OPINION: A slightly presumptuous explainer on corresponding adjustments in the VCM

Quantum Commodity Intelligence - Pedro Martins Barata is associate vice president, carbon markets and private sector decarbonization at US-based NGO Environmental Defense Fund.

For years now, there has been a debate, sometimes a raging one on the desirability of applying corresponding adjustments to purely voluntary carbon market transactions.

By such "voluntary carbon market transactions" I will mean transactions undertaken by agents for actions that are not required to consolidate with national greenhouse gas accounts and that as such fall outside the purview of the Paris Agreement.

A trip down memory lane

First let's understand what a "corresponding adjustment" is. Under the Paris Agreement, nations have a wide variety of "commitments" (the word itself was anathema for some in the negotiations, ergo the inverted commas), called Nationally Determined Contributions (NDCs). This wide variety posed a challenge to negotiators who wanted to insert a carbon trading possibility across these varied NDCs.

This was a new problem. The previous international accounting framework under the Kyoto Protocol (KP) had been developed with a single type of commitment in mind, and it was built from the ground up as an enabling environment for trading: no less than three articles in the KP were dedicated to trading, and the entire reporting system was built around the trading platform. In order to take part in trading but also to comply with the KP, Parties — even if not engaging in trading — had to have registries connected centrally to the international transaction log. Their targets would be converted onto Assigned Amounts that would be 'unitized' and deposited on each Parties' registry.

Article 17 then enabled these units to be traded, Articles 6 and 12 developed two additional project-based mechanisms, and most crucially Articles 3.12, 3.13 and 3.14 established the rules by which countries would add and subtract from their Assigned Amount units — what we would now call, if we wanted to be precious about it, corresponding adjustments.

So in allowing for a wide diversity of NDCs, the problem of how to adjust that framework to account for international trades took centre stage. Given that, unlike Kyoto, there was no clearly defined budget to subtract from or add to, another fixed point had to be envisaged.

The obvious point was to look at how all countries would have reporting obligations based on their inventoried emissions. So the national inventory became that fixed point. This realisation was provided to me in a hugely entertaining brainstorming session between myself and several other negotiators/friends at the WRI headquarters in Washington, DC, years in advance of Paris itself.

As the national inventory is itself sacrosanct, negotiators determined that it would be a different fixed point, based on, but distinct from the national inventory — the so-called "emission balance" that would be adjusted.

Opposite to Kyoto, now a "buyer country" would need to adjust downward its "balance" rather than adjust downward its carbon budget, but this adjustment did the trick. After tortuous years of trying to convince all Parties, in particular Brazil that the system required this adjustment for all transactions, this provision found its way into the Glasgow decision on Article 6 in 2021. Much more complex solution than poor old unacknowledged Article 3 of the KP, but in line with the complexity of the new regime.

Allowing for Corsia and emissions not covered in national totals in national GHG inventories

As this system was developed, international aviation and maritime emissions were outside of it. All of EU efforts to the contrary, it was never possible to find an allocation rule that would allocate cross-border emissions/removals to countries.

This issue dates back to 1996, when UN negotiators tried to hammer these into the KP framework. Ultimately, they failed, and the KP requested, through Article 2.2 of the KP, for action to be undertaken by the sector organisations — the International Civil Aviation Organization (ICAO) and International Maritime Organization (IMO).

Countries would continue to report separately their international emissions (aviation and maritime) but with precious little by way of guidance from the Intergovernmental Panel on Climate Change on how to do so. Incidentally, that also meant that projects to address emissions from international aviation would be outside the scope of KP mechanisms — despite attempts from several companies and project developers, there was simply no agreement on which budget would be impacted by the generation of these emission reductions.

It took many years (too many) but ICAO finally managed to get its act together, just in time for their Corsia framework to be considered by negotiators looking into the accounting of Corsia trades.

The obvious solution was to consider international aviation and maritime emissions as outside the scopes of any national inventories and therefore to be seen as a quasi-Party. Thus, when Party Brazil issues credits that are used in the context of Corsia, one could consider ICAO as the other Party. Brazil clearly acts as if ICAO is another Party with distinct and non-overlapping obligations.

Corresponding adjustments are therefore, and rightly, required for all Corsia transactions, as they reduce emissions in one country in order to compensate emissions from an airline. Crucially, these airline emissions are a different pool of emissions from national emissions. When Delta flies from Dulles to Lisbon, these emissions are international. They are not addressed by national US or Portuguese totals.

So Delta will have to adjust its inventory as a quasi-Party in relation to credits bought to compensate that international emission, and these credits must be adjusted by the host country — if not, Delta would be subsidising the attainment of the host country's NDC and planetary-wise, emissions totals would increase. The same emission reduction would impact the 'ICAO' party and the "host country" party.

All of this would also play out in the IMO discussions.

So Glasgow added an additional paragraph on "other international mitigation purposes", specifically designed to account for such trades and it mandates host country adjustments. There is no "corresponding adjustment" because these emissions are not captured by national totals in emission balances for each country. They are a separate pool of emissions.

OK, so host country adjustments to national balances are a requirement and a necessity for the integrity of the accounting framework for Corsia. How about voluntary carbon market (VCM)transactions?

Following the exact same logic as done for Corsia: just like international aviation and maritime emissions, projects in the VCM are very likely to impact host country NDCs. However, unlike Corsia or maritime emissions, these VCM transactions are not likely — unless under extreme expropriation scenarios — to make their way to national totals of any Party. Again, Microsoft or Netflix do not nest their accounts onto any national total.

So the first point to make is to issue a correction: it is not appropriate to talk of "corresponding adjustments" in this case. When Microsoft or Netflix buys a credit as part of its corporate engagement with the market, no government will be using these credits towards compliance. So the question really boils down to: should it be a requirement to impose an adjustment to the national balance of the host country?

Arguments against applying corresponding adjustments to VCM transactions

The first major argument against applying host country adjustments is that as explained above it is not required by the accounting framework.

The second one is that asking a host country government to adjust its national total after a decision by an economic agent to sell internationally a credit implies a transfer of risk from the private or community agent in the country to the national government of the host country.

While the agent gets the revenue from the sale of credits, the government will now have to "make up" the difference through additional measures. One potential counter-argument is that NDCs have slack in them, but I humbly suggest that is not a good starting point for any discussion.

In other words, a decision by a private agent supposedly from the global North would result in an increase in the compliance burden by the developing country. So much for differentiated responsibilities.

Yes, the government would need to factor that into a calculation of the tax on the host country adjustment, so that it would make good economic sense to sell a credit and cover the cost of the required additional mitigation. But the first point here is that this additional cost would constrain the overall trade in carbon credits and would lead to lower mitigation overall, as the cost of mitigation goes higher. There is a mitigation deterrence effect in any host country adjustment.

The third argument against imposing a host country adjustment requirement is that it would lead to added uncertainty on the VCM. Anyone who has had exposure to the LoA system under the KP's Clean Development Mechanism is aware of the potential for transaction costs inherent in that requirement.

Private sector agents are much less well equipped to incur these costs than are governmental institutions in government-to-government relations. Applying host country adjustments leads to setting yourself up for this. There is a real potential for directly unproductive activities (economist's language) in making these actions contingent on government approval.

So what is the case for applying corresponding adjustments on VCM transactions given all of these arguments to the contrary?

Alas, this is not the whole story. There are indeed scenarios under which not applying corresponding adjustments would lead to lower overall ambition, in spite of the accounting framework integrity not being in dispute. The fact of the matter is that NDCs are a recurring game (as in "game theory"), in which a government could, when faced with the possibility of receiving large amounts of carbon finance to fund its NDC actions that would not be subject to adjustments to its national totals, would learn that in setting laxer NDCs it would open up more space for carbon finance to replace its own financial burden.

This effect could lead to gaming by host countries — lowering ambition to make themselves available to outside carbon credit-induced finance.

Note, however, that this is always the case, whenever international financial flows are in order. Whether in the context of structural aid in the EU or IMF, development aid, etc.., there is always the potential for countries to adjust their policy and their baseline to maximise their intake of foreign financial flows.

In fact, the first time I came across the terms "financial additionality" was in the context of EU Structural Funding. The coarse way that the European Commission ensured that national governments would have skin in the game was to have minimum co-financing requirements. These obviously led to structural mistakes in EU lending — Portugal has no less than three parallel highways running from Lisbon to Porto and "financial additionality" did not at all address this incentive-led behaviour. These are what economists call "principal-agent issues".

The likelihood of that happening though is conditioned by a few issues:

First, how credible is it that countries would formulate NDCs on the expectation of carbon credit-induced finance? In Portugal and EU Structural funding, this was an enormous issue: in some years, public investment in Portugal consisted almost exclusively of EU-funded projects; the potential to displace other, more interesting options was enormous and impacted the development of the economy. How would it differ from NDCs formulated on the basis of international, government-to-government climate finance?

Second, would the financial flows carried by carbon credits be easily replaced by other climate finance flows? A case can be made that some areas (e.g. nature-based solutions) have been more successfully financed through voluntary carbon transactions (though not at scale) than through other mechanisms. As such, a country would not be trading off climate finance sources, it would be building a total portfolio of mitigation actions and optimising financial flows according to specific characteristics.

So there is an issue. It is a potential issue. It is unlikely to be observed at this stage in the development of the VCM internationally. On the strength of this potential issue, should we deter mitigation by mandating host countries to adjust their national totals upwards and increase their mitigation burden?

At this stage, I would say no. There is a trade off between choking off the increased, additional mitigation that the VCM can leverage and this potential risk. Should we however monitor for this effect and devise ways to identify it? Yes. At the current levels of carbon market demand, the likelihood of effects on ambition of developing countries is extremely small. But if the hopes of many are realised and we have a large VCM, the allure of trying to manage down baselines may be enough to justify reconsidering this position.

But what about claims and offsetting? Surely it is wrong to claim neutrality when after all the host country is also claiming the same emission reduction, right?

This is where we go into a more ethical landmine-ridden landscape. As mentioned before, accounting-wise, the neutrality commitment or pathway of a company has no bearing on national emissions totals and hence there is no double counting. Nor is there double claiming in the same sense as between NDCs and Corsia.

There is an argument, which is much more tenuous but understandable, that when a company is putting forward a claim based on credits in a host country and that same country will be using that credit for its national goals, this is somehow wrong, as it seems like the company is appropriating itself of an emission reduction that the country should have factored in its NDC.

I doubt that the majority of people who have issues with "carbon neutrality" goals and with carbon credits have this so elaborate understanding as us, experts. I also feel that while one interpretation of the carbon neutrality claim of a company is that "my activities do not harm the climate in total", I find that it stretches the imagination that people would have that interpretation, even if companies would only be too keen to have it that way.

I believe the majority of people do understand "carbon neutrality" to mean "I invested in projects that will on average balance out my emissions for this (year/decade/etc..)". Most people would not think that somehow there are no emissions involved in Shell's activity to give but one example.

So... contributions?

That said, I would grant those with differing views: after this many years of controversy, it may well be the case that not claiming neutrality, but rather some more convoluted and less misleading, in their view, claim would make more sense. And as much as I have resisted and still do, there is maybe a scenario in which "contribution claims" make more sense than "neutrality claims".

I would still view it as a downgrade as I believe for many companies, this language smacks of charity. But if contributions are encapsulated within a near-binding framework that recognises/acknowledges/encourages use of high-integrity carbon credits (nod, nod, wink, wing, SBTi) more than the current neutrality framework, well then, out with the old wine, in with the new.

But lets be clear about a couple of things:

a) the claim does not change the integrity of the credit. It does nothing in relation to its additionality, permanence, etc... This is an use issue, not a generation or issuance issue.

b) there is the contention, by some including in the NGO and "think tank" community that would somehow lower the standards for "contribution grade" credits rather than "neutrality grade" credits.

I believe this is nonsense and dangerous. Carbon credits have to be credible period. If I am claiming that I am making a contribution to a country's NDC with X tonnes of CO2 equivalent, then that credit must meet the same additionality requirements as if it were used as offsetting a companies' emissions.

Why? Because the underlying incentive would be totally out of whack. Because once you start on that road, then literally anything goes — those credits from renewables that everyone believes are non-additional from old vintaged credits become game. Those HFC-23 credits that have historically been over-credited can see yet another life in them. At total system wastage and no environmental benefit. So yes, call it contribution, if you will, but don't start on this slippery slope.