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International carbon trading rules come into focus as COP26 enters final week

07 November 2021 Max Tingyao Lin

UN member states are struggling to finalize the Paris Agreement's rule book as they remain in heated discussions over future regulations for international carbon trading.

During the first week of COP26 in Glasgow, negotiators only made limited progress in agreeing on the enforcement mechanisms for the 2015 climate deal's Article 6, which covers carbon markets.

While some technical differences were sorted out, COP26 President Alok Sharma confirmed government ministers will need to be engaged in political discussions during the final week of the meeting.

"We are getting the point where the rubber hits the road, where we're going to have to make tough decisions in terms of text," Sharma said during a 6 November press conference.

Other parts of the Paris rule book were finalized in 2018, allowing countries to report and review their climate efforts. But negotiators have been in contentious debates on how to maintain market integrity and whether to tax trading proceeds from country-to-country transactions, among other points, ever since.

"We've been discussing a whole range of these issues for six years without resolution, and I think that shows you just how challenging this is," Sharma said.

Many environmentalists, business leaders, and government officials believe well-designed carbon market mechanisms can trigger large low-carbon investments and advance the UN climate goals in limiting global warming.

The International Emissions Trading Association (IETA), a trade body representing carbon market participants, estimates Article 6 could reduce annual decarbonization costs by $250 billion per year while removing an additional 5 billion metric tons (mt) of CO2 emissions by 2030.

But observers say there remained more than 100 areas of difference as of 6 November based on a draft text released by the UN. This was despite many countries viewing completing the Paris Agreement rules as a central goal of COP26, which is due to conclude 12 November.

UK Lead Climate Negotiator Archie Young admitted: "The mood is mixed…It is tense right now."

Ongoing debates

Article 6 aims to encourage countries to achieve or exceed their Nationally Determined Contributions (NDCs) via three different mechanisms: the first is a UN-governed market for carbon offsets changing hands between public and private sector players; the second is an exchange of carbon credits between countries; and the final mechanism is based on non-market-based international cooperation.

A substantial portion of the talks of recent days centered around the first two mechanisms, defined in articles 6.2 and 6.4, as delegates sought to reform international carbon trading.

The Kyoto Protocol, the Paris Agreement's predecessor that expired at the end of 2020, allowed companies in low- and middle-income countries to develop carbon offset projects under the Clean Development Mechanism (CDM). The offsets would then be sold to counterparties in industrialized countries to meet their emission caps.

Back then, the EU was the main buyer of CDM credits because it was the only major economy that ratified the protocol. But the bloc's demand for those offsets collapsed due to a reduction in emissions after the 2008 financial crisis. In addition, European regulators began to limit the use of CDM credits in its Emissions Trading System in 2012 amid doubts over their actual decarbonization effects.

Countries have yet to find a way to carry over the activities and credits from the CDM. The IETA, an observer organization to COP26, said the legacy issues remained contentious in Article 6 talks.

In general, China, India, and Brazil—major host countries for CDM projects—want many leftover credits to become eligible carbon offsets under the new mechanisms. Developed countries hold an opposite stance. The Least Developed Countries and the African Group side with the former group in country-to-country transactions, and the latter in carbon trading that involves the private sector.

Another sticking point is on countries' levies on trading proceeds, according to IETA.

Based on Article 6, countries can impose a tax on carbon market transactions and use the income to administer new mechanisms and provide adaptation technologies to developing nations.

There is consensus that this levy should apply to the transactions between public and private corporations; however, industrialized countries want the transactions between national governments to be exempted, while developed countries are seeking no exceptions.

Extra complexity

All parties to the Paris Agreement will set emission targets under their NDCs, so the new rules for international carbon trading are expected to be more complex. Moreover, an increasing number of companies are buying carbon credits to meet their voluntary emissions targets, and it is not known how these efforts contribute to the national carbon budgets of the countries where they operate.

"The market will want to understand what the implications could be for their intergovernmental accounting," Standard Chartered CEO Bill Winters told the Green Horizon Summit 5 November.

"It would be wonderful if there was clarity between how the NDCs are interacting with a voluntary market transaction," the financial services executive said

A link between Article 6 mechanisms and voluntary trading could boost liquidity. Ecosystem Marketplace, a financial information provider, said voluntary carbon markets could reach $1 billion in annual transactions for the first time this year due to corporate net-zero commitments.

But carbon offset projects remain controversial in some corners, as environmentalists often question whether they could be prone to double counting of emission reductions in host and sponsor countries. Moreover, the actual decarbonization effects of the projects designed to prevent deforestation are hotly debated.

During COP26, Swedish activist Greta Thunberg dismissed offsetting as "hypocrisy" and "often a dangerous climate lie." She said: "Polluting profiteers see offsetting as their 'get out of jail for free card' in the climate game."

Building momentum

At the national level, more countries now believe putting a price on emissions would be essential to their decarbonization efforts. Aside from the EU, Australia, Canada, China, Indonesia, Japan, New Zealand, and South Korea are either running or developing carbon trading schemes. Some countries are also developing carbon tax regimes.

This partly contributed to high hopes that delegates could finally finalize the Article 6 rules at the Glasgow summit.

Alex Hanafi, director of multilateral climate strategy at non-profit at Environmental Defense Fund, said ahead of COP26 that a compromise among countries is "within reach."

Also, the market mood was optimistic. According to the IHS Markit Global Carbon Index, the weighted price for carbon credits reached $41.20/mt on 5 November, up from $40.50/mt at the beginning of October.

The Organisation for Economic Co-operation and Development estimated almost half of all energy-related CO2 emissions in G20 economies are already covered by a carbon price. Associated mechanisms "need to become significantly more stringent, and globally better coordinated, to properly reflect the cost of emissions to the planet," Secretary-General Mathias Cormann said 27 October.

Many industry experts, including IHS Markit Senior Vice President for Global Energy Carlos Pascual, expect the success of COP26 to be judged based on the outcome of the Article 6 talks.

"It's very important that we try and conclude on Article 6 on this occasion," COP26 President Sharma said. "It's vitally important."

Posted 07 November 2021 by Max Tingyao Lin, Principal Journalist, Climate and Sustainability

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