Some prospects for linking emissions trading systems after COP26

A post by Giulio Galdi (University of Trento) and Albert Ferrari (FSR)

While the climate crisis has taken the backseat in social and mass media lately (for very understandable reasons), it is far from getting better. By contrast, recent overlapping crises are making coordination on climate policy all the harder. For instance, concerns over western dependency on fossil fuels imports made some countries keener on renewing efforts on domestic production of fossil fuels and the recent energy price spike cast doubts on the political feasibility of pricing mechanisms to decarbonise energy-intensive sectors.

In this complex picture, let’s recall the important results secured at the COP26, and the major role that the Paris Agreement can play in bolstering carbon market integration. This piece builds on the evidence gathered for the fourth LIFE DICET report and on the policy brief on the implications for linking of different offsets provisions among Emission Trading Systems (ETSs). In both works, we reflected in particular on the implications of Article 6 of the Agreement, where the market and non-market mechanisms are introduced. We have drawn from the experience with the Clean Development Mechanism (CDM) under the Kyoto Protocol to highlight how ETSscould interact with the provisions under Article 6 of the Agreement. 

What role for international carbon markets under the Paris Agreement? 

For the sake of making this post accessible to a wide audience, let’s introduce the two market approaches of Article 6 of the Paris Agreement, both outlining the ways to exchange Internationally Transferable Mitigation Outcomes (ITMOs).
  • First, we have Article 6.2 that introduces the possibility of voluntary exchanges of mitigation outcomes between two signatories of the Agreement. As this is considered as a decentralised cooperation approach, it does not need to go under the scrutiny of other countries or bodies. Most importantly for our project, ETS linkages would fall within this category.
  • Second, we have Article 6.4 that concerns the market-based mechanism where each signatory can purchase mitigation outcomes from other countries (or sell them, if they can prove they have already put forward policies to achieve their Nationally Determined Contribution) under the supervision of a UNFCCC body. This is considered to be the heir of the CDM, as they function in much the same way. As for the CDM, private actors can buy credits for offsetting purposes. However, in case the credits are not used towards the fulfilment of NDCs, they are not recognised as ITMOs and do not require corresponding adjustments.

The dissatisfaction with the CDM is however still fresh and widespread. Scholars and activists lament that most carbon credits issued under the CDM did not correspond to real emissions abatement. The linking of the CDM market to some ETSs led to a collapse in their allowance prices (in NZ and the EU, for instance) that cast doubts on the environmental effectiveness of cap-and-trade systems. No surprise that this led jurisdictions to delink their ETSs from the CDM market. It also makes clear why it was so important for the credibility of the Paris Agreement that its outcome could be seen as a jump forward in terms of ambition, with respect to the CDM and the Kyoto Protocol in general. In this respect, the greatest relief perhaps concerns the safeguards against double counting of mitigation outcomes, which instead troubled the CDM. More robust methodologies to ascertain additionality of carbon projects (i.e. “real” emissions reductions connected to the certificates) were also central in distinguishing the CDM from the mechanism under Article 6.4.

Linking emissions trading systems under the Paris Agreement

In our works, we have also analysed a few aspects that specifically relate to the interactions between ETS linking and the Paris Agreement. There is little scientific literature on this specific topic, with the ICAP report on the implications of ETS linking on the achievement of Nationally Determined Contributions representing a notable exception. From our own research and reflections, we believe the following are the most relevant channels of interactions between ETS linkages and the Paris Agreement:

  • Target setting: there is a fundamental, yet arduous question to answer: “how is the Agreement going to influence ETS reforms?”. The canonical approach for increasing the environmental ambition of an ETS is lowering its cap (if present). However, in theory, if one jurisdiction in a linkage were to sell its allowances as ITMOs, the possibility to sell the allowances on this international carbon market could discourage the policymakers from decreasing the cap in the future. To the extent that this limits the convergence in environmental ambition with other ETSs, this might constitute an obstacle to a linkage.
  • Fungibility: the COP26 convened also on using tonnes of CO2e to measure mitigation outcomes. This greatly facilitates an equivalence with allowances from ETSs and means that, from a technical perspective, one ETS regulator in a linkage could decide to accept ITMOs as compliance units. If its cap is not reduced by an equivalent amount of allowances, the cap of the linked market would be effectively increased, putting downward pressure on prices and compromising the functioning of carbon markets. 
  • Future linking pathways: it could well be that the mechanism under Article 6.4 will be the main platform for carbon market integration, taking the spotlight from bilateral or multilateral ETS linkage. Integration through a market-based mechanism would also not require much political capital to be invested, compared with the necessary alignment on some design features for ETS linking.

Overall, we can say that the Paris Agreement, and its Article 6 provisions, will play a major role in international climate policy. At the same time, the rapid uptake of ETSs across the world signals that they will still represent a crucial policy tool to achieve national objectives. The developments of and the interaction between these two elements of climate policy will thus be of the utmost interest in the next few years, provided that climate policy will not suffer other unfortunate delays.

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The views and opinions expressed in this post are solely those of the author(s) and do not reflect those of the editors of the blog of the project LIFE DICET.