COP26 Features

Dawn of a New Era for Carbon Markets

Agreement on Article 6 was applauded at COP26, but its implications are not yet clear for investors trying to decarbonise their portfolios.

One of the key developments of COP26 came near the end of the summit when nearly 200 countries agreed to implement Article 6 of the Paris Agreement, creating common rules around carbon trading.

It may have been six years in the making, but the end of long-drawn-out negotiations on Article 6 essentially gives the green light for the global trading of carbon offsets and credits, with the ultimate aim of reducing the amount of CO2 in the atmosphere, thus providing a potentially significant boost to the fight against global warming.

A key outcome of the Article 6 deal is that countries will be able to purchase carbon credits representing emission cuts by others as a way of partially meeting their own targets, with a share of the proceeds from trading going toward adaption finance in less-developed countries.

Positive outcome

This could lead to countries linking their domestic emissions trading systems. But there are also hopes that more transparency and regulation around carbon trading will enhance the credibility of voluntary offset markets. Under voluntary schemes, companies can meet part of their net zero commitments by buying offsets, which may represent other firms’ emissions cuts or the outputs of projects that sequestrate carbon through natural or technology-assisted means.

“It is a positive outcome. The new rules governing carbon trading among countries ensures that emissions reductions do not get counted or claimed twice, that they are standardised and that there is a place for credits from the old global offsetting mechanism under the now-expired Kyoto Protocol. It will increase transparency,” says Maria Kolos, Carbon Market Analyst at Refinitiv.

Importantly, Article 6 does not create a new carbon market out of the blue, but it provides a solid regulatory framework for international cooperation including an international registry and reporting platform, key elements of market infrastructure. It might now spur countries, she adds, to ramp up their climate ambitions, knowing that they can rely, to some extent, on international co-operation to reach their targets.

So how does this agreement between countries relate to the participants in nascent voluntary carbon markets in the private sector, often regarded with scepticism for a lack of rigour, scale and transparency?

Although such players are not bound by Article 6, they are affected because its rules require parties (governments) to authorise carbon credits to be used for purposes other than trading between countries to meet their respective nationally determined contributions (NDCs). The seller country can authorise ‘emission reduction units’ to be market transactions for purposes such as corporate offsetting – but for any authorised carbon credits, the host country must apply corresponding adjustments.

“Since as per the new rules, any authorisation of carbon transfers means application of corresponding adjustments, the authorising country – by the very act of authorising credits for use by another party or purpose – may no longer count those units toward its own NDC. This makes units backed by corresponding adjustments available to corporate buyers and other voluntary carbon market players,” Kolos explains.

But these units are mainly likely to be of interest to large corporates which have a strong interest in maintaining the credibility of their net-zero strategies to investors and other stakeholders.

“If I am a large corporate buyer and I want to make a good impression on my carbon neutrality and transparency to investors, I will adjust,” Kolos says. “But if I am a small buyer which in the past has bought OTC, I am not going to reach out to a host country and ask for authorisation. I can do it one-to-one with a project owner. It is permitted, it is legal, and I don’t care if any investor would have a negative or positive opinion of me. Article 6 matters, but it depends on what kind of buyer you are.”

Structural problems

Nitesh Shah, Director of Research, Europe at WisdomTree Investments, expects the structural problems of the voluntary markets to remain. “Carbon trades in the voluntary market at such low prices. It makes it questionable whether it really has the teeth to actually do the job it sets out to do. Is the price of carbon sufficiently high to encourage technological advancements to decarbonise?” he says.

At 95MtCO2e/year in 2020, demand in the voluntary carbon markets currently equates to around 0.5% of reductions pledged in NDCs by 2030, and 0.2% of the cuts required keep the world on a pathway to limiting global warming to 1.5 degrees Celsius, according to a recent report by Trove Research.

Trove describes prevailing prices in the voluntary carbon markets as “unsustainably low”. Currently at a level of US$3-5/tCO2e weighted average, carbon credit prices need to “increase significantly if they are to have high environmental integrity”, said the report. This means rising to at least US$$20-50/tCO2e by 2030, and potentially much higher. According to EMBER, the price of carbon emissions in the EU Emissions Trading System (ETS) has more than doubled in 2021, reaching almost €80/tonnes (US$90/tonnes) in early December.

Markus Zimmer, Senior ESG Economist at Allianz, says there is an urgent need to address the supply/demand imbalance in the voluntary sector if it is to contribute meaningfully to emissions reduction efforts.

“We need not just a carbon offset market but a negative emissions market. We need to ramp it up quickly and institutionalise the process. The prices in the voluntary markets have increased but they are still very low value. They are not enough to generate the amount of projects we want to see on the supply side, which will actually offset emissions. The central point is additionality, we need to see it in the process,” he insists.

Toward transparency

Zimmer acknowledges that COP26 did not bring hoped-for progress in terms of greater transparency for investors over the cost of carbon emissions produced by investee companies. At present, only around 20% of global emissions are subject to carbon pricing schemes, meaning investors are unable to accurately track and compare costs and risks in their portfolios. Not just investor networks but also UN Secretary General Antonio Guterres made ‘putting a price on carbon’ a priority in the run-up to COP26.

The UN-convened Net Zero Asset Owner Alliance, of which Allianz is a member, has called for governments to explore new carbon pricing mechanisms in regulated markets, including a hybrid approach, which sits conceptually between emissions trading or cap-and-trade schemes and carbon taxes and levies. A minimum floor market price would be set to give certainty to investors and a guardrail against price crashes. A maximum market price, the ceiling, would also be introduced.

“If we had this, you could have something you could apply in your evaluations, but it didn’t come at the COP,” Zimmer says.

Nevertheless, My-Linh Ngo, Head of ESG Investment at BlueBay Asset Management, said the Article 6 agreement was significant and would be welcomed by the investment community.

“Investors do not want a disorderly and disruptive transition and in order to plan and make appropriate investment decisions, having certainty about the regulatory carbon framework is critical,” she says, adding that the development of carbon markets will help investors to tap into terrestrial- and marine-orientated nature-based solutions to tackle climate change.

Although arcane, the ‘nuts and bolts’ of the Article 6 deal reached in Glasgow matter to the future of the fight against climate change. As a result of 2% of newly issued carbon credits being cancelled under the agreement, overall emissions will be reduced, Ngo points out.

“The fact that agreement was achieved on the ‘thorny issues’ of avoiding double accounting, the quality of carbon credits and the setting of a levy that will benefit developing countries and allowing for the use of historical credits in the new system was a step forward,” she says.

“Having more information on these areas means investors can start to better refine their analysis of how different countries, sectors and companies are likely to be impacted, and think how this could be factored into their investment analysis. But given much is still to be worked on and agreed on in terms of the details, investors are limited in how much they can distil this down to.”

Delivering on promises

Much still depends on implementation, enforcement and delivery of the promises made in Glasgow, Ngo admits. Further effort is also required to add more details to the Article 6 compromise, to toughen up some of its “soft language”.

“The fear is that without these, the framework will not avoid double accounting of credits for example, or that there is no rigour around what activities qualify for inclusion,” she says. “Clarifying these aspects would bring more transparency to the market, which is needed by the investor community. Furthermore, governments need to tighten the framework specifically around enabling the historical credits to still count, as too much supply could hinder the system’s effectiveness and fail to incentivise the necessary behaviour.”

Even with a tightening up of the deal agreed at COP26, there are several barriers to be overcome. A robust global carbon trading mechanism can only help to reduce global emissions in tandem with an effective carbon price which incentivises high emitters to decarbonise their processes.

This is some distance away given that today’s emissions trading schemes are diverse, fragmented and at different stages of development. China’s newly introduced scheme, currently limited to the power generation sector, prices credits well below the level required to incentivise change. The more mature EU ETS is due for an overhaul, augmented by a planned carbon border adjustment mechanism, which will introduce tariffs for embedded carbon in imports.

“The EU currently has a proposal in place, and this will provide a platform for the issue to be discussed more widely. Encouragingly at COP26, the US and EU did agree on a tariff deal on steel and aluminium that could form the foundation for controls of goods that do not meet carbon intensity thresholds,” says Ngo.

Functional and credible

The voluntary carbon markets may have a chequered past, but scaling up the offset market can be a vital way of channelling investment into projects that sequester carbon and protect biodiversity.

COP26 may have not made progress on all fronts, but WisdomTree’s Shah has hope for the future. “Fixing double accounting and getting a credible pricing mechanism is key for voluntary markets to make a real-world difference,” he says. “It is not possible to get to net zero without the existence of these voluntary markets. It is important they become functional and credible soon.”

This does not solve the investor’s critical challenge of putting a price on carbon emissions. While efforts to that end continue, other routes to portfolio decarbonisation are being explored.

“Regulations for reporting are rapidly improving and we are getting more emissions data from companies, which helps when evaluating them,” Allianz’s Zimmer adds. “We assess each asset in our portfolio. But we don’t divest, we want to have an impact, to help a company transition. It’s about having a decarbonisation goal for your portfolio and engaging.”

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