What role for carbon markets in the 2015 climate agreement?

6 February 2015

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.

Anthony Mansell, International Fellow with the Center for Climate and Energy Solutions (C2ES)

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