The Paris Agreement’s New Article 6 Rules
The promise and challenge of carbon market and non-market approaches
Carbon markets have been exuberant lately. Anticipating the final agreement from the UN Climate Conference in Glasgow, carbon offset markets for airlines have grown by 900% and corporate carbon offsets by 170% so far this year. With the Article 6 “rulebook” negotiations of the Paris Agreement finally completed in Glasgow, the International Emissions Trading Association (IETA) with the University of Maryland forecast that additional financing from carbon markets could exceed USD 1 trillion by 2050.
When the Paris Agreement was approved in 2015, its Article 6 was viewed as a major advance for achieving the objective of the United Nations Framework Convention on Climate Change (UNFCCC) and the evolving international climate regime, given that it embraced more clearly the notion that “cooperative approaches” (often indicating “markets”) could help governments achieve their national carbon reduction and removal targets. This advance could occur through international transactions in carbon reduction credits, and cooperative approaches could also encourage the private sector to contribute to greenhouse gas (GHG) emissions reductions. Notably, the Paris Agreement also embraced outright “non-market approaches” among two or more parties.
In the six years that followed, however, negotiators struggled to agree upon the detailed rules for how these “cooperative approaches” would function. The outcome of the UNFCCC’s Twenty-Sixth Conference of the Parties (COP 26) in Glasgow marks a breakthrough in finalizing these rules and opening up the promise of carbon markets.
Learning From the Past
A key question, however, is whether the recent exuberance for the new carbon market rules is fully warranted. This concern has particular resonance given that prior international carbon market-style arrangements and the UNFCCC Kyoto Protocol’s “flexibility mechanisms”—most notably the Protocol’s Clean Development Mechanism (CDM)—have a controversial track record in actually lowering GHG emissions. Moreover, some past CDM projects had adverse social impacts.
Governments spent years creating CDM rules, which were administered by a centralized supervisory body charged with overseeing thousands of projects intended to help developing countries reduce or avoid GHG emissions. Years of work in refining the CDM rules helped create the first global carbon market. However, controversy plagued the CDM after it began approving projects in 2004, a process that kicked off after the CDM’s rules were adopted as part of the Marrakech Accords in 2001.
For example, some observers contend that the CDM has been a centralized bureaucracy hampered by unclear measurement tools for verifying the quantity and quality of emission reductions or removals through offsets. There were also questions about whether these emission reductions were additional and permanent, including because there were unclear accounting rules to prevent carbon emissions being counted twice. In some cases, CDM project financing led to perverse incentives that generated additional GHG emissions, notably for industrial gases such as hydrofluorocarbons and nitrous oxide. Others criticized the CDM for focusing too widely on sustainable development outcomes, with project approvals delayed and hamstrung by complex environmental and social safeguards, arguing that projects should narrowly focus on the UNFCCC and Kyoto Protocol greenhouse gas mitigation objectives.
Throughout the course of the Article 6 negotiations, governments sought to ensure that the new international market rules would learn from the mixed record of the CDM. The conclusion of Article 6 rules at the Glasgow COP is therefore a notable achievement on several fronts. The new rules are designed to ensure that GHG emission reductions cannot be counted twice. The rules limit the number of past CDM projects that a country can count toward its reporting under its Nationally Determined Contribution (NDC). And the new rules establish a new international mechanism to oversee one portion of international carbon market activity.
Perhaps as important as these and other details, Glasgow has reaffirmed that international carbon markets are an important means toward reaching the Paris Climate Agreement goal of limiting average global temperature increases to 1.5 degrees Celsius from pre-industrial levels.
What Does the Glasgow Climate Pact Say on Article 6?
The Article 6 negotiations at Glasgow finalized three key sub-articles through “decisions” reached by the parties to the UNFCCC and Paris Agreement, namely CMA 12a, CMA 12b, and CMA 12c. CMA refers to the Conference of the Parties serving as the meeting of the Parties to the Paris Agreement—in other words, the forum under which countries gather to oversee how the Paris Agreement is being put into practice. There are also Annexes on Guidance (6.2), Rules (6.4), and a Work Programme (6.8).
Article 6.2 covers bilateral actions to reduce or remove GHG emissions. Article 6.4 creates a new multilateral mechanism to replace the old CDM. Article 6.8 addresses non-market international cooperation among governments. These new rules cover both government-to-government and government-to-private sector markets. Some early signals suggest these new rules will guide the practices of fully private sector or voluntary carbon market activities.
Below, we look at some of the most important details of the 6.2 and 6.4 outcomes, and what needs to happen to make them work effectively. For a more detailed analysis of the Glasgow Article 6 outcome, the European Roundtable on Climate Change and Sustainable Transition provides a comprehensive breakdown of what these rules entail.
Notably, neither Article 6.2 nor 6.4 mentions the term “markets.” The absence of the term may reflect the wariness of some developing countries toward the use of capital markets to resolve adverse environmental impacts, given the concern that this could absolve rich countries of the need to take actions regarding the harmful effects of their own economic growth. Instead, the legal text sets out the norms and tools to ensure “common approaches” contribute to a country’s NDC. Such approaches can range from one country financing another’s energy or transport sector efficiency upgrades or purchasing carbon offsets in its forests, peatlands, or wetlands.
The Glasgow Climate Pact finalized what the UNFCCC refers to as those “fundamental norms” intended to ensure international carbon markets are real, additional, and verifiable in delivering further reductions in greenhouse gas emissions. The Article 6 text clarifies how international carbon markets involving governments should function. To help ensure reductions and that these are real, additional, and verifiable, private markets should follow those norms and detailed standards, or consider more stringent approaches, regardless of whether they are directly regulated to do so.
Article 6.2 sets out guidelines covering internationally transferred mitigation outcomes (ITMOs) between two governments that are Parties to the Paris Agreement. (The term ITMOs has been used since the 1997 Kyoto Protocol to refer to internationally traded carbon credits between two governments.) Article 6.4 establishes a new, unnamed multilateral mechanism that resembles the function of the former Clean Development Mechanism—notably in a Supervisory Board that would approve all 6.4 projects—while potentially allowing some technical flexibility. For example, instead of using a set formula for establishing a baseline of carbon emissions, this new mechanism will examine individual party baseline estimates and allow them to be adjusted to their circumstances.
Ensuring Environmental Integrity
The Glasgow Pact includes common metrics to ensure the “transparency, accuracy, completeness, comparability, and consistency” of carbon measurement systems. Notably, governments have adopted new environmental integrity rules that aim to ensure all recorded carbon credits use verifiable and comparable accounting systems, and that no traded unit—or ITMO—leads to “a net increase in emissions of participating parties within and between NDC implementation periods.” This is set out in Article 6.2. D.17.
The infrastructure to ensure environmental integrity is so comprehensive that it will be technically challenging to assemble and function. Under Article 6.4, it comprises a centralized project authorization system overseen by a new supervisory board, a central accounting framework, a central registry, and an Article 6 database. The details of these administrative systems will take months to set up. A recent report by the Asian Development Bank points out it could take until 2030 for all the requisite measures to be put in place so that the Article 6 “common approaches” can be developed. Confirming this view, the COP decisions on Article 6 note a range of interim activities to implement this infrastructure that could stretch out to 2030.
Since Article 6 is about carbon markets, Article 6 environmental integrity provisions do not stray beyond carbon credit measurement and ongoing verification. Clearly, projects based on Article 6 will need to include a wider definition of integrity that embeds wider environmental, social, and governance (ESG) standards and safeguards to avoid perverse or environmentally destructive outcomes. Examples of this include single-species large-scale afforestation projects that can uproot Indigenous and local communities, harm biodiversity, or ruin downstream freshwater tables. Indeed, the decisions on 6.2 and 6.4 show consensus for the need for transactions to address sustainable development, and environmental and social safeguards. (For the purpose of the Article 6.4 mechanism, this means that, as was the case with the CDM, it will need to consider these issues and develop rules for how they are to be taken into account.)
Second, Glasgow resolves long-standing concerns that the same ITMO-connected carbon reduction credit could be counted twice by the home and host country. New rules to avoid double counting—set out in the details of corresponding adjustments—are welcome, notably in empowering the host country to decide if it will forgo booking carbon credits within its own NDCs, or if it will instead sell those credits to an international government purchaser. Corresponding adjustment rules take effect immediately.
Negotiators left for another day whether ITMOs will include “emission avoidance.” They will need to come up with ways to ensure reporting is consistent among these offsets, along with how these are recorded in both domestic and international registries. They will also need to address how to ensure parties can reach the ambition of these ITMOs, while not interfering with the “nationally determined nature” of NDCs. Reporting will also have to demonstrate how the aforementioned “environmental integrity” is being implemented.
An unwelcome outcome of the Article 6.4 corresponding adjustment rules is what appears to be the disallowance of any sharing of carbon credits from cross-border electric power projects. There is growing interest, particularly among Asia-Pacific, Central Asian, and Central American countries, in building joint low-carbon electric power generation projects. These projects consist of cross-border transmission grid connections, with common regulations, standards, pricing, and integrated systems, and are designed to increase regional energy security, reduce development costs, and reduce GHG emissions.
For example, work has been underway for more than a decade in cross-border energy integration in the Greater Mekong region. In September 2021, Laos signed a power purchase agreement with Vietnam to import 600 MW of power generated from wind. The new Article 6 rules create disincentives for these kinds of deals by disallowing any splitting of avoided emissions between two or more countries that share a single electric power generating facility.
Third, the Glasgow negotiators agreed that an equivalent of 5% of the “share of proceeds” from carbon markets linked to the 6.4 multilateral mechanism will be transferred to the Global Adaptation Fund to help developing countries finance their efforts to adapt to the impacts of climate change. This is set out in Article 6.4.VII, 67. Despite months of haggling, this rule does not cover Article 6.2, where instead governments are strongly encouraged to do the same. Article 6.4 transactions will also be subject to a 2% cancellation fee, in order to help ensure a guaranteed net reduction, albeit at this relatively small share of the overall ITMO. These transactions may also be subject to an administrative fee. Certainly, the “international tax” related to Article 6.4 transactions bears watching to see what impact or potential disincentive it has on future transactions, how the tax is paid, and how this share of proceeds contributes to adaptation benefits in practice.
Fourth, Glasgow reached a compromise to weed out some, but not all, legacy carbon credits. That no one knows how many carbon credits have been generated from past CDM financing in itself highlights some of the flaws of the previous regime. Estimates by the UNFCCC suggest that past CDM certified emission credits were anywhere between 300 million to 2.3 billion credits. Other estimates put the total at 4 billion credits, making labels like “zombie credits” hard to shake. The Glasgow compromise allows credits generated after 2013—anywhere between 120 and 300 million credits—to be eligible for inclusion in the first tranche of a country’s NDC. It does not allow any such inclusion for activities that were “REDD+” transactions for avoided deforestation.
Rather than being the final word, Glasgow should now initiate a detailed review at the national level of those post-2013 CDM credits, with a view to removing those CDM credits that not only have weak guarantees regarding additionality and permanence but also that do not complement NDC conditional ambitions like closing coal-powered facilities. Among the largest recipients of CDM projects are China, India, Brazil, and South Korea.
Implementation: The role of development finance
A key concern as Article 6 moves ahead is to ensure that developing countries have the capacity to benefit from international market transactions. The complex administrative machinery set out in Article 6.4 is intended to do just that. However, multilateral development banks and bilateral agencies need to support the capacity of developing countries to benefit from the new Article 6.2 and 6.4 rules. This support should include helping countries assess their own potential carbon market opportunities, including their carbon sequestration options, along with helping build their capacities for measurement, accounting, and verification. If international carbon markets reach anywhere near the levels projected by IETA—and it is unclear right now to what extent the United States, the European Union, or China will look for offset credits outside of their borders—then more work will be needed within developing countries to embed wider ESG standards and safeguards.
Some of this work is already underway, given that most of the COP 26 rules were anticipated well before governments met in Glasgow. For example, initiatives like the San Jose Principles, adopted in 2019 by 32 of the parties to the Paris Agreement, aim to bolster market integrity and transparency details. These principles show that some governments have been steadily working on key measurement, accounting, and auditing rules. International financing initiatives like Japan’s Joint Crediting Mechanism, which is comprised of 65 projects valued at over USD 500 million in 17 developing countries, and the World Bank’s Transformative Carbon Asset Facility of USD 210 million, have further helped developing country governments and the private sector prepare for carbon markets. Joint work under a Switzerland–Peru–Ghana agreement is the first country-to-country agreement to put Article 6.2 rules into practice. These pilot activities can develop the data to help ensure the future Article 6 market activities fully address environmental and social safeguards.
Ensuring Additionality and Permanence
While the Article 6 rules from Glasgow show a marked improvement compared to earlier approaches under the Kyoto Protocol, there are potential pitfalls that governments and private actors alike would do well to learn from.
As noted above, environmental groups were correct in noting that too often Kyoto Protocol offsets were claimed for activities that were not truly additional. In other words, they were claimed for emissions reductions that either would have happened anyway or were the result of a deliberate increase in GHG emissions-related production that was undertaken in order to market the subsequent emission reductions.
Even with the rules adopted in Glasgow, a number of NGOs and developing country stakeholders still contend that the market approach creates a perverse incentive for host parties to keep their NDC ambition low. This would allow them to keep the baseline lower than it otherwise would be and offer marketing opportunities for rich countries to continue business as usual and still fulfill their NDCs. Once again, we see the essential element of upward ambition as tied to the credibility of the market.
Furthermore, some environmental groups are concerned about the permanence of offsets. In other words, they question whether the emissions reductions claimed for offsetting activities, such as planting trees, will last in perpetuity (or at least for as long as the carbon emission equivalent will last in the atmosphere). However, it may be that the more ironclad the permanence of the offset, the more expensive the transaction. For example, higher costs may result from the purchase of a buffer asset or political risk “insurance” should the offsets fail to deliver. Failure could occur because of fire or blight or a host party government that reverses a commitment to maintain forest cover or to renewable energy or sustainable agricultural policies.
There is more work being done to improve our understanding of the full costs involving in protecting against such threats. Already there are examples concerning the purchase of pledged buffer assets, and discussions for some form of guarantee, such as political risk insurance against government breach or interference in the carbon contract. For these reasons, market advocates have noted that advances in carbon monitoring technology and real-time data tracking of carbon emissions and retention could help address concerns of permanence to some degree by enhancing the credibility and enforceability of offsets.
Government Versus Private Markets
The Paris Agreement provides governments with a new set of rules to make international carbon markets work. A big question coming out of Glasgow is to what extent will purely private sector, voluntary carbon markets conform with the new Article 6 rules.
Moreover, how will governments, particularly those in host countries, react to and/or regulate private carbon offset transactions that impact lands they consider as sovereign? How will they approach transfer payments into their country for private transactions that involve payment to Indigenous and other communities for services on lands they consider to be their own? These questions remind us that in many countries there remains a lack of clarity on how governments will treat and define carbon rights.
Steps by the Task Force on Voluntary Carbon Markets on the demand side and recommendations from the Voluntary Carbon Market Initiative on the supply or seller side are encouraging in trying to address these questions, while underscoring how much more needs to be done. Recently, an informal outline of where Japan may head with regards to a greater role of private markets is intriguing, while the private sector third-party carbon offset body Gold Standard, which already requires that projects address environmental and social safeguards, has also signalled that it will require corresponding adjustments within its voluntary markets. Since there are dozens of leading voluntary carbon market certification bodies, a practical challenge for the private sector involves multiple and diverging financial accounting standards. The November 2021 launch by the International Financial Reporting Standards Foundation of a new International Sustainability Standards Board with an initial release of a proposed standard for reporting on climate change could provide some early guidance for Article 6-related treatment in corporate financial and non-financial statements.
While the focus in both this article and in the press overall has mostly been around the “markets” side of Article 6, we should also note the resolution of the rules related to Paris Article 6.8, the so-called “non-market approaches” (NMAs). The Glasgow decision on Article 6.8 notes that NMAs may include social inclusivity, financial policies and measures, circular economy, blue carbon, just transition of the workforce, and adaptation benefit mechanism. The decision also notes that these approaches should involve more than one party. However, NMAs are not “transactions” and would not be “regulated” under the rules of 6.2 or the 6.4 mechanism.
For those who have concerns about market approaches, NMAs may offer the brighter hope for emission reductions or at least represent “low hanging fruit.” For example, about 75% of European building stock is energy inefficient and responsible for more than a third of EU GHG emissions. Regulations tackling this inefficiency would not have to rely on a market transaction. Indeed, policy measures aimed at improving efficiency as well as climate finance to upgrade buildings can be effective mitigation and adaptation actions at the same time while also meeting the Glasgow Pact objective of a “just transition” through construction-related employment.
A notable example of potential Article 6 NMA actions may emerge from the China–U.S. Joint Declaration, which identifies areas for joint cooperation such as regulatory actions to cut methane emissions, energy-efficient policies and standards to reduce electricity waste, steps to phase out coal, and efforts to reduce fossil fuel subsidies.
The Road Ahead
While the completion of the Article 6 negotiations in Glasgow marks an important milestone in sorting out crucial details to stop double counting of credits and limiting the carry-over of legacy credits, thereby promising to improve past mechanisms, the administrative steps to make Article 6.2 and 6.4 actually work are complex and will take time to implement. At this early stage, it appears that those seeking to engage in cooperative approaches may find it simpler to follow an approach under 6.2, which appears to be a more streamlined and less prescriptive system than 6.4. On the other hand, the possibility that an approach under 6.4 will have more oversight may give some comfort to other Article 6 participants, especially developing countries that have not had much experience in such transactions and would like assurance of some proceeds going toward adaptation funding. These very distinctions between the two articles raise risks of two dissimilar international carbon markets emerging.
In the months ahead, caution will be needed to temper markets—especially private markets tenuously linked to the Article 6 outcomes—from irrational exuberance. Already, some traders have proposed using cryptocurrency to back trades, a proposal both daunting for many developing countries struggling with global financial markets, and worrisome that carbon markets may become increasingly volatile and speculative. Given the sheer number of net-zero corporate promises around the Glasgow COP, there are risks that markets overestimate the carbon offset potential of investments. In turn, investors may pour funds into large-scale, single-crop afforestation projects reminiscent of agricultural land grabs. There are also potential development risks, whereby developing countries sell their least-cost carbon mitigation or removal options, only to face more expensive domestic NDC actions down the road that worsen their overall development prospects.
While the fundamental rules are now settled, the myriad details to make them function are not. Now the hard work begins to see if the promise of the market can deliver real and additional benefits to the climate and society.
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