What does Article 6 mean for the voluntary carbon markets ahead of COP26?

LONDON(ICIS)–Participants of the voluntary carbon market (VCM) will be watching developments closely as policymakers gather at the 26th UN Climate Conference (COP26), in Glasgow in November.

At the heart of the conference will be the ambition to achieve greater commitment towards drastically reducing global greenhouse emissions this decade.

The focus of the VCM will centre on the role of international carbon markets in achieving this ambition through implementation of Article 6 of the Paris Agreement.

Article 6, adopted at COP21 in December 2015 but not yet agreed, formed a framework for international action to tackle climate change by mobilising cross-border cooperation through international carbon markets.

Article 6 comprises three approaches – or mechanisms – for cooperation between parties as summarised below:

1. Article 6.2; transfer of “mitigation outcomes” from one country to another by providing a framework for international cooperation. In simple terms allowing a country that has ‘overachieved’ against its climate pledge to transfer to a country that has ‘underachieved’
2. Article 6.4; establishing a new centralised international carbon market which is governed by the UN. This is set to build on the older clean development mechanism (CDM) known as the sustainable development mechanism
3. Article 6.8; establishing a programme for “non-market approaches” in achieving their Nationally Determined Contributions (NDCs)

However, parties have so far failed to agree upon the implementation of this framework.

Implementation of Article 6 will have profound implications on the supply and demand landscape of the VCM. At present the market is dominated by the private sector looking to reduce its carbon footprint.

Dr Raul Rosales, research fellow at Imperial College Business School says that “the uncertainty about implementing Article 6 will hold back the development of carbon finance markets at the required speed and slow down supply.”

On 25 October, the UN released an update to the synthesis of climate action plans as communicated in countries’ NDCs. The report highlighted that while the slew of new national climate action plans “can be effective in reducing greenhouse gas (GHG) emissions over time,” they will still lead to a 16% increase in global GHG emissions in 2030 compared with 2010.

The report states that this is likely to lead to a temperature rise of about 2.7°C by the end of the century, therefore highlighting the need for urgent, more ambitious targets by parties.

The UN report also emphasised that many of the parties aim to use Article 6 as one of the means to achieve emission reduction targets. The World Bank agreed saying, “accelerating the establishment of global carbon markets is going to be critical to meeting these mitigation goals.”

This is even more important as many countries intend to use international carbon markets for achieving to achieve their updated and higher ambition NDCs and net zero targets by 2050 or 2060.

“We believe that the resolution of Article 6 would eventually lead to a more significant role for integrated market mechanisms to mitigate the impact of climate risks and enhance financial flows and investments,” Dr Rosales added.

According to Hugh Salway, head of environmental markets at Gold Standard, “from a VCM perspective, three things matter [at COP26]: that a deal is done, that it provides solid foundations without loopholes, and that it provides a route for countries to account robustly for voluntary market activity within their territory. Achieving this seems possible: much of the technical work is done, and what is needed now is political will.”

Alignment with Article 6 will also help achieve clarity on the supply and demand dynamics of the carbon emissions reductions. According to The World Bank, this can be achieved through “clear rules, procedures, and guidance on accounting of emissions; scope and type of emissions reduction units; and, how market transactions facilitate increased finance flows to countries in need (share of proceeds).”

What is contested and why does it matter?

Article 6.2 is perhaps the most debated of the above three mechanisms that make up Article 6 in relation to VCMs.

The main issue surrounding international transfer of credits is the issue of double counting. For example, a credit produced in country A is used by country B against its NDC only if country A does not also use the same credit against its own NDC. These transferred credits are referred to as internationally transferred mitigation outcomes (ITMOs).

The proposed accounting framework looks to solve this issue through corresponding adjustment (CAs), which is the adjustment of accounting once the transfer has been made in both the host country and the country taking the credits.

However, not everyone agrees on the proposed framework, with uncertainty surrounding the use of credits in compliance (NDC) and voluntary (private sector) uses. Some participants believe that governments and the private sector should both be able to claim against the same offset, while others argue this is green washing and reduces the tangible benefits against climate action through use of credits.

Crediting claims are split between compensatory or non-compensatory claims. Some argue that as compensatory claims are offsetting, they should not be used by the host country as well as the claimant. In comparison non-compensatory claims may see companies look to reduce emissions outside of their value chain and not to claim emissions offsetting of their own. In this instance the host country should be able to claim the credit against its own NDC.

According to Gold Standard, what makes agreements on the above important is if, as seems likely, Article 6.2 “will also allow countries to authorise and account for mitigation outcomes for purposes other than achieving NDCs, including voluntary use by private actors.” This introduces a new model for market activity against the largely private sector dominated drivers presently in action.

If there is no alignment with Article 6, one of the key risks is potential bifurcation of the market between private and government sectors, which could hinder the development of the VCM.

The World Bank argues that convergence between compliance and voluntary markets is essential as the corporate sector has been so active in setting net zero targets and making plans to utilize carbon assets from international carbon markets. Convergence will help avoid market fragmentation and confusion over different rules for different markets.

“We’re seeing growing recognition that credible carbon neutrality claims rely on credits going beyond the ambition of the host country’s NDC, to which the buyer has a unique claim,” added Salway.

In fact, 12 major banks made a similar claim earlier this week under the Sustainable Markets Initiative (FSTF). According to FSTF, “strong demand for high-quality carbon credits is expected to increase financing available to technology and nature-based projects.”

The report highlighted that a company’s pathway to achieving net-zero should be able to include additional actions or investments that mitigate emissions beyond its value chain. In other words, CAs provide the clearest route in closing the emissions gap between current NDC ambition and what the science says is needed.

“We hope that any Article 6 outcome will give governments the option to apply corresponding adjustments for credits used in the voluntary carbon market, to make this possible in the near future and enable companies to narrow the emissions gap to 1.5C,” Salway says.

What is the likelihood of a decision?

According to Verra, the technicalities of what needs to be addressed in the Article 6 rules are now well understood, as are countries’ positions in terms of their NDCs. What remains is the final adoptions of a firm set of international rules or country-to-country cooperation under Article 6 of the Paris Agreement.

Salway argues that “the cycle of COP negotiations, with short bursts of negotiations every six months, is not well-suited to the task of developing complex rules for market design and accounting. But I hope that with three years of extra time, negotiators will be able to finalise the details that could not be agreed two years ago.”

The recent UN NDC synthesis report is likely to speed this up as is the need to facilitate the call for action on more ambitious targets. Many in the VCM space argue that without a proper international market, many mitigation pledges will not be met, or will be extremely costly.

Dr Rosales adds that the issue is that there is “plenty of politics around this, a lack of knowledge about climate risks, and a lack of understanding about voluntary carbon markets and the opportunity.”

Finalising the requirements to put Article 6 into operation will help in developing a common understanding of requirements for the VCM and the desired level of standardisation across market players, and most importantly, provide clarity on what role host countries will play to support the market development.

What happens if Article 6 is not implemented?

In absence of Article 6 alignment, it is still likely that the market will continue to operate and grow as it has done recently, dominated by private sector ambition.

Bilateral trading arrangements between parties already exist as seen with the agreement between Switzerland, Peru and Ghana, signed in late 2020. There are also many initiatives operating under a pilot Article 6 framework basis, that would eventually generate ITMOs once Article 6 is put into action.

These pilot projects look to set up capacity and infrastructure although demand for transactions operating under such projects remains unclear.

“Regardless of the result of discussions at COP26, VCMs will move ahead driven by private sector initiative and capital markets,” Dr Rosales says. However, he adds that “this will not occur at the required speed demanded by the market.”

There are also mechanisms created by independent standards such as Gold Standard and Verra. Both proposed approaches look to include procedures for corresponding adjustments to avoid the double claiming issue which could be used in compliance markets.

Such an example is the Joint Crediting Mechanism operated by the Ministry of Environment of Japan, which facilitates multilateral partnerships among JCM partner countries and the Japanese private sector.

The increased standardisation of transactions is also expected to continue. Exchange-traded derivatives are growing in popularity including the CBL Global Emission Offset (GEO) on CME, with an increasing diversity of buyers, intermediaries and brokers entering the market.

Chetan Patel is Lead Reporter for Renewable Energy Markets at ICIS. He can be reached at Chetan.Patel@icis.com.