Carbon markets under the Paris Agreement: how can environmental integrity be ensured?

Abstract

The 2015 Paris Agreement allows countries to use international carbon market mechanisms to achieve their nationally determined contributions (NDCs). Carbon markets provide flexibility where and when emissions are reduced and could thereby lower the cost of mitigating climate change. This can help countries to enhance the ambition of their NDCs. If not designed and implemented robustly, however, carbon markets could lead to higher emissions and increase the cost of mitigating climate change. Ensuring environmental integrity of carbon market mechanisms is thus an important prerequisite for achieving their objectives. This thesis assesses how the environmental integrity of international carbon market mechanisms can be ensured in the new context of the Paris Agreement in which all countries have NDCs. The thesis assesses how environmental integrity could be defined – here it is assumed to be ensured if the engagement in international transfers of carbon market units leads to the same or lower aggregated global emissions –, what the risks for undermining environmental integrity are, what approaches could be used to address these risks, and what this means for the future role of international carbon market mechanisms. The thesis identifies four factors that influence environmental integrity (Chapter 2): The accounting for international transfers of carbon market units; The quality of units generated (i.e. whether the market mechanism ensures that the issuance or transfer of units leads to emission reductions in the transferring country); The ambition and scope of the mitigation target of the transferring country; and Incentives or disincentives for future mitigation action, such as possible disincentives for transferring countries to define future mitigation targets less ambitiously or more narrowly in order to sell more units. Robust accounting is a key prerequisite for ensuring environmental integrity. The diverse scope, metrics, types and timeframe of NDC targets is an important challenge, in particular for avoiding double counting and for ensuring that the accounting for carbon markets units is representative for the mitigation efforts by countries over time. The thesis identifies three ways in which double counting can occur: through double issuance (e.g. by issuing units from the same project under two crediting programs), through double claiming of the same emission reductions by the country where the emission reductions occur and the entity using the carbon market units, and through double use of carbon market units. A key finding is that double counting can also occur in rather indirect ways which can be challenging to identify. Effectively avoiding double counting mainly requires rules for accounting of unit transfers, appropriate design of carbon market mechanisms, and consistent tracking and reporting of units (Chapter 3). Unit quality can, in theory, be ensured through appropriate design of carbon market mechanisms; in practice, existing mechanisms face considerable challenges in ensuring unit quality. The thesis assesses an interesting real-world example of how carbon markets can create perverse incentives and thereby undermine unit quality. It shows that projects abating HFC-23 and SF6 waste gas emissions under the Kyoto Protocol’s Joint Implementation mechanism increased waste gas generation to unprecedented levels as a means to increase credit revenues. Due to these perverse incentives, about two third of the issued credits do not represent actual emission reductions. This case study provides important lessons for carbon markets under the Paris Agreement because Joint Implementation was implemented in countries that had mitigation targets, and thus in a similar context as for countries with NDC targets (Chapter 4). Unit quality is also an important matter for the new Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) adopted by the International Civil Aviation Organization. The scheme requires airline operators to purchase carbon market units to offset the increase in emissions above 2020 levels. It could constitute the single largest demand for carbon market units after 2020. The thesis shows that environmental integrity would be undermined if the scheme allows the unlimited use of credits from already implemented projects. While additionality and the quantification of emission reductions are, in principle, key considerations for unit quality for crediting mechanisms, the greenhouse gas (GHG) emissions impact from using credits from already implemented projects is more complex. If the supply of credits considerably exceeds demand, a key consideration for the global GHG emissions impact is whether already implemented projects would continue to reduce GHG emissions even without credit revenues, or whether they are ‘vulnerable’ to discontinuing GHG abatement. A detailed assessment of the status and operating conditions of projects under the Clean Development Mechanism, and their marginal costs of supplying credits, shows that most projects would continue GHG abatement even if they cannot sell credits. If CORSIA allows airline operators the unlimited use of offset credits from these projects, this will not only undermine its environmental objectives but also lead to continued low carbon prices, and thus neither offer incentives for new investments nor lead to any significant revenues for already implemented projects. The thesis recommends limiting eligibility under CORSIA to new or ‘vulnerable’ projects (Chapter 5). Unit quality is also a key consideration when linking emissions trading systems (ETSs). As linking of ETSs faces several practical and political challenges and risks, including with regard to whether allowances have ‘quality’ and whether linking provides incentives or disincentives to enhance the ambition of caps, policy-makers are considering also restricted forms of linking ETSs. The thesis uses a simple economic model and three criteria – abatement outcome, economic implications, and feasibility – to assess three different options for implementing restricted linking of ETSs: quotas, exchange rates, or discount rates. The analysis shows that quotas can enhance cost-effectiveness relative to no linking and allow policy-makers to retain control on the extent of unit flows. Exchange rates could enhance abatement and economic benefits or have unintended adverse implications for cost-effectiveness and total abatement, depending on how rates are set. Due to information asymmetries between the regulated entities and policy-makers setting the exchange rate, and uncertainties about future developments, setting exchange rates in a manner that avoids such unintended consequences could prove difficult. Discount rates, in contrast, can ensure that both cost-effectiveness and total abatement are enhanced. The thesis recommends the consideration of quotas or discount rates, but to refrain from using exchange rates, due to the environmental integrity risks (Chapter 6). The varying scope and ambition of current NDC targets, and possible disincentives to broaden their scope and enhance their ambition, could be addressed by facilitating the adoption of ambitious and economy-wide mitigation targets and by preventing the transfer of carbon market units in situations of high environmental integrity risks. This latter approach could be implemented through eligibility criteria or limits on the generation, transfer or use of carbon market units. Limits could in particular address the risk that some countries have mitigation targets that correspond to higher levels of emissions than independent projections of their likely emissions. If such ‘hot air’ can be transferred to other countries, it could increase aggregated emissions and create a perverse incentive for countries not to enhance the ambition of future mitigation targets. The thesis proposes a typology for such limits, explores key design options, and tests different types of limits in the context of fifteen countries. The analysis indicates that limits to international transfers could, if designed appropriately, prevent most of the hot air contained in current mitigation targets from being transferred, but also involve trade-offs between different policy objectives (Chapter 7). The thesis concludes by discussing how four strategies to mitigate environmental integrity risks – robust accounting, ensuring unit quality, facilitating economy-wide and ambitious mitigation targets, and restricting international transfers – could be implemented under the Paris Agreement and CORSIA (see Figure S-1). Crediting mechanisms pose higher risks for environmental integrity than linking of ETSs and should therefore have a limited role in the future. International oversight can reduce the risks to environmental integrity to some extent. Acquiring countries could also reduce risks by only acquiring units from countries that also have ambitious NDC targets. Overall, policy-makers should not regard carbon market approaches as the one and only ‘silver-bullet’ to mitigating climate change but carefully assess what policy instrument or mix of instruments is best suited achieve and balance different policy objectives, in particular in light of the rapid transition that is necessary to achieve the goals of the Paris Agreement (Chapter 8).