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The new climate deal includes several provisions relevant to market-based emissions reductions efforts.

At a UN conference in Paris, France in December countries agreed to a new framework for international cooperation on climate change. The “Paris Agreement” ties together nationally determined contributions (NDCs) with international rules and procedures to ensure transparency and promote rising ambition. Paris also provided a future for international market mechanisms as a tool for countries to fulfil their NDCs.

Many NDCs submitted as part of the Paris process demonstrate an enthusiasm for market approaches. Sixty-five governments say they will use international markets and another 24 will consider using them in the future. Many groups such as the Carbon Pricing Leadership Coalition (CPLC) urged support in Paris for the use of market mechanisms and a ministerial declaration issued by 18 governments at the close of the conference was designed to send “a clear signal to the global carbon market…that there is an important role for markets in the post-2020 period.”

The Paris Agreement includes provisions that can advance carbon markets in two ways: by ensuring there is no double counting when countries engage in emissions trading, and by establishing a new mechanism to facilitate trading. In both areas, however, the text provides only broad parameters and important details remain to be decided. This article addresses the current state of carbon markets, their history in international climate agreements, and relevant provisions of the Paris deal – including issues still to be negotiated before it comes into effect.

Carbon market context

Carbon pricing is currently in place in 38 jurisdictions, according to the World Bank, encompassing both carbon taxes and emissions trading schemes (ETS). A number of additional policies are scheduled to enter force between now and 2020 including carbon taxes planned for Chile and South Africa. Ontario will develop an ETS similar to neighbouring Québec and US states Washington and Oregon are considering the same. In terms of scale, the most significant will be a new national ETS in 2017 across China, the world’s largest greenhouse gas (GHG) emitter.

Not all carbon market programmes seek to trade internationally; some focus solely on domestic emission reductions. Nevertheless, bottom-up linkages are already occurring. For example, California and Québec have linked their cap-and-trade programs, making carbon allowances and offsets fungible between programs. There are also ongoing discussions in California about using sector-based offsets that reduce deforestation – known as REDD+ – from Acre, Brazil and Chiapas, Mexico. The EU Emissions Trading System (EU ETS) and Swiss ETS have agreed a link, pending ratification by each.

In addition, the International Civil Aviation Organisation (ICAO) is to decide by the end of this year on the design of a global market-based mechanism (MBM) to reduce emissions from aviation. The MBM would come into force in 2020, around the same time the Paris Agreement aims to be in place.

History of international market mechanisms

Market-based approaches are not referred to in the founding 1992 UN Framework Convention on Climate Change (UNFCCC) document, but were integral to the design of its first sub-agreement, the 1997 Kyoto Protocol.

Under Kyoto, participating developed countries have binding emission limits – “quantified emission limitation and reduction commitments” – inscribed in Annex B of the agreement. They are allocated “assigned amount units” (AAUs) in line with those targets and, to enable least-cost emission reduction, are permitted to trade AAUs and other certified emission units.

Kyoto established three methods for transferring units – either emission allowances or emission reductions – between countries. International Emissions Trading (IET) allows countries that have reduced emissions below their targets to sell excess allowances to countries whose emissions exceed their targets. Joint Implementation (JI) allows Annex B countries to earn emission reduction units (ERUs) through emission reduction or removal projects in other Annex B countries. The Clean Development Mechanism (CDM) allows Annex B countries to earn certified emission reduction (CERs) credits through emissions-reduction projects in developing countries.

Emissions trading under the Kyoto Protocol relies on international oversight. All transfers are tracked using a registry called the International Transaction Log (ITL). A common accounting standard applies to all countries with emission targets. An executive board must approve the methodology CDM projects propose using. Finally, under the Protocol, only the international transfers it sanctions are considered legitimate to fulfil a country’s emissions-cutting obligations.

The Kyoto model provides important infrastructure for an international carbon market. Common accounting procedures ensure that any transfer meets an internationally agreed level of environmental integrity. An AAU allocated to Switzerland represents a metric tonne of emissions measured using the same standard as an AAU allocated to Norway. Common offset methodologies give a blueprint to replicate in projects across the globe. The CDM has been able to issue 1.4 billion credits – each representing a metric tonne of avoided emissions – and mobilise over US$400 billion in investment using this international rulebook for managing offset projects. Moreover, when countries submit their national GHG inventories, any recorded transfers can be verified by checking the international registry thereby reducing the potential for emissions double counting.

The Kyoto Protocol’s market mechanisms have, however, lately encountered shrinking participation. One reason has been a reliance on the EU ETS as a source of demand, where low economic growth and restrictions placed on the types of credits has created a generous oversupply of CDM credits.

The Paris Agreement and carbon markets

The Paris Agreement establishes a fundamentally different framework from Kyoto. Rather than binding emission limits, which readily lend themselves to market approaches, the new climate regime requires all parties to undertake nationally determined contributions of their own choosing. As of writing, 187 countries had put forward NDCs, presenting various 2020-2030 target reduction dates.  These contributions are not legally binding and come in many forms, ranging from absolute economy-wide targets to peaking years, carbon intensity reductions, and so on. A new transparency system will apply to all parties, but will be less prescriptive than the accounting of AAUs that underpinned the Kyoto Protocol.

Fitting market approaches into this new landscape poses a different set of challenges. In a literal sense, the Paris Agreement is silent on markets, in that the term does not feature in the text. This is not unusual, the Kyoto Protocol also did not include the term. Instead, the new agreement houses markets under Article 6, geared towards addressing “voluntary cooperation” between parties in achieving their NDCs.

Article 6 recognises that parties may choose to pursue voluntary cooperation in implementing their NDCs. If these “cooperative approaches” involve the use of “internationally transferred mitigation outcomes,” or ITMOs, robust accounting shall be used to avoid double counting. The use of ITMOs are voluntary and authorised by participating parties.

The same article also establishes a mechanism to contribute to GHG mitigation and support sustainable development. The new mechanism will be under the authority of meeting of parties to the Paris Agreement. It has four listed aims including to promote greenhouse gas mitigation while fostering sustainable development; incentivise and facilitate participation by public and private entities who are authorised by a party; contribute to reduction of emissions level in host country, which can also be used by another party to fulfil its NDC; and deliver an overall reduction in global emissions. In addition, emission reductions occurring from the new mechanism must not be double counted. A share of proceeds will be used to cover administrative expenses and assist developing countries to meet the costs of adaptation, which is similar to the share of proceeds under the CDM, a portion of which was channelled to the Adaptation Fund. Article 6.8 and 6.9 contain a framework for promoting “integrated, holistic and balanced non-market approaches.”

So what comes next? When the CDM, JI, and IET were established under the Kyoto Protocols, the details were not finalised until the Marrakech Accords four years later. Similarly, the COP21 outcome sets a work plan for negotiators to deliberate and decide how the Paris system will work, to be addressed in upcoming UNFCCC meetings.

Cooperative approaches accounting

The existing UNFCCC accounting system is bifurcated between developed and developing economies. Under the Convention, GHG inventories are required each year for industrialised countries, while these are included in national communications submitted every four years for developing nations.

The Paris Agreement establishes an “enhanced transparency framework for action and support,” with built-in flexibility to take into account national capacities. Under this framework each party must submit a national greenhouse gas inventory. An accompanying decision elaborates that all countries – except least developed countries and small island developing states – shall provide these inventories at least biennially.

On markets the Subsidiary Body for Scientific and Technologic Advice (SBSTA) will develop and recommend guidance on how to apply “robust accounting” for cooperative approaches, for adoption at the first session of governing body of the Paris Agreement, known as the CMA . Countries will need to be “consistent” with this guidance, but not necessarily follow it strictly. How to determine if a country’s accounting is consistent is not clarified in the Paris agreement, though it will likely be reviewed as part of the new transparency system.

Pending decisions will provide greater clarity on a number of issues. On ITMOs, it will be useful to define the scope of what can be considered a “mitigation outcome” transferred between countries. Under Kyoto, AAUs serve as a unit of account for transferring obligations, but also define the scope of accepted international transfers. In other words, only transfers involving AAUs are accepted when submitting national GHG accounts. Parties will also need to consider whether other forms of co-operation – such as Japan’s Joint Crediting Mechanism (JCM), which is similar to the CDM, or the bilateral linking of two ETSs –would be considered ITMOs. Transfers involving one or more countries without absolute economy-wide targets could complicate the methodology needed to avoid double counting.

On the accounting system, the CMA could take an active role in facilitating transfers, including through a central registry similar to the ITL. Alternatively, in a more decentralised system, it may require that parties maintain their own accounting – such as double-entry bookkeeping – and rely on the transparency arrangements to provide oversight. The provision referencing ITMOs also requires parties to “promote sustainable development and ensure environmental integrity.” The SBSTA guidelines will need to define these terms and how countries will meet them when undertaking transfers.

Paris “mechanism”

Another accompanying COP decision recommends that the CMA adopt “rules, modalities, and procedures” for the new mechanism at its first session. The parameters for these are: voluntary participation authorised by each party involved; real, measurable, and long-term benefits related to the mitigation of climate change; specific scope of activities; reductions in emissions that are additional to any that would otherwise occur; verification and certification of emission reductions resulting from mitigation activities by designated operational entities; experience gained with and lessons learned from existing mechanisms and approach adopted under the Convention.

This leaves much to be hammered out by governments. A key area to address will be the type of system. The new mechanism may continue to credit at a project level. A Brazilian proposal in Paris envisioned a mechanism similar in scale to the CDM, referred to as an “enhanced CDM,” or “CDM+.” Conversely, in prior discussions for a “new market mechanism” (NMM), both the EU and the Environmental Integrity Group negotiating group have proposed a scaled-up or sector-based crediting mechanism.

The future of the Kyoto flexibility mechanisms is also unclear, in particular whether the new mechanism will succeed the CDM and JI, or will sit alongside either of these. The Paris Agreement does not mention the CDM or JI, but notes that the new mechanism should draw on the experience gained from existing mechanisms. Similarly, it is unclear whether units generated under the Kyoto mechanisms will be eligible for compliance after 2020 and if so, whether they will need to be converted to an alternative credit type to conform with credits issues under the new mechanism.

Negotiators may also decide to transfer project methodologies over from the CDM to apply to the new mechanism, discard some of these existing approaches, or move away from project level crediting altogether as noted above. They may also consider other methodologies used outside the UNFCCC. Finally, the Paris Agreement frames sustainable development on a par with GHG mitigation, so parties may require measured sustainable development outcomes to be eligible for crediting.

Parties will need to decide on governance arrangements for the new mechanism. The CDM is managed by an Executive Board of ten government officials, comprising one member from each of the five UN regional groups, two other members from parties included in Annex I, two other members from non-Annex I parties, and one representative of the small island developing states. Similarly, JI has a supervisory committee (JISC) to oversee the verification of projects. The new mechanism could incorporate governance from either of these existing platforms.Guidance on rules and procedures will also need to be clarified. The CDM and JI have existing procedures for developing projects that are ultimately credited. Countries could transfer these rules to the new mechanism or adopt new procedures.

Given the breadth of views across governments on the role of market mechanisms, reaching conclusions on these issues will be challenging. The slow progress since 2011 in the UNFCCC toward a “framework for various approaches” (FVA) and NMM demonstrated the difficulties in gaining consensus on the subject. Nevertheless the importance afforded to international markets by many countries in their NDCs implies there is a strong impetus to find a workable system for international transfers.

Efforts beyond UNFCCC

It is possible that initiatives undertaken outside the UNFCCC will inform efforts within. The Carbon Market Platform established under the G7, for example, is a strategic political dialogue that can complement the UNFCCC in developing guidance on accounting for international transfers. The system that ICAO builds could seek consistency with the Paris Agreement. For example, it would be beneficial if credits used for compliance in the UNFCCC and ICAO are fungible, to prevent project developers choosing between separate customers. It remains to be decided what types of international credits will be used for compliance in the ICAO MBM, but this should take into account the emergence of the new mechanism. In addition, the accounting system used by ICAO should at least be consistent with that used under the Paris system, insofar as this would avoid the double counting of units used for compliance in both ICAO and the UNFCCC.

Unfinished business

Paris reaffirmed carbon markets as an instrument for meeting climate goals. Outside of the agreement itself, groups such as the CPLC are building strong momentum for market approaches as a key component to meeting the mitigation targets set by NDCs. COP21 did not, however, finalise a new system of international carbon markets or cooperative approaches. Accounting for ITMOs and other forms of voluntary cooperation require elaboration and guidance. The role of the new mechanism remains to be negotiated. And if these talks become stalled, as was the case for the FVA/NMM deliberations, interested countries may pursue bottom-up linkages elsewhere rather than continue to search for solutions within the UN climate talks. The pace and extent of progress under the UNFCCC will determine how central a role multilateral platforms will play on these issues in the future and the prospects of a truly global carbon market.

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Will the current UN climate talks do enough to create common standards for international emissions trading in the future or should interested parties look outside the multilateral process? 

Around the world governments are increasingly pursuing market-based approaches to reduce their greenhouse gas (GHG) emissions. South Korea’s emissions trading scheme entered force at the start of this year and is currently the world’s second largest carbon market. Many other carbon pricing policies are either in force or in the planning stages, including in emerging markets such as Brazil, China, and Mexico as illustrated in Figure 1.

Parties to the UN Framework Convention on Climate Change (UNFCCC) are due to meet in Paris, France later this year to finalise a new global climate agreement to replace the current Kyoto Protocol and the Copenhagen Accords when these expire at the end of this decade. One important consideration is the degree to which the new agreement can help facilitate the growth and integration of carbon markets. This article examines the existing international emissions trading regime under the Kyoto Protocol; the status of market-related issues in the ongoing UN climate talks; and potential options to encourage market approaches and policy co-ordination outside the UNFCCC.

Figure 1: Emissions Trading Schemes World Map, July 2014

Source: Copyright 2012, International Carbon Action Partnership (ICAP)

The origin of market mechanisms: The Kyoto Protocol

The development of a market for carbon emissions was a significant component of the UNFCCC’s Kyoto Protocol, which is currently in its second commitment period, running from 2012 to 2020. Parties with emissions reduction targets – listed in Annex B of the Protocol – are allocated “assigned amount units” (AAUs) that represent the total emissions permitted to meet these targets. Domestic reduction policies help to bring actual emissions in line with the allocated AAUs. Parties then submit national greenhouse gas inventories annually to the UNFCCC that account for all emissions that occurred within that year.

To give countries greater flexibility to meet emissions targets, which in turn should help to reduce the overall costs of cutting emissions, three methods for transferring units – either emissions or emission reductions – between countries are sanctioned in the Kyoto Protocol. Article 17 provides for International Emissions Trading (IET), meaning that countries that have reduced emissions below their targets and therefore have excess units, can sell their excess allowances to countries whose emissions exceed their targets. Another transfer option is Joint Implementation (JI), which allows Annex B countries to earn emission reduction units (ERUs) through emission reduction or removal projects in other Annex B countries. The Clean Development Mechanism (CDM) allows Annex B countries to earn certified emission reduction (CERs) credits through emissions-reduction projects in developing countries.  Finally countries can also earn removal units (RMUs) based on land use, land-use change, and forestry (LULUCF) activities.

Emissions’ trading under the Kyoto Protocol relies on international oversight. All transfers are tracked using a registry called the International Transaction Log (ITL). A common accounting standard applies to all countries with emission targets. An executive board must approve the methodology that CDM projects propose to use. Finally, under the Protocol only the international transfers it sanctions are considered legitimate to fulfil a country’s emissions-cutting obligations.

The Kyoto model provides important infrastructure for an international carbon market. Common accounting procedures ensure that any transfer meets the internationally agreed level of environmental integrity. An AAU allocated to Switzerland represents a tonne of emissions measured using the same standard as an AAU allocated to Norway. Common offset methodologies give a blueprint to replicate projects across the globe. The CDM has been able to issue 1.4 billion credits – each representing a tonne of avoided emissions – and mobilise over US$400 billion in investment using this common rulebook for managing offset projects. Moreover when countries submit their national greenhouse gas inventories, any recorded transfers can be verified by checking the international registry, reducing the potential for a double counting of emissions.

The Kyoto Protocol’s rigidity, however, has undermined broad participation. This goes beyond international trading. For example, there is little flexibility in the types of commitments that countries must meet, namely quantified economy-wide emission reduction targets. Furthermore, as the CDM illustrates, Kyoto uses a binary differentiation between developing countries ­­– that host projects – and developed countries – that finance them. More fundamentally Kyoto establishes binding emissions targets for developed countries and no new commitments for developing countries.  Many countries have said that such a bifurcated structure would not be politically acceptable in a future UNFCCC agreement. The post-2020 regime will likely need to reflect a less rigid form of international governance, including at the level of emissions-reduction tools, if it is to garner broad support.

Bringing markets into the new regime

The Paris climate deal is being negotiated under the UNFCCC’s Ad Hoc Working Group on the Durban Platform for Enhanced Action (ADP). Its mandate is to “develop a protocol, another legal instrument or an agreed outcome with legal force under the Convention applicable to all Parties, which is to be completed no later than 2015 in order for it to be adopted at the twenty-first session of the Conference of the Parties (COP) and for it to come into effect and be implemented from 2020.”

By the end of March, parties will begin submitting their intended nationally determined contributions (INDCs), which constitute what a country proposes to do to combat climate change after 2020. At COP20 held in Lima, Peru last December countries agreed to some broad definitions of areas and information to include in the INDCs. Some parties are likely to include the use of markets as part of their INDC as a way to achieve emissions-reductions.

The ADP’s mandate does not address carbon markets.  Within the ADP negotiations so far questions relating to carbon markets have arisen primarily in the context of emissions accounting. Many parties believe that, in a regime lacking the top-down architecture of the Kyoto Protocol, minimising the potential for double counting is an imperative if markets are to play a positive role. Responsibility for avoiding double counting could rest on countries that choose to use markets with discretion as to how they do so. Alternatively a common accounting procedure could be agreed internationally to account for market transfers between countries.

Meanwhile, other issues related to the future role of carbon markets are being negotiated outside the ADP, within the UNFCCC’s Subsidiary Body for Scientific and Technological Advice (SBSTA). In this track, parties are seeking agreement on a Framework for Various Approaches (FVA), as a way of co-ordinating market and non-market based mitigation actions that relate to commitments under the Convention. Such a system could facilitate the transfer of units between different countries in the absence of a Kyoto-like architecture, and establish a New Market Mechanism (NMM), as well as Non-Market Approaches (NMA). However, parties have yet to agree on a definition of any of these three concepts, which prevents the discussions from moving forward. A number of countries have also expressed reservations about market mechanisms from an ideological point of view.

At the most recent Lima COP the FVA discussions hit deadlock after negotiators disagreed on whether these talks should continue in SBSTA or be transferred to the ADP. Some parties did not want to continue with the technical discussions since they believed it would pre-judge outcomes under the ADP and the inclusion, or not, of markets in the new climate agreement. The FVA discussions will continue at the June SBSTA session in Bonn, Germany, but prospects for agreement on these issues in Paris are not high.

For carbon markets to continue to grow post-2020 it would be important that the Paris agreement at the very least not disqualify international transfers as a way for parties to implement their nationally determined contributions. An affirmative recognition that parties may employ market mechanisms would provide a positive signal although some parties, including some favouring the use of market mechanisms, do not believe this would be legally required to move forward with market tools. The Paris agreement could consider establishing a process to agree common accounting standards, and other relevant measures, at a later stage. Any such agreement, however, would need to overcome the divergent views on the use of markets.

Looking beyond the UNFCCC

Other forms of policy co-ordination can play an important role in the absence of international consensus.  Linking binds together different emissions trading schemes into a common market. In the context of the post-2020 regime, if there is agreement that transferring units to satisfy a country’s emissions-cutting obligations are legitimate – or at the very least do nothing to preclude it – such linkages could occur even in the absence of a specific, international framework such as the FVA.

Some governments have already gone down this route. The EU ETS and Australia’s carbon pricing mechanism entered linking negotiations before the Australian government repealed their policy last July. At the sub-national level, California and Québec held their first joint auction of carbon allowances this past January, completing the process of joining their cap-and-trade programmes together. California is also exploring the possibility of allowing forestry offsets from sub-national provinces in Brazil, Indonesia, and Mexico.

Creating these linked emissions-reduction markets offers several advantages for governments seeking to take action on climate change. A common carbon price between jurisdictions could alleviate some of the economic competitiveness concerns about uneven abatement costs faced by businesses, particularly when the link occurs between key trade partners. A linked market would, in theory, equalise the carbon price faced by firms in each jurisdiction. Some companies may be hesitant for their government to link to a market where the carbon price is higher because of concerns this will raise their individual compliance costs. Nevertheless, a broader pool of allowances and offsets would reduce the aggregate cost of reducing emissions across the entire market, by allowing firms with relatively high abatement costs to import allowances from firms located in another jurisdiction who face lower abatement costs.

A common carbon price between jurisdictions could alleviate some of the economic competitiveness concerns about uneven abatement costs faced by businesses, particularly when the link occurs between key trade partners.

Bilateral linking does require prior co-ordination. For example, the accounting standards used to measure emissions must be consistent, to ensure a tonne is a tonne across the common market. The use of market stabilisation measures, for example setting a minimum and maximum price within a carbon market, must be harmonised to prevent firms from exploiting arbitrage opportunities.

The EU and Australia, as parties to UNFCCC, had the benefit of being under the Kyoto architecture where many of these technical questions were already agreed internationally. California and Québec are both members of the Western Climate Initiative (WCI), established in 2007 to facilitate a regional carbon market between US states and Canadian provinces. Agreeing common approaches during the design phase of these market programmes has made bilateral connections easier to pull off.

The potential risk of these bilateral arrangements is if governments agree linkages without putting in place sufficiently stringent accounting or technical standards. In the absence of international guidance on the kinds of transfers that are acceptable, and a common accounting framework, the responsibility to ensure environmental integrity rests with the jurisdictions that link. Governments that link bilaterally or in a club would need to agree to stringent accounting rules, registry systems, among other aspects, and those wishing to join the scheme would need to meet these standards.

Moving forward with carbon trading

The most effective solution to co-ordinate market policies is a set of agreed international rules and mechanisms. The Kyoto architecture provides a common unit, common approaches, and common accounting that offer some certainty to carbon market investors. Ultimately, however, that system is tied to a view of differentiation and requires a level of international governance that does not engender broad participation.

A new UNFCCC regime could develop rules in line with these political realities. Whether this occurs under a FVA, or a new set of deliberations in the ADP, developing common multilateral standards for markets will require international consensus. However, anti-market sentiment could harm prospects for agreeing to meaningful, robust rules. In the meantime, there are approaches outside of the UNFCCC that can advance market linkage from the bottom-up, without waiting for top-down direction. So long as the new international climate regime does not prohibit the transfer of market units, interested governments could establish talks on common approaches, and lay the groundwork for bilateral or plurilateral linking. While this may not have the unifying effect of a global standard, or a common carbon price, it could allow those who wish to co-ordinate their market policies to do so unencumbered by the need for international consensus.

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This report examines how three companies—Pacific Gas and Electric (PG&E), Rio Tinto, and Royal Dutch Shell—prepared for carbon pricing programs in the U.S. and around the globe, their experiences under carbon pricing programs, and lessons learned.

Partnership for Market Readiness, World Bank, Washington, DC. License: Creative Commons Attribution CC BY 3.0 IGO

The post Preparing for Carbon Pricing: Case Studies from Company Experience: Royal Dutch Shell, Rio Tinto, and Pacific Gas and Electric Company appeared first on Center for Climate and Energy Solutions.