Carbon market players face 'significant' sovereign risk from Article 6 activities: IETA

The need to obtain a corresponding adjustment from the host government exposes sellers and buyers engaging in Article 6 activities to a "significant" sovereign risk, the International Emission Trading Association said in a discussion paper on Article 6 implementation released June 6.

Article 6 of the Paris Agreement allows governments to use carbon credits to meet and even increase the mitigation action mandated by the Paris deal, on top of other instruments such as emission trading schemes or carbon taxes. It was finalized at the Glasgow UN Climate Conference in November 2021 after years of negotiations.

Under Article 6, governments can set up carbon projects on their domestic soil and use the credits produced to meet their own NDC.

They are also allowed to sell the credits produced domestically to other governments or entities. They can also buy the carbon credits produced by other governments or entities.

"Project developers and private sector players engaging in Article 6 transactions are exposed to a series or risks throughout the lifecycle of the trade, which may extend several years in the case of forward emission reduction purchase agreements," the association said, calling for a system of incentives and penalties to encourage positive behavior by host governments.

The main risks identified by IETA are that the host government:

-- delays or denies the issuance of letters of authorization;

-- declines to honor previously issued letters of authorization;

-- does not issue internationally transferred mitigation outcomes (ITMOs) for verified emissions reductions from authorized projects;

-- changes the scope of sectors eligible for Article 6 credits;

-- does not apply corresponding adjustments or does not do so correctly;

-- favors 'ex post' authorization of ITMOs.

Mechanisms to reduce this risk should be identified by government taking part in Article 6 activities, also with the help of international institutions and multilateral development banks, IETA said, and could include the provision of sovereign political risk insurance.

The warning comes as part of a broader paper encouraging governments to clarify their position towards the use of Article 6 as a means to reach their Paris deal targets, or Nationally Determined Contributions.

More clarity on how and if governments intend to engage in Article 6 activities would help maximize the impact of Article 6, and to mobilize resources and investments from the private sector, IETA said.

The paper was released ahead of the mid-year UN Climate Change Conference which takes place in Bonn over June 6-12. The conference is designed to prepare for the annual UN Climate Change summit (Conference of the Parties 27) to be held in November.

Six steps

The need to offer tools to protect market players from the sovereign risk related to Article 6 activities is just one of the six steps that governments should take to help fulfill the potential of Article 6.

Governments should first clarify and make public if they intend to resort to Article 6 to reach their targets and in which capacity.

"Countries should determine whether they intend to participate or allow participation in Article 6 either as a seller, a buyer or both," the paper reads.

Prolonged ambiguity or postponement of decisions will discourage investments and private finance, IETA warned.

Host countries should specify which activities will be able to generate credits under Article 6, as well as which vintage years.

Governments are requested to provide transparency on how they intend to use Article 6 to reach their NDC, and show how the use of carbon credits will help them increase their climate ambitions. Transparency in this regard is needed to prevent overselling of credits or a reduction of climate ambitions.

Corresponding adjustments

Step four in the IETA list is about establishing an effective interaction between the Article 6 market and the voluntary carbon markets to avoid double counting.

A host country can authorize the international transfer of credits when this is requested by domestic project developers or by international buyers.

Once a credit is transferred abroad, the host country can't use the emission reductions associated to those credits to meet its own NDCs.

However, IETA says, when the international transfer of credits happens without the authorization of the host country (and therefore without corresponding adjustment), the host country "should ensure that the emission reductions associated with those credits remain in the host country GHG emission inventory and count towards the NDC of the host country."

Lastly, IETA wants governments to clarify the areas where capacity building is required, from policy support to reporting and accounting, authorization frameworks and others.

Making clear what is needed will encourage initiatives from the private sector and civil society, IETA said.

IETA estimates the cost reductions that could be achieved through Article 6 cooperation when compared with the independent implementation of NDCs by countries in excess of $300 billion per year in 2030.