Carbon Markets - Beyond COP 26

Carbon Markets – An Overview

The pricing of Carbon emissions along with clear policies was highlighted by the United Nations Framework Convention on Climate Change (UNFCCC) as one of the key instruments governments should implement to drive GHG emissions reduction. 

Article 6 of the Paris Agreement established a mechanism that may serve as the foundation for a market mechanism to allow for greenhouse gas emissions or carbon trading activities, either between Parties to the Paris Agreement or with the involvement of the private sector (for example, through the sale, purchase or creation of credits).However, negotiations around Article 6 have been contentious, and until COP26 was the only remained the only element of the Paris Agreement Parties had not reached agreement. However, at COP26 in Glasgow in November, the Parties finally agreed the terms for a global market mechanism. In principle the agreement will enable countries that are ahead of meeting their emissions targets to trade carbon allowances with countries that are lagging to offset their emissions. The rules governing the mechanism, which are yet to be agreed, will pave the way for an enhanced transparency framework with consistent accounting and reporting targets and potentially laying the foundations for a global carbon market. It is important to note that several countries have already ruled out utilising such a mechanism to deliver on their Net Zero targets.

Many of the major oil and gas players have called for a robust Carbon market and pricing to support investment in abatement and shift to lower carbon sources. The geographic coverage of Carbon Pricing is currently limited but growing, with approximately 22% of global emissions currently covered by Carbon Pricing. The price of Carbon today in most markets is well below a price corridor that can effectively drive the reduction in emissions and incentivises investment in Carbon abatement. However, with many countries (90% of GHG covered) now pledging to Net Zero targets to limit temperature to 1.5 deg C below, Compliance Carbon Markets are going to play an increasing role

What are Carbon Markets?

Carbon markets price: the right to emit and the value to cut carbon emissions to atmosphere. Enabling emitters to procure emission GHG rights and report reductions and developers or investors to secure revenue from new of emission reduction or removal projects. When operating effectively and efficiently Carbon Price should reflect the actual cost to close emissions towards the intended target. Too low a price and the Carbon Market is at risk of sustaining current emissions levels as it is cheaper to emit than take action. Essentially the two types of carbon markets which today operate quite independently, they are: 

1.    Compliance Carbon Markets such as the EU Emissions Trading Scheme (ETS), UK ETS and China ETS. Compliance markets establish a carbon price by laws or regulations which control the supply of allowances that are then distributed by national, regional and global regimes. These allowances are then traded within a regulated emissions trading scheme, which economically incentivises emitting organisations to reduce their carbon footprint or invest in carbon abatement measures. 

The ETS market operates as a Cap-and-Trade mechanism where an emissions target is set the ‘Cap’. This Cap translates as a target for each individual emitting site falling under the jurisdiction of the ETS. Those emitters that exceed the Cap/emissions target need to buy allowances. Those emitters that are below the target can sell their allowances. The Carbon price is determined by the balance of allowances in the market. This balance is governed by the ETS and, in general, is gradually reduced over time. The higher the number of allowances in the market, the higher the price and vice versa.

Carbon Tax is also considered part of the Compliance Carbon Market. It is a predefined tax rate targeting specific emission sources. The Netherlands is the first country to introduce a Carbon Tax on Industries that have lagged on decarbonisation

2.    Voluntary Carbon Markets. Not legally mandated. Carbon credits/certificates are issued by a number of recognised but self-governed global registers. Carbon credits/certificates are largely utilized by Corporates wishing to voluntarily report a reduction and, in some cases, negative GHG emissions through the purchase of carbon credits. However, it is worth noting that the SBTi Corporate Net-Zero Standard excludes the use of carbon credits and do not count as reductions toward meeting the science-based targets. The standard requires that companies should only account for reductions that occur within their operations and value chain.

Carbon credits/certificates are issued to projects which have been registered, certified and verified under the rules of the register.

How does the Voluntary Carbon Market Function?

Although there is no single global carbon marketplace for voluntarily trading of credits. The Global Voluntary Market is currently served by a range of international Carbon registries that govern, certify and verify credits issued and retired from Carbon removal and reduction projects. Project developers of registered projects are able to freely sell their credits directly to buyers or via a broker or an exchange or trading platform

The key roles of the registries are to ensure that the Carbon credit can be traced to a real emissions removal or reduction project, and that once reported, is retired to avoid double counting.

The majority of Carbon Credits are purchased by corporates, wishing to voluntarily report reduced emissions, negate legacy emissions or even report negative emissions. Currently, some of the leading Carbon registries that govern, certify and verify the issuing and retirement of credits are highlighted below:

·      Verra (Voluntary Carbon Standard) – VCU

·      The Gold Standard – VERs

·      Plan Vivo – PVC

·      Climate Action Reserve – CRT

·      American Carbon Registry - ERT

Each carbon registry involves different procedures for measuring, verifying, and certifying emissions reductions and GaffneyCline can advise on identifying a suitable option for companies.

Carbon Projects – An Overview

Voluntary markets are built on individual projects that are certified as removing or avoiding the GHGs emissions into the atmosphere. The certificates are issued for every 1 tonne of carbon dioxide equivalent (tCO2e) removed or avoided. All projects must adhere to the principles below:

·      Real: project is proven to have taken place

·      Additional: project must go beyond regulatory requirements, must not be built or able to operate without revenue from the Carbon Credits

·      Measurable: reductions are accurately measured using recognized tools against credible measurement baseline. Adjustment should be factored for uncertainty and leakage

·      Verifiable: reductions are verified by an independent third-party. If complying with ICROA auditor must be accredited in accordance with ICROA approved standards

·      Permanent: the credit is for a permanent emission reduction and removal for 100 years

·      Unique: assurance no double counting with credits issued and retired from an independent registry i.e., one credit for one tonne of CO2 reduced or removed.

High-quality projects are those that demonstrate more comprehensive GHG emission reductions and project assurances than these basic characteristics. Buyers can ensure they are purchasing high-quality offsets by only working with projects that are validated according to the leading voluntary standards. 

Carbon offset projects can generally be divided into two categories: carbon removal or carbon reduction projects. Carbon removal projects examples include Carbon Capture and Storage, forestry (reforestation and afforestation), agriculture land use restoration and management and renewable energy. Carbon reduction projects include energy efficiency and fuel switching. Caron removal projects, in general, are attracting a growing interest which is reflected in the higher, and growing, prices. 

Current Carbon Prices

Today’s average prices for offsets traded in the voluntary carbon market are around US$5/tonne of carbon, rising to about US$8-10/tonne for NBS offsets with high co-benefits. Factors which affect the price include project type, quality, location, standard and volume with large-scale bulk purchases securing lower costs per tonne. Buyers can obtain discounts to the market depending on the delivery and project risks that they are willing to take, whereas sellers typically apply a cost-plus approach or investment rate of return to set their offer prices.

Relative to the compliance market, the price of carbon in the voluntary market is very low. The price of the Compliance markets is driven by emissions targets or fixed by Carbon tax where applicable emitters are obliged to comply or buy and therefore, the price of Carbon more accurately reflects the cost to close the emission abatement gap. On the other hand, the Voluntary market is dominated by low-cost abatement projects where price is largely driven by supply and demand and demand is not compulsory.

COP26 and New Rules on Article 6

The new rules on Article 6 of the Paris Agreement, which were agreed at COP26 in Glasgow apply to the mandatory compliance markets only. The new rules will greatly assist in improving the transparency and reliability of carbon markets, by establishing more stringent rules on the double counting of the international trade of emissions. This will provide reassurance that the offsets are of a high quality and therefore attain greater credibility. In addition, the international governance framework established by the new Article 6 rules will enable countries to trade emissions at international levels and utilise them in their Nationally Determined Contributions (NDCs) commitments. 

While the new rules did not explicitly set up a global carbon market, they have certainly helped in making such an objective a closer reality. Article 6.2 allows a nation that overachieves on its GHG emissions targets to transfer carbon credits to another nation to allow that nation to meet its target. Article 6.4 establishes the new Sustainable Development Mechanism (SDM), the newer version of the Clean Development Mechanism (CDM) and Joint Implementation (JI), which is governed by the United Nations. The CDM allowed emission-reduction projects in developing countries to earn certified emission reduction (CER) credits which can be traded, sold and used by industrialized countries to a meet a part of their emission reduction targets under the Kyoto Protocol. The JI allowed industrialised countries to meet part of their required cuts in greenhouse gas emissions by paying for projects that reduce emissions in other industrialised countries and earning emission reduction units (ERU). The SDM allows private companies or countries to trade emissions reductions. The mechanism can generate carbon credits from specific emissions avoidance or removal activities in the host nation to count toward another nation’s targets.

Conclusions

The recent COP26 agreements on Article 6 will assist in improving the transparency and reliability of compliance carbon markets and marks a substantial step forward in improving confidence. As a result, it is expected that there will be an increase in the number and scope of compliance markets in the future. It is also likely that the voluntary markets will continue to exist in parallel to compliance markets for the time being. Overall carbon pricing is becoming an integral issue to client decision making and there is an emerging investment case for carbon mitigation including Carbon Capture, Utilisation and Storage.