Carbon Pricing and Markets Update: Can Santiago Climate Change Conference Agree on Mechanism to Deliver Ambition?

4 October 2019: Over the last months, we saw a number of reports released by government agencies and non-governmental organizations (NGOs), including from the business, research and technology communities, that address carbon market expectations, challenges and solutions. These are indicative of ongoing preparatory work ahead of the upcoming negotiations on market mechanisms under Paris Agreement Article 6 (cooperative approaches), expected to conclude at the Santiago Climate Change Conference in December. This Update highlights recent reports and news releases, and provides a backgrounder to the anticipated negotiations on the issue.

Negotiations at the Santiago Climate Change Conference will focus on the operational guidance for cooperative approaches provided for in Paris Agreement Article 6, which refers to non-market and market approaches, including a sustainable development mechanism. The goal of cooperative approaches is to create opportunities for cost-effective mitigation to enable higher levels of ambition. Critics, however, warn that there is no guarantee that market mechanisms lead to higher levels of mitigation.

IETA Study Finds Article 6 Can Halve the Cost of Implementing NDCs by 2030

A study by the International Emissions Trading Association (IETA), co-sponsored by the Carbon Pricing Leadership Coalition (CPLC), calculated that potential cost reductions over independent implementation of countries’ Nationally Determined Contributions (NDCs) total about USD 250 billion per year in 2030. Investing these cost savings in enhanced ambition could facilitate additional abatement under the Paris Agreement by 50% or about 5 gigatons of carbon dioxide (GtCO2) per year. When coupled with natural climate solutions in lands and forests, the authors argue, benefits could become even greater, with an additional 5 GtCO2/year of abatement.

Business Advocates for Carbon Prices

A report published by the CPLC’s High-Level Commission on Carbon Pricing and Competitiveness concludes that supportive government policies, coupled with a critical mass of businesses committed to adopting low-carbon strategies, will be crucial for a shift towards low-emission goods and services. Such commitment has been shown. “As of 2018, over 1,300 companies – including more than 100 Fortune Global 500 companies with a collective annual revenue of USD 7 trillion – disclose that they use an internal carbon price or are planning to do so within the next two years,” reports the World Business Council for Sustainable Development (WBCSD).

In its 2019 policy paper, the Council confirms its interest in long-term policies that place a direct cost on carbon emissions and in a robust global carbon market, comprised of links between emission trading systems (ETSs) and transfer of carbon units, underpinned by environmental integrity. The Council notes that the total value of the world’s carbon pricing initiatives, including both taxes and ETSs, was USD 82 billion in 2018. It encourages governments to put carbon prices in place as soon as possible and to set them between USD USD 40-80 per ton of CO2 (tCO2) by 2020 and USD 50-100/tCO2 by 2030, provided a supportive policy environment is in place.

Taxes on Polluting Fuels Remain Too Low for a Low-carbon Transition, OECD Finds

A report by the Organisation for Economic Co-operation and Development (OECD) finds that 70% of energy-related CO2 emissions from advanced and emerging economies are entirely untaxed, offering little incentive to move to cleaner energy. The report titled, ‘Taxing Energy Use 2019,’ shows that taxes on polluting fuels are too low and need adjusting, which, along with state subsidies and investment, could encourage a shift to low-carbon energy, transport, industry and agriculture.

The report also finds, inter alia, that:

Taxes on natural gas are often higher than on coal, which are close to zero in most countries;
Taxes on road fuel still fail to fully internalize environmental cost, especially with some road transport sectors offered preferential rates; and
For international flights and shipping, fuel taxes are zero.

The authors note that only four countries (Denmark, the Netherlands, Norway and Switzerland) tax non-road energy above EUR 30/tCO2, which is considered a low-end estimate of the costs of carbon emissions to the climate. To make the low-carbon transition easier, in another report, the OECD suggests focusing on inclusive fiscal reform, employment and creating synergies with other goals like clean air, healthy eating and accessibility of services.

Germany Releases CO2 Pricing Mechanism for Fuels Starting 2021

In an effort to achieve climate targets, Germany released its Climate Protection Program 2030. The Program includes a CO2 pricing mechanism, in the form of a national ETS, for fuels used in the building and transport sectors starting 2021. The long-term goal is to integrate these sectors into the EU ETS, which already covers greenhouse gas (GHG) emissions from Germany’s energy, industry and domestic aviation sectors.

A CO2 price will be charged at the upstream level to fuel importers, and apply to heating oil, liquefied petroleum gas (LPG), natural gas, coal, petrol and diesel. The government will start with a fixed price on CO2 emissions by issuing allowances of EUR 10/tCO2 in 2021, rising to EUR 35/tCO2 in 2025. From 2026 onwards, a cap on emissions will replace the fixed price and decline each year. Allowances will be allocated through auctions, and the cap will be based on Germany’s reduction targets for the non-EU ETS sectors, as defined in the EU Effort Sharing Regulation. In 2026, auctions of allowances will contain a price corridor of EUR 35-60/tCO2, with a potential post-2026 price corridor to be decided.

Revenue from selling allowances at the fixed price and from auctioning will be used for compensating consumers and financing measures of the Climate Protection Program. These include a number of incentives and regulations in areas such as: renewable energy and electric car expansion; budget increase for public transport systems; tax support for energy-efficient modernization of buildings; and a ban on newly installed oil-fired heating systems from 2026.

Subnational Actors Engage in Carbon Markets

Subnational actors, including US federal states like California, have also long shown interest in carbon market mechanisms, including subnational cross-border carbon market cooperation. They can add another component of governance oversight and environmental integrity issues many are concerned with. Forest offset projects under the US Forest Protocol used in California’s cap-and-trade program, for example, have recently been scrutinized by a group of researchers at the University of Berkeley.

The Protocol has generated 80% of offset credits, or 97 million tons of CO2 reductions, in California’s cap-and-trade program. Researchers analyzed credits generated by 36 compliance forest offset projects through 23 March 2019. They found that 82% of these credits likely do not represent true emission reductions due to the Protocol’s use of lenient leakage accounting methods. Leakage, in the context of the Protocol, occurs when a reduction in timber harvesting at a project site causes an increase in timber harvesting elsewhere to meet timber demand. Critical of the way the Protocol accounts for leakage, the authors suggest that over-crediting results from: an unsupported assumption of a low leakage rate; inconsistency between the timing of when increases in on-site carbon storage and releases due to leakage are accounted for; and a lack of clarity on requirements for forestland owners to increase carbon stocks to account for leakage.

California Approves Standard for Assessing Tropical Deforestation Credits

In related news, the California Air Resources Board approved a Tropical Forest Standard (TFS) for assessing offset crediting programs that reduce emissions from deforestation. This could allow national and subnational jurisdictions to link forestry offsets to California’s cap-and-trade program as well as other markets around the world. The Board, which will approve their use for compliance in the system on a case-by-case basis, cited the potential for TFS-aligned programs to supply the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA). The approved TFS includes the following eligibility criteria:

Reference level: reductions must be measured against historical emissions in the implementing jurisdiction over a consecutive ten-year period. The reference level should be based on the annual estimate of total native forest area cleared and consistent with Intergovernmental Panel on Climate Change (IPCC) methodologies.
Crediting baseline: to ensure the additionality of sector-based offsets, implementing jurisdictions are required to establish a baseline that begins at least 10% below the reference level and declines to the jurisdiction’s 2050 GHG emissions target for forestry.
Leakage: implementing jurisdictions are required to include a framework and mechanisms for addressing and accounting for carbon leakage from the forestry sector, including by demonstrating how economic activities that drive deforestation have been replaced with more sustainable activities or how practices have been improved.
Social and environmental safeguards: implementing jurisdictions have to demonstrate inclusion of relevant stakeholders, including indigenous populations, as well as consistency with the UNFCCC Cancun Agreements and Governors’ Climate and Forests Task Force Guiding Principles.
Permanence and reversal risk: TFS requires jurisdictions to calculate a risk-reversal factor from which credits will be deducted and placed in a buffer pool equal to at least 10% of total credits issued per year. This is to ensure that reductions that are reversed through leakage and other activities do not endanger the environmental integrity of the credit. Emission reductions have to endure for at least 100 years.

Research Draws Lessons from Kyoto Protocol

Informing some of these debates and the developments in carbon markets and related policy instruments are lessons learned from the flexibility mechanisms under the UNFCCC Kyoto Protocol, comprising international emissions trading and two project mechanisms, Joint Implementation (JI) and the Clean Development Mechanism (CDM), as well as from national and regional experiences like the EU ETS. Looking back, we see limitations of emissions trading. The EU ETS suffered from weak prices, market volatility and even criminal activities exploiting regulatory loopholes. Under the CDM and JI, it was unclear if projects met the additionality requirement – a requirement that ensures projects result in real, measurable and lasting climate benefits.

Yet some estimates suggest that during the Protocol’s first commitment period (2008-2012), “the flexibility mechanisms collectively mobilized in excess of USD 140 billion in climate finance, a vast majority of which went to developing countries.” Others emphasize that for some Parties, such as Japan, the use of the flexibility mechanisms proved essential to meet their emission reductions commitments. They also draw attention to how the EU has since strengthened its regulatory framework, including through a dynamic supply adjustment mechanism, the Market Stability Reserve (MSR), to accelerate withdrawal of surplus allowances, among others.

Still, critics are warning that the EU carbon market is currently unfit to accommodate national coal phase-outs. Analysis by Carbon Market Watch shows that as EU countries phase out coal over the coming years, 2.22 billion surplus pollution permits could flood the EU carbon market between 2021 and 2030. The authors call on EU governments to combine coal plant closures with the cancellation of unused allowances, and on the EU Commission to strengthen the EU ETS MSR to absorb more surplus pollution permits off the market and avoid another crash in carbon prices.

For the upcoming negotiations on the guidance for market approaches under the Paris Agreement, lessons from the past highlight the need for robust mitigation targets and governance that ensures transparency of emissions and safeguards. It remains to be seen whether Parties’ diverging views on how to achieve this can be reconciled by the end of 2019. Given that the purpose of Article 6 is to allow for higher ambition, the pressure is high as Parties enter the next phase of the Paris Agreement’s ambition cycle. In 2020, Parties are expected to communicate their new NDCs (those Parties with NDCs running to 2030 are expected to update or communicate progress on their current NDCs) and their mid-century long-term low-emission development strategies.

Blockchain Solutions to Carbon Market Challenges

Research by the UN Environment Programme Partnership with the Technical University of Denmark (UNEP DTU Partnership) suggests that blockchain solutions could be applied within the new carbon market mechanism of Paris Agreement Article 6. During the OECD Global Blockchain Policy Forum 2019, researchers presented possible blockchain architectures to serve as a decentralized infrastructure. They highlighted the value of blockchain technology, including an immutable audit trail of transactions, cheap and borderless transfer of values and automated execution of contracts. These features, participants at the Forum concluded, could help address some of the previous carbon market challenges related to: environmental integrity; transparency and information asymmetry; double counting, administrative costs; and unit quality.

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The SDG Knowledge Hub publishes monthly climate finance updates, which largely focus on multilateral financing and cover, inter alia, mitigation and adaptation project financing news and lessons, institutional events and news, and latest developments in carbon markets and pricing. Past climate finance updates can be found under the tags: Finance Update: Climate Change and Finance Update: Sustainable Energy.