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Are carbon markets a solid mechanism to ensure the Paris Agreement’s success?

The Paris Agreement rulebook has yet to be finalized in Glasgow. COP26 will have to ensure negotiations deliver on rules that will operationalize market and non-market mechanisms for the mitigation of GHG emissions, namely finalize Article 6 of the Paris Agreement.

The use of carbon markets as a mechanism to reduce/compensate Greenhouse Gas (Ghg) emissions has been included by countries as an instrument as a measure to curb their emissions in their NDCs.

Carbon markets are at the heart of the carbon neutrality concept as achieving net-zero carbon dioxide emissions can be done through removal or offsetting. Nonetheless, this topic is not new and reflects decisions and ideas that carry weight from the past, namely whether to allow “carryover” of carbon credits generated under the Kyoto Protocol and how to avoid “double counting” of emissions reductions.

The Kyoto Protocol signed in 1997, allowed the creation of “carbon credit” markets, which can be divided in two types: i) cap and trade or regional regulated markets such as the one in place in Europe (ETS) since 2005; and ii) voluntary markets for carbon credits generated through mitigation projects which allow compensation via purchases / sales negotiated over-the-counter.

In this last category, there are three sub-markets:

i) markets regulated by international mechanisms of the United Nations under the Kyoto protocol: Clean Development Mechanism; Joint Implementation;

ii) voluntary carbon offsets markets that are used as part of emission reduction strategies that call for standard “gold standard” or “checked carbon standard” certifications; and

iii) regional, national and sub-national credit markets which are administered by regional and national authorities.

For the ETS type market, the operation is as follows: in a region, a target for reducing greenhouse gas emissions is set. This objective is then broken down over industrial units in the geographical area considered, which receive an allocation of annual emissions over a period of several years. These quotas can be allocated either free of charge, on a historical basis through negotiation, or through auctions.

Subsequently, to reach the level of the emission quota which represents an effort to reduce emissions in comparison with a reference situation, the operator of the industrial unit then has two choices: investing effectively in measures that allow it to physically reduce its emissions or buy carbon credits on the markets from players who have succeeded in reducing their emissions below their quota. Latin America has, so far, limited experience in such market.

In 2020, Mexico launched the first initiative in LAC for full compliance in 2023 and will cover 37% of national emissions are going to be covered before a full and more global scheme is established. Colombia is also aiming to complete the design of its own carbon market, and Chile passed a reform of the country’s carbon tax in 2021.

Nonetheless, negotiations and agreements at an international level will have to be preceded and followed up by strong national and local efforts. Carbon markets require data, transparent and solid MRV mechanisms and bold governance to ensure their credibility. Lessons learned from methodologies and tools from the Kyoto Agreement. These include the definition of the baseline of calculation (what is the situation without the implementation of the project) and how to demonstrate the additionally of the project (it must be established that without the contribution of income linked to the sale of carbon credits, the project will not be implemented).

To date, the carbon credit mechanisms under the Kyoto Protocol have generated more than 70% of the carbon credits over the past 30 years and mostly concerned emission reductions of industrial greenhouse gases (HFC, SF6, N2O, etc.), renewable energy, and reduction of methane emissions. It should be noted that for the most part, these are projects in which emissions are reduced compared to a prospective baseline scenario where no action allowing the reduction of greenhouse gas emissions takes place.

The negotiations should also take into account the dynamics behind the different schemes, for example, the voluntary offset market is much more dynamic: it represented only 15% of the carbon credit in 2015; and now represents almost 70% of carbon credits generated in 2019, mostly used by private entities. Its turnover has grown significantly, and we could expect that it will continue to do so in the future, with a real risk on the evolution of the quality of its very specific projects and not always easy to implement. In 2018, Latin America with Peru was leading this market. Furthermore, a recent study finds Latin American to hold the main world potential to generate forest-based carbon credit up to 900 t CO2 eq/year with Brazil and Columbia the most active countries.

As countries work on their Long-Term Strategies it is important to remind ourselves a conclusion of the 2020 IETA Report “The simple message in both scenarios: if Article 6 is allowed to work efficiently, it could lower costs and make targets more affordable” and consider all instruments when looking towards achieving a carbon-neutral development, including carbon taxation.

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