The Road From Paris: Green Lights, Speed Bumps, And The Future Of Carbon Markets

This is the second in a two-part series examining the role of carbon markets under the Paris Accord. Click here to read the first installment, which offers an introduction to Article 6.

1 February 2016 | When climate negotiators signed off on the historic Paris Agreement in December, market practitioners praised what they said was a clear signal to companies around the world: reduce emissions now, or pay a steep price later.

“Over the last two years, you’ve heard corporate leader after corporate leader step forward and say, ‘We need carbon pricing in order to really let a transformation take place in our sector,’” said Dirk Forrister, President and CEO of the International Emissions Trading Association (IETA). “This sends a very clear message to business: ‘That price is coming.’”

The agreement, however, doesn’t explicitly say how the private sector or carbon markets will be deployed. Instead, Article 6 of the agreement assumes that countries will develop markets internally, and it says they can trade “Internationally Transferred Mitigation Outcomes” (ITMOs) among themselves to deepen the targets they’ve set in their Nationally-Determined Contributions (NDCs).

“It must also be emphasized that these paragraphs do not, by themselves, create a market or a price for carbon,” wrote IETA founder and former CEO Andrei Marcu, in a paper for European Policy Studies (CEPS). “What these paragraphs do is provide the ability to create an international market if any Parties so desire. They have no relevance to domestic mitigation actions, or their outcomes, until they are transferred internationally.

“The fact that the word ‘market; does not appear is neither here nor there,” he added. “It does not appear in the Kyoto Protocol (KP) either. The absence of the work ‘market’ is deliberate, not accidental.”

[Scroll down to “Article 6: Annotated” for the relevant text]

Countries that use this to develop international trading must, however, keep a clear accounting of the impact those transfers have on their own carbon inventories, and their accounting must pass muster with the United Nations Framework Convention on Climate Change (UNFCCC).

[Part One: “Building On Paris, Countries Assemble The Carbon Markets Of Tomorrow”]

“The Paris Agreement establishes implicitly the distinction between ITMOs on the one hand and the generation of credits on the other,” says Former Dutch negotiator Jos Cozijnsen, who now advises environmental NGOs. “Parties like the European Union, for example, need to prove that the overall outcome meets accounting rules, but they are sovereign to decide what kind of credits companies can use under the European Union Emissions Trading System (EU ETS).”

That same reasoning applies to dozens of other countries and parties that are now either running or developing domestic carbon markets – some of which are already linked internationally.

The path forward, however, is not an easy one, as we can see by first looking back to the Kyoto Protocol.

Lessons from Kyoto

To make up for the inherent differences between rich countries and poor countries, the Kyoto Protocol divided all the parties to the UNFCCC into two distinct types: those with caps on their emissions, and those without caps on their emissions.

The capped parties were supposed to be rich – or at least on their way to becoming rich – but they included struggling nations like Romania and Portugal. The uncapped countries, on the other hand, were supposed to be poor or developing, but they included China, Brazil, and scores of nations whose per-capita GDP was higher than that of the poorest capped countries.

When trading happened between countries, it was either between two capped countries (through the “Joint Implementation” mechanism, known as “JI”) or between a capped country and an uncapped country (through the “Clean Development Mechanism”, known as the “CDM”).

“Under the Paris Accord, ITMOs can be credits from other Parties with an NDC, which would look like the current JI,” says Cozijnsen. “Also, don’t forget the CDM still exists for poorer countries.”

And, on top of that, there’s the centralized mechanism that Article 6 also describes. Currently dubbed the “Sustainable Development Mechanism” (SDM), it’s expected to be a sort of CDM 2.0.

In both cases, the accounting was simpler than what’s being proposed under the Paris Agreement, because capped countries were all capped in similar ways. If a German company financed a clean-power plant in Romania, for example, it was a fairly simple matter for Romania to first track those emission reductions domestically and then transfer them to Germany, with the net result showing an emissions reduction for Germany, but not for Romania. If that same company financed a wind-farm in China, it was even easier: as an uncapped country, China didn’t have to worry so much about tracking and transferring emission reductions.

Under the Paris Agreement, however, no countries have UN-determined caps, but none are off scot-free, either. Instead, each has a different NDC. This opens two cans of worms – one of which caught some developing countries by surprise in Paris.

Can-of-Worms One: the Double-Counting Kerfuffle

In the lead-up to Paris, scores of countries submitted conditional early-stage NDCs (which were called “INDCs” before Paris, with the “I” standing for “intended”).

Conditional NDCs offered two emission-reduction targets: shallow ones that countries could achieve on their own, and steeper ones they could achieve if carbon markets or other international mechanisms were part of the final agreement.

In the closing days of the Paris negotiations, however, many of the countries that had presented conditional NDCs balked when they learned that they’d have to transfer their emission-reductions to a buying country. Some countries, in other words, weren’t aware that if they sold an emission reduction, they were no longer allowed to deduct that from their own carbon inventory.

“Under Kyoto, they didn’t have to do that, so I can see why some would have been caught off guard,” said Peter Graham, a former Canadian negotiator now working for the World Wildlife Fund (WWF). “This is why we have such strong language against double-counting in there now.”

Keohane pointed out that the kerfuffle was a win for environmental ingegrity. “This is exactly the kind of thing we have to get straight now, so that countries can come up with real, informed, and actionable strategies in the year ahead, rather than wishful thinking,” he told Ecosystem Marketplace in December.

That’s true, but the misunderstanding could have profound implications on the supply of emission reductions coming from countries whose conditional NDCs were built on the premise that they could reduce their own emissions by selling emissions reductions abroad. Some could water down the ambition of their emission reduction targets as a result. Or, they might focus instead on “payments for performance” that finance emission reductions in the home country but don’t result in emissions reductions being transferred abroad.

The Supply Shortage

From a market perspective, it could mean countries export fewer of their “low-cost” emission reductions, and instead use those to meet their own targets, according to Jeff Swartz, IETA’s International Policy Director.

“We may see those countries saying, ‘Well, I’m not just going to export my low-cost abatement to you anymore; I want to keep the low-cost stuff for myself,’” he said. “That’s fine, too, because the countries I see buying aren’t going to be looking for the cheapest offsets they can get anymore.”

Can-of-Worms Two: The Quality Conundrum

That brings up the other can of worms: how to account for differences in ambition from country to country? One answer could be conversion rates.

“If I’m Switzerland, and I’ve got a link with the EU ETS, and my target is higher than the EU ETS, then I might need to discount the value of an EU allowance,” says Swartz – meaning that Switzerland could buy two allowances from EU ETS (or from any comparable system, for that matter) and count it as one ton against its target.

He urges countries to develop such strategies on their own rather than waiting for them to emerge under the UNFCCC.

“That approach is complex enough as a sovereign decision, and it could be unworkable if we try to do it with a universal UN rule,” he says. “Plus, the reality is that we now live in a 1.5-degree world, not a 2-degree world, and countries need to act now. You can’t be sitting around in Bonn meeting rooms making excuses anymore. Those days are over.”

…and the Demand Dilemma

Assuming the questions around ITMO supply can be worked out and countries are willing to transfer high-quality, singly-counted emission-reduction units, the question of demand still looms: Will there be willing buyers on the other end?

Over half of the parties to the UNFCCC said that they plan to use or are considering market-based instruments to meet their national climate targets. But only half a dozen of them – Canada, Japan, New Zealand, South Korea, Switzerland, and possibly Norway – are likely buyers of international offsets. The rest are developing countries hoping to be on the supply side.

Major players – including the European Union and the United States – explicitly stated that they plan to meet their climate commitments without engaging in emission-reduction markets. But some experts think this might change as governments are faced with the economic realities of meeting their targets.

Ash Sharma, the Special Adviser for Climate Change to the Nordic Environment Finance Corporation recently wrote that “it is likely that such positions may evolve over the coming years,” particularly when the UNFCCC takes stock of global progress in 2018, at which point countries will be expected to ramp up their ambition accordingly.

But even countries that choose not to purchase emission reductions internationally may develop carbon markets at home in order to meet their targets, potentially creating significant new pockets of domestic demand.

Swartz sees this as a likely scenario, pointing out that China, the United States, and the European Union will face tremendous demand for offsets, but can probably meet that demand internally. Demand for international credits will likely come “from smaller countries that need international abatement because of domestic constraints – Switzerland or Korea or New Zealand, for example,” he says.

“Those countries are going to be pursuing credits with very high environmental integrity,” he adds. “That’s what they’re going to have to do in order to defend their respective program in front of their electorate.”

Markets aren’t the form of climate finance for developing countries, which the Paris Agreement confirmed should be at least $100 billion per year. Some of this finance could flow through bilateral or multilateral results-based agreements that make the transfer of funds contingent on the recipient demonstrating quantified emission reductions – for instance, those associated with halted deforestation. In December, Norway, Germany, and the UK pledged $5 billion to tropical forest countries in exactly this kind of results-based framework.

But results-based finance does not necessarily constitute “demand” for ITMOs, since the financing countries may not want to count the emission reductions against their own national targets. In this case, the unit might be more like an IMO (international mitigation outcome) – a verified result that simply isn’t transferred.

That, however, is an acronym for another day – and there will be plenty to come, as international negotiators, domestic authorities, environmental NGOs, and private-sector participants digest the implications of the Paris Accord.

Article 6: Annotated

Here is the full text of Article 6, with brief summaries of each paragraph in simple English.

1. Parties recognize that some Parties choose to pursue voluntary cooperation in the implementation of their nationally determined contributions to allow for higher ambition in their mitigation and adaptation actions and to promote sustainable development and environmental integrity.

Countries can cooperate with each other to ramp up their climate change strategies (“allow for higher ambition in their mitigation and adaptation actions”) and promote sustainable development.

2. Parties shall, where engaging on a voluntary basis in cooperative approaches that involve the use of internationally transferred mitigation outcomes towards nationally determined contributions, promote sustainable development and ensure environmental integrity and transparency, including in governance, and shall apply robust accounting to ensure, inter alia, the avoidance of double counting, consistent with guidance adopted by the Conference of the Parties serving as the meeting of the Parties to the Paris Agreement.

Countries can meet their emissions reductions targets (“nationally determined contributions”) by trading emissions reductions (“internationally transferred mitigation outcomes”) among each other, and they can create their own governance structures to manage the process, but they must make sure the trading promotes sustainable development, and they must follow accounting principles approved by the UNFCCC.

Questions Raised:

The Paris Accord allows the transfer of emissions reductions between countries, but the national climate strategies are not as uniform as the caps were under the Kyoto Protocol.Interestingly, the Paris Accord does say that trading must promote sustainable development, which seems like a remnant from the days of differentiation.

3. The use of internationally transferred mitigation outcomes to achieve nationally determined contributions under this Agreement shall be voluntary and authorized by participating Parties.

No countries are obligated to participate in the carbon markets.

4. A mechanism to contribute to the mitigation of greenhouse gas emissions and support sustainable development is hereby established under the authority and guidance of the Conference of the Parties serving as the meeting of the Parties to the Paris Agreement for use by Parties on a voluntary basis. It shall be supervised by a body designated by the Conference of the Parties serving as the meeting of the Parties to the Paris Agreement, and shall aim:

1. To promote the mitigation of greenhouse gas emissions while fostering sustainable development;
2. To incentivize and facilitate participation in the mitigation of greenhouse gas emissions by public and private entities authorized by a Party;
3. To contribute to the reduction of emission levels in the host Party, which will benefit from mitigation activities resulting in emission reductions that can also be used by another Party to fulfil its nationally determined contribution; and
4. To deliver an overall mitigation in global emissions.

The UNFCCC will also create a centralized trading platform that countries can use to trade emissions reductions. Some are calling this the “Sustainable Development Mechanism”.

5. Emission reductions resulting from the mechanism referred to in paragraph 4 of this Article shall not be used to demonstrate achievement of the host Party’s nationally determined contribution if used by another Party to demonstrate achievement of its nationally determined contribution.

If one country transfers an emissions reduction to another country, then it can no longer deduct those emissions from its own carbon inventory. In other words: no double-counting.

6. The Conference of the Parties serving as the meeting of the Parties to the Paris Agreement shall ensure that a share of the proceeds from activities under the mechanism referred to in paragraph 4 of this Article is used to cover administrative expenses as well as to assist developing country Parties that are particularly vulnerable to the adverse effects of climate change to meet the costs of adaptation.

Some of the money raised from the central platform will go to maintaining the mechanism, and some will go to least-developed countries.

7. The Conference of the Parties serving as the meeting of the Parties to the Paris Agreement shall adopt rules, modalities and procedures for the mechanism referred to in paragraph 4 of this Article at its first session.

High-level negotiators will provide more details on the Sustainable Development Mechanism at the end of this year in Marrakesh.

8. Parties recognize the importance of integrated, holistic and balanced non-market approaches being available to Parties to assist in the implementation of their nationally determined contributions, in the context of sustainable development and poverty eradication, in a coordinated and effective manner, including through, inter alia, mitigation, adaptation, finance, technology transfer and capacity-building, as appropriate. These approaches shall aim to:

1. Promote mitigation and adaptation ambition;
2. Enhance public and private participation in the implementation of nationally determined contributions; and
3. Enable opportunities for coordination across instruments and relevant institutional arrangements.

Countries can also cooperate without using markets, and non-market approaches can be integrated with market-based approaches. Non-market approaches have been promoted by countries such as Bolivia and Venezuela and might include policies to promote renewable energy, as an example.

9. A framework for non-market approaches to sustainable development is hereby defined to promote the non-market approaches referred to in paragraph 8 of this Article.

This is the second in a two-part series exploring the role of markets in the Paris Accord. Click here to read Part One: “Building On Paris, Countries Assemble The Carbon Markets Of Tomorrow“.

Steve Zwick is Managing Editor of Ecosystem Marketplace. He can be reached at [email protected].