The 29th Conference of Parties (COP29) to the United Nations Framework Convention on Climate Change (UNFCCC) held over the past two weeks in Baku, Azerbaijan, concluded in the early hours of Sunday morning, as negotiators as usual worked frantically against the clock to finalise a deal. As is often the case, the results of this COP have been greeted with mixed reactions from observers, with many decrying the COP as a failure and highlighting concerns that the progress to mitigate climate change is too slow.
However, COP 29 has delivered one very significant breakthrough which has eluded previous COPs, and which potentially has far reaching implications. After nine years of negotiations, the final outstanding decisions for the framework of the Article 6 mechanisms of the Paris Agreement have been agreed upon and adopted. This effectively means these mechanisms are operational and can begin to be utilised.
At Energex, we follow the COP negotiations primarily from the perspective of carbon markets and the implications for carbon pricing more generally. In this article, we explore what has been agreed upon and what it could mean for developments in carbon markets going forward.
What is Article 6 and why does it matter?
Under the Paris Agreement, countries must submit plans and targets in the form of Nationally Determined Contributions (NDCs), setting out how they intend to contribute to the Paris Agreement target of keeping global warming below 1.5 degrees Celsius above pre-industrial levels. The Article 6 mechanisms of the Paris Agreement are the tools through which countries can choose to voluntarily co-operate with each other to assist them in achieving those NDC targets.
Article 6 incorporates two market-based mechanisms, Article 6.2 governing country-to-country trading at a national level and Article 6.4, the UN centralised carbon credit market, and one non-market-based mechanism, Article 6.8. We will explore these market-based mechanisms in more detail in this article.
Until now, these mechanisms have been largely inactive, mainly due to a lack of agreement on several key regulatory issues and a lack of consensus on how these mechanisms will function. COP 29 has changed this, and the Article 6 mechanisms are, effectively, now operational. Although some work remains to be done, what has been agreed at COP 29 is a significant and historic breakthrough for international carbon markets.
Art 6.2 – Country-to-country trading Mechanism
The first of the market-based mechanisms of Article 6 is established under Art 6.2. This mechanism enables countries to meet their NDCs through bilateral cooperation agreements. Countries can effectively trade and transfer a type of carbon credit between one another in the form of Internationally Transferrable Mitigation Outcomes (ITMOs).
Project activities that generate carbon reduction or removal outcomes can generate ITMOs, which are issued by a government appointed body in the host country and transferred to the receiving country. The types of projects that are eligible to generate such ITMOs are determined through the bilateral agreements and can vary from country to country. Art 6.2 could, therefore, be described as a decentralised market, operating under the Art 6.2 guidelines.
In the past couple of years, there have been several bilateral agreements entered into, with countries such as Switzerland and Japan being particularly active in such arrangements. However, until the recent agreement at COP29, a number of question marks around the Art 6.2 mechanism remained and Art 6.2 transactions carried significant risks. There was uncertainty, for example, around the concept of “authorisation” by a host county and its ability to revoke that authorisation, therefore creating the problem that a country could back track on commitments and cancel an ITMO, amending its net emissions balance and NDC accordingly. Several other such risks were also left unresolved.
The decisions adopted at COP29 go a long way to derisking the Art 6.2 mechanism, by establishing the rules around authorisation and timing of authorisation, revocation, and several other crucial technical elements such as transparency and reporting of inconsistencies in country net emissions balances. Countries should now report to the UNFCCC Secretariat through the Centralised Accounting and Reporting Platform (CARP), enabling a level of transparency and accountability that was previously lacking.
The agreed rules enable countries to enter into Art 6.2 bilateral agreements, with far greater certainty over how such transactions are governed, registered and reported and clarity over the process for the issuance and transfer of ITMOs.
Art 6.4 – Paris Agreement Crediting Mechanism
Equally significant and perhaps even more relevant for companies and institutions seeking to participate in carbon markets, COP 29 has delivered a decision on the operationalisation of the Art 6.4 mechanism, now referred to as the Paris Agreement Crediting Mechanism (PACM).
The PACM is largely recognised as the successor to the Clean Development Mechanism (CDM) of the Kyoto Protocol, the first international carbon market. The PACM creates a centralised market for carbon credits, which can be generated from project activities that reduce or remove carbon emissions from the atmosphere. Such carbon credits can be recognised by the host country of the project and approved (or not) by the Designated National Authority (DNA) of the host country. Approved projects receive a “corresponding adjustment” from the host county, effectively meaning they are attached to an ITMO and therefore accounted for in the host country net emissions balance. This newly adopted rule therefore goes a long way to reducing the risk of double counting.
The PACM is overseen by the UNFCCC through the Supervisory Body, who are responsible for registering project activities and issuing carbon credits (Art 6.4 ERs). Furthermore, all carbon credit issuance, transfer and cancelation is done through a centralised registry, again overseen by the UNFCCC Secretariat. This further ensures that double counting risk is significantly reduced.
It is expected that the PACM registry will be operational in early 2025, with carbon credits under the PACM also likely being issued in mid to late 2025.
What now for carbon markets?
The long-awaited agreement on the final rules of the Art 6 mechanisms could mark a historic moment for carbon markets, potentially transforming the way carbon credits are traded going forward.
Since the end of the first Kyoto Protocol period in 2012, international carbon markets have lacked a clear fundamental demand driver. Kyoto was extended until 2020 under the second phase, but market demand for Kyoto carbon credits (Certified Emission Reductions) had already been saturated and an oversupplied market meant that CER prices collapsed. The Voluntary Carbon Market (VCM) stepped into the void left after Kyoto, adopting the methodologies of the Clean Development Mechanism and building upon them to enable existing project activities to continue to generate carbon credits and new projects to receive much needed climate finance.
However, in the last couple of years, following a barrage of negative media coverage, transaction volumes have reportedly shrunk in the VCM as buyers have become wary of certain project types and some standard bodies have come under criticism. Demand for many carbon credits has stalled as buyers sought clarity over what they should buy and what associated claim they could make from that purchase.
The Art 6 market mechanisms go a long way to addressing those concerns, providing assurance to buyers that the carbon credits they purchase and retire can be accounted for under the framework of the Paris Agreement, therefore contributing to the Paris Agreement targets.
The carbon credits under Art 6.4 are issued by the UNFCCC directly into a centralised, UNFCCC administered registry. If the host country of the project provides authorisation, those credits are effectively backed by an ITMO and are therefore correspondingly adjusted in that country’s net emissions balance. Companies can therefore buy these carbon credits, knowing that they are buying a mitigation outcome that directly contributes to the objectives of the Paris Agreement.
The carbon credits methodologies are approved by the Supervisory Body and the project activities are checked and validated by recognised third party validators. The transfer of those carbon credits, through the centralised registry, is recorded and tracked.
These recent developments can provide the foundations for a new and improved international carbon market, ensuring projects meet minimum quality criteria, providing clarity and transparency on project activities and accounting for the activity under the framework of the Paris Agreement. If implemented correctly, the global carbon market has the potential to grow exponentially in the coming years.
After almost ten years, the international carbon market can now function as it was intended to under the Paris Agreement. The COP29 presidency called1 the agreement a “breakthrough” that is expected to save as much as “$250 billion per year in implementation of national climate plans”.
It is safe to say that challenges do remain, and participants will need to be aware of and manage a number of possible risks, as with any commodity or investment, but this is huge leap forward. The global carbon market is now open for business.
If you would like to understand more about carbon markets and their implications for business, please contact Michael Fulton at Energex Partners mfulton@energex.partners