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Carbon markets in a nutshell

Globally, companies are increasingly making commitments to achieve net-zero carbon emissions. This is often achieved with a regulatory nudge but sometimes out of a voluntary commitment. Carbon credits will be one of the key components of the net-zero toolbox, allowing companies to offset emissions that they are not able to cut. The carbon credit market is expected to expand significantly in the coming years.

There are risks and potential associated with carbon credits. As long as carbon credit programs are correctly managed, they will reduce the global emissions. If carbon credits are created in developing countries, they could help in other sustainable development goals.

Carbon credits can generate these positive outcomes only if the integrity of the credits is ensured. The regulation of carbon markets is sluggish and fragmented. There exist legitimate concerns that some credits could be little more than greenwashing.

Concerned about these issues, the international community took important steps in the Glasgow Climate Change Conference in 2021 to strengthen the credibility of carbon credits. This included new regulations for both standards and procedures for credits (e.g. regarding government approvals; methods for measuring reductions in emissions; in addition to monitoring, reporting, and verification). The rules aim to ensure that carbon credit projects genuinely lead to a measurable reduction in global emissions, and provide transparency to the process. Given the scope and complexity of the issue these rules are complex and difficult to comprehend in the real world.

The new rules don’t necessarily apply to all aspects that are a part of the carbon market. National regulators and private credit certifying organizations are currently deciding how to incorporate the new rules into their work offering a chance for stakeholders to have an impact on how the rules are implemented. Early signs suggest the changes will change the structure of standards both for private and public this year, improving integrity and, eventually it will reduce fragmentation. If successful the rules will allow carbon credits to fulfill their potential to reduce global emissions, and encourage businesses to invest in these instruments as part their net zero pathway, and provide important opportunities to investors to finance credit-generating projects.

In Article 6, the Paris Agreement sets out the basic mandate for carbon credit exchange markets, allowing countries to fulfill their international climate obligations (nationally decided contribution also known as NDC) by purchasing carbon credits. The big development in Glasgow was the long-awaited agreement on the”Paris Rulebook. “Paris Rulebook” that aims to implement this mandate. Here, we present carbon markets as well as”the” Paris Rulebook, and their interplay.

Carbon markets in a simple way. Carbon credits are given in conjunction with an initiative in an “host” country to decrease or remove emissions. Each credit grants the right to emit a particular amount of carbon. Typically, it is 1 ton for each credit. The credits are purchased by a business or a country with voluntary or compliant markets:

In compliance markets, companies buy credits that can be used to satisfy obligations to reduce emissions under (i) international schemes (e.g., by countries to achieve their NDC pursuant to the Paris Agreement or by airline operators to offset their emissions under CO2 offset schemes such as the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA)) or (ii) national schemes (e.g. the use of NDC by businesses to lower their liabilities under a domestic carbon trading program (ETS) or carbon tax). Every regulator decides on the extent carbon credits may be used to fulfill legal requirements and eligibility criteria for credits.
The voluntary carbon market (VCM) businesses purchase carbon credits to help support voluntary claims (e.g. voluntary net-zero pledgesthat are called “offset claims,” or to show support for emission reduction initiatives, which are called “impact assertions”). At present, there is no international standard or guidelines on the carbon credits’ quality that are available for the VCM.

The Paris Rulebook in a nutshell. The Paris Rulebook develops two approaches for the international transfer of carbon credits. The first is there is the Cooperative Approach (Art 6.2) is applicable when two countries exchange carbon credits or, according to some rules, when the country that hosts permits another country or company to use credits, even if it has not signed an agreement with a different country. For instance, as an example of the Cooperative Approach, Switzerland and Peru have signed an agreement that allows Switzerland to fund credit-generating projects in Peru in return for carbon credits that Switzerland will use to achieve its 2030 NDC target. The second is the Sustainable Development Mechanism (SDM) (Art 6.4) establishes an international mechanism to approve credit-generating projectsthat are typically run by investors from private funds.

Each method is covered by it is necessary to follow the Paris Rulebook sets out substantive and procedural rules to guarantee the credibility of the credits — credits that contribute meaningfully in reducing global emissions.

What are the fundamental requirements under the Paris Rulebook?

(1) (1) No double counting The carbon credit can be counted once. The country hosting the credit may in writing consent not to utilize it to fulfill its own NDC and, instead, allow the credit to be used for different carbon mitigation goals (e.g., by another country to fulfill the requirements of its NDC for example, or even by a company that is located in another country). In that case, the credit is not considered by the host nation and the other country or company.

(2) Additionality The credit-generating project has to result in emissions reductions or eliminations which would not have been possible in the absence of the projected income stream from the sale of credits that the project generates. This ensures that the project will have the potential to have an added — impact on decreasing emissions in the host country regardless of the person who is using the credit. In the SDM Approach (Art 6.4) contains additional requirements regarding how to determine the magnitude of emissions reductions.

What are the key difference between these two approaches in the Paris Rulebook?

(1) Approval from the international community: According to the Cooperative Approach (Art 6.2), the credit-generating project is run under the authority of the host country but without the endorsement of an international supervisory body. Even though there is no international body, all parties must adhere to specific disclosure and transparency requirements that require the approval of independent technical experts who can issue (nonbinding) advisory public statements. However, under the SDM Approach (Art 6.4) there are other layers of supervision. A project has to be approved by the country hosting it and a newly created international supervisory body, which relies on recommendations issued by the independent body of verification.

(2) Levies on mandatory use: As per the SDM Approach (Art 6.4), mandatory levies that total 7% are charged on carbon credits. These levies are intended to aid in climate adaptation for developing nations (5 percent of them are credited to the United Nations Framework Convention on Climate Change Adaptation Fund) and also to ensure additionality (2 2 percent are removed). Levies that are mandatory are not enforced in the Cooperative Approach (Art 6.2) but they are “strongly advised.”

The new rules grant the host country a key part in projects that generate credit. They are able to decide (i) the standards that apply (the Cooperative Approach, SDM Approach or an alternative outside the Paris Rulebook) and (ii) whether a carbon credit is used to meet the country’s own NDC in the first instance or not. The way the choices are made will determine the significance and the possible uses of the carbon credit that is resulting.
The effect on carbon markets is the result of Paris Rulebook on carbon markets. Even though the Paris Rulebook provides only limited direct regulation of carbon markets, it is anticipated to have a significant impact on market regulation, boosting the quality of credits in both compliance and voluntary markets. In fact, even though a number of aspects that are part of the Paris Rulebook are still to be formulated, efforts are being made to increase credibility of carbon credit in conformity with. In addition, the most prominent private credit-certifying bodies, like Gold Standard and Verra, are currently upgrading their standards to reflect the requirements to the Paris Rulebook.

The effects from the Paris Rulebook on carbon markets. Even though it is true that the Paris Rulebook provides only limited direct regulation of carbon markets, it’s anticipated to have an impact on market regulation and improve the quality of credits both in compliance and voluntary markets. Although a variety of the provisions of the Paris Rulebook are still to be developed, efforts are being made to boost standards for carbon credits the spirit of it. Notably, leading private credit-certifying bodies, such as Gold Standard and Verra, are in the process of strengthening their standards in light in the Paris Rulebook.

In the VCM, there are no uniform international standards for the credit quality. The situation could be changing. Private initiatives are currently developing guidelines to increase the credibility of credit (e.g. The Voluntary Carbon Markets Integrity Initiative), with the first guidelines anticipated in April. In the meantime, the Paris Rulebook requirements on double-counting transparency, additionality, and double-counting are likely to influence the guidelines. As time goes on, certain national regulators might also regulate credits for purposes of voluntary use for example, by defining quality requirements for credits that are used by a business to satisfy net-zero pledges.

On compliance markets national regulators sometimes allow a company to use credits to meet the majority or even all of its obligations under the carbon tax or ETS. Regulators can now make eligibility criteria more demanding in line with the Paris Rulebook. Other countries with an ETS or carbon tax might be more inclined to allow the use of high-quality credits that meet standards of Paris Rulebook requirements. Although the CORSIA scheme for offsets of emission from aviation international has relatively demanding rules for Carbon credits’ quality, countries could further improve those standards.

The Paris Rulebook is also expected to affect pricing. Credits that conform to the Rulebook will have greater integrity and will likely to be eligible for use in more markets. Therefore, they can expect to be rewarded with an additional price.

There are risks and opportunities for all the stakeholders. It is obvious that the current state of rapidly changing market and regulatory dynamics creates huge opportunities and threats for all parties. Of particular note:

Companies have the option to purchase carbon credits of high quality to fulfill their net zero commitments (either voluntary or maybe mandatory). Increased scrutiny on the integrity of carbon credits from both consumers and regulators underpins the need to carefully choose the correct carbon credits “product.”
Investors and project developers are able to invest inand create projects of high-quality, but with some questions as to how the market and regulatory aspects will unfold (including, e.g., pricing dynamics , and the stability/liquidity of the market as it develops).
Regulators will now have to develop in order to apply the Paris Rulebook and decide whether they want to modify the eligibility criteria under their own local ETS or carbon tax scheme. Internationally, regulators must consider how the rules impact schemes such as CORSIA and whether or not they want to expose different industries (e.g., the shipping industry) to similar schemes.
Host countries can take advantage of the opportunity to receive additional financing for carbon-reducing projects and should carefully consider the best carbon credit strategy to apply to cut emissions as well as to encourage sustainable development.

We stand ready to assist people in navigating this confusing landscape. This may include, for instance providing advice to clients regarding the risks and opportunities with financing their own emission-reducing projects by the generation and selling of carbon credits; buying carbon credits in order to reduce their emissions and meet net zero targets the ability to secure carbon credits in the future considering the rapid-changing regulations as well as working with governments to maximize the benefits and decrease the risks of participating in the carbon market.