The compliance carbon markets are back, but it has consequences for the voluntary market!

Not only are EUA prices (the carbon credit in the EU carbon compliance market for large industrials known as the EU ETS cap and trade system) at record highs since its collapse between 2011-2013, but COP26 reintroduced the carbon compliance offset markets after the previous compliance offset market, called the Clean Development Mechanism (CDM), faded away. However, the voluntary carbon markets will be impacted by the reintroduction of the compliance offset market.

Voluntary Carbon Markets allow companies to purchase carbon offset credits. These enable them to action their net zero transition strategies by financing additional projects to offset unavoidable carbon emissions during their path to net zero. The carbon offset market is gaining momentum again, mainly through the demand from corporate ESG initiatives.

The role of carbon offsets

Voluntary carbon offsets are often viewed negatively. The perception is that corporates use them as an easy way to reduce their carbon footprint without addressing their own emissions. I tend to disagree with this point of view. I think that carbon offsets can act as a catalyst for the transition to a low carbon future. Any genuine carbon reduction projects will make a difference. So, it makes sense for corporates to invest in carbon offsets whilst pursuing internal carbon reduction projects.

That’s not to say that elements of the current system are without issues. Carbon offsets can only be an effective way of reducing carbon emissions in the short term if the offsets are credible. Corporates need to be sure that the credits are not double counted as otherwise it can be perceived as carbon washing, as in the new greenwashing. For instance, how can corporates be certain that the realised carbon reduction is not double claimed (and thus double counted) i.e. by the corporate itself and by the host country of the project?

Article 6

In the so-called Paris Agreement, countries have individually agreed to what extent they will reduce their carbon emissions, also known as the Nationally Determined Contributions (NDCs). Article 6 of the Paris introduced the market mechanism for the Paris Agreement which in turn deals with the issue of double counting/double claiming (which was agreed at COP26). Article 6 has two important paragraphs:

  • Article 6.2 deals with countries trading emission reduction under their NDCs (this is known as Internationally Transferred Mitigation Outcome, or ITMOs). This means a country that is ahead of its NDC could ‘sell’, on a bilateral basis, part of this additional mitigation to a country that might struggle to realise its NDC.
  • Article 6.4: This article effectively reintroduces a carbon centralised offset market similar to the CDM for the purpose of the Paris Agreement. That is, the projects abatement will have to be registered with the UN.

A host country wishing to monetise its greenhouse gas abetment opportunity now has three options. In the first two options, it can monetise GHG abatement opportunity either as a carbon offset project under article 6.2 or 6.4., in both cases a corresponding adjustment of the host countries carbon tally. The third option is that the host country will not make a corresponding adjustment in which case the carbon offset is not genuine as the carbon reduction unit could be double counted.

The problem the voluntary market now faces is that article 6 does not include voluntary markets in the requirement for corresponding adjustments. Plausibly, article 6 means that voluntary carbon offsets without a corresponding unit are, almost by definition, double claimed or double counted.

A solution for the voluntary carbon offset market?

Arguably and potentially counterintuitively, COP26 provides a solution for the voluntary carbon offset market. Corporates voluntarily wishing to reduce their carbon footprint through carbon offsets should now tap into the compliance offset market as well and ensure that the carbon offset projects have corresponding adjustments. This will ensure them that their carbon emission reductions are genuine and not double counted.

Not only is it key for a project activity to genuinely reduce emissions, but corporates should be confident that the underlying projects are sound. They need to be certain that the counterparty is financially credible. The LSE has taken a positive step and is seeking to develop a new market solution that seeks to address these issues. The system enables funds that invest in projects producing carbon credits to list on the LSE. Having a dedicated market for voluntary carbon offsets funds can increase liquidity, but crucially, it should be accompanied by transparency. Similarly, project developers and owners need transparency about the investors, especially if they agree to long-term offtake contracts of the carbon credits. The LSE will have to ensure that all underlying carbon offset projects are part of Article 6 and have a corresponding adjustment.

At COP26, financial institutions, representing nearly $130 trillion in assets, pledged that they will try to cut the emissions from their lending and investments to net zero by 2050. These pledges are promising and could fuel the momentum in the carbon offset market. However, there are still several hurdles to be taken before funders will start to invest. At least the compliance offset market seems to be on the right track.

Let’s hope lessons have been learned - it can make a genuine difference to the climate crisis.

This piece was written by Dr Coos Battjes, Energy Markets Specialist. Find out more about Downing's Energy & Infrastructure team here.