Tough trade-offs for new international carbon market mechanisms

Several countries’ national determined contributions (NDCs) highlight climate finance as a precondition for the ambitious action needed to achieve development paths compatible with limiting global warming to 1.5°C in 2100. Many hopes have been pinned on new market mechanisms in this context, but the trade-offs demanded by carbon trading schemes continued to be hotly debated at the UNFCCC last week, not least due to their political and economic implications.

Almost USD 110 billion per year are needed by 2030 in order to achieve the renewable energy targets of the NDCs. This calls for a radical shift of energy finance in two key areas: finance streams need to be redirected from fossils fuels to renewables, and the focus of clean energy investments has to move from North America, Europe and China to the countries of the Global South.

In 2017, developing countries received only 11% of renewable energy investment volumes, and they need far more support to implement their own low-carbon transitions. The direct link between international investment and the Paris goals was one of the topics discussed at the long-term finance workshop at SB50 last week.

High hopes for market mechanisms

The hope is that new market mechanisms will foster this shift. A decision on the rules for implementing Article 6 was not reached last year at COP24, but incoming COP25 President Carolina Schmidt from Chile declared last week that she will do her best to ensure an outcome by the end of this year.

At the heart of these controversial debates are differing proposals for the design of market mechanisms. As always, the devil is in the details. The main bone of contention in the Art. 6 negotiations is the question of whether a fresh start would be preferable to adapting the existing structure for earlier market mechanisms established under the Kyoto Protocol, namely, the clean development mechanism (CDM). This debate is focussed on three different trade-offs, which I will outline below.

Old rules for a new game?

Proposals to update the CDM methodology for a new market mechanism are very controversial. Some developing countries argue that it would be wrong to waste the insights gained from applying CDM and costly investments in capacities. Others point to the importance of investor confidence, which might be shaken by an entirely new system. Yet, the CDM experience has been mixed, and some rules have been harshly criticised. Civil society advocates are in favour of stronger social and environmental safeguards and human rights protection. Several countries are demanding more transparency in order to avoid double counting and ensure carbon emission reductions. A fresh start could build new trust in these mechanisms.

A new climate architecture and the danger of ambition gaming

The question of whether new or existing CDM projects could be automatically transitioned or re-registered under a new market mechanism is another contentious issue. The architecture of the international climate regime has changed fundamentally since the CDM was established. Under the Kyoto Protocol, most countries did not have any greenhouse gas reduction targets of their own and could earn money by selling reductions to developed countries, which were the only ones obliged to reduce their emissions.

The main argument for the CDM was cost-effectiveness – the most emission reductions per invested dollar. Industrialised countries were encouraged to first tackle “low-hanging fruits” in other countries. Since the Paris Agreement includes emission targets for all countries, the emphasis is no longer on cost-effectiveness. Indeed, the Paris Agreement advocates using market mechanisms only for additional reductions, which is a laudable goal but extremely difficult to track.

It can be argued that “additionality” only comes into play if market mechanism projects target the “high-hanging fruits” that a country would not have reached on its own. It is this difference that fuels doubts as to whether existing CDM projects should be automatically transferable under the new market mechanism. This trade-off could also have adverse systemic consequences, discouraging countries from raising their domestic climate ambitions in their NDCs, since this might limit “additional” investments under a market mechanism.

Maximum scale or maximum price effect?

The question of the transferability of CDM projects – or existing carbon credits – to a new market mechanism is closely linked to the question of whether countries should aim

a) for maximum impact in scale – with as many climate action projects as possible, or

b) for a maximum price effect in order to establish a global carbon price and encourage more investment in renewable energies. A transferability scenario described by the perspectives climate group foresees lower international carbon price signals over a period of several years.

With lower investment costs, CDM projects might be able to issue billions of credits at marginal costs below one euro per certified emission reduction (CER). Apart from the systemic effects this would have on global carbon markets, others warn of the systemic effects of a successful, but sudden diversion of finance to the countries of the Global South. The spectre of a “climate finance curse” has been raised. Different accounting and transparency rules, combined with a minimum or maximum CDM project transferability might lead to financial inflows of between 3.5% and 14% of a country’s GDP. Especially in the latter case, there could be an increased risk of undesirable side effects fostered by rent seeking and corruption as well as the creation of political dependencies.

Tough choices ahead at COP25

A decision on the design of a new market mechanism is expected at COP25 in Chile in December 2019. The dividing lines in the negotiations are determined by the political economy of the trade-offs outlined above. Thus the question of what a given market design implies in terms of distributing financial risks and costs needs more attention.

The countries that attracted the most CDM projects, namely Brazil and India, are arguing vociferously for full transferability of CDM projects and credits. Least developed countries (LDCs) and many African countries are, on the other hand, scared of being overwhelmed by new bureaucratic requirements and therefore favour the transferability of CDM accounting rules. Others, including the Independent Alliance of Latin America and the Caribbean (AILAC), the Environment Integrity Group (EIG), the EU, Japan, Canada and New Zealand, are arguing for greater transparency in order to avoid double counting. With the most to lose from climate inaction, they have established ambitious domestic climate goals and are hoping for a level global playing field with stronger carbon prices in order not to be disadvantaged by their own climate actions in a global economy. From their perspective, stronger rules and a minimum transferability make sense.

So it is important to keep the political economy of international carbon markets in mind, since a fair distribution of benefits supports the coalition building necessary for any agreement. It remains to be seen whether the new instrument will encourage a reorientation of energy finance and strengthen worldwide climate action, or whether it will at worst lower ambition in the Global South while the Global North seeks an easy way out by purchasing carbon credits for a few cents.