Carbon markets under a 2020 climate agreement
Developing countries must claim their share of atmospheric space
Looking back at the Kyoto Protocol (KP), we were amazingly naïve but we have learnt a huge amount in 15 years of working with carbon markets.
The KP created an environmental asset, the Assigned Amount Unit (AAU), and distributed it to Annex 1 nations (OECD countries and Economies in Transition) based on rudimentary negotiations. Non-Annex 1 nations believed they were getting off lightly because their status implied no responsibilities for emissions. Meanwhile some Annex 1 Governments monetized these assets. Over-issuance, exacerbated by the US refusal to ratify the KP, resulted in a glut and price collapse but not before Annex 1 consumers had been charged for the privilege of living in a Kyoto Protocol world and EU Governments had handed out billions of Euro's worth of sovereign assets to polluting industries.
Non-Annex 1 countries were offered the Clean Development Mechanism (CDM) which came with a relatively transparent, though not perfect, allocation system - CDM projects could create assets called Certified Emission Reductions (CERs) if they could meet criteria including an additionality test to confirm that the project activities would not have taken place without the KP.
Joint Implementation (JI) allowed projects to be undertaken between Annex 1 Parties but did not rely on an additionality test because emission reductions transferred between countries were matched by the transfer of AAUs in a zero-sum transaction. Removing the requirement of the additionality test was consistent with the design of JI but suffered from two major problems - host Governments were allowed to apply their own "eligibility criteria" i.e. there was no specific requirement for a transparent process of allocating sovereign assets to private companies; and due to the surplus of AAUs in certain countries, host Governments did not particularly need to ensure projects were real or additional.
What have we learnt from the Kyoto Protocol and what does it mean for a market mechanism in a post 2020 climate regime?
- The process of declaring and submitting Intended Nationally Determined Contributions (INDCs) with a view to turning these into some form of legally binding commitments will create an environmental commodity in the form of a sovereign right to emit a tonne of CO2e. Governments are now negotiating how much of the available atmospheric space they are demanding for their development. In a classic fight over a truly global common property resource, every Government should demand as much as possible even in the knowledge that doing so destroys the climate. Only through a process of negotiation can targets then be reduced so that we use only the remaining 2°C atmospheric space. Those hard-won emission rights are valuable assets. Countries can either consume them by burning fossil fuels and emitting non-CO2 GHGs or, if the Parties agree, they can sell them. But this time around, citizens should be aware of the value that is being created and they must hold their Governments accountable for those assets.
- No Government will burden its economy with a significant cost of carbon unless its competitors do the same thing. This calls for converging levels of ambition and a means of equalizing the costs - which can be achieved through an international market.
- For participating nations that have an agreed commitment, and report on their annual emissions, the JI model is the appropriate mechanism to use as a market. Emission rights which are exported from the country must be added to the national inventory and those imported, deducted. It is not necessary for any international body to oversee the allocation of sovereign assets to third parties (i.e. there is no need for a CDM-style registration and issuance process) But host countries must transparently account for their actions to their constituencies.
- For participating countries that do not make commitments, an enhanced CDM style project mechanism can be used but there are three drawbacks - a) additionality and baselines will always be criticized by some, making the mechanism risky for investors; b) such a mechanism stops these countries from participating in the monetization of their emissions and hence it denies them a powerful tool for domestic policies; and c) if we are still using emission reductions to offset emissions by 2050, then we have failed: Offsetting re-locates emissions and helps some entities achieve targets, but emissions still take place.
- Finally, this only works if there is a high level of ambition. Countries which end up with excess emission rights by any other means than the implementation of clearly defined GHG emission reducing policies, need to follow an agreed procedure to readjust their commitments. Excess allowances and over-allocation undermined the KP and have continued to dog numerous national emission trading mechanisms. Alternatives, which warrant further exploration, include:
a. Rating carbon assets, recognizing that units arising from countries with lower levels of ambition are simply worth less (in environmental and hence financial terms); and
b. Moving rapidly to an auction mechanism where countries buy what they need and the revenues are recycled to finance low and zero carbon development.
Developing countries must realize that the INDC process is leading to the commoditization of the remaining 2°C atmospheric space. This space is finite. It is a valuable asset, without which countries will be forced onto alternative development pathways. For many developing countries, a once in a lifetime opportunity exists to negotiate their rights to a fossil fueled development pathway and then sell those rights to finance a renewable energy pathway.