Much of the implementation guidelines of the Paris Agreement have been finalised. However, negotiators at COP26 still need to resolve a few outstanding issues, including devising the implementation guidelines for Article 6. Article 6 of the Paris Agreement permits voluntary cooperation between Parties to allow for higher ambition in mitigation and adaptation actions through cooperative approaches. These include the transfer of mitigation outcomes under paragraph 2, a market mechanism for mitigation under paragraph 4, and non-market approaches for mitigation, adaptation, and sustainable development under paragraphs 8 and 9.
Negotiations associated with the Article 6.4 mechanism include the issue of a possible transition of the Clean Development Mechanism (CDM) from the Kyoto Protocol regime to the Article 6.4 mechanism. A possible CDM transition encompasses the transfer of activities (projects and programmes of activities), carbon credits (known as certified emission reductions or CERs), methodologies for setting baselines and monitoring emissions, and infrastructure and institutional arrangements to the Article 6.4 mechanism. Out of these four facets of a possible CDM transition, the transition of CERs remains the most contentious issue, stemming from contrasting views among Parties, on the path forward. Taking cognisance of the positions of various Parties, this paper objectively evaluates the viability of a possible transition of CERs with a view to suggesting potential solutions to advance negotiations.
- CDM activities, set up primarily in large emerging economies, are left with a large stock of unutilised CERs as demand from Annex B countries (which made emissions reduction commitments under the Kyoto Protocol) dried up and prices fell by nearly 95 per cent after 2011.
- Some Parties, particularly Brazil, India, and China, support the full transition of CERs from the perspective of preserving the mitigation contribution of existing investments, thereby maintaining private sector confidence in UNFCCC market mechanisms.
- Other Parties, that include several developed countries, the Alliance of Small Island States (AOSIS), the Independent Alliance of Latin American and Caribbean States (AILAC), the Least Developed Countries (LDCs), and the African Group of Negotiators (AGN), have expressed concerns over a possible transition of CERs. These include:
- Concerns that the transition of pre-2020 units (units associated with historical emissions reductions up to December 31, 2020) could disincentivise new emissions mitigation activities in the Nationally Determined Contributions (NDCs) implementation periods as Parties could opt to offset their emissions with pre-2020 units;
- Concerns over the environmental integrity of mitigation actions stemming from a possible double counting of emissions reductions: pre-2020 units being used for offsetting post-2020 emissions with the underlying emissions reductions already factored into host countries’ progress towards their NDCs;
- Concerns over the additionality and environmental integrity of some CDM activities; and
- Concerns that permitting the eligibility of pre-2020 CERs would flood the NDC-related compliance carbon markets and depress prices of carbon credits.
- Taking cognisance of the positions of various parties, this paper evaluates the viability of a possible transition of pre-2020 units by assessing the likely balance of demand and supply. The analysis indicates that a total supply of 4.46 billion CERs could materialise in the event of a full transition of units. Out of these units, the total unsold CERs requesting transition could total 3.91 billion. This estimated supply of unsold CERs comprises two components:
- Latent CER issuance totalling 3.51 billion, which accounts for possible retrospective issuance by registered CDM activities which have monitored their emissions mitigation but have not been issued CERs.
- Available CERs totalling 0.95 billion, which represent the stock of unutilised CERs (those that have not been retired or cancelled) out of those actually issued. Out of these units, only 0.40 billion CERs in the form of holdings in the CDM registry represent unsold CERs (for which no payment has been made to the developer).
- The large stock of unutilised CERs and latent issuances stems from subdued demand (and consequently low CER prices) associated with existing sources in the pre-2020 regime. These include demand for offsets from carbon pricing initiatives such as emissions trading schemes and carbon taxes instituted by governments, demand from countries for compliance with Kyoto Protocol obligations (outside carbon pricing initiatives), demand for offsets from the International Civil Aviation Organisation’s (ICAO) Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) pilot phase, and demand from voluntary markets.
- Primary demand from these sources taken together stood at 13 million CERs in 2020, representing a sharp decline from 50 million in 2015. Demand for CERs has remained limited due to qualitative restrictions on eligibility based on vintage and geography imposed by these markets.
- In the event of a CERs transition, pre-2020 units could be directly purchased by Parties towards the fulfilment of their NDC commitments. A gap equivalent to 21.4 GtCO2 over 2021-2030 exists between global current policy emissions trajectories and those corresponding to unconditional NDC commitments. As of July 2021, many Parties continue to express reservations about permitting the utilisation of pre-2020 CERs towards NDC commitments. If these positions remain unchanged, it is improbable that the consensus necessary for permitting the use of pre-2020 CERs towards NDCs would materialise at COP26.
- If the CERs transition cannot be accomplished, CORSIA and voluntary markets represent possible sources of demand for pre-2020 units outside the Paris Agreement. Eligibility conditions for CORSIA first phase and second phase, which collectively represent demand for offsets equivalent to 2.59 GtCO2 over 2024-2035 (contingent on a recovery in aviation traffic post the COVID-19 pandemic), have not yet been determined. However, if vintage-related eligibility restrictions similar to the pilot phase (2021- 2023) are imposed, CORSIA is unlikely to represent a large source of demand for pre-2020 units. The annual demand from voluntary markets stood at around 0.1 GtCO2 in 2019 with demand in 2020 expected to remain at similar levels. Even without considering potential eligibility restrictions, the overall size of these markets is inadequate for absorbing pre-2020 units.
- Given the current demand-supply equation, a full transition of pre-2020 CERs seems to be an untenable proposition and sources of demand outside the Paris Agreement also seem to be inadequate to absorb the potential supply. Various observers have suggested a limited transition of CERs based upon geographic, vintage, or sectoral restrictions as a compromise solution. While such solutions could rationalise the potential supply, these appear arbitrary from the perspective of developers and could undermine private sector confidence in UNFCCC market mechanisms.
- Given the urgency of the need to accelerate mitigation action, as highlighted by the Intergovernmental Panel on Climate Change’s (IPCC’s) Sixth Assessment Report, Parties must take decisive action at COP26 to usher in the Article 6.4 mechanism in order to facilitate more ambitious global mitigation.
In case a consensus on the CERs transition remains elusive, the following proposed compromise could help to break the existing deadlock at negotiations.
- If Parties proposing the carry-over of CERs were to withdraw their proposal in exchange for compensation offered to the associated CDM activities, it could set the stage for the implementation of the Article 6.4 mechanism from a blank slate, that is, with a viable balance of demand and supply. Such a scenario would also address concerns associated with the environmental integrity of post-2020 mitigation action.
- In exchange for a compromise that results in no transition of CERs but achieves agreement on the Article 6.4 mechanism, this paper proposes that the Conference of the Parties serving as the Meeting of the Parties to the Kyoto Protocol (CMP), the highest decision-making body of the Kyoto Protocol, initiate deliberations on the constitution of a compensation fund for developers of CDM activities associated with pre- 2020 CERs. This paper proposes that the Conference of Parties (COP) guarantee the constitution and capitalisation of the compensation fund by acknowledging proceedings associated with the fund in the outcome text of COP26. This would ensure that discussions may be taken up at future climate summits in case an agreement on such a fund cannot be reached in Glasgow.
- This paper proposes that the fund compensate developers of CDM activities that would otherwise remain uncompensated for their emissions mitigation achievements if CERs were to be excluded from the Article 6.4 mechanism. Such an exclusion would total 3.91 billion CERs, representing latent issuances and the unsold portion of issued CERs. In order to assuage any concerns over end use of proceeds from the fund, certain conditionalities could be applied on end use. For example, developers may be required to restrict deployment of proceeds towards either supporting existing CDM activities or investing in new mitigation activities. If proceeds are used for making new investments in mitigation activities, these should be consistent with the standards of environmental integrity to be determined for the Article 6.4 mechanism. Developers could also be required to monitor and report on the end use of proceeds.
- Since current prices of USD 0.20-0.30 per CER are distorted due to the near absence of demand stemming from limited commitment to the Kyoto Protocol by developed countries, these do not reflect fair prices for determining the compensation amount. Developers should not be penalised for concerns over additionality or environmental integrity translating into low demand since the registration of these activities was approved by the CDM Executive Board (EB) itself. This paper proposes two alternatives to arrive at fair compensation.
- The first option is using global weighted average prices of carbon offsets across voluntary crediting mechanisms to determine the compensation price. Based on market data sourced from the World Bank, these currently stand at around USD 3 per unit. At this level of pricing, the estimated size of the proposed compensation fund is USD 11.7 billion.
- The second option involves using a reverse auction mechanism for the discovery of compensation prices. In this mechanism, developers holding CERs can bid for a price from a compensation fund. Such a mechanism could potentially result in the rationalisation of the compensation price and the compensation amount needed.
- While the paper recommends two alternative means of determining the compensation amount, it proposes that the fund be capitalised by developed countries (the COP in coordination with the CMA and the CMP could designate to a subsidiary body the task of identifying the specific countries that capitalise the compensation fund) for the following reasons:
- A compromise requires parties on both sides of negotiations to work together and make concessions— if developing countries withdraw their proposal on the CERs transition, developed countries should reciprocate by agreeing to capitalise a compensation fund for developers of the associated activities.
- Inadequate pre-2020 climate mitigation by some developed countries has reduced the carbon space for developing countries. The envisioned voluntary purchase and cancellation of CERs by developed countries could help them demonstrate their commitment to the success of the UNFCCC process. At the same time, this could spur emerging economies to adopt more ambitious future decarbonisation trajectories.
- Such a compromise could potentially settle the debate over the CERs transition and usher in a viable Article 6.4 market mechanism.