Delegates at the COP24 annual UN climate conference in Poland in December agreed on large parts of the Paris Agreement “rulebook,” the operating manual needed for when the global deal enters into force in 2020. However, a key unresolved agenda item was postponed until next December’s COP25 conference in Chile: to discuss and agree on the rules that will govern the “next generation” of carbon markets for the trading of carbon emission allowances.
Damaged by the global financial crisis and carbon credit import restrictions, carbon prices collapsed in 2012, when supply far exceeded demand and the world community was unable to agree on a framework for climate policy after 2012.
The Paris Agreement has now re-ignited interest in carbon markets.
The main issues still to be resolved concern rules for voluntary market mechanisms under Article 6 of the Paris Agreement. This includes Article 6.2, under which countries can trade overachievement of their pledges to curb greenhouse gas (GHG) emissions, as well as Article 6.4, under which individual projects can generate carbon credits for sale.
Article 6.4 is intended to replace the “Clean Development Mechanism” (CDM)—the world's only global system of carbon trading—which was established under the Kyoto Protocol, the precursor to the Paris Agreement. The CDM was also designed to benefit developing countries, because it allowed developed countries to source and buy credits from these countries derived through eligible low-carbon investments. Under the CDM, the primary carbon market ballooned from US$2.47 million annually in 2000, to US$7.9 billion at its height in 2007, according to a recent report by the World Bank Group’s Independent Evaluation Group on Carbon Finance.
How Carbon Markets Contribute to Emissions Reduction
There are two ways to motivate firms to cut their GHG emissions: carbon taxes, which provide a direct incentive to reduce emissions, and carbon markets, which help reduce the cost of meeting emissions reduction targets, and thereby provide an indirect incentive to meet the targets.
For carbon markets to play their role as a tool for climate mitigation, there needs to be predictable demand for low-cost carbon credits. When there is no demand for carbon credits, there will be no market for generating and supplying these credits.
Under Kyoto, carbon markets worked when developed countries had (1) clear and binding commitments to reduce emissions, and (2) the political willingness to import the cheaper credits from other countries. Through the “flexible mechanisms”, the international carbon markets facilitated the transfer of cheaper credits from developing countries and transition economies to help developed countries meet their targets at lower cost.
Following the collapse of the international carbon markets in 2012, some countries have moved towards establishing domestic markets which may not allow imports of any foreign carbon credits. While domestic markets are relevant, mitigation efficiency might be limited when such markets to do not allow international transfers and countries with lower costs to supply the credits, and therefore emission reduction costs may remain high – limiting the potential to raise the mitigation ambition.
The World Bank Group was one of the first movers and a key player in creating the carbon markets under Kyoto, starting in the late 1990s. Overall, IEG has found that the World Bank Group’s experience under Kyoto affirms that carbon markets can play a critical role in stimulating low-cost climate mitigation and support clean and green investments in developing countries.
IEG held a panel discussion on Feb 5, 2019 about the Future of Carbon Markets for Climate Change Mitigation
Watch the re-play of the live event.
How the Next Generation of Carbon Markets Can Become More Effective
The current need for piloting and demonstrating the market mechanisms under the Paris Agreement echo the early period of Kyoto Accord. Countries, international organizations, donors, and the private sector can leverage their comparative advantages to revitalize the carbon markets and facilitate this transition and to support greater emission reductions, consistent with the high ambition of the Paris Agreement.
Key issues to consider for the future of carbon markets, based on the Kyoto experience, include the following:
For the greater climate policy and carbon finance community
- Reduce policy uncertainty. The next generation of carbon markets need to be built on a stronger foundation and policy environment from the past. This requires policy clarity, stable and higher prices, and predictable and longer-term demand for emission allowances.
- Improve efficiency and transparency of regulatory systems. The project cycle and the regulatory process under Kyoto has been criticized for being lengthy, costly and unpredictable, which increased the transaction costs and the project risks for investors in low-carbon alternatives. Learning from the Kyoto experience, better standardization of the validation, monitoring and verification systems are key to improve transparency and legitimacy of the regulatory system.
- Attract and leverage private investments to scale up climate change mitigation. In addition to rebuilding trust in markets, incentives for the private sector are stronger when carbon finance improves the returns and bankability of the investment (for example, when frontloading of carbon revenues is possible to secure the financial closure of projects).
For the World Bank Group
- Mainstream carbon finance with development and climate finance to support transformational change. This requires going beyond trust-funded, project-focused and small-scale activities to scale up emission reductions and to raise ambition. The uptake and integration of carbon finance with other World Bank Group instruments and operations can be enhanced by improving internal coordination and moving toward larger project funding with lower transaction costs.
- Link climate mitigation through carbon finance with development and environment benefits. The additional benefits (co-benefits) add incentives for client countries to use carbon finance for climate mitigation. Development co-benefits include greater access to clean and affordable energy and reduced poverty, and environment co-benefits include reduced pollution and improved health.
- Revitalize, stabilize and expand markets targeting new opportunities. The World Bank Group can leverage its accumulated experience, expertise, financing instruments and thought leadership from the Kyoto period to inject new momentum and help revive the carbon markets. Stronger leadership would be key to innovate, catalyze and deepen markets and to reduce market risks, especially in underutilized sectors and underserved regions and countries.