Negotiations on Carbon Credits Expected to Continue at COP27

Alert

21 September 2022

16 min read

Seth Kerschner |

Taylor Pullins |

Ingrid York |

Tom Robinson |

Janina Moutia-Bloom

Greenhouse gas emissions reduction or removal credit transactions allow governments, companies or individuals to purchase credits that are often referred to as "carbon credits" in an effort to mitigate climate change by financing activities that reduce greenhouse gas emissions or remove greenhouse gases from the atmosphere.

Article 6 of the Paris Agreement that was approved by the 21st Conference of the Parties to the United Nations Framework Convention on Climate Change ("UNFCCC") aims to incentivize international cooperation in mitigating climate change through carbon credit market mechanisms. One Article 6 market mechanism proposal concerns greenhouse gas emissions reduction or offset credit trading whereby countries that are Parties to the Paris Agreement could sell unused greenhouse gas emissions reduction or offset units. Another proposal focuses on an international mechanism overseen by a UN body for the issuance of greenhouse gas emissions reduction or offset credits, known as A6.4ERs, which may then be sold to countries, companies or individuals.

Initial rules as to how the Article 6 market mechanisms would function were agreed at the 26th session of the Conference of the Parties to the UNFCCC ("COP26") in Glasgow in November 2021.¹ These rules, collectively known as the 'Article 6 Rulebook', established a procedural framework for the functioning of the market, set out eligibility requirements for credit issuance and resolved a number of the most contentious issues regarding the functioning of the Article 6 market mechanisms, including double-counting, the legacy of the Clean Development Mechanism ("CDM") and the level of credit transaction proceeds to be contributed to a Global Adaptation Fund.

The agreement of the Article 6 Rulebook marked a significant step forward in the establishment of a global carbon credit market, but many issues were left to be dealt with in subsequent negotiations. Many of the outstanding points for negotiation relate to the establishment of the highly complex administrative infrastructure contemplated by Article 6, which is likely to take years to set up. In addition, there remain questions as to the types of activities that may give rise to credits under the Article 6 mechanisms, and the methodologies to be applied. Finally, the level of private sector participation in the credit market established under Article 6 remains to be seen.

While many of these issues were discussed on at the UNFCCC Subsidiary Body meetings in Bonn in June 2022, including progress regarding the establishment of the administrative infrastructure contemplated by Article 6, further negotiations are expected at the 27th session of the Conference of the Parties to the UNFCCC ("COP27") in Sharm El-Sheikh in November 2022. In particular, it is expected that discussions will focus on eligibility criteria for credits under Article 6 (particularly with respect to greenhouse gas emissions avoidance), the methodologies for applying corresponding adjustments, the scope of disclosure obligations, the rules of procedure for the Supervisory Body and the CDM transition period.

Article 6 of the Paris Agreement

To ensure the operationalization of climate action, Article 6 aims to incentivize international cooperation in implementing nationally determined contributions ("NDCs") through various proposed mechanisms. In particular, Articles 6.2 and 6.4 provide the framework for an international greenhouse gas emissions reduction or offset credit market:

Article 6.2 of the Paris Agreement provides a framework for countries that are Parties to the Paris Agreement to enter into agreements to facilitate the transfer of one country's greenhouse gas emissions reductions to another country seeking to use those reductions to achieve their NDCs via "Internationally Transferred Mitigation Outcomes" ("ITMOs"). Countries like Switzerland and Japan have already committed to buying ITMOs from other countries, and to counting them towards their NDCs;
Article 6.4 of the Paris Agreement provides a framework for a multilateral carbon credit market that would be overseen by a body designated by the Conference of the Parties serving as the meeting of the Parties to the Paris Agreement. The oversight body is referred to as the "Supervisory Body". This new Article 6.4 mechanism may eventually resemble some aspects of the CDM market mechanism that operated pursuant to the Kyoto Protocol. Under this new Article 6.4 mechanism, project developers would seek approval from the host country Party in respect of their projects and then make an application to the Supervisory Body. Once approved, the Supervisory Body would issue approved credits, known as A6.4ERs, which may then be sold to countries, companies or individuals.

In line with the incremental approach of the international climate change regime, the Paris Agreement laid out a high-level framework as to the functioning of the global carbon credit market established under Article 6, leaving most of the details as to how the market would work in practice to be agreed at subsequent negotiations.

Glasgow COP26: the Article 6 Rulebook

Following the conclusion of the Paris Agreement in 2015, negotiators struggled for years to agree upon the detailed rules as to how the global carbon credit market established under Article 6 would function. The agreement of initial rules on the functioning of Article 6 at COP26 in Glasgow, known as the 'Article 6 Rulebook', therefore marked a significant breakthrough in the implementation of the Paris Agreement. In particular, significant decisions were made with regard to: (i) the procedural framework for the functioning of the global carbon credit market under Article 6; (ii) the eligibility requirements for projects and activities; (iii) the accounting rules to be applied in respect of NDCs when carbon credits are transferred internationally; (iv) the legacy of the CDM; (v) contributions to the Global Adaptation Fund; and (vi) the protection of peoples and communities negatively affected by carbon crediting projects.

Procedural framework for Article 6 of the Paris Agreement. One of the breakthroughs at Glasgow was the agreement of a framework for the trading of ITMOs between countries under Article 6.2 and the registration and approval of carbon credits under the Article 6.4 mechanism overseen by the UN:
- A framework was agreed for countries to design their own systems for trading ITMOs under Article 6.2 in a way that ensures consistency in global approach and compatibility with UN rules. In particular, agreement was reached as to participation in the mechanism,² and the reporting, recording and tracking of ITMOs transactions;³
- A framework was agreed in respect of the market mechanism established under Article 6.4. In particular, agreement was reached as to the composition of the Supervisory Body,⁴ the requirements for validating projects⁵ and the procedure in relation to the issuance and registration of A6.4ERs.⁶ The rules envisage the participation of the private sector in the global carbon credit market mechanism through the purchase of carbon credits.⁷
Eligibility requirements for projects and activities. In order to be eligible for the mechanisms established under Article 6, projects and activities must satisfy certain basic criteria agreed in the Article 6 Rulebook. In particular, it was agreed at COP26 that projects and activities must satisfy criteria in relation to the following:
- Reduction/removal vs. avoidance. The carbon credit trading mechanisms under Article 6 of the Paris Agreement apply only to credits issued in respect of greenhouse gas emission "reductions and removals" achieved by projects or activities in participating countries. Avoided greenhouse gas emissions, where assumptions are made about how the project could lead to future greenhouse gas emissions being avoided, do not currently qualify as a basis to create ITMOs under Article 6.2 or A6.4ERs under Article 6.4.⁸ This contrasts with the approach in the voluntary carbon credit markets, where standard-setters generally do not preclude the issuance of credits in respect of emissions avoidance;⁹
- Additionality, permanence and social impacts. One of the criticisms levelled at the CDM under the Kyoto Protocol is that credits were issued in respect of greenhouse gas emissions reductions that would have happened anyway, potentially leading to a net increase in global emissions. To address this, the Article 6 Rulebook places emphasis on the requirement of additionality. Specifically, to qualify for a credit, it must be demonstrated that the greenhouse gas emissions reduction or removal would not have occurred in the absence of the funding facilitated by the mechanism, taking into account national policies and legislation. In addition, it must be demonstrated that projects deliver real, measurable and long-term benefits leading to permanent greenhouse gas emission reductions or removals, and must minimize negative environmental and social impacts;
- Conservative baselines. The baseline against which greenhouse gas emission reductions are measured for an activity under Article 6.4 must be set at the average greenhouse gas emission level of the best performing comparable activities in similar circumstances.
Corresponding Adjustments. A detailed set of accounting rules was agreed regarding the adjustments that must be made to NDCs when credits are transferred from one country to another under Article 6 (known as 'corresponding adjustments'):
- Corresponding adjustments must be made to the host country's NDC when it transfers its Article 6 credits internationally to another country, or to a company or individual located in another country. This involves the host country deducting the transferred greenhouse gas emission removals or reductions from its own inventory, so that the buying country, company or individual can count them towards their own targets. Corresponding adjustments are necessary to prevent greenhouse gas emission reductions or removals being double counted, which would undermine international efforts to combat climate change;
- Corresponding adjustments must be applied to carbon credits that have been formally 'authorized' for transfer by the host country Party and that are sold internationally under the Article 6 mechanism. By contrast, there is currently no obligation for corresponding adjustments to be applied when credits that have not been authorized for transfer under Article 6 are sold internationally to private companies on the voluntary carbon credit market. This has led to fears that, unless this ambiguity in the rules is clarified in subsequent negotiations, unregulated private schemes could potentially lead to double counting and greenwashing by companies.
Legacy of the CDM. One of the key issues in the negotiations was the extent to which legacy credits under the CDM (the precursor to the mechanism under Article 6.4 of the Paris Agreement) could continue to be used towards NDCs under the new Article 6 regime:
- It was agreed that certified emission reductions ("CER") under the CDM could be counted towards achievement of NDCs provided that certain conditions are satisfied, including that: (i) temporary and long-term CERs may not be used; (ii) the CDM project or activity was registered on or after January 1, 2013; and (iii) the CER may be used towards the achievement of the first NDC only;
- In addition, it was agreed that ongoing CDM projects could become A6.4ER credits provided that they comply with the rules and methodologies under the Article 6.4 regime and receive approval from the host country Party and Supervisory Body within a transition period lasting until December 31, 2025. In contrast to A6.4ER credits, no corresponding adjustments are required in respect of legacy CER credits when they are transferred internationally, nor must a share of sale proceeds be transferred to the Adaptation Fund.
Adaptation Fund. It was agreed that an equivalent of 5% of the "share of proceeds" from credits under the 6.4 mechanism would be transferred to the Global Adaptation Fund to help developing countries finance their efforts to adapt to climate change. Although this obligation does not extend to Article 6.2, governments are strongly encouraged to do the same with respect to Article 6.2 transactions.
Grievances. It was agreed that an independent body would oversee grievances flagged by peoples and communities negatively affected by projects giving rise to credits under the Article 6.4 mechanism.

Outstanding issues following COP26

The agreement of the Article 6 Rulebook marked a significant step forward in the establishment of a global carbon credit market, but many issues were left to be dealt with in subsequent negotiations.

Administrative infrastructure. The Article 6 Rulebook envisages the creation of a highly complex administrative infrastructure to facilitate the functioning of the Article 6 market mechanisms. In particular, Article 6.4 comprises a centralized project authorization system, a central accounting framework and registry, and an Article 6 database, which could take until 2030 to put in place.¹⁰ Details as to the functioning of this administrative infrastructure were left to be decided in the years following COP26.
Environmental integrity of the global carbon credit market. As noted above, provisions regarding additionality, permanence and methodological approaches were incorporated into the Article 6 Rulebook to address concerns regarding the environmental integrity of credits issued under the CDM. However, the relevant provisions are high-level in detail as compared to the detailed tests proposed in respect of the voluntary carbon credit markets, for example, the draft assessment framework proposed by the Integrity Council for the Voluntary Carbon Market. It seems likely that the rules on additionality, permanence and methodological approaches will need to be supplemented in subsequent negotiations. In addition, as noted above, negotiators left the question of whether "emission avoidance" will qualify for credits under the Article 6 mechanisms to be decided subsequently to COP26.
Incorporation of broader ESG and sustainability standards and safeguards. The rules require that the broader social impact of activities generating credits are taken into account, as well as the principle of sustainable development, but the precise details as to how these broader considerations will be safeguarded have been left to future negotiations. It has been argued that projects based on Article 6 will need to include a wider definition of integrity that embeds wider environmental, social and governance (ESG) standards to avoid environmentally destructive outcomes.¹¹ In addition, details as to the grievance mechanism in respect of peoples and communities negatively affected by activities generating credits are still to be fleshed out.
Interface between international and voluntary carbon credit markets. While the Article 6 Rules expressly provide for the global carbon credit market to be linked to the voluntary market, the extent to which the two markets will interlink remains to be seen:
- The Article 6 rules envisage that governments might authorize the use of credits on the voluntary market as mitigation outcomes authorized to be transferred "for other purposes". If credits are authorized for use on the voluntary market in this way, then the rules provide that corresponding adjustments must be applied in respect of the voluntary market transactions. This would assuage one of the key concerns currently deterring investment in the voluntary carbon credit market, namely double counting. As noted above, however, there is an ambiguity in the rules, which potentially allows 'unauthorized' credits to be sold on the voluntary market, which could lead to double counting and claims of greenwashing. This ambiguity will need to be clarified in subsequent negotiations;
- In addition, the extent to which voluntary carbon credit markets will conform to the new Article 6 rules remains to be seen. If voluntary standards such as the Gold Standard and VCS fall below the standards established in respect of credits issued under the Article 6 mechanisms, then this will likely reduce demand for credits issued on the voluntary market. Likewise, if the standards established in connection with the Article 6 mechanisms fall below those adopted by standard-setters such as Gold Standard and Verra, then this will undermine the credibility of the Article 6 mechanisms. It seems likely that the detailed standards being developed by initiatives such as the Integrity Council for the Voluntary Carbon Market (ICVCM) and the Taskforce on Scaling Voluntary Carbon Markets (TSVCM) to ensure the environmental integrity of the voluntary carbon credit market will influence the standards adopted and applied in respect of the Article 6 mechanisms.
Interface with compliance markets. Under the CDM, compliance markets such as the EU emissions trading system ('EU ETS') were initially linked with the CDM. However, in light of concerns regarding the environmental integrity of credits issued under the CDM, the EU passed legislation preventing the use of CDM credits under the EU ETS. If Article 6 succeeds in remedying the defects of the CDM, then there is a possibility that compliance systems such as the EU ETS will be joined to the market under Article 6.

Bonn Climate Change Conference

Discussions at the Bonn Climate Change Conference built on the progress made in Glasgow, with a view to paving the way for COP27 in Sharm El Sheikh. With regard to Article 6.2, discussions focused on development of rules for the tracking and reporting of ITMOs transactions, as envisaged under the rules agreed in Glasgow. As for Article 6.4, discussions focused on developing the procedures necessary for the implementation of the market mechanism overseen by the Supervisory Body, fee structures under the Article 6.4 mechanism and the CDM credit phase out/transitional period.

COP27: what to expect

With COP27 set to focus on Loss and Damage under Article 8 of the Paris Agreement, it is unlikely that Article 6 will receive the same level of media attention that it did at COP26. Nonetheless, significant progress is expected in relation to Article 6.2 and 6.4.¹² In particular, it is expected that negotiations will focus on the following issues:

Corresponding adjustments. Further guidance will be developed on the methodology for applying corresponding adjustments, including in relation to the averaging of greenhouse gas emissions over a period of time;
Emissions avoidance. There will be further consideration of whether future greenhouse gas emissions avoidance will qualify for credits under the Article 6 mechanisms;
Disclosure of information and confidentiality. There will be negotiations on the scope of information that must be disclosed in relation to ITMOs transactions, and related confidentiality issues;
Technical expert review. Further guidelines will be developed in relation to the technical expert review on compliance with the Article 6.2 reporting framework;
ITMOs registry. Details as to the administrative infrastructure for creating a registry for ITMOs transactions under Article 6.2 will be discussed;
Article 6.4 infrastructure. Elements of the administrative infrastructure under Article 6.4 will be negotiated, including guidance for registries, the Article 6 database and the centralized accounting and reporting platform;
Supervisory Body. The rules of procedure for the Supervisory Body under Article 6.4 will be considered for adoption;
CDM transition period. The CDM credit phase out/transitional period will be subject to additional negotiation;
Fee structures. Fee structures, including registration and issuance fee levels, calculations and exemptions, will be negotiated.

Conclusion

The agreement of the Article 6 Rulebook marked a significant breakthrough. In particular, the Parties to the Paris Agreement agreed a procedural framework for the functioning of the Article 6 market mechanisms, set out eligibility requirements for credit issuance and resolved a number of contentious issues, including in relation to double-counting, the legacy of the CDM and the level of credit transaction proceeds to be contributed to a Global Adaptation Fund. However, many gaps were left to be filled, including further provisions necessary to ensure the environmental integrity of credits, to protect against environmentally or socially destructive outcomes and to clarify the link between the international and the voluntary carbon credit markets. Further progress is expected at COP27 in relation to many of these issues, while others will be subject to negotiation in years ahead.