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Groundbreaking principle for carbon finance is emerging as Article 6 negotiations unfold

  • Featuring
  • Silvia Favasuli
  • Commodity
  • Electric Power Energy Transition
  • Topic
  • COP26 Energy Transition Environment and Sustainability

Policymakers meeting at the United Nations Climate Change Conference, or COP26, in Glasgow in November will face a subject set to change the future course of the voluntary carbon markets: the corresponding adjustment.

A decision on this outstanding issue could be so strong it would cement a new core principle for carbon finance and may possibly trigger a split in the market.

Under the Paris Agreement, governments worldwide have pledged nationally determined contributions to put in place mitigation efforts to reach specific targets in the fight against climate change. The ultimate goal is to collectively limit the global temperature increase by the end of this century to 2-degree Celsius compared to pre-industrial levels, with an attempt to further limit the increase to 1.5 degrees.

The draft Article 6 of the Paris Agreement allows countries to achieve their mitigation goals in several ways: by setting up compliance instruments such as carbon taxes or industry-wide emission trading schemes, by resorting to a yet-discussed new crediting mechanism akin to the UN Clean Development Mechanism, and by exchanging voluntary carbon credits among each other.

While countries have already put in place the first two types of actions, they haven't been able so far to also resort to voluntary carbon credits—which have been used only by the private sector to compensate their greenhouse gas emissions. Voluntary carbon credits are financial tools issued by projects that avoid or remove GHG emissions from the atmosphere. Each carbon credit demonstrates that 1 mt of carbon dioxide (or equivalent GHG) has been avoided or removed from the atmosphere.

Governments have been unable so far to use these credits to meet their NDCs because of the lack of a mechanism to keep track of where credits go to avoid the same credit from being counted by both the host country and the purchasing country.

For example, a credit produced by a forestry project located in Brazil (the host country, in this case) could be used by the UK government to reach its own NDCs.

But the exchange will only be possible after a framework is put in place to prevent that same credit to be counted by both Brazil and the UK against their NDCs.

COP26 in Glasgow will be where discussions on how to set up such a framework will happen.

Under the proposed accounting framework, when a host country transfers credits, it would make an adjustment to its emission balance. At the same time, the receiving country would make a corresponding adjustment on its side, just in the different direction. Hence the name "corresponding adjustment".

The big disagreement

While everyone agrees that each credit has to be counted either by the host country or by the purchasing country, and that a framework to facilitate the accounting of credits is needed, a tense debate is unfolding on whether or not private buyers of carbon credits should also be part of this accounting.

Some argue that it's perfectly fine to have the same credit used by a private company to offset its emissions and also by the host country (the country where the underlying carbon project is located) as a way to reach its NDCs. In other words, the same credit would be used as part of two parallel schemes at the same time.

For example, a credit issued by a cookstove project in China could be used by a US private company to offset its carbon emission, and it would also be counted by China against its NDCs.

However, another group of stakeholders believe that each credit should be used only once, either by the private company to offset its emissions, or by the host country as a tool to meet its NDCs.

For some, the debate is meaningless as it mixes a compliance market—the Paris Agreement's NDCs—with a private voluntary market where private individuals or companies give themselves offsetting goals outside of any national or international scheme.

Verra, one of the world's largest certifiers of carbon projects, is of this view.

"The two types of claims are fundamentally different. The host country's claim is being made against their NDC under the Paris Agreement. A company's claim is a voluntary one that is not tied into any NDC anywhere else," Verra CEO David Antonioli said.

"Under our approach, a company can claim that they have contributed toward their climate goal by buying credits from a project—and a host country can also do that [by claiming the same credits against its NDCs]," Antonioli said.

Forbidding host countries to use credits produced on their territory and used by private companies as offsets would slow down the deployment of carbon projects, he added.

"Host countries would lose the ability to claim the credits against their NDCs, so the effect will be that they will be disincentivized to authorize projects in their jurisdictions, to the detriment of the need to solve the climate emergency, which requires accelerated and massively scaled-up actions," Antonioli said.

But those who advocate for a one-time use of carbon credits—either as part of the Paris Agreement or for private offsetting purposes—believe that a double claim will discourage host governments from putting in place crucial reforms needed to shift the economy away from fossil fuels.

"Many Gold Standard credits are being used by companies pledging to offset their emissions. We want to make sure that companies can trust the integrity of the credits that they buy. In the Paris context, this means ensuring that credits used by companies are not also claimed towards the host country's NDC, potentially displacing other emission reductions," said Hugh Salway, Head of Environmental Markets at Gold Standard.

Carbon credits corresponding adjustment

Deterring further action

It is from this latter argument that a new core principle for voluntary carbon finance seems to be taking shape: the requirement to not deter further mitigation action.

There are currently set core carbon principles or requirements that carbon projects must meet to be allowed to issue carbon credits. Only when a project meets these requirements, would a certifier like Verra or Gold Standard allow these credits be used to offset emissions.

The five core principles are additionality, overestimation, permanence, exclusive claim, and the provision of additional co-benefits in line with the UN's Sustainable Development Goals.

These principles constitute the basis on which the whole voluntary carbon market is built. They are there to ensure that where an organization or individual emits, the atmosphere is no worse off as long as the emission is compensated elsewhere.

The exclusive claim principle already requires that each carbon credit is only claimed once, and it must include proof of retirement once it has been used to reach one's mitigation targets.

But this alone is not preventing some to argue in favor of a double claim of the same credit as part of parallel schemes.

Under the additionality principle, a carbon project can issue credits only when it is not already financially attractive in the absence of carbon credits, it is not common practice or legally required.

For some, this principle alone should prevent a double use of a credit in a voluntary and compliance system since the carbon credit would finance a reduction which the host country in any case committed to make. It won't be additional anymore.

But the debate around the corresponding adjustment seems to be highlighting the need for a completion of these two principles.

A non-deterrence principle is also emerging. It requires that a carbon project—or voluntary carbon finance in general—doesn't discourage host countries to put in place the action mandated by the Paris Agreement.

It's a principle helping define the relationship between voluntary carbon markets and compliance carbon markets.

Shrugging off a stigma

The introduction of a non-deterrence principle may well help voluntary carbon markets shrug off the perception that their very existence is preventing the transition to greener technologies.

By offering companies and governments worldwide a way to compensate for GHG, voluntary carbon markets may de facto discourage industry players to invest in greener technology and move away from fossil-based solutions.

It appears important for this reason to have a principle in place to preserve the need for compliance markets, whose purpose is to push the economy towards greener technologies.

Compliance markets such as carbon taxes or cap and trade systems aim to put a constantly increasing price on carbon—often by limiting the number of available carbon allowances—so that greener alternatives become economically viable over time.

Voluntary markets, meanwhile, are there to offer a way to reduce or remove emissions that are still deemed unavoidable while we wait for cleaner alternatives to rise.

While the price of voluntary carbon credits may well soar, forcing companies to get greener, there is no guarantee that this will happen and for how long. After all, the price in the voluntary carbon credits space is merely determined by the forces of demand and supply—with no government or international intervention targeted at pushing carbon prices up.

But if the very existence of voluntary carbon markets hinders the deployment of compliance markets by host countries, will voluntary markets end up hindering the transition towards greener technologies instead of supporting it?

A split market

A Glasgow decision in favor of a framework involving privately used credits may well split the current voluntary carbon market in two halves.

On the one hand is a market of voluntary credits with a corresponding adjustment, usable either by companies and individuals to offset their emissions or by governments to meet their NDCs. On the other hand, a market of credits without corresponding adjustment, usable only by host countries to meet their NDCs and not by private companies for offsetting purposes.

The second market would rely on a contribution model, with carbon projects financed by donations either from individuals or companies with no offsetting needs.

"This model won't be [based on] tradable units. It would be based on targeted donations,"said Florian Eickhold, climate finance and environmental markets expert at Germany's project developer Atmosfair.

Demand for this type of projects may soon emerge, Eickhold said: "At Atmosfair we are preparing projects ready to receive a donation. We see upcoming demand. Some companies are moving from an offsetting approach to a contribution claim, or combine both."

Projects combining both models could see part of the project financed through donations, and the remaining part financed through the issuing of carbon credits linked to a corresponding adjustment. Only the credits linked to a corresponding adjustment could be purchased by end-buyers and used for offsetting purposes.

All the others would be used by the host country against its NDCs.