“There is no vaccine for the planet. Nature needs a bailout,” warned UN Secretary-General António Guterres, describing the state of the planet in a speech at Columbia University in New York in December 2020. He identified global recovery from the COVID-19 pandemic as an opportunity to solve the climate crisis and make peace with nature, using the SDGs and the Paris Agreement on climate change as a blueprint.

Guterres highlighted three imperatives in addressing the climate crisis:

1) Achieving global carbon neutrality

2) Aligning global finance behind the Paris Agreement

3) Delivering a breakthrough in adaptation to protect the most vulnerable. Among positive developments, the Secretary-General acknowledged commitments made by the EU, Japan, the Republic of Korea, and the UK to achieve carbon neutrality by 2050 – a process where producers, consumers, and investors can all play a part, and where carbon markets can act as a catalyst. As countries prepare for the Glasgow Climate Change Conference (COP 26), Guterres urged compromise on Article 6 of the Paris Agreement (market and non-market approaches) and welcomed efforts “to get us the clear, fair and environmentally sound rules carbon markets need to fully function.”

With negotiations on rules that would operationalize market and non-market mechanisms for the mitigation of greenhouse gas (GHG) emissions ongoing, it remains to be seen how countries will ensure market mechanisms incentivize ambition while maintaining environmental integrity. At the same time, as the EU pointed out during Article 6 negotiations at COP 25, “the absence of rules to operationalize Article 6 does not prevent parties from having carbon markets,” and numerous voluntary schemes are functioning around the world.

This Policy Brief looks at the evolution of international rules on market mechanisms from the Kyoto Protocol to the Paris Agreement and discusses efforts to foster cooperative approaches in reaching nationally determined contributions (NDCs), promote sustainable development, and ensure environmental integrity and transparency.

Market Mechanisms in International Climate Regime:

From Kyoto to Paris Market mechanisms are complementary measures that help achieve climate change mitigation targets at the lowest possible cost. They can apply to specific GHGs and sectors, and be implemented by participating entities at the international, regional, national, and subnational levels. Market mechanisms incentivize entrepreneurship to develop mitigation actions, and allow participating entities to internalize the cost of their emissions by generating or buying carbon credits.

The 1997 Kyoto Protocol introduced binding emissions reduction targets for industrialized countries. While countries with quantified emissions reduction commitments under the Protocol must meet their targets primarily through national measures, the Kyoto Protocol also created three “flexibility mechanisms” to help countries achieve their commitments while reducing the financial burden them at the same time. The three mechanisms are:

• Emissions trading;

• Clean Development Mechanism (CDM); and

• Joint Implementation.

Emissions trading limits the total of emissions from all regulated entities to a certain amount. It lets countries that have carbon emission units spare – emissions allowed them under the Kyoto Protocol but not “used” – to sell this excess capacity to countries that are over their limits. In 2005, the EU replicated the Kyoto Protocol’s emissions trading, creating the EU Emissions Trading Scheme (ETS) – the largest regional carbon market. Other jurisdictions followed by putting regional, national, or subnational ETSs in place, including New Zealand, California in the US, British Columbia and Quebec in Canada, and Tokyo and Saitama in Japan. China is expected to launch its national ETS in the middle of 2021.

The CDM and Joint Implementation are project-based mechanisms where emission reductions result from investment in green projects. While the CDM allows a country with an emissions reduction target under the Kyoto Protocol to implement mitigation projects in developing countries, Joint Implementation generates emission reduction units (ERUs) by allowing industrialized states to implement green projects in other developed countries.

The Kyoto Protocol’s second commitment period expired in 2020. To ensure continuity between the Protocol and the Paris Agreement, parties agreed to establish three tools to help countries deliver their NDCs:

• Cooperative approaches through the use of internationally transferred mitigation outcomes (ITMOs) (Article 6.2);

• a new market mechanism, sometimes referred to as a “sustainable development mechanism” (Article 6.4); and

• a framework for non-market approaches mechanism (Article 6.8).

With the Glasgow Climate Change Conference postponed due to COVID-19, countries have not yet agreed to Article 6 operationalization details. These issues are due to be resolved when COP 26 meets, currently scheduled for November 2021. Meanwhile, negotiations on the new market mechanism focus on rules, modalities, and procedures for the mechanism, including, inter alia, its supervisory body, activity cycle, avoidance of double counting, use of emission reductions for other international purposes, response measures, and transition from the Kyoto Protocol. 

Negotiations under Article 6.8 are currently dealing with a work program under the framework for non-market approaches. Given the lack of consensus, the non-market approaches mechanism “can be anything and everything” – as long as it is not market-based – and could focus on cooperation on climate policy through, for example, fiscal measures such as putting a price on carbon or imposing taxes to discourage emissions. 

Consensus on guidance on cooperative approaches referred to in Article 6.2 has likewise remained elusive. Parties have stressed the importance of ensuring that cooperative approaches avoid double counting, raise ambition in mitigation and adaptation actions, promote sustainable development, and ensure environmental integrity, limits, and safeguards. However, views have diverged on applying corresponding adjustments, preventing or limiting the use of Kyoto Protocol units, allocating a share of proceeds to the Adaptation Fund, and ensuring overall mitigation of global emissions through the cancelation of ITMOs, among other issues.

However, countries have already been engaging in cooperative initiatives and mechanisms that can serve as pilots under Article 6 and inform the development of relevant guidelines under the Paris Agreement. According to Climate Focus, since 2018, there has been a proliferation of Article 6 piloting activities.

Article 6 Piloting: Examples of Good Practice

It has been argued that future Article 6 projects could roughly fall under four categories:

• Upcoming initiatives specifically intended to be linked to Article 6;

• Pre-existing initiatives under the CDM or Joint Implementation that might continue to qualify under Article 6;

• Initiatives linked to readiness for carbon pricing; and

• International carbon market regimes outside the UNFCCC.

The NEFCO-Peru pilot project is an example of an Article 6 initiative specifically intended as such. It aims to create collaboration between Peru and other countries to reduce emissions in the solid waste sector. If implemented, it would enable Peru to increase its waste recovery, reduce emissions from the waste sector while reducing air pollution, minimize the spread of diseases, decrease water and soil contamination, and transfer ITMOs to the partnering country.

An example of a pre-existing initiative regarded as an Article 6 pilot is Japan’s Joint Crediting Mechanism (JCM), established in 2013 as a way for Japan to cooperate with partner countries to reduce emissions by transferring decarbonizing technologies, to contribute to achieving NDCs and sustainable development. Unlike most Article 6 piloting activities, currently in their preparatory stages, the JCM has progressed to the piloting phase and is considered a “frontrunner” of Article 6 piloting. The JCM is a bilateral cooperation mechanism, that has extensive experience with Article 6 implementation, having already generated credits that can be used towards NDCs in Japan and one of the 17 partner countries. In October 2019, the SDG Knowledge Hub featured a guest article on how the JCM can contribute to the implementation of NDCs and the SDGs.

Initiatives linked to readiness for carbon pricing include multilateral initiatives, such as the World Bank’s Transformative Carbon Asset Facility – a platform to enable developing countries to enhance their NDCs while developing robust carbon accounting measures to enable the transfer of ITMOs between different parties in the future. Another example is the Asian Development Bank’s (ADB) Article 6 Support Facility which aims to provide developing countries with capacity-building and technical support to help them develop and test mitigation projects under Article 6.

International carbon market regimes outside the UNFCCC include the International Civil Aviation Organization’s (ICAO) Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA). CORSIA is a market-based offset scheme designed to allow the international aviation sector to achieve carbon-neutral growth after 2020. CORSIA consists of three phases. The pilot phase is scheduled from 2021-2023, after which the voluntary first phase will be implemented between 2024-2026. A mandatory second phase will occur between 2027-2035. It is not yet clear whether and how CORSIA might become part of NDC accounting in the future and whether it will be eligible under Article 6.

Looking Ahead: Saving Costs and Delivering Environmental Benefits

According to a study conducted by the International Emissions Trading Association (IETA) and the University of Maryland, US, Article 6 has the potential to reduce the total cost of implementing NDCs by more than half (USD 250 billion per year in 2030), or facilitate the removal of 50% more emissions (around 5 GtCO2 per year in 2030), at no additional cost. The value of the potential carbon market is estimated to reach approximately USD 167 billion per year in 2030, USD 347 billion per year in 2050, and USD 1.2 trillion per year in 2100.

However, for Article 6 to deliver on its promise, it must maintain its environmental integrity. Experts have cautioned about risks associated with some countries’ mitigation targets corresponding to higher levels of emissions than business-as-usual (BAU) projections. As a consequence, they estimate the amount of “hot air” contained in current NDCs to be similar in magnitude as the total mitigation pledged by countries with NDC targets that are more stringent than BAU. Transfers of hot air to other countries could increase GHG emissions, create perverse incentives, and compromise the environmental integrity of international carbon markets.

Therefore, as UNFCCC Executive Secretary Patricia Espinosa has stated, we need markets that support cooperation, with consistent rules underpinned by environmental integrity and in line with sustainable development objectives. As parties strive for a transparent, coherent, and high-quality approach to carbon markets, experiences, insights, and lessons learned in Article 6 piloting activities could serve as valuable input to the negotiations.