By Ash Sharma, Special Adviser for Climate Change to the Nordic Environment Finance Corporation (NEFCO)

December’s historic Paris Agreement was clinched after the highest profile event of its kind, attracting the largest number of heads of state and government in history. As always, there are many interpretations of the outcome, which will enter into force in 2020. However, in terms of the market mechanisms, despite the muted language in the final text, these are firmly back on the agenda as an instrument for climate action.

The emphasis of the climate negotiations in recent years has shifted away from the Kyoto type top-down approach to a bottom-up model. This is reflected both in the Paris outcome and in the approach to the harnessing of markets.

There is clearly much work to be done. The negotiations will continue under a new body called the ‘Ad-hoc Working Group on the Paris Agreement’ (AWG-PA), which has been given the task to flesh out the detail on many issues ahead of the implementation of the new framework.

The AWG-PA aims to finalise its work programme by the first COP following ratification and the entry into force of the Paris Agreement. It is unclear how long this will take as the Agreement will enter into force after 55 countries that account for at least 55% of global emissions have deposited their instruments of ratification. The process, dependent on approval by national legislatures, could last several years. There is time therefore to work on the modalities and procedures of a market mechanism.

A Role for the Markets Enshrined in the Agreement

As expected, there is a framework for the use of market mechanisms or cooperative approaches as they are referred to. The nine paragraphs of Article 6 of the Agreement describe, albeit in the broadest possible terms, the use of “internationally transferred mitigation outcomes” (ITMOs to add to the UNFCCC alphabet soup of jargon) or loosely speaking, tradeable carbon credits. In particular, Article 6.4 establishes a mechanism.

The new instrument is likely to share many characteristics with the successful Clean Development Mechanism (CDM) and Joint Implementation (JI) schemes established under the Kyoto Protocol, which led to a huge international (although primarily EU-centred) trade in project-based credits to meet compliance needs. However, it is likely that the future carbon markets will be quite different to those we were used to in the heady days of Kyoto.

Rules are to be developed progressively by the AWG-PA, as was the case after Kyoto. Established principles that will underpin the new markets are referred to in the Paris decisions and include environmental integrity, transparency, additionality, avoidance of double counting, verification and certification of designated operational entities, supervision by a body similar to the Executive Board and so on. It can therefore be expected that much of the body of modalities and procedures to be developed in the next few years will build on the CDM/JI experience.

It should be noted that the term ‘mitigation outcome’ is used in the Paris outcome instead of ‘project’, which suggests that the scope of the new mechanism could be broader than the project-based CDM, and could encompass elements such as the CDM Programme of Activity (PoA) and certain types of sectoral crediting mechanisms and other bilateral instruments.

Where will the demand come from?

A critical issue, as we have witnessed in the post-2012 carbon markets, may be a lack of demand for ITMOs. The European Union and US have already stated that they will not use international market mechanisms to achieve their INDCs. However, it is likely that such positions may evolve over the coming years as the UN negotiations continue, particularly if expected and required by the Agreement there is a ratcheting up of the level of ambition in the next round of INDCs (the 2018 “stocktake”). In addition to the EU, US and China, the UNFCCC’s synthesis report on the aggregate effect of INDCs stated that over half of the INDCs submitted indicate that Parties plan to use or are considering the use of market-based instruments from international, regional or domestic schemes, at least for part of their targets. Emission trading schemes in these jurisdictions could open up for the use of ITMOs. So far, it seems that there is certainty from only a handful of buyers. The demand picture will develop only over the next few years, and the Paris Agreement also supports the development of regional markets.

No certainty for the continuation of the CDM

As for existing instruments, there is no clarity regarding the CDM. Some analysts believe that existing CDM projects cannot be deemed additional post-2020 and that CERs will not have any further value attributed to them through the UN process after the end of the second commitment period of the Kyoto Protocol (2013-20). Others believe the CDM and CERs can interact with the new mechanism. Currently, few buyers are making any purchases let alone post-2020 commitments, but there is some potential supply from PoAs which have long crediting periods (up to 28 years).

What happens next?

The next couple of years will see intense activity under the AWG-PA, probably through sub-groups, to further define the new mechanism, its nature and scope and develop its modalities and procedures. The building blocks such as project methodologies are in place and the post Paris momentum is strong.

In the meantime, countries will continue to design, test and implement market-based domestic carbon pricing programmes, such the multi-donor Transformative Carbon Asset Facility announced by the World Bank in Paris. In particular, there is scope for road-testing sectoral crediting mechanisms as part of Nationally Appropriate Mitigation Actions (NAMAs) or “learning by doing” type activities under broader INDCs, possibly developing verified ITMOs (VITMOs?). The Nordic countries issued a Statement on Innovative Climate Finance, and will likely support such initiatives.

Only time will tell the success of the market, but it is clear that beyond developing reliable rules and infrastructure (much of which is in place), critical success factors will include deep demand for the ITMO asset class and the re-engagement of the private sector and market actors.

Ash Sharma is Special Adviser, Climate Change at the Nordic Environment Finance Corporation (NEFCO).  He is lead specialist on climate finance and policy, heading up strategic initiatives and major programmes in climate adaptation and mitigation in the Nordic countries and internationally.  He also manages the global NorCaP facility and NEFCO portfolio in Latin America.  He’s currently overseeing NAMA climate programmes in Honduras, Mozambique, Nicaragua, Peru and Vietnam, and various investments in Africa and LATAM.