By Sebastien Cross and Tommy Ricketts, BeZero Carbon

Last week’s UN agreement on a Paris Agreement Article 6 rulebook is bullish for the role of market-based mechanisms in supporting global climate action.

It validated the existing voluntary carbon market structure by guaranteeing a future for non-correspondingly adjusted credits. Much needed clarity was also given on countries’ ability to use international cooperation to meet their Nationally Determined Contributions (NDCs).

Market participants can rejoice at a huge source of uncertainty being lifted. But the new dawn comes with added complexities.

NATIONAL FIRST, GLOBAL SECOND

Prior to the COP26 conference, carbon credits were a global asset. Project developers in the developing world were largely free to sell accredited offsets anywhere and to anyone without consideration of national emissions targets, so called non-corresponding adjusted credits.

Carbon rights mattered, you can’t sell what you don’t own, but the chief barrier to delivery was accreditation from a cost and complexity stand point.

Article 6 changes this. It enables sovereign governments to effectively have first refusal on any domestic emissions reduction schemes. Carbon has become a national asset with geographical boundaries.

Arise a new set of carbon market gatekeepers and players – governments – with their own agendas, and potentially deep pockets.

THEN THERE WERE THREE (CARBON MARKETS)

the post-Article 6 world is multi-layered, with activities split between a new multilateral mechanism; bilateral agreements; and the existing voluntary carbon market.

Under Article 6.4 a new version of the UN’s Clean Development Mechanism (CDM) will be created. Think of it as CDM 2.0.

The original CDM enabled trade between countries with UN emissions reduction targets and those without. All countries now have targets and must work out which credits, if any, they are willing to export to be counted towards other countries’ targets.

CDM 2.0 is a welcome iteration but adds considerable complexity, with accounting regimes yet to be decided, and costs, with projects taxed 7% of total issuance for adaptation finance and to ensure overall mitigation.  The good news is exchanges are already racing to fill the gap via innovations, such as national registries.

Another innovation is Article 6.2, which allows bilateral agreements to be struck country to country or country to developers/corporates.

On the face of it this appears to be a new market mechanism helping countries meet their NDCs. However, the extent to which these transactions contribute to an active and liquid market is yet to be seen.

VOLUNTARY MARKET LIVES ON

Market participants remain free to create and trade credits that have not been adjusted in the host country’s NDC. Not throwing the proverbial baby out with the bathwater ensures all the terrific work over the past 20 years from developers, exchanges, accreditors, and registries can be leveraged.

But the thorny issue of double-counting lingers on. It is not clear if both systems can co-exist in the medium-term.

For example, standards manager Verra supports the continuation of non-correspondingly adjusted credits for voluntary offsetting purposes while the Gold Standard plans to phase in corresponding adjustments for offsetting by 2025.

This split creates further uncertainty for buyers on the eligibility of different instruments for their broader climate goals and what they can credibility claim as an offset.

This Balkanisation adds uncertainties just as billions of dollars are lining up to be deployed into new carbon projects. Left unresolved, such fragmentation risks impeding the very liquidity that market mechanisms are designed to support.

INFLATIONARY FOR CARBON PRICES

Carbon prices have soared in 2021. Article 6 adds to these inflationary pressures via rising costs, and risk premiums.

In a world of corresponding adjustments, governments will likely quickly soak up as many of the cheapest mitigation measures in their own NDCs as possible.

This buying pressure will push developers and the market up the cost curve. Over time higher prices will make projects that were previously too expensive price competitive. Regimes imposing corresponding adjustments, such CORSIA, will also likely see continued upward price pressures as demand grows.

Another driver of higher prices will be the time it takes to create the infrastructure for new markets and adapt to its mechanisms. Today’s backdrop is one of subdued near term supply of new projects amidst rising demand.

Longer-term, project developers face two questions; will a project be granted a corresponding adjustment and if not, what risks does that pose to the project going forward? The increased uncertainty and political risk this creates will lead to investors requiring high risk premiums to participate in the market, and again keep prices high.

ADDITIONAL NUANCE

BeZero uses a six-risk factor framework to assess the efficacy of any carbon project in order to provide research ratings via our markets platform.

The biggest single driver is additionality, i.e. the likelihood that a credit purchased and retired leads to a tonne of CO2e being avoided or sequestered that would not have otherwise happened.

For accreditors, additionality is a yes no binary question that drives whether credits can be issued. This is an essential mechanism without which you couldn’t have issuance, and therefore a tradable instrument.

For market participants, additionality is a spectrum that can be compared and contrasted to understand relative value.

Showing a that project is more additional should, in an efficient market, mean that credits from that project command higher prices. In simple terms, this is because more of its revenues go directly to the climate solution it supports.

In a post-Paris market of NDCs and corresponding adjustments, additionality has never been further from a binary question. The policy backdrop will become an increasingly important component of any project assessment.

Transparency on individual countries’ NDCs is a crucial part of this. It also puts a huge emphasis on ensuring analysis of this market becomes even more forward-looking.

BEYOND BINARIES

The clarity an agreement on Article 6 brings is welcome. The race is now on to understand the new markets and structures it creates.

Navigating carbon markets has arguably never been harder for everyone in the carbon market value chain – project developers, investors, intermediaries, end consumers. Everyone needs to be able to assess carbon efficacy, in order to ensure value for money and maximum climate impact.

The need for data and analytic research tools to assess risks and returns across the carbon entire market has never been higher. Without them, the market will struggle to move beyond binaries and scale effectively.

Sebastien Cross and Tommy Ricketts are co-founders of BeZero, which offers a carbon ratings service that provides a top-down assessment of the environmental integrity of voluntary credits using a fixed income-style grading system. The firm’s team uses a blend of qualitative and quantitative analysis to assign a rating, including satellite imagery, machine learning and data-driven techniques.