Carbon markets – how to stop worrying and COPe with change

Indonesia and Papua New Guinea recently announced they would be pausing the authorisation of new Voluntary Carbon Market (VCM) credits. This has led to broader questions about the quantity and type of future supply in the market. We see this as the start of country level accounting impacting the VCM, as the mechanisms laid out in Article 6 of the Paris Agreement begin to be implemented.

The VCM continues to lay the groundwork for the assetisation of carbon. Article 6 is set to further enable this process at a national level. As both markets grow and intersect, there are two key factors to consider: accounting and value.

At a country level, Nationally Determined Contribution (NDC) accounting means that all carbon is considered domestic by default. A government must give explicit consent for a carbon to be “exported” through a corresponding adjustment and accounted for in another country’s NDC.

This means that currently the VCM is effectively a mechanism for attracting international capital to finance domestic emissions reductions and removals.

To many, it seems counterintuitive for these countries to stop this flow of funding ahead of these frameworks being implemented.

This is where value comes into play; governments will increasingly be looking to capture the value of any assetised carbon, whether that is through the VCM or by allowing it to be correspondingly adjusted.

Article 6: progress report

Last year’s Conference of the Parties (COP) saw a breakthrough in agreeing the role of market mechanisms in achieving the Paris goals through Article 6. However, much of the detail on how this will be implemented in practice remains to be decided or agreed.

Ahead of Article 6 being fully operational, countries should be preparing to make decisions on how they plan to use this mechanism to meet their NDCs. As a simplistic example, a country must:

1. Set its NDC

2. Map out the actions required to achieve it

3. Cost up all of these actions

4. Lay these out on a decarbonisation cost curve to calculate both the average and marginal cost per tonne of meeting their NDC

Theoretically speaking, if a country’s marginal cost of achieving its NDC is higher than the global price of carbon then it should import carbon, and vice versa.

As far as we know, most countries are a long way off thinking about their decarbonisation strategies in this level of detail. There is also no global price of carbon. Article 6 markets are yet to be set up so there is currently no price for correspondingly adjusted carbon.

Indonesia as a case study

Projects based in Indonesia have issued over 90 million credits to date. The highest year was in 2015 when they issued 19 million credits, accounting for c.14% of the total VCM issuance.

If the price of those credits had been $40, the lower end of what the Stiglitz-Stern report estimates is required to meet the Paris commitment, then this would have been equivalent to just under 1% of Indonesian government spending that year.

While not a significant amount for the 16th largest economy in the world, for frontier economies such as Papua New Guinea, the ability to monetise their outperformance of their NDCs has the potential to be transformative.

Indonesia is worried that credits currently being sold through the VCM should instead be available to domestic corporates once their own internal carbon market is launched. Given that the carbon is automatically counted in Indonesia’s NDC, the concern seems more on the value of VCM transactions captured by Indonesia.

Ensuring market continuity

The VCM is entering a transition phase; the policy frameworks agreed through Paris are slowly being implemented. This should not mean the market grinds to a halt in the meantime.

But the private sector is ready to act now. Demand for carbon credits is at record highs as corporates around the world take responsibility for their GHG liabilities. Policy uncertainty cannot be allowed to derail this, rather the market must continue to exist in a world of disparate policy regimes.

This makes ratings even more valuable. Market participants, all across the carbon value chain, need a tool that translates theory into practice.

The assertion that the implementation of this new policy regime means that the current market is invalid is not only wrong but dangerous. Trust in the market is so important for the private sector to play an ever growing role in meeting our global climate targets. Capital cannot be invested in a market that is redefined or re-litigated every few years.

Indonesia is a very interesting case study - we find peatland credits to be effective due to poor policy implementation. Despite a moratorium on peatland land-use change since 2011 (transitioned to permanent policy in only 2019), there is ample evidence that this has not been effectively implemented in practice.

In addition, estimates of the cost of peatland restoration in Indonesia indicate an insufficient allocation of both national and donor-country finance, currently enough to cover only 5% of peatland area. This is a good example of where private sector capital is intervening to finance domestic policy failure.

The Indonesian government's recent announcement means any new vintages that are authorised to be issued at a later date will require an assessment of their effectiveness in the context of any new policy regime. But the existing credits in the market continue to be a source of high quality carbon.

The beginnings of a sovereign carbon framework

The birth of sovereign carbon accounting gives rise to the need to assess carbon at both a project and country level. Variance in the quality of country level accounting will mean ratings are just as important for carbon at a country level as they are at a project level.

The BeZero Carbon Rating already takes account of country level risks in our ratings framework through metrics like policy effectiveness and property rights. We assess the availability and quality of information, both at a project and a country level, to understand the carbon efficacy of issued credits.

As new market structures, mechanisms and instruments emerge, BeZero will continue to provide market products and intelligence that bring clarity to every decision made.

This article originally appeared in Carbon Pulse on 31/05/22, it can be found here.