Glasgow, Egypt and the carbon market breakthrough: the promise of Article 6

What role does the United Nations play in carbon pricing?

Since the adoption of the Kyoto Protocol in 1997, the United Nations climate process has played a key role in developing carbon pricing, both directly through UN mechanisms and indirectly by influencing regional, national and private systems. The largest UN crediting mechanism by volume, the Clean Development Mechanism (CDM), has issued over 2.3 billion certified emission reductions – carbon credits that each represent one tonne of carbon dioxide-equivalent of emission mitigation.[1]

The decisions at COP26 in Glasgow in 2021 on Article 6 were among the final elements of the rulebook for implementation of the 2015 Paris Agreement to be adopted by Parties. This long delay evidenced both divergent views on market mechanisms as a tool of climate policy and competing interests amongst Parties over the specifics of how the new tools will function.

At the COP27 climate conference in Egypt in late 2022, and in the weeks that followed, multiple agreements and initiatives to put the Paris Agreement’s carbon market framework into practice were announced.

Further major developments are expected in 2023, including from the Supervisory Body for the new UN centralised market mechanism, which next meets in March. In the coming months, carbon market participants will face important milestones in both the international regulation of Article 6 activities and the development of an Australian government position on Article 6 participation.

Source: Nationally determined contributions under the Paris Agreement, Synthesis report by the UN climate secretariat, 26 October 2022, para. 96ff

The Paris Agreement provides for two trading-based approaches:

• a centralised UN mechanism, which will be implemented under detailed rules agreed multilaterally (the new mechanism) - Preparation for operationalisation of the new mechanism under article 6.4 is ongoing
• decentralised, direct cooperation between Parties, pursuant to UN guidance but ultimately governed according to the rules agreed by the Parties concerned - Parties are already engaging in article 6.2 cooperative approaches

In both cases, the ITMO is the main form of credit which can be issued, bought and sold.

Article 6 builds on the experience of the Kyoto Protocol’s ‘flexibility mechanisms’ - but with major departures

The different nature of the Paris Agreement means that voluntary cooperation under Article 6 has the potential to scale far beyond the size of the Kyoto mechanisms, as Article 6 is free of the limitations and timebound nature of the Kyoto Protocol.

• Under the Kyoto Protocol quantified mitigation commitments were limited to those developed (‘Annex I’) Parties that had accepted them.

Developing countries did not undertake corresponding commitments. The flexibility mechanisms reflected this bifurcation. The CDM enabled developed Parties with Kyoto commitments to source carbon credits from developing Parties, in effect investing in climate mitigation projects in the global South and getting carbon credits to count against their own Kyoto targets in return.

• Under the Paris Agreement commitments are not limited to a specified subset of Parties - each Party has mitigation targets as communicated in their NDC.

Article 6 voluntary cooperation is not limited to one subset of Parties and does not ascribe different roles to developed and developing countries. For example, Australia, as a developed Party, can be both a host of Article 6 activities and the purchaser of Article 6 credits resulting from activities abroad.

…But Bringing Article 6 to life via frameworks has faced challenges

The development of robust carbon crediting frameworks under Paris has proven challenging, in part because NDCs are very diverse and their mitigation outcomes are expressed in various metrics, in contrast to the uniformity of Kyoto commitments.

This complexity continues to be reflected in the challenge of crafting regulations to bring Article 6 to life. The Glasgow guidance[2] from the meeting of Parties to the Paris Agreement (known as the CMA) on cooperative approaches set basic requirements for interparty cooperation.

Post Glasgow, emission removals will become increasingly important

Emission removals did not play a major role in the Kyoto-era markets but are expected to be increasingly important.

The guidance includes a definition of ITMOs, which are emission ‘reductions and removals … when internationally transferred’.

Accommodating the diversity in NDC mitigation targets, Article 6.2 ITMOs may be measured in tonnes of CO2e ‘or in other non-greenhouse gas (GHG) metrics determined by the participating Parties’.

A participating Party may authorise ITMOs for international transfer for one of three purposes:

1. Use towards achievement of another Party’s NDC
2. ‘International mitigation purposes’, enabling use in the international aviation offsetting scheme, CORSIA, and potentially a future international shipping carbon market
3. ‘Other purposes’, undefined but commonly taken to mean the voluntary carbon markets.

The environmental integrity of ITMOs is based on the requirement of ‘corresponding adjustments’, a form of double entry bookkeeping with the aim of preventing double-counting of emissions mitigation.

A Party transferring ITMOs must adjust its national emissions balance by adding the volume of the transferred ITMOs while a receiving Party makes a corresponding subtraction from its balance. Importantly, this requirement applies even if the mitigation activity falls outside the transferring Party’s NDC, so there is no perverse incentive to limit an NDC’s scope or ambition.

Corresponding adjustments are not however required for credits from the Article 6.4 mechanism which have not been authorised for transfer for one of the three purposes. In Sharm El-Sheikh, Parties designated these credits as ‘mitigation contribution’ Article 6.4 emission reductions and noted that they ‘may be used, inter alia, for results-based climate finance, domestic mitigation pricing schemes, or domestic price-based measures, for the purpose of contributing to the reduction of emission levels in the host Party’.[3] As there is no corresponding adjustment, the sale of such credits would help finance the achievement of the host country’s NDC. Corporate or philanthropic buyers would not be able to claim an offset for their own emissions but would be able to claim that they are financially supporting domestic climate mitigation activities.

Although Parties participate in Article 6.2 cooperative approaches without the need for UN approval, international technical expert review teams will review Party reporting for any inconsistencies.

The new crediting mechanism: a Supervisory Body & appeal process

In a separate decision in Glasgow, Parties adopted rules for the (as-yet unnamed) Article 6.4 centralised trading mechanism.

Parties designated a Supervisory Body to supervise the mechanism and provided for the mechanism’s activity cycle, which is similar to that of the CDM but has some important differences. New features will include:

• a process to appeal Supervisory Body decisions (e.g. to refuse to issue credits) and
• an ‘independent grievance process’ which should enable stakeholders negatively affected by activities to make complaints and seek redress.

Another important change is that the new mechanism goes beyond offsetting by providing for ‘overall mitigation of global emissions’, to be achieved through compulsory cancellation of two percent of the credits issued from each activity. Provision was also made for the transition of certain CDM activities and credits, on application. In Egypt, Parties set the Supervisory Body a June 2023 deadline for developing a procedure for transition requests concerning CDM activities.

There are implications for voluntary markets – and legal issues for businesses

The Article 6 decisions do not directly regulate the voluntary markets but will exert significant influence on them, due to the novel provision for governments to authorise credits for use in the VCMs. This has implications both for VCM participants that plan to utilise Article 6 and those that do not.

• VCM participants that plan to utilise Article 6 must address many legal issues, including the need to:
  • tailor transactional structures to Article 6
  • address political risks related to ITMO authorisation and to potential host country restrictions or bans on the export of carbon credits.
• VCM participants that do not plan to utilise Article 6 will face reputational challenges to the extent that carbon credits backed by a corresponding adjustment come to be accepted as a premium product of verified environmental integrity.

Buyers of other, non-authorised and probably cheaper credits may face a reputational challenge concerning investors, consumers and other stakeholders.

What does it mean for Australia? Building global capacity, but domestic participation uncertain

Australia’s updated NDC, communicated to the UN by the Albanese government in June 2022, neither confirms nor rules out Australian participation in voluntary cooperation.[4] Domestically, Article 6 has been under consideration in several policy and legislative processes. Internationally, Australia is leading or participating in a number of initiatives to build capacity for Article 6 participation, including in neighbouring developing countries.

The possibility of Australia using domestic emission reduction credits towards its NDC

As part of its September 2022 amendment of the Carbon Credits (Carbon Farming Initiative Act) 2011, the Australian Parliament amended the definition of a ‘prescribed eligible carbon unit’ to enable units to be prescribed if they can be used to meet Australia’s Paris Agreement climate targets.[5] A ‘prescribed eligible carbon unit’ is a ‘prescribed unit that is issued under a scheme relating to either or both of’ emission removal or avoidance, whether issued in our outside Australia, and must represent abatement that can be used to meet Australian targets under listed international agreements.[6] The Act had previously listed the Kyoto Protocol and ‘an international agreement (if any) that is the successor (whether immediate or otherwise) to the Kyoto Protocol’. If Article 6 units were to be so prescribed and in the case that the government approves Australian hosting of Article 6.4 activities, this amendment could enable the Clean Energy Regulator to buy domestically sourced Article 6.4 emission reduction units (those which have not been authorised toward achievement of another Party’s NDC or other international purposes) to count towards Australia’s NDC target.[7] In its explanatory memorandum, the government noted that ‘[n]o units are currently prescribed for the purpose of this definition’.

International offsets not applicable for domestic obligations of businesses - yet

The government does not currently support use of international credits to meet domestic obligations and its proposed reforms to the Safeguard Mechanism would not enable covered facilities to utilise international credits to stay below their emissions baseline.[8] A prior consultation process attracted a large volume of feedback, including on the question of international credits. The government has stated that while ‘international offsets are not proposed to be part of the initial enhanced Safeguard Mechanism’, it ‘is giving ongoing consideration of a legislative framework for the possible inclusion of international offsets, which would need to be of the highest integrity and count towards Australia’s Paris targets’.[9]

Australia’s focus on helping neighbouring nations with their emission reduction efforts

While some other Paris Agreement Parties are already engaged in Article 6.2 cooperative approaches, Australia has confined its activity to international capacity-building initiatives aimed at helping developing country partners and other stakeholders to participate in voluntary cooperation.

• The Indo-Pacific Carbon Offsets Scheme (IPCOS) was launched by the Australian government in 2021. IPCOS is a ten-year programme which ‘will align with Article 6 of the Paris Agreement’. While the IPCOS is reported to be more focused on capacity-building in partner countries Fiji and Papua New Guinea than in the procurement of carbon credits, there is potential for it to develop into a cooperative approach if participating governments so wish. At the February 2023 Australia-Papua New Guinea Ministerial Forum, the two sides ‘committed to sign the IPCOS Joint Action Plan as early as possible this year’.
• The ‘Quad Climate Change Adaptation and Mitigation Package (Q-CHAMP)’ was announced by the Quad partnership of countries in May 2022. This is to include ‘cooperation and capacity building support to advance high integrity carbon markets under Article 6’.[10]
• The Article 6 Implementation Partnership, an initiative of the Japanese government aimed at building readiness for Article 6 participation, welcomed Australia as a new partner at COP27.

In its August 2022 review of international offsets, the Climate Change Authority made several recommendations encouraging the Australian government to prepare for participation in Article 6, including regarding the development of the IPCOS.[11]

Post-Egypt frameworks around Article 6.2: tracking, reporting and reviewing cooperation (but more to come)

At COP27 in late 2022 at Sharm El-Sheikh, the CMA filled in some of the gaps regarding Article 6.2 infrastructure, reporting and review.[12]

On tracking and recording ITMOs, the CMA set out the required functions of registries and the minimum required information to uniquely identify each ITMO.[13]

• On reporting, the CMA contentiously placed no limitation on the ability of Parties to identify information as confidential.[14] After much negotiation, the CMA merely decided that a Party declaring information confidential ‘should provide the basis for protecting such information’.[15] The use (or abuse) of this confidentiality prerogative may impact the transparency of the ITMO market.
• On auditing for compliance and consistency, the CMA adopted guidelines for technical expert review of Party reporting on cooperative approaches. The need to facilitate the ‘application of robust accounting’, among other principles, will guide the process.[16] Technical expert review will focus on evaluating consistency of reporting with the Article 6.2 guidelines, across different reporting requirements and across all participating Parties.[17] In the absence of any centralised oversight, technical expert review will be a key safeguard of the integrity of cooperative approaches. It is however narrowly focused in terms of both its approach[18] and the matters that can be considered.[19]

Following the Egypt conference, the UNFCCC Secretariat released interim arrangements for accounting and reporting concerning Article 6.2 activities.

The market awaits outcomes on significant issues – but progress pushes on

Many other important matters were deferred by the CMA for later decision. These include:

• Further guidance on corresponding adjustments to avoid double-counting
• Whether ITMOs can include emission avoidance, in addition to emission reductions and removals
• Whether Parties can make changes to authorisations of ITMOs towards particular uses
• Issues arising from the conversion of non-greenhouse gas metrics into tonnes of CO2e.[20]

The CMA’s June 2023 negotiating session will address some of these matters.[21] In 2023 Parties and market participants will continue to build cooperative approaches, with the CMA yet to pronounce itself on key issues which can be expected to have a major impact on the future development of this market.

Despite the halting progress of the UN negotiations, new Article 6 agreements and initiatives were announced during the 2022 COP in Egypt and in the weeks following. Significant developments include:

• the first authorisations of ITMOS for transfer
• new bilateral agreements on cooperative approaches
• the launch of the African Carbon Markets Initiative
• the launch of a 90-day public consultation by the International Organization of Securities Commissions (IOSCO) on sound compliance carbon markets and enhancing the resilience and integrity of VCMs.

These developments evince a high level of interest among Parties and other stakeholders in putting Article 6.2 into practice.

What next? A year of greater regulatory clarity and trading activity in 2023