The carbon market to the rescue in the fight against global warming
The carbon market was first conceived and implemented in 1997 under the Kyoto Protocol, and has undergone substantial changes since then. It now plays a key role in tackling global warming. Between internationally-recognized principles and a pragmatic approach in the implementation of regional markets, extending the carbon market and maximizing its efficiency is vital if the transition strategies of the world’s economies are to succeed.
Tackling global warming essentially involves reducing greenhouse gas (GHG) emissions by both people and the industrial sector. This was acknowledged by the various countries present at the COP26 in November 2021: They have committed to reducing their GHG emissions by 45% by 2030 (compared with 2010 levels) in order to achieve net zero in the next twenty years.
Internalizing the cost of greenhouse gas emissions
To achieve this ambitious target – given that emissions levels have continued to increase in recent years – carbon trading mechanisms have been introduced: A market-based formula that favors an incentive-based approach to reducing emissions based on internalizing the costs of damage to the planet.
By putting a price on carbon emissions, quota markets effectively transfer the social cost of future climate change damage to the stakeholders responsible for generating the emissions. Carbon offsetting mechanisms were devised under the 1997 Kyoto Protocol and are currently managed within the framework of international climate negotiations through the United Nations Framework Convention on Climate Change (UNFCCC).
The principles of the Kyoto Protocol
Under this agreement, the signatory states undertake initiatives to reduce emissions across their territories, to use carbon sinks, or to make use of the flexibility mechanisms provided for, including the Clean Development Mechanism (CDM) and the Joint Implementation Scheme (JI), which act as compensation mechanisms. They provide the means for signatories to the Protocol to offset their emissions by financing GHG emission reduction projects outside their borders.
The Kyoto Protocol expired in 2021, having enabled the emergence of an international carbon market, which has remained, however, modest. Article 6 of the Paris Agreement has taken over, bringing with it increased targets and introducing the aim of making it easier for parties to meet their Nationally Determined Contributions (NDCs) – in other words, their voluntary commitments.
The approach adopted by the Paris Agreement and COP26
To this end, the Paris Agreement has adopted a cooperative approach by allowing countries to trade their mitigation results (the equivalent of quotas) via a carbon credit market from carbon reduction or sequestration projects. COP26 was given the task of finalizing the scheme’s operation, and it did so by breaking new ground and creating two carbon credit markets: One for companies and governments and the other for bilateral trade between countries. These markets oblige polluters to pay for credits when they exceed their quotas, and these payments are then used to finance projects to reduce CO2 emissions.
In order to ensure that the commitments made by companies to achieve net zero remain realistic, only 5 to 10% of their emissions can be offset. Furthermore, the agreement restricts “double counting”: If a company sells a carbon credit to another country or company, only one of the two will now be able to count it towards its emissions targets. It is also worth noting that India, China and Brazil have been granted the right to keep the credits generated via the Kyoto Protocol, i.e. 300 million low-environmental quality credits, thus enabling them to land on the new market with a start-up capital. Less effort will therefore be required for them to meet their commitments.
The European carbon market model
European Union Member States have adopted this trajectory by creating the most regulated carbon market: In 2005, the EU created a common ad hoc mechanism governed by the Commission. Known as the European Union Emissions Trading Scheme (EU ETS), this market allocates CO2 emissions quotas to companies. One quota represents the right to emit one ton of CO2.
Each year, the European states set the number of quotas to which the companies concerned by the carbon market are entitled. If a company emits fewer GHG emissions than its allocated quota, it can either sell the difference on the carbon market or keep it. If it exceeds the limit, it must buy additional quotas, the cost of which is set by the market. This way, it bears the additional cost of its activity. Currently, more than 12,000 industrial facilities in the chemical, power generation, paper, cement, and steel industries are concerned, accounting for more than 50% of Europe’s emissions.
In order to achieve the target of a 55% reduction in CO2 emissions by 2030 (based on 1990 levels), the cap on emissions allowed under the EU ETS has been reduced. With the removal of some of the excess quotas which were the reason for the price per ton of CO2 emissions falling, the price exceeded €100 in February 2022 – a level that provides companies with a serious incentive.
A European market destined to evolve
Extending the EU ETS to include maritime transport starting in 2024 should also help to support the price of carbon. Emissions from road transport and the construction sector will have their own dedicated market, to avoid destabilizing the current market. In addition, an EU Border Carbon Adjustment Mechanism (BCAM) is under way.
The stakes are high: The EU’s imports account for 20% of its total GHG emissions. To prevent European companies from thinking that they can avoid this tax by simply relocating their activities to other countries, the BCAM requires importers of goods from third countries to purchase certificates from the national authorities of these countries. The price of these certificates will be based on the price of CO2 in the European carbon market. The implementation will gradually be phased in starting on January 1, 2023, with payment effective as of 2026.
Numerous initiatives at regional level
This mechanism is of concern to third countries, which see it as a way of introducing hidden customs duties. This is particularly the case in the United States, which has introduced carbon markets, but at a much more modest rate than in Europe. The Regional Greenhouse Gas Initiative (RGGI, or ReGGIe), for example, was creaetd out of an alliance of the country’s north-eastern states to reduce their GHG emissions. It came into force in January 2009 and now covers 11 states. At the same time, the state of California introduced a cap-and-trade system with Quebec in 2014 as part of the Western Climate Initiative, which was extended to include Ontario in 2017.
Other countries are following suit: New Zealand, China, South Korea, and the United Kingdom – which has left the European Union – have also set up carbon markets. While they operate in a similar way to the European mechanism (and although they are in line with the objectives of Article 6 of the Paris Agreement), they differ in that they have their own basis and ambitions. These specific features are primarily due to the definition of the initial allocation of allowances and the sectoral scope of the market.
The rigor of measures and emissions checks through mandatory and harmonized monitoring, reporting, and verification procedures is also variable. Finally, they can adopt flexibility measures over time, through banking and borrowing, and over space, through compensation mechanisms, which also vary.
The challenge of efficient carbon markets
If the market works properly, the carbon price offsets the costs of reducing emissions by the various stakeholders and enables reduction targets to be achieved at the lowest possible cost. This objective requires regular adjustments: Quota volumes have to be redefined, the scope of the companies concerned needs to be broadened, and minimum prices need to be introduced in order to maintain the incentive nature of the efforts to reduce emissions.
Improving the efficiency of the various carbon markets by interconnecting them remains a challenge to accelerate the fight against climate change. Thanks to blockchain technology, for example, it might be possible to render their quotas tradable from one market to another, thus promoting price convergence.