Carbon trading: Out of trouble, but will chaos or coordination prevail?

8 June 2016

The carbon market has had a bit of a bad rap recently, with over-supply, lack of demand, so-called hot air and collapsing prices all creating headlines. Rumours of its demise, though, have been greatly exaggerated. In fact, the agreement reached in Paris at the United Nations Framework Convention on Climate Change (UNFCCC) meeting in December 2015 (the Paris Agreement) means the patient is off life support and back on its feet again. Carbon markets will be crucial to the success not only of the Paris Agreement but also of the UN’s 2030 Sustainable Development Agenda, including its Sustainable Development Goals (SDGs) but only if they evolve in a coordinated, rather than a chaotic, way.

Some 50 of the Intended Nationally Determined Contributions (INDCs) tabled by governments ahead of Paris included either an explicit intention to use, or left open the option of using, carbon markets to help meet governments’ carbon emission reduction targets that kick in after 2020. In New Zealand's neck of the woods (the Asia-Pacific), carbon trading is poised to grow exponentially, with Japan, Korea, Thailand, Viet Nam and Singapore - to name only a few - actively looking at forms of carbon pricing and trading. The development of a national market in China next year will be the real game-changer: its size will more than counter-balance the current market dominance of the European Union’s Emissions Trading Scheme.

Against most expectations, the real-world fact of carbon markets was ultimately reflected in Article 6 of the Paris Agreement, which sets out a three-part harmony of provisions consisting of a UNFCCC mechanism, a provision for internationally transferred mitigation outcomes (ITMOs), and a non-market framework. The new mechanism will probably – like the Kyoto Protocol’s Clean Development Mechanism (CDM) – generate carbon units through a centralized process, while ITMOs will need a “code of conduct” to accommodate the trading between national schemes that is implied by the new acronym. These markets outcomes are balanced politically with an acknowledgment of the role of non-market approaches in reducing emissions.

As negotiators now work to put flesh on the bones of Article 6, we can be confident of plenty of "anatomical" debates. What will the “son of CDM” new mechanism look like? What is the scope of guidance to be developed for ITMOs? Will carbon units exist as the “currency” for trade? And how will carbon credits be recognised as contributing to governments’ mitigation targets? These and other questions need to be answered well ahead of 2020, because carbon markets – perhaps even more than other markets, given they’re a regulatory creation – need policy certainty to underpin them.   

Clarity will also be important because the post-2020 universe of carbon trading won't be anything like the world of the Kyoto Protocol that preceded the Paris Agreement. Between them, 189 INDCs will generate substantially higher market demand for carbon credits than existed under the Kyoto Protocol. The number of active players will be far greater and the North-South divide will disappear as developing countries move to operate as both buyers and sellers in the new market. In this environment, a properly functioning, liquid international carbon market must operate smoothly and with environmental integrity, which means it should lead to real emission reductions, not hot air, and mitigation must only be counted once.

Getting the structure of carbon markets right is key to helping the world rise to the ambition challenge posed by the Paris Agreement. To state the obvious: the more Parties can cooperate to meet targets, the more challenging those targets can be and the more climate change mitigation can potentially be achieved. Ambition goes beyond the Paris Agreement, though.

Tackling climate change is part of the fabric of the Sustainable Development Goals also agreed in 2015, not only as a goal in its own right, but as a critical element and potential co-benefit of other goals dealing with (inter alia) energy, food security, cities, forests, resilient infrastructure, and oceans. Goal 7, for example – “ensure access to affordable, reliable, sustainable and modern energy, for all” – has social, economic and climate change co-benefits. There are thus good potential synergies between the growth of carbon markets and the UN's 2030 Sustainable Development Agenda, not least thanks to the coincidence in timeframe for achieving both the sustainable development goals and (most) climate change targets. INDCs are the basis for comprehensive and ambitious investment plans that, when implemented, will deliver not only on the Paris Agreement but also many of the SDGs. Well-designed and properly functioning carbon markets are a key to INDC implementation and will also allow the link with climate finance to be exploited. Emissions trading is a tool for influencing private sector investment decisions towards renewable energy and low carbon infrastructure, so are an obvious way to direct some of the massive investment needed to support sustainable development. This means that carbon trading must develop in a way that supports the shift from brown to green investment in multiple sectors of the global economy.

Right now, we're at a carbon markets cross-roads. They exist, they are real, and they will be a big part of the future. The question is, though, will they develop by design, or through chaotic trial and error? I know which road I'd prefer to take. An internationally designed "code of conduct" on the regulation of carbon markets would provide important guidance for governments. It may not be a perfect solution, and may take a little time to conclude (though a lot of thinking has already been done), but it's a less winding road, and one with fewer diversions, than the alternative. More than that, the collective desire of many to just get on with the job is palpable, as evidenced by the multiple permutations of "carbon clubs" springing up among groups of countries and private sector interests – all looking for ways to expand the market and get it properly linked up. If rational thought prevails, these ambitious groups will help the UNFCCC with its task. If it doesn't, they'll likely move ahead anyway, albeit in a less coordinated fashion, because the time to get carbon pricing right is now.             

Jo Tyndall was, until recently, New Zealand's Climate Change Ambassador. Jo is a frequent speaker at ICTSD dialogues on carbon markets, trade and climate change.