Carbon markets and COP26

International

After six years of negotiation, COP26 resolved one of the outstanding issues of the Paris Rulebook when it reached a consensus on a global carbon market mechanism.

Article 6 of the Paris Agreement set out the principles of the market, without providing a full framework for it. But now – although some details still remain to be finalised and some uncertainties will only be resolved once the new system is implemented – the framework exists and the international community can push ahead with replacing the system previously put in place by the Kyoto Protocol.

Importantly, the Paris Agreement does not seek to regulate voluntary carbon markets. But the introduction of the new system may nevertheless have a significant impact on those markets, as we explain below.

What are carbon credits?

Carbon credits are designed to reduce emissions by financially incentivising polluters to decarbonise. They are typically produced by projects such as tree planting, deforestation and carbon capture schemes. A credit is basically a certification that a tonne of carbon has been reduced or removed from the atmosphere.

Polluters can offset their emissions by purchasing or being given a carbon credit allowance, which they can sell if they don’t use it. Those whose emissions exceed their credits have to buy extra credits from others.

Effectively, a polluter ‘buys’ the reduction of emissions or removal of greenhouse gases by another party, and then uses the amount of reduction/removal they’ve bought to offset their own emissions in their greenhouse gas accounting.

Article 6.2

Article 6.2 and 6.4 of the Paris Agreement deal with different types of carbon market.

Article 6.2 enables countries to establish bilateral or multilateral ‘cooperative approaches’ to trading credits (in this context called Internationally Transferred Mitigation Outcomes, or ITMOs), in order to meet their decarbonisation targets. Crucially, it provides accounting standards for transfers between countries, which reduce the scope for any double counting of ITMOs.

The key accounting concept is ‘corresponding adjustment’. In essence, the country receiving the ITMO subtracts the relevant amount of carbon from its total emission levels, but the country transferring the ITMO will have to add the same amount to its own total. So only the country that receives the ITMO can benefit from the ITMO in its carbon accounting.

Article 6.2 transactions are not governed by a central UN authority, but are regulated by bilateral agreements. However, there are various reporting requirements, and the creation of an international registry, an Article 6 database and a centralised accounting and reporting platform has been agreed.

While Article 6.2 concerns the transfer of ITMOs between nations, there should be be opportunities for private sector participation in related projects.

Article 6.4

Article 6.4 establishes an international carbon market system, to be governed by a central supervisory body, whose role will include approving the methodologies that can be used to generate mitigation outcomes, establishing a central registry and accrediting national supervisory bodies.

In the wording of the agreement, the Article 6.4 mechanism has been created “to contribute to the mitigation of greenhouse gas emissions and support sustainable development”. It is a framework within which countries can create their own markets, establish rules and enforce penalties, so there may be some significant differences between markets operating under Article 6.4.

bodies established by host nations will approve and authorise projects for inclusion in the system, assuming they comply with the criteria established by the central supervisory body and any additional local requirements.

For Article 6.4 credits – sometimes referred to as Article 6.4 emission reductions, or A6.4ERs – to be traded internationally, host nations will have to make corresponding adjustments, as they do under Article 6.2.

Businesses will be able to participate in the system, both through activities that create A6.4ERs and by acquiring A6.4ERs.

The new system will not be fully operational for some time, not least because the supervisory body – which will meet at least twice in 2022 – needs to resolve questions of methodology and administration.

Cancellations and funding

To the disappointment of many campaigners – and developing nations – the Glasgow agreement does not include a comprehensive carbon credit levy to fund climate adaptation.

Where trading occurs under Article 6.4, a mandatory 5% of credits traded will be cancelled, to contribute to the Adaptation Fund, which helps developing countries tackle climate change. A further 2% will be cancelled as a contribution to ‘overall mitigation’ and a payment will be made to fund scheme administration.

However, there is no such arrangement for bilateral national transfers of credits under Article 6.2: instead, countries are ‘strongly encouraged’ to make a voluntary contribution.

Many parties to the agreement believe the 2% cancellation ratio is inadequate, and will probably press for it to be increased in due course. According to the Alliance of Small Island States, “the mandatory 2% cancellation rate under 6.4 is major compromise … The small silver lining is that we will revisit this rate, in five years”.

Closing loopholes

Historically, there have been major weaknesses in carbon markets. For example, the price of credits has tended to be too low to motivate significant emission reductions, and penalties have not acted as a deterrent (in the EU, the fine is 100 euros per excess tonne of carbon, which is not significantly higher than the price of the credit itself).

A global patchwork of varying rules, systems and enforcement mechanisms has also resulted in ‘leakage’, with businesses relocating to countries where rules are more relaxed.

The new rules have attempted to close some of these loopholes. The supervisory body is expected to require robust monitoring and calculation of emission reductions from approved activities, as well as proof of ‘additionality’. (In simple terms, additionality is a certification that the emissions reductions or carbon removal from a particular activity would not have happened anyway.)

One loophole that was not completely closed is the use of existing credits, many of which are seen as low-quality. In a concession that was necessary to achieve agreement, millions of these credits will be allowed into the system, and will not be subject to some of the restrictions outlined above. However, only credits created since 2013 can be carried over, and they can only be used toward a country’s NDC for a limited period.

There is also a window for projects and programmes registered under the old system to apply to transition to the Article 6.4 system, which will include conforming to the more rigorous Article 6.4 requirements.

Voluntary markets

The Paris Agreement does not cover voluntary carbon markets. Used predominantly by businesses – but also open to other parties including governments, NGOs and investors – these are potentially more fluid than the ‘compliance’ markets covered by Article 6. They are capable of providing financing for projects that would otherwise struggle, and can offer more immediate investment for developing nations, especially where there is scope for nature-based carbon reduction at scale. They are also useful in projects where the gathering of adequate data on carbon reduction activity is problematic. But they are often accused of being vulnerable to greenwashing and lacking transparency.

The Glasgow agreement may enable host countries to attach corresponding adjustments to some credits traded in the voluntary markets, which would give them the option of incorporating voluntary market credits in their Article 6 accounting. But this was not explicitly agreed, and we may have to wait for the development of the regulatory regime to get a clear answer on whether this will be permissible.

At the moment, voluntary markets are only a very small fraction of the size of the compliance markets. But they are expected to grow further, with some commentators arguing that improvements in areas such as governance and standardised contracts would enable a substantial scaling-up. There are projects underway that aim to achieve this, notably the Voluntary Carbon Markets Integrity Initiative and the Integrity Council for Voluntary Carbon Markets, both represented at COP26.

Many Article 6 provisions are likely to be taken up by the voluntary markets as best practice as they seek to compete with compliance markets in the provision of higher-quality credits. And in the short term the voluntary markets will certainly continue to grow, as the new Article 6 system will take some time to implement and bed in. But it remains to be seen whether the voluntary markets can develop in a way that achieves the growth projections made by the Taskforce on Scaling Voluntary Carbon Markets, which envisages the voluntary markets expanding from about $1bn today to $50bn by 2030.

What does this mean for businesses?

Businesses will want to see more practical detail on how Article 6.4 is implemented, and how voluntary carbon markets respond to it. But it is already clear that the Glasgow agreement will create a level of certainty – and guarantees of quality – that will enable businesses to make better and more effective use of the carbon markets, whether they are engaged in activities that create credits or are purchasers of credits.

However, one point of the agreement is to incentivise reductions in carbon emissions by increasing the cost of credits to polluters, thus making investment in cutting emissions more commercially viable. Businesses that want to avoid accusations of greenwashing will need to ensure that they buy high-quality credits, which are likely to be more expensive. And funding and cancellation mechanisms will also tend to push prices up.

The fact that European carbon markets hit an all-time high after COP26 suggests some confidence in what was agreed at the conference. According to an OECD report, though, they will still have to rise from that level – around €68 per tonne, at the time of writing – to €120 per tonne by 2030 to achieve mid-century net zero.

Article co-authored by Erin Crawley, Trainee Solicitor at CMS.