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11 January 2022

Carbon markets get amber light from COP26

Agreement on Article 6 in Glasgow sets the stage for a global carbon market – but buyers and sellers have a world of complexity to navigate first.

By Mark Nicholls

The agreement reached on carbon markets at COP26 was six years in the making. It was bedevilled by arguments about environmental integrity and spats over the remaining spoils from the Kyoto Protocol. Resolution of the 2015 Paris Agreement’s infamous Article 6 proved elusive – and held up many millions of dollars of climate finance. The deal reached in Glasgow provides much needed clarity, yet building the market infrastructure will take time, and numerous questions remain on how buyers and sellers will adjust to the new rules.

Agreement on Article 6 demonstrates “the desire to create a global carbon market to serve the compliance requirements of the Paris Agreement”, says Jonathan Shopley, managing director of external affairs at ClimateCare-Natural Capital Partners, a UK-based supplier of carbon credits to corporate buyers. He adds: “That is a big breakthrough, because there has been lots of uncertainty around that.”

The agreement reached at COP26 promises to unlock global carbon markets. (Photo by Shutterstock/Rafapress)

“This will really accelerate private sector involvement in investing in cost-effective emission reductions,” says Abyd Karmali, climate finance executive at Bank of America in London. “We saw with the Kyoto Protocol how much investment can flow when you have relatively clear rules and a governance mechanism in place.”

Article 6 has two main components. Article 6.2 is essentially an accounting mechanism, by which countries can transfer carbon reductions, known as internationally transferred mitigation outcomes. It will allow for the linkage of national or regional emissions markets. Its primary function is to prevent ‘double counting’ – ensuring that any emissions reduction only counts towards one country’s climate target.

Article 6.4 creates a mechanism by which specific projects can earn carbon credits, with a similar design to the Kyoto Protocol’s Clean Development Mechanism (CDM). As with the CDM, a UN body is created that will oversee the mechanism, approving project types, setting baselines against which projects can claim reductions, and registering the creation and transfer of credits.

The deal reached in Glasgow also addressed the extent to which historic carbon credits earned under the CDM can be carried over to the Paris regime – a key demand of countries with large inventories of such credits, such as Brazil. It will allow for roughly 300 million to be used towards the first round of governments’ Paris targets, which cover emissions from 2020 to 2025, as set out in countries’ Nationally Determined Contributions (NDCs).

Sensible compromise

Most observers welcomed the Article 6 deal as a sensible compromise between the use of historic CDM credits and the stringency of the new Article 6.4 rules. “It is an excellent outcome,” says Axel Michaelowa, managing director of Perspectives, a Zurich-based consultancy. “I feared we would see a very tough CDM transition and weak rules for Article 6 in the future. Fortunately, the UK presidency played a superb diplomatic game.”

While some environmental groups have been critical of allowing CDM credits generated between 2013 and 2020 to be counted towards NDCs, Michaelowa argues that “these units will be gobbled up fairly quickly”.

Andrea Bonzanni, international policy director at the International Emissions Trading Association (IETA), agreed it was better for the environmental integrity of the system to allow for the use of some old credits than to open the door to less environmentally sound new credits. “It is better to make a compromise in an area where the supply already exists,” he says.

The agreement at Glasgow was also important for what it did not do. “They didn’t regulate the voluntary carbon markets – that is really important,” says David Antonioli, chief executive of Verra, a non-profit that runs the world’s largest voluntary carbon market standard and registry.

The fear before COP26 was Article 6 would require all international carbon transactions to be backed with corresponding adjustments – which means the reduction is deducted from the host country’s emissions inventory and added to that of the buyer’s. This would have likely brought the voluntary market to a halt until host countries decided which types of emission reductions – if any – they were prepared to export in this way.

Deeper emissions cuts

The main objective of carbon markets under the Paris Agreement is to enable governments to deepen their emissions targets. “Article 6 is incredibly important since it allows buyer countries to take on more ambitious [climate] targets, which can be met through acquiring international credits,” explains Maria Carvalho, head of public affairs at South Pole, a Zurich-based advisory company and project developer. On the other hand, many countries’ NDCs include deeper emissions cuts that are contingent on attracting international climate finance.

Article 6 also encourages countries seeking finance through carbon markets to decide what role those markets might play, she adds. Critically, it will be up to governments to decide whether transactions under Article 6.2 or Article 6.4 come with corresponding adjustments. Without them, the emissions reduction cannot count towards another country’s emissions target (and/or to a corporate net-zero target).

“It really puts a lot more control in the hands of nation states and particularly countries that host mitigation projects, because they can now decide whether those emission reductions get used for their own NDCs, or help other countries meet theirs,” says Shopley.

Countries might be willing to offer corresponding adjustments to attract carbon finance into harder-to-abate parts of their economy. Alternatively, as the Chinese government did with the CDM, they might heavily tax sales of emission reductions, enabling them to make additional reductions to compensate for those they export.

Bonzanni expects the voluntary market will split in two, with those credits that come with a corresponding adjustment trading at a premium compared with those that don’t. “It will be down to the buyer to decide which credits they want to buy,” he says.

A question of resources

However, Mark Kenber, the co-executive director of the Voluntary Carbon Markets Integrity Initiative (VCMI), is concerned poorer developing countries will take the view it is simply not worth setting up the legal and regulatory frameworks to enable corresponding adjustments. His concern is that, as with the CDM, most carbon finance will flow to middle income countries – the CDM was nicknamed by some the “China Development Mechanism”.

“Some of the countries we work with are wondering whether they want to spend the little money they have creating institutions and sophisticated registries for a carbon market they might not have much of a role in,” he says. “I think that is a rational response. If rich countries see these countries as a valuable source of forest conservation, or want to promote their low-carbon transformation, they are going to need to pay.”

There is also considerable work to be done at the UN level to create the Article 6 mechanisms. “It is important that the 6.4 mechanism is operationalised as quickly as possible,” says Bonnazoni at the IETA. He notes that a supervisory board needs to be appointed, which will then have to draw up rules of procedure and credit calculation methodologies for projects. “We are looking at a two-year timeframe before the first credits are issued, and we hope it is not much longer than that,” he says.

“The whole process is not aligned with the urgency of the problem,” warns Charlotte Streck, co-founder of Climate Focus, an Amsterdam-based advisory company. Her concern is that corporate buyers could step back from the market until they know what they are actually buying. “For the voluntary carbon market, it would be really, really bad to go into a paralysis.”

Corporate claims

For companies seeking to use carbon markets to help them meet net-zero targets, Glasgow answers some questions but leaves others hanging. Before COP26, a key concern was avoiding double-counting, whereby a carbon offset is claimed both by the corporate buyer and the host country. This is the problem corresponding adjustments are designed to solve.

However, buyers hoping to quickly secure corresponding adjustments are likely to be disappointed, says Streck. Such adjustments are “a state asset” and “there needs to be a legal basis which will take a while to be put in place”, she explains.

Meanwhile, corporate buyers should be cautious about demanding corresponding adjustments that risk the host country failing to meet its emission reduction pledges under Paris. “What is completely missing from the discussion is the risk of non-compliance with NDCs,” Streck says. “If a company is making its claim of carbon neutrality on the back of a developing country not meeting its NDC… that is not a good look.”

Kenber suggests that, regardless of corresponding adjustments and a rigorous accounting system, political leaders are likely to try to have their cake and eat it. In other words, they will seek to sell emission reductions with corresponding adjustments while still claiming those reductions towards their national targets – especially given the system lacks an enforcement mechanism. “It is no different to the UK claiming to have reduced its emissions by 45% when much of that is because manufacturing has shifted to China or Vietnam,” he adds.

Getting to net zero

An alternative approach for companies is to invest in an emissions reduction activity in a host country, but not seek a corresponding adjustment, nor claim those reductions against their own targets. A number of standards and frameworks support this approach. “The Science Based Targets initiative [SBTi] is clear that carbon credits can be used by companies to support global efforts to achieve the Paris climate targets,” says Carvalho at South Pole. “It is also clear that carbon credits cannot be used by corporations to claim they have achieved their internal reduction targets.” The SBTi is shortly due to produce guidance on the use of corresponding adjustments.

“The question that hasn't been tested yet is whether there is enough value to the corporate to direct large sums of finance to [emission reductions that do not count towards its own targets],” says Shopley. That, he suggests, depends on how those climate claims are perceived by key audiences, such as investors, environmental NGOs, employees and customers.

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“We need to find a nuanced way of presenting these investments,” says Streck. “We need some language that gives the corporates comfort they get full recognition for their investment, while respecting host countries’ need for investment.”

The VCMI is planning to publish guidance in April 2022 on how, and under what circumstances, companies should be using carbon credits, including what claims they can make for their use, says Kenber.

“Some companies are potentially looking at using these offsets in the context of some sort of net-zero commitment, and a question they are asking is, can non-Article 6 units be used towards any commitments being made,” says Karmali at Bank of America. “At the moment, we need more details to answer this.”

Taking early action

Despite the ongoing uncertainty, there are actions both buyers and sellers can take now to prepare for rules and procedures under Article 6. Bonzanni at IETA suggests companies planning to generate credits can begin monitoring, reporting and verifying their current emissions to create baselines against which reductions may be measured. He recommends that buyers closely watch developments in the voluntary carbon market, given the close interactions between the 6.4 mechanism and voluntary market modalities.

“In a few years, they might be able to make claims or comply with obligations based either on 6.4 mechanism credits or certain types of credits that use current private voluntary standards,” he says. “It is important to understand the complexity of carbon markets, because the complexity and fragmentation is unlikely to disappear.”

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