Unlocking the potential of carbon market mechanisms in the Paris Agreement

Negotiators from across the globe are currently meeting in Spain at the 25th Conference of Parties (COP) to the United Nations Framework Convention on Climate Change (UNFCCC). On their agenda is a complicated item – how should countries use carbon markets to meet the global climate challenge?

Why does carbon need a market?

Climate change is a market failure. In spite of the climate impacts of economic activities, the economic costs of such impacts are not accounted for in market prices, leading to higher emissions than ideal for a sustainable planet. Addressing climate change requires internalizing these costs. Pricing carbon does this by providing a price signal to current emitters and offering incentives to invest in reducing future emissions.

The Paris climate agreement allows countries to use market-based mechanisms for GHG mitigation. Ninety six countries mention plans or considerations for the use of market-based or price-based mechanisms in their national climate plans or Nationally Determined Contributions (NDCs).

What does the Paris Agreement say about carbon markets?

The Paris Agreement allows voluntary trading between countries to meet their NDC goals. If a country reduces more GHG emissions than its target, it can sell the emission reduction to another country as an “internationally traded mitigation outcome” (ITMO).

The Paris Agreement also establishes a new activity-based Sustainable Development Mechanism (SDM) for countries to meet their NDC goals by using emission reduction credits. Like the earlier Clean Development Mechanism (CDM), this mechanism allows private sector participation in GHG mitigation, aims to contribute to sustainable development, and channels a share of the proceeds to adaptation in vulnerable developing countries.

Why does this matter?

If done right, the market-based mechanisms under the Paris Agreement have the potential to halve the costs of meeting current climate goals. Or, at no additional cost, they can provide incentives to increase the ambition of global climate action by almost 50% (i.e. around 5 billion tonnes of carbon dioxide annually in 2030). They can also encourage action by private and sub-national public entities allowing for GHG reductions higher than the currently pledged NDCs. Reliable price signals from a stable market can also enable finance flows to developing countries and to sectors in which fossil fuels or manufacturing processes are harder to change.

Some countries may choose to deploy domestic carbon taxes, while others could create domestic cap-and-trade systems. Article 6 of the Paris Agreement creates a platform for an international carbon market as well as an approach for convergence across domestic market approaches. By aligning themselves to a common framework, countries could use the emission reductions from such market-based mechanisms to meet their own NDC targets or to trade them with other countries. For example, India could design a domestic trading system that enables Micro, Small and Medium Enterprises (MSMEs) to gain from implementing industrial energy efficiency improvements.

What’s the catch?

Countries have not been able to come to an agreement on the rules around carbon markets due to three main issues:

Baselines and additionality

The Paris Agreement NDCs were supposed to represent the highest possible climate ambition determined by countries at the time. If so, any further reductions under the new market mechanism would be additional, i.e. above and beyond what would have happened in its absence. But what is business as usual? How do we estimate emissions that would have happened in the baseline scenario? What happens when a country announces its next more ambitious NDC – does that become part of the country’s baseline? Different approaches and methods have left the issue unresolved. For example, some assert that in sectors that are not covered under a country’s NDC, all emission reductions should be considered additional. But others argue that uncovered sectors should also be included in future NDCs and that the accounting of emission reductions in such sectors needs to be adjusted accordingly.

Avoiding double counting

‘Double counting’ refers to both the buying and selling countries counting the same emission reduction against their NDC targets. It requires clear accounting procedures, including adjusting the national inventories to account for reductions from voluntary transfers or projects. But this is far from simple, since the NDCs of different countries are very different from each other, covering different gases and spanning different timeframes. When emission reduction is traded across countries with very different contexts, does it need to be adjusted to account for the different baselines in the buying and selling countries? How can the accounting rules ensure that ambitious climate action is not compromised? This is particularly contested when it comes to SDM activities -- a country may sell the emission reductions from its SDM activity to another country, but the selling country’s national GHG inventory will be lower as a result of the SDM activity. Should the rules require the selling country to account for this by adjusting its national inventory? The counterargument has been offered that no adjustment is required since any SDM activity will be additional to the host country’s baseline scenario.

Using credits created under the Kyoto Protocol

There are concerns that these older credits will flood the new market and depress prices. Some believe that the older credits were awarded for business-as-usual actions. Others argue that since existing projects will continue to operate, these should now be considered part of the baseline, and credits from such projects should not be used. But developing countries with huge credit inventories from the Clean Development Mechanism (CDM) will look for a smoother transition to avoid losses against issued credits, maintain investor confidence, and provide a reliable market signal for future mitigation. In India, for example, the CDM helped mobilize investments of over 1.3 trillion INR (while reducing 170 Mn tCO2e) in its first phase and built domestic capacity for low carbon development.

What can we expect at COP 25?

In addition to reaching an agreement on these rules and procedures, countries also need to resolve other contentious issues like the level and timing of the share of proceeds, the governance of Article 6, and linkage with the transparency framework under Article 13 of the Paris Agreement.

The satisfactory resolution of these issues is key to ensuring that Article 6 delivers the potential economic benefits of market mechanisms while also delivering sustainable development, promoting a higher level of ambition, and upholding environmental integrity and equity.