ANALYSIS: What next for international carbon trading under Article 6 of the Paris Agreement?

21 Dec 2023

Quantum Commodity Intelligence – A much-anticipated expansion of international trading of carbon credits under the Paris Agreement will next year have to navigate around the failure to get agreement on key texts at COP28, particularly for project-based, rules-reliant Article 6.4. The bilateral Article 6.2 market will be broadly unaffected, but will still be watchful of potential risks posed by future rules to be agreed at UN level.

As thousands of representatives from various areas of the carbon market returned home from Dubai, multiple post-COP28 debriefings underlined the view that the voluntary carbon market (VCM) will be emboldened by various integrity initiatives and high-level political backing would dominate in terms of volume next year and most of the momentum on deals.

The political imperative of using Article 6.2 (A6.2) for national compliance will remain strong with the most active players on the buy-side, such as Singapore, South Korea, Sweden and Switzerland, likely to broaden their reach over the next 12 months and more host countries issuing 'letters of authorisation' (LoAs), which are regarded as a key step in firming up deals.

“[The progress of] 6.2 is definitely straightforward, full steam ahead. We have what we need,” said Lisa DeMarco, chief executive of Toronto-based law firm Resilient told a post-COP webinar hosted by carbon trading lobby IETA.

But dealmaking on A6.2 is not without potential complications, various observers at COP said as the dust settled over a messy outcome from the UN talks on markets.
“Some of the positions [in Article 6.2 negotiations] taken under word guise of 'environmental integrity' are likely to have a negative impact on consolidation” in this segment of the talks at future COPs, DiMarco said, pointing to trenchant positions taken by negotiators.

The failure to agree a final text on Article 6.2 centred on several disagreements on fundamentals. These included such as how to define “co-operative approaches” – effectively the scope and scale of bilateral agreements – and the level of oversight that should apply to A6.2, which in the eyes of the US is supposed to be a highly-flexible foil to the more centralised project-based A6.4 market.

Negotiators far apart

Negotiators' positions were also far apart on the role of registries, including whether these should be linked with those for A6.4, to what extent credits issued under 6.2 could be revoked (cancelled) and the level of confidentiality that should apply to bilateral deals.

Because the A6.2 text failed to find agreement on these issues, existing contracts and those negotiated ahead of the next COP in Baku, Azerbaijan, next November are subject to the default position, which is the status quo of what was agreed at Glasgow (COP26) and Sharm el-Sheikh (COP27), said Lev Gantly, a partner at Dublin-based law firm Philip Lee.

“You can either interpret a cooperative approach strictly and have two parties, or you can continue doing what some countries like Rwanda and Malawi have done recently,” he said, referring to these countries issuing LoAs for projects on their territories.

Bilateral LoAs had likely been issued in expectation that the UN negotiating parties will eventually clarify that for other national mitigation purposes. For instance, LoAs can be issued in order to enable the functioning of Corsia – the UN's market-based decarbonisation scheme for aviation – and decarbonisation of shipping.

Under the Paris Agreement, supplier countries choose whether or not to authorise carbon credit exports – including those through the voluntary carbon market via a mechanism called 'corresponding adjustments' (CAs). In recent weeks, Switzerland-based registry Gold Standard and US-based Verra have both issued credits with Article 6 authorised labels from projects in Rwanda and Malawi. But for some in the carbon market, LoAs represent an intention rather than a firm commitment by countries to authorise VCM credits, and there is also a risk that they will be revoked later on.

The EU took a hard line during COP28 on the position of the US and others for a loosely-defined interpretation of bilateral trading, and an internal briefing note from the bloc leaked at the start of the talks noted with suspicion that VCM standards would be deployed as means to implement Corsia under 6.2. But, assuming that all major negotiating parties do end up defining more clearly the terms of bilateral trading and make compromises at COP29, this outcome is unlikely to be a major issue for contracts, said Gantly.

“If LoAs are not compliant with any future rules, they'll just need to amend them. The LoAs that I've seen so far are not hyper-detailed, simply because there isn't a huge amount of detail. It's actually in the 6.2 rules that this was the point. It's supposed to be very decentralised [as a mechanism],” he said.

One mitigating factor delivered by COP28 was the climate meeting’s adoption of paragraph 31 in the “Global Stocktake Text” on how to scale up targets, which emphasises “the urgent need for accelerated implementation of … the use of voluntary cooperation, referred to in Article 6, paragraph 1, of the Paris Agreement”. This, observers say, will mean that COP29 will prioritise work on advancing rules for Article 6.2 and 6.4.

With clearer rules and definitions of bilateral trading under A6.2 still lacking political sign-off, and tangible progress at the political level in A6.4 delayed until Baku, it is the VCM that will be the main focus of carbon credit finance next year with pressure mounting for clear assessment criteria from various integrity initiatives to deliver a bedrock of better credit quality and higher prices.

“We'll see a bigger push towards voluntary carbon markets and in particular towards standards like the IC-VCM, the VCMI and overarching integrity frameworks like those for trading, and broad principles that are being issued by the G7, Carbon Markets Platform, as well as the Iosco and other securities regulators,” said Resilient’s DiMarco said.

Tremendous development

Pedro Martins Barata, associate vice president of carbon markets at NGO Environmental Defense Fund and a board member of the IC-VCM, said the evolution of various national carbon markets with offset provisions means there is “tremendous development” and that a lack of A6 texts won’t stop countries, such as India and China, refining their markets.

Various advocates of the VCM point out that this market has delivered billions of tonnes of verified emissions reductions since the Paris Agreement was signed in 2015, while the politically-driven Article 6 markets have in the same time produced practically zero.

A major source of uncertainty for developing countries is whether prices in a broad range of VCM sectors will rise to levels close to what is being cited for Article 6.2 – about $25 a credit, according to snippets of price discovery from bilateral deals – or what could have been achieved from 6.4, but will now have to wait given this market is effectively in limbo.

Prices of least $25 a tonne of carbon dioxide have also been targeted by developing countries through A6.4, with this market a motivating factor for several of them in recent months to pass enabling legislation so that regulations on registries, accounting and revenue splits with government and communities can be drawn up to give investors and finance ministries greater certainty.

But the higher revenues and possibility of stable demand from project-based 6.4 looks like an increasingly distant prospect, given that this market is effectively in limbo for another 12 months and even if a dedicated text is agreed in Baku, a further couple of years at least will be needed before it could be fully operationalised.

Project developers in the past year had increasingly factored in potential operationalisation of 6.4 into their longer-term plans, with the revenue from that market always anticipated as a substantial and much needed premium to the VCM given some of the much higher fixed costs for some types of projects in the UN markets.

But with political sign-off on methodologies and removals still illusive under 6.4, developers lack sufficient clarity by which to pursue investments through the UN route, and will for the time being have to calibrate their plans to the VCM and those sectors where abatement and removals projects can secure worthwhile prices.