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The impact of the Paris Rulebook on carbon markets

Companies around the globe are increasingly taking on the challenge of achieving zero carbon emissions, often by way of a regulatory push and occasionally, they do it voluntarily. Carbon credits are an essential component of the net-zero toolbox helping companies offset the emissions that they haven’t yet reduced. The market for carbon credits is expected to expand significantly over the next few years.

There are both risks and opportunities associated with carbon credits. In the event that carbon credit initiatives are appropriately run, credits will lower the global emissions. When carbon credits are produced in developing countries, they may aid in other sustainable development goals.

Carbon credits could bring these positive outcomes only if the credibility of the credits is ensured. Carbon markets are sluggish and fragmented. There are justifiable concerns that some credits may amount to little other than eco-friendly shaming.

To address these concerns, the world community took major actions in the Glasgow Climate Change Conference in 2021 to improve the quality of credits. These include new regulations for both standards and procedures for credits (e.g. for example, government approvals; methods of measuring emissions reductions; in addition to monitoring, reporting, and verification). The new rules seek to ensure that carbon credit projects bring about measurable reductions in global emissions and they add transparency to the process. Due to the complexity and scope of the problem the rules are intricate and difficult to understand in the real world.

The new rules won’t automatically apply to the entire spectrum that are a part of the carbon market. National regulators and private credit certifying organizations are currently deciding on how to implement the new rules to their own activities, with a window of opportunity for the stakeholders to make an impact on the outcome. Early signs suggest the changes will change the structure of public and private standards this year, increasing their integrity and, in the future decreasing fragmentation. If successful the rules will allow carbon credits to meet their potential to lower global emissions, and encourage businesses to invest in these instruments as part their net-zero pathway and offer significant opportunities for investors to fund credit-generating projects.

Article 6 of the Paris Agreement sets out the essential mandate for carbon markets, which allows nations to fulfill their international climate commitments (nationally decided contribution also known as NDC) through the purchase of carbon credits. The most significant development that took place in Glasgow was the much-anticipated agreement on the so-called “Paris Rulebook,” which seeks to implement this obligation. Below, we discuss carbon markets and The Paris Rulebook, and their interplay.

Carbon markets , in a nutshell. Carbon credits are awarded as part of an initiative in the “host” country in order to cut or remove emissions. Each credit is granted the right to emit a specific amount of carbon, typically one ton per credit. The credits are purchased by a firm or country with voluntary or compliant markets.

In compliance markets companies purchase credits that can be utilized to fulfill obligations to reduce emissions as part of (i) international programs (e.g., by countries to fulfill the requirements of their NDC in the Paris Agreement or by airline operators to offset emissions in accordance with the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA)) or (ii) national schemes (e.g., by companies to reduce their liability under a domestic emission trading scheme (ETS) or carbon tax). Each regulator determines to what extent carbon credits can be used to fulfill standards for compliance, as well as the conditions for obtaining credits.
Within the voluntary market for carbon (VCM) businesses purchase carbon credits to help support voluntary claims (e.g., voluntary net-zero pledgesthat are known as “offset claims” or to show support for emission reduction projects, which are called “impact claim”). There is currently no uniform international regulation or standard for the quality of carbon credits that are available for the VCM.

The Paris Rulebook in a nutshell. The Paris Rulebook develops two approaches to the international transfer of carbon credits. First, The Cooperative Approach (Art 6.2) is applicable when two countries trade carbon credits or, as per some guidelines, when a host country permits another company or country to use credits, regardless of whether the host country has not signed an agreement with a different country. For instance, as an example of using the Cooperative Approach, Switzerland and Peru signed an agreement for Switzerland to provide financing for credit-generating projects in Peru in return for carbon credits that Switzerland will use to achieve its 2030 NDC target. The second is the Sustainable Development Mechanism (SDM) (Art 6.4) is an international mechanism for the approval of credit-generating initiatives, typically run by private investors.

For each method, each approach, the Paris Rulebook sets out substantive and procedural guidelines to ensure the authenticity of credits -credits that have a meaningful contribution in reducing global emissions.

What are the essential obligations of the Paris Rulebook?

(1) There is no double counting A carbon credit is able to be counted only once. The country hosting the credit may in writing decide not to use the credit to meet its own NDC and, instead, let the credit be used for additional reasons to reduce carbon emissions (e.g. or by another country to fulfill their NDC for example, or even by a business in another country). In that scenario, the credit is not counted by both the host country and by the company/other country.

(2) Additionality: A credit-generating project must result in emissions reductions or eliminations which wouldn’t have happened without the expected income stream generated by the sale of credits that the project generates. This guarantees that the project will have an actual — and added — impact on lowering emissions in the host country regardless of the person who is using the credit. In the SDM Approach (Art 6.4) provides more details on how to calculate the amount of emissions reductions.

What are the key differences between the two approaches to the Paris Rulebook?

(1) Approval from the international community: In accordance with the Cooperative Approach (Art 6.2) the credit-generating program is conducted with the approval of the host nation but without the approval of an international supervision body. While there isn’t an international body, parties must comply with specific transparency and reporting requirements with the approval of independent technical experts who may make (nonbinding) advisory public statements. However, under the SDM Approach (Art 6.4), there are extra layers of supervision: A project requires approval from the country hosting it and a newly created international supervisory body which operates on the basis of recommendations issued by an independent verification body.

(2) Mandatory levies: In the SDM Approach (Art 6.4), mandatory levies of 77% are assessed on carbon credits. These levies are intended to aid in climate adaptation within developing economies (5% contribute to the United Nations Framework Convention on Climate Change Adaptation Fund) and to guarantee additionality (2% are canceled). Levies on mandatory levies are not required in the Cooperative Approach (Art 6.2) However, they are “strongly advised.”

The new rules provide the host nation a crucial role in projects that generate credit. They can determine (i) the standards that apply (the Cooperative Approach, SDM Approach or an alternative that is not part of the Paris Rulebook) and (ii) whether carbon credits are utilized to satisfy its own NDC or not. How the choices are made will determine the potential value and use for the resulting carbon credit.
The impact on carbon markets is the result of Paris Rulebook on carbon markets. While it is true that the Paris Rulebook provides only limited direct regulation of carbon markets, it’s expected to have a significant impact on market regulation, increasing the credibility of carbon credits in compliance and voluntary markets. While various aspects of the Paris Rulebook are still to be fleshed out, moves are being made to increase credibility of carbon credit conformity with. Notably, some of the top private credit-certifying bodies, such as Gold Standard and Verra, are currently increasing their standards as a result to the Paris Rulebook.

The impacts of the Paris Rulebook on carbon markets. Even though the Paris Rulebook provides only limited direct regulation of carbon markets it is anticipated to have a major impact on market regulation, improving the integrity of carbon credits in voluntary and compliance markets. Indeed, while various aspects included in the Paris Rulebook are still to be developed, efforts are being made to enhance the quality of carbon credits in conformity with. In addition, the most prominent private credit-certifying bodies, such as Gold Standard and Verra, are currently strengthening their standards in light in the Paris Rulebook.

In the VCM there aren’t uniform international standards for the quality of credit. It is possible that this will be changed. Private initiatives are working on guidelines to enhance the integrity of credits (e.g., the Voluntary Carbon Markets Integrity Initiative), with the first guidelines due in April. These guidelines will be based on the Paris Rulebook requirements on double-counting as well as additionality and transparency will likely guide these guidelines. As time goes on, certain national regulators could also regulate credits used for voluntary purposes such as establishing quality requirements for credits that are used by a business to satisfy net-zero pledges.

On compliance markets regulators in national jurisdictions sometimes allow a company credit to fulfill the majority or even all requirements under the carbon tax (also known as ETS). Regulators can now make eligibility criteria more stringent, according to the Paris Rulebook. Other countries with an ETS or carbon tax could be more likely to permit the utilization of credits with high-quality that comply with those Paris Rulebook requirements. Even though the CORSIA scheme for offsetting carbon emissions from air transport already has relatively demanding rules for how carbon credit quality is assessed, some countries might be able to improve the quality of those standards.

The Paris Rulebook is also expected to have an effect on pricing. Credits that comply with the Rulebook will have greater integrity and will likely to qualify to be used in greater markets. They may, therefore, be expected to pay a price premium.

There are risks and opportunities for all stakeholders. It is obvious that this period of rapid change in regulatory and market dynamics presents substantial opportunities and risk for all stakeholder. Of particular note:

Companies have the option to purchase high-quality carbon credits in order to satisfy their net-zero commitments (either either voluntary or even mandatory). The increased scrutiny of the authenticity of carbon credits by both regulators and customers underscores the necessity to choose the best carbon credit “product.”
Investors and developers of projects can choose to invest in and develop quality projects, however with some uncertainties about how the market and regulatory aspects will play out (including, e.g., price dynamics and the stability and liquidity of the market as it develops).
Regulators must now further refine in order to apply the Paris Rulebook and decide whether and how to adapt the eligibility requirements for their domestic ETS and carbon tax systems. Internationally, regulators must consider how the rules impact schemes such as CORSIA and whether or not they want to expose other industries (e.g. ships shipping) subject to the same schemes.
Countries that host them may profit from the opportunity to get additional funds for carbon reduction projects and should carefully consider which carbon credit method to pursue to reduce emissions and encourage sustainable development.

We’re ready to assist individuals in navigating the complex environment of the carbon credit exchange market. This includes, for example giving clients advice on the potential and risk associated of financing their own emissions reduction projects through the production and sales of carbon credits purchasing carbon credit to help offset emissions and meet net zero targets future-proofing carbon credit investments due to the ever-changing regulatory landscape and working with the government to maximize the benefits and minimize the risk of engaging on the market for carbon.