The role of carbon markets in the Paris Agreement
In the run-up to 2015’s historic COP21, there was a lot of debate about the role carbon markets should play in the final negotiated Paris Agreement. Many, myself included, called for inclusion of carbon trading; and I recall a general sigh of relief when Article 6 of the Agreement was accepted, seemingly creating space for a new carbon market mechanism (Article 6.4) and transfer of International Mitigation Outcomes (ITMOs) (Article 6.2).
However, as the dust settled and the full implications of the Agreement started to become clear, I began to doubt the efficacy of carbon markets under the Paris Agreement. Today, I believe that a new market mechanism is practically unworkable and ITMOs are likely to be Government-to-Government transactions agreed on political rather than economic terms. Why have I arrived at these conclusions?
The basis of my volte-face comes from the fundamental differences between the Paris Agreement and its predecessor, the Kyoto Protocol (KP). The KP established emissions trading as an economic solution by solidifying the concept of greenhouse gas (GHG) emissions as a commodity through the Assigned Amount Unit or AAU. The KP set top-down targets on GHG emissions for Annex 1 countries (developed countries and economies in transition), and devoted multiple Articles to the infrastructure needed to regulate trade in AAUs, including international transfers, registries, accounting, compliance, penalties for non-compliance, carry-over and how to prevent Parties from trading their way out of compliance. It also created the flexibility mechanisms to help Parties meet their targets including bubbles, International Emissions Trading (IET, Art 17), the Clean Development Mechanism (CDM, Art 12) and Joint Implementation (JI, Art 6). All of this was possible because of the targets created for Annex 1 countries. While these targets were not necessarily fair or proportionate, they were set through ex ante negotiations.
Nevertheless, the KP’s market mechanism failed to deliver. At the heart of the failure was a lack of demand / an over-supply of units caused by inter alia over-allocation of AAUs (exacerbated by the US’s failure to join and the subsequent economic collapse following the 2008 financial crisis); and unexpectedly large supply of new emission reductions from the CDM. But many other things happened too: IET allowed the transfer of hot air; JI was never subjected to adequate scrutiny concerning the transfer of rights to the private sector to sell sovereign assets; the CDM was not sufficiently robust in spite of a substantial array of checks and balances; and through CDM and JI’s links to the EU Emission Trading Systems (ETS), we observed how a low level of environmental ambition in certain sectors and countries triggered a transfer of wealth from European companies to selling countries, raising concerns in the European Parliament and further challenges to the environmental integrity of the mechanism.
The Paris Agreement was born from the failures of the Kyoto Protocol. It could not be more different. The Paris Agreement rejected a top-down market-based mechanism, and opted instead for a global agreement based on bottom-up voluntary commitments which become legally binding on ratification but have no penalties for non-compliance.
Under this approach, there really is very little scope for an international market mechanism beyond Government-to-Government transactions. The greatest barrier to reviving a market mechanism under the Paris Agreement is the moral hazard attached to the adoption of voluntary targets. What is to stop a country from adopting a less ambitious target so that they have more units to sell, and therefore what guarantee is there that buyers are getting value for their money? We learnt these lessons in under the Kyoto Protocol. The upshot is that, in my opinion, it is highly unlikely that any future ETS would risk linking to an international project-based emission reduction or mitigation market mechanism.
There are many other challenges to international transfers of emission reduction units including:
- setting a fair price for an emission reduction: considering varying levels of ambition, one market price based on global supply and demand is not adequate;
- regulating the sale of sovereign assets: there is a lot of money to made from the sale of these assets from countries that may lack the institutional infrastructure to account transparently for the sale;
- scope for fraud is massively increased; and
- there are the double counting provisions of the Paris Agreement which require any emission reductions exported to be declared as emissions by the exporting country, hence actually making it harder for a selling country to meet their NDC.
This is not to say that these obstacles cannot be overcome, but it seems overly-ambitious to think that we can address all of these challenges within the context of the Paris rulebook based on just two sub-paragraphs of Article 6 of the Agreement, when the Kyoto Protocol needed perhaps ten full Articles to create the infrastructure to support a similar objective, and even that failed.
So, is there a role for carbon markets under the Paris Agreement? In my view, no. But that does not mean that all we have learnt is wasted. There are many uses for the knowledge, experience and institutional capacity we have gained from the KP. Here are just two of them:
The first involves emission trading linked to taxes on GHG emissions. For example, the South African carbon tax proposes to allow taxed entities to offset their liabilities by investing in projects which generate emission reductions or sequester carbon. This is a potentially powerful mechanism whereby a tax on a small number of large point sources (power stations and fuel importers) can trigger emission reductions across the economy, but within the national accounting boundary.
The second offers a chance to continue to finance project-based activities / programs in a similar manner to the CDM but focusing on adaptation rather than mitigation. The African Development Bank and the Government of Uganda, support by the Government of Cote d’Ivoire, are proposing the creation of an Adaptation Benefit Mechanism (ABM), which is a project-based mechanism designed to offer a price signal for adaptation to private sector investors. It has much in common with the CDM and could be viewed as a combination of the CDM and a results-based payment mechanism. The ABM uses similar modalities and procedures as the CDM but differs in a couple of fundamental principles: a) the units generated are not fungible – there are no quantified adaptation targets, so there is no need for fungibility; and b) the units are not linked to the Agreement’s primary accounting units so the ABM allows for transparent and credible transfer of finance to support adaptation without impacting on, or being impacted by, host country policies or ambition. Adaptation Benefit Units issued under the ABM will help households, communities and economies become economically stronger and hence less vulnerable to climate change. They will also bring mitigation co-benefits to the host country and will help in achieving the UN Sustainable Development Goals (SDGs).