High stakes, low politics and great expectations
Despite mounting pressure to accelerate cuts in greenhouse gas (GHG) emissions in line with Paris Agreements targets, progress developing rules governing global carbon markets to underpin such policies has remained slow at best.
With carbon markets – trading systems where carbon credits are bought and sold to help companies compensate for GHG emissions – seen as a crucial tool to help nations hit climate commitments, COP28 represents an opportunity to provide the necessary regulatory clarity.
Success at COP – a crucial venue for policy-makers and industry as the United Nations' main climate conference – will turn in large part on addressing concerns around transparency and accountability in carbon markets that were left unresolved at last year's COP27 summit. But what are the prospects?
There are currently two types of carbon markets:
Compliance markets are governed by national, regional and/or international policy or regulatory requirements. These markets aim to establish a carbon price, either through a tax or cap-and-trade schemes. The EU emissions trading system, the world's first major carbon market, operates on a cap-and-trade principle. Under these systems the total amount of emission allowances under the scheme is capped and the cap is reduced year-on-year with the aim of lowering total emissions. Allowances are generally issued by a central registry and regulated businesses can buy allowances directly at auctions or from one another. In some instances, allowances are also issued for free. At the end of a compliance period, usually a year, regulated businesses need to surrender a volume of emission allowances proportional to their total emissions.
Voluntary carbon markets (both national and international) are incentive-based and allow individuals and corporate entities to trade carbon credits on a voluntary basis, to compensate for their GHG emissions. Currently, most of the supply of voluntary carbon credits comes from private entities that are involved in the development of projects certified by unregulated carbon standards that generate emission reductions and/or removals. Once the emissions impact of the underlying project has materialised, the credits can be verified, issued to a registry and traded. Such projects can include everything from reforestation initiatives to the replacement of cooking stoves or carbon sequestration in agriculture or science-based approaches.
The goals of both types of markets are different but complementary. Compliance markets aim to create a hard cap on emissions within a geographical area and thereby progressively reduce overall emissions. Voluntary carbon markets allow individual actors to reduce their carbon footprint by removing a tonne of carbon somewhere else to compensate for a tonne they produced. While not an alternative to actual decarbonisation, voluntary carbon markets will remain necessary to compensate for unavoidable emissions, allowing private actors to reach and maintain net zero.
In complement to existing compliance and voluntary carbon markets, the Paris Agreement, through Article 6, foresees an international regulatory framework for carbon trading among states but also involving private actors, divided into two mechanisms.
At COP27, discussions continued in relation to a carbon trading scheme, building upon the broad framework agreed at COP26 in 2021, where negotiations relating to the operation of Article 6 mechanisms under the Paris Agreement were at the centre of debate.
A key outcome of COP27 was the publication of a draft document setting out how carbon trading would function, which outlined the two-tier system for carbon trading. COP27 also saw the agreement of a new kind of carbon credit, the "mitigation contribution" unit under Article 6.4. As mentioned above, these are not authorised for use for international mitigation purposes but they may be used, among other things, for results-based climate finance, domestic mitigation pricing schemes or domestic price-based measures or for contributing to the reduction of emission levels in the host party.
However, and despite the need for effective carbon markets to achieve climate goals, concerns of corporate greenwashing through double-counted offsets have been raised, because private entities buying contribution credits could claim the same emissions reduction as the country where the climate projects are based.
The draft document also allows governments to class information about bilateral carbon trades between countries as confidential, which has raised concerns around transparency and accountability.
Further decisions have been delayed until COP28, leaving businesses unclear on the full picture of the operation of Article 6-backed carbon markets.
COP28, and the first Global Stocktake of the Paris Agreement, a process for countries to assess their progress towards climate targets, will provide a milestone opportunity for heads of state, world leaders, NGOs, companies and other stakeholders to discuss tangible climate action. The wider agenda for COP28 is focused on four core actions, one of which is transforming climate finance. COP28's Director-General Majid al-Suwaidi has also highlighted that standardisation of voluntary carbon markets is a key priority for the summit. This focus aims to drive the development of solutions that move private capital at scale towards climate action in developing countries.
The European Commission President, Ursula von der Leyen, has also called for international leaders to formulate a proposal for a global carbon price for compliance markets at COP28.
Without supply-side reform, project quality and the credibility of carbon credits are serious concerns for businesses looking to participate in carbon markets.
High-quality carbon credits are scarce due to varying accounting and verification methodologies and because the benefits of carbon credits are often not well defined. Verra, the world's leading certifier for voluntary carbon markets, faced claims earlier this year that more than 90% of the rainforest offset credits it has approved are likely 'phantom credits', not representing genuine carbon reductions. But ventures such as the Voluntary Carbon Market Integrity Initiative are seeking to introduce and scale the use of new threshold standards to help increase the integrity of carbon credits.
Businesses are also sensitive to issues relating to the possibility of double counting emissions reductions, human rights abuses and greenwashing, and the reputational risks arising as a result.
On the supply side, low carbon prices mean many projects are unviable. Project developers lack access to finance due to low investor risk appetite and the fragmented nature of carbon markets. Developers also lack the capacity to efficiently market credits to multiple buyers, which could be aided by financial institutions pooling resources from multiple buyers or sellers to create economies of scale and reduce transaction costs on both sides.
COP28 is expected to bring progress on the framework to trade carbon offsets. Finalising the operation of the article 6.4 mitigation mechanism, which could provide a platform for a global carbon market, could create more clarity for the private sector.
On the other hand, it remains unclear whether this centralised solution is the right approach regarding COP28's aim to make voluntary carbon markets more accessible, transparent and equitable. The inertia and bureaucracy of a multilateral, intergovernmental organisation may prevent the framework from adapting quickly enough to changes in methodology and market realities and thus may not represent an attractive alternative to the current decentralised system. It may also exclude smaller actors from the market by setting an unreasonably high regulatory barrier of entry.
A push for standardisation does not necessarily require more centralisation; as carbon trading solutions based on the blockchain and smart contract technologies emerge, increasing transparency and preventing double-counting, the article 6.4 mitigation mechanism may be outdated before it even enters into force.
Either way, substantial progress at COP28 on carbon markets would go a long way towards helping to forge credible regimes to price and offset carbon emissions that companies can rely on as a core part of their net zero agendas.
Senior Associate, London
Senior Associate, Johannesburg
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