and to help vulnerable developing countries adapt to climate change. The Paris Agreement relates this provision to Article 6.4 – which covers discrete projects or activities – but some countries want it extended to transactions under Article 6.2.

Hone at Shell disagrees. Article 6.2 is expected to be used to allow countries to join emissions trading systems. “The share of proceeds rule makes sense when you have got a defined project,” he says, not in a traded commodity market. Forrister concurs: “That has been a very bitter pill to swallow for a lot of negotiators.” They feel like the UN would be imposing a tax on transactions it is not really involved in, Forrister says.

Holding the market to account

Perhaps the thorniest issue is one of the more technical aspects of the Paris architecture – governing how emissions reductions are tracked once they are traded. Without sufficiently rigorous rules, environmental groups are concerned about ‘double-counting’, where two governments claim the same emissions reduction. The Environmental Defense Fund (EDF), a US NGO, has warned that up to 30% of global emissions are at risk of double counting.

“It would be better not to have [any agreement] than something that could undermine ambition at a time when we are really far from where we need to be,” says Yamide Dagnet, director of climate negotiations at the World Resources Institute, an environmental think tank based in Washington, D.C. “We cannot risk greenwashing.”

To address this problem, governments will be required to subtract the emissions reductions they sell from their emissions inventory and give them to the buying country. Some countries, notably Brazil, have argued that activities outside sectors covered by NDCs (which are not required to include a country’s entire economy) should not be subject to such “corresponding adjustments”. This would allow Brazil to attract investment into forestry projects that earn carbon credits, while retaining ownership of those emissions reductions.

Catching the voluntary carbon market

Mandating corresponding adjustments risks chilling the voluntary carbon market, however. While buyers and sellers wait for decisions from the UN process, that market is booming. The latest figures from information provider Ecosystem Marketplace show traded volumes from the first eight months of 2021 up 27% year-to-date, equivalent to 240 million tonnes of CO2, and up 58% in value terms, to $748m.

Much of this demand has emerged from companies signing up to net-zero targets. These targets typically go beyond regulatory requirements, and many companies plan to use carbon credits to at least partially meet their goals. However, when these transactions are not counted towards country goals, they should not need to be matched with corresponding adjustment, say many in the voluntary carbon market.

“I would hope that this COP doesn’t ensnare the voluntary carbon market in the rules of the Paris Agreement,” says David Antonioli, chief executive of Verra, a non-profit that runs the largest voluntary carbon market standard and registry. He argues that corresponding adjustments should track trades of carbon emissions used by countries to meet their Paris pledges. Voluntary transactions “never get reported to national governments”, he says.

“Nobody disagrees that an emission reduction can only be measured against one NDC,” says Charlotte Streck, managing partner at Climate Focus, a leading climate advisory company. “The question is whether double claiming between [voluntary] corporate goals and national goals is a problem. It isn’t from a Paris accounting point of view,” she adds.

It does raise a broader ethical question, however, argues Pedro Barata, a senior director at EDF. He explains that if a German car company invested in a project in Latin America, it would “be a bit strange” if the former claimed the reduction against its voluntary target and the host country also counted it towards its NDC.

Barata suggests that work by the Voluntary Carbon Markets Integrity (VCMI) Initiative could bring clarity. The VCMI recently published a consultation report that also sought input on questions around “double claiming” and corresponding adjustments.

Lacking capacity

Another challenge for carbon traders is that corresponding adjustments will require an approval process in the host country as well as regulatory and bureaucratic infrastructure that, in many cases, does not exist. This is already halting projects, says Antonioli. “We have heard of [buyers] asking developers to guarantee them a corresponding adjustment,” which developers cannot currently do. “You are going to be putting millions of dollars of climate action on ice.”

Corresponding adjustments also, Antonioli argues, raise issues of global equity. If a developing country is required to transfer emissions units to a rich country, it would move away from its own emissions target, requiring it to fund additional reductions. “You are basically asking countries in the Global South to help finance voluntary action [by rich-world companies],” he says.

Dagnet at the WRI is unmoved. “There would be some indirect repercussion for the private sector but we need, at the country-level, high standards … The market will adapt,” she says.

Market participants believe a compromise at COP26 is likely, one that would see corresponding adjustments phased in over the next few years. This would satisfy some voluntary market developers. Ed Hanrahan, chairman of project developer ClimateCare, says he would like that to be linked to milestones that host countries have to meet. “We must get to a point where we take responsibility for every tonne of carbon,” he says.

Time is short

Everyone agrees that time is running out. Mischa Classen is director of procurement at the KLIK Foundation, set up by the Swiss government to buy Paris-compliant carbon credits to offset emissions from transport. He notes that, even if Article 6 is agreed at COP26, it will take several years before legal and regulatory frameworks are created in host countries, and projects can be initiated, approved and start reducing emissions. This leaves little time for projects to earn a return before the end of the Paris Agreement window of 2030. “We could easily find that the first mitigation outcomes aren’t happening until 2025,” he says. “We sometimes feel as if the train has left the station.”

Agreement on Article 6 will not provide clarity on the relationship between domestic and international action either, says Martijn Wilder, founding partner of Pollination Group, a climate investment and advisory company. While it will likely resolve how carbon reductions are transferred between governments, the creation of those carbon assets will depend on domestic legislation.

Demand is another challenge. At present, mandatory emissions trading systems, such as those in the EU and North America, do not allow (or at least severely constrain) the use of overseas offsets, reducing interest from the private sector. In addition, few governments – aside from Sweden, Switzerland and, to some extent, Norway – have been experimenting with pilot Article 6 projects.

“We need much stronger signals on compliance demand, initially from governments and corporates,” says Ash Sharma, senior director at the Nordic Environment Finance Corporation, an international financial institution that was active in the Kyoto markets. However, without resolution around project methodologies and market infrastructure, for which “market expectations… are currently low,” the outcome is likely to be “a market which is sluggish, characterised by low demand and prices”.

“Unless we make a success of Article 6.4, the future carbon markets will be quite different from the CDM in its heyday,” he says.

However, Wilder has seen a “big shift in the last six months” in demand for project offsets, largely driven by companies with net-zero commitments but also financial investors. Moreover, he expects that domestic emissions trading systems under development around the world will become increasingly open to carbon offsets.

Forrister at IETA agrees that mandatory demand was a key driver of climate finance through the CDM. He also thinks that, over time, policymakers will begin to open the door to international offsets. It is a question, he says, of re-establishing confidence that market mechanisms can demonstrate “environmental integrity and economic efficiency”.

The original version of this article appeared in Energy Monitor. This article is part of a special series GlobalData Media is publishing in the run-up to COP26, which takes place in Glasgow from 1-12 November 2021. Our focus is on the opportunities and challenges for business of the transition to clean energy and net-zero greenhouse gas emissions. Other articles in this series include:

Just Food – Food giants need to pick up pace on greenhouse gas emissions

Energy Monitor – Why success at COP26 is vital for business

just-drinks.com – What drinks brand owners should know about COP26

Verdict – Inside Cervest’s plan to map the world’s climate risk