Author: Matthias Taft, CEO, BayWa r.e.
COP26 concluded in November 2021 and generated extensive media commentary, both positive and critical. There is no doubting it was a landmark COP and milestone deals were made. However, it also served to further highlight that reaching a consensus on climate action is incredibly challenging.
The Carbon Markets deal was one I was watching closely. By sending predictable and long-term price signals for emissions, an optimally functioning carbon market can be seen as underpinning to all other climate initiatives. If we get the carbon price right, the rest will follow based on economics and economic incentives.
Did COP26 unlock the potential of the carbon market? Well, I don’t think I need a spoiler alert here if I say, yes, to a significant degree it did. However, there remain some significant concerns.
Activities that mitigate greenhouse gas emissions contribute equally to the fight against climate change wherever they take place in the world. However, the economic cost of reducing emissions varies significantly across different sectors and regions.
Carbon markets turn emission reductions and removals into tradeable assets, known as credits. Provided the market sends an adequate, predictable and long-term price signal for emissions, carbon markets can fulfil a critical role as a cost-effective solution to reduce global greenhouse emissions.
In practice, credits are generated from emission reduction projects, such as a solar or wind farm, or pollution allowances allocated by government cap-and-trade systems, and the credits are then sold to buyers. Buyers are typically governments or private companies who are looking for cost-effective ways to cut emissions or meet a target. Buying credits, priced per tonne of CO2 or other greenhouse gases, is often cheaper than attempting to reduce all emissions within, for example, a national border.
Carbon markets have the capacity to attract new investment in clean innovation and reduce the cost of achieving reduction targets, particularly for less developed countries.
Sounds like a good idea? Well, in principle, it is. And carbon markets of different shapes and sizes already existed around the world, including legally mandated cap-and-trade markets for certain sectors in Europe, the US and China, and an expanding market for voluntary offset credits bought by companies.
But there were various problems, especially within the voluntary market. Different rules and standards, inaccurate accounting and, in some cases, deliberate misrepresentation all contributed to some fundamental flaws. These included instances of double counting, offsets not corresponding to the stated volume of emissions and/or generating funding for projects that would have happened anyway without the carbon market. Essentially, a significant risk for greenwashing was created, either through lack of diligence or through deliberate abuse of the market.
The good news is that COP26 resulted in some significant and positive steps forward.
It implemented Article 6 of the 2015 Paris Agreement and established a new global carbon market with clear, transparent rules for the trading of carbon credits. The market will be supervised by the United Nations (UN) and it is the UN who certifies which carbon projects can generate credits for governments. This, in turn, should then help ensure confidence for the buyers of those credits.
The risk of ‘double counting’ was also addressed and significantly reduced. Previously, there was ambiguity when emissions were reduced in one country, but the corresponding credits sold to another. Which country could be said to be meeting its obligations? Now, that ambiguity is gone and the country hosting the emission reduction project determines if the reductions go towards its own target or are sold as carbon credits to the market, and it must then notify the UN accordingly.
Although voluntary markets are not exclusively regulated by the agreement made at COP26, it will have a significant impact upon them and will lead to changes in regulations. A resulting surge in market activity is therefore anticipated as the new trading mechanism established by the agreement lends transparency, reliability and liquidity to voluntary markets and smaller-scale voluntary offsets.
While figures vary, it is estimated that the value of the new carbon market could reach as much as US$200 billion a year by 2050. The developing world stands to be a potentially significant beneficiary as a 5% share of proceeds (SoP) raised from offsets authorised under Article 6.4 of the agreement will be put into a fund for climate change adaptation in developing countries. Furthermore, it is anticipated investment will be attracted into projects and clean innovations in regions where they are cheaper to develop, with the option that any resulting credits could be traded.
COP26 has achieved some significant and very positive steps forward. But…and isn’t there always one…there are concerns and ‘grey areas’. The decision was made at COP26 to allow the predecessor to carbon credits, certified carbon emissions (CERs), to be traded on this new market if they were issued between 1 January 2013 and 30 December 2020.
While giving certainty for investors, environmentalists are concerned that this will undermine the rigor of the new market. Indeed, Carbon Market Watch went so far as to call it a “travesty” that will dilute the positive impact of the new carbon market. The precise way in which CERs will interact with the new credits needs further clarity.
There is also the whole question of ‘policing’. For example, rules to avoid double counting are of course very welcome, but those rules will need implementing and a key part of that will be scrutiny. If rules can be circumvented, then the credibility and confidence sought will be undermined.
At least some of these issues could be addressed during the first half of 2022 as standards are further developed, including the Taskforce on Scaling Voluntary Carbon Market’s ‘Core Carbon Principles’ that will identify high-quality carbon credits, and supervisory bodies are put in place, such as the Voluntary Carbon Markets Integrity Initiative.
Did COP26 reshape the future of carbon markets? Yes, I believe it did. And while more clarity is needed, I’m optimistic about the future. Carbon markets have a fundamental role to play on the way to net zero, and the decisions made at COP26 represented a significant step forward in unlocking that potential.
However, to succeed from an environmental, social and economic perspective, everyone must have complete confidence in the origination and quality of the carbon credits being generated and traded. As it stands, that confidence isn’t there yet. But there is a strong impetus to see carbon markets succeed, things are moving quickly and I’m hopeful 2022 will bring more clarity.