Unpacking The New Developments In The Carbon Markets

Carbon markets are growing in significance. More and more experts are recognizing the importance of these markets in reaching global climate goals. Although they are being widely recognized, this does not mean that these markets have been without downturns. Last year, the Voluntary Carbon Market almost halved —from $ 1.87 billion to $723 million —primarily due to integrity concerns over genuine emission reduction, according to the World Bank's State of the Carbon Market Report 2024. Despite that, the market is expected to grow, with some one estimate suggesting the market is likely to be between $10 billion and $40 billion by 2030.

Last month's decision—Article 6—by the United Nations gives reasons to be even more optimistic about these markets as it offers them a new kind of legitimacy. The decisions guide countries on using carbon credits to meet their Paris-aligned climate targets and national climate goals. A carbon market is a trading system that allows the sale and purchase of carbon credits. A carbon credit represents the reduction, removal or avoidance of greenhouse gas emissions. One carbon credit is equal to a ton of greenhouse gas emissions.

The outcomes of Article 6 are relevant not just for countries or governments but also for companies, investors and other stakeholders interested in climate action. For instance, companies can now invest in UN-backed high-integrity funds under Article 6.4 that contribute to their country's climate targets. That is a big step forward.

Given the significance of these new developments, it is worth exploring some of the components of the decision —particularly market approaches— to understand what they are and the kind of real-world changes they can bring.

Green Signal To Countries To Trade On Carbon Credits

Countries can now trade with each other on internationally tradable mitigation outcomes such as carbon credits through cooperative approaches and include them in their climate goals. At COP 29, there was a discussion about cooperative approaches and whether they should be strictly defined as unilateral, bilateral, or multilateral arrangements. The US pushed for unilateral approaches, such as between countries and private corporations, while the EU supported bilateral agreements between the two countries. The outcome does not specify either, allowing countries great flexibility to enter into agreements that suit their circumstances.

Furthermore, under the new rule- Article 6.2, companies' actions in the carbon markets can count towards a country's climate goal. For example, Businesses can sell their carbon credits internationally. Suppose they receive authorization from the country where these credits are generated. In that case, the buying country can count these credits toward its emission reduction targets instead of the seller country counting them in its targets. The country authorizing the carbon credit would have to adjust its climate reduction to reflect the corresponding adjustment. Simply put, it's the plus and minus in the system— plus in one country's emissions and minus in another to reflect the buying and selling— which will help ensure no double counting of emissions.

The meeting last month also clarified rules around whether and to what extent the countries should coordinate, for instance, should there be a common kind of sequencing to the authorization with a template, but eventually, it was decided to have allow flexibility to the countries.

Each country must also maintain a dedicated registry to track such carbon trade. These registries will help manage the different stages, such as authorization, transfer, acquisition, cancellation or transfers. Indonesia, last week, became the newest country to set up an international platform for carbon trading, IDXCarbon Platform.

All of the above is excellent progress. Many countries already have agreements, yet few have reached the authorization phase, which is a vital step in initiating the transfer. Some countries are faster than others in issuing the authorization letter, highlighting the need for capacity-building among seller countries. Ghana issued a letter of authorization to Switzerland at the end of 2023 for a climate-smart rice project. The letter came two years after the agreement was signed, a rather long wait, according to a report. In 2024, Switzerland and Thailand became the first countries to conclude an Article 6 transaction. It took about 9 months to move from the agreement to the letter of authorization phase. As many as 98 countries have identified designated national authorities to issue these authorization letters.

New Standards And A UN-Backed Centralized Carbon Market

The new decisions have set guardrails to address double counting and over-estimating emissions from the carbon credits— which can improve credibility in the system. Building credibility is particularly important as experts have raised strong concerns from time to time about whether carbon credits can reduce emissions. A study published in Nature last year found that only about 16% of the carbon credits constituted real-world emissions reductions. Their analysis covered one-fifth of the credit volume issued, almost 1 billion tons of CO2.

The new international trading mechanism, the Paris crediting mechanism, will be a platform for the trade of carbon credits under the UN guidance, standards and methodologies of Article 6 of the Paris Agreement. Credits registered under this will be called Article 6.4ERs. This multilateral mechanism replaces the old Clean Development Mechanism. In addition, two standard documents annexed with the decision go into the details of methodologies for assessing activities under this Article.

One key methodological change, as outlined in the standards document, is the acceptance of the downward adjustment of baseline emissions. This downward adjustment applies when baseline emissions are estimated based on existing or historical data. For example, consider a company connected to a power grid that decarbonizes over time due to an increasing share of renewable energy. If the emission factor of the grid remains constant in project calculations, it would lead to an overestimation of carbon credits, as reductions would appear as a result of the company's decarbonization activities. Still, a part of it could be from broader grid decarbonization. The downward adjustment of baseline emissions ensures a more accurate reflection of actual reductions achieved through the company intervention. Such a downward adjustment was not required under the earlier methodologies.

Another interesting change is including the scope for suppressed demand. Consider villages in remote areas with a small carbon footprint because they may not have access to modern technologies or energy sources. Under the earlier mechanism, such villages were overlooked, as their emissions before the project were almost zero, but that is no longer the case under the new mechanism. The standard document lists several changes like this in more detail, which could be useful guidance for companies and project developers in the field.

With clearer rules and stronger safeguarding by a UN-backed international mechanism, carbon markets are undoubtedly entering a new phase. In the coming years, the focus will be on ensuring smooth implementation and scaling up execution in many countries while maintaining credibility and transparency to really pump-up confidence in these markets and support global climate goals.