In search of transformational change (part 2)

Aug 8, 2017 | Transformational change

Article 6 of the Paris Agreement opens up opportunities for international collaboration on emissions reduction.

Article 6.2 allows Parties to engage in “cooperative approaches”, whereby international transfers (Internationally Transferred Mitigation Outcomes, ITMOs) can be used by importing countries to meet their Nationally Determined Contributions (NDCs).

Article 6.4 establishes a mechanism “to contribute to the mitigation of greenhouse gas emissions and support sustainable development.”

Many of the details – rather important details – about how these approaches will work in practice have yet to be worked out. A burgeoning exegetic literature has sprung up, parsing the “shalls” and “shoulds”, “wills” and “wherefores” in the Paris Agreement text, in an attempt to shed light on what we can expect.

References to “real and measurable” emission reductions, additionality, and verification and certification by designated operational entities suggest that the Article 6.4 mechanism – which isn’t named in the text of the Paris Agreement and which is variously referred to as the Sustainable Development Mechanism (SDM) and the Sustainable Market Mechanism (SMM) in the subsequent literature – will be a crediting mechanism, probably a sectoral crediting mechanism. This could be a stand-alone instrument or just one of a number of instrument ‘windows’ that accommodate a range of approaches.

Sectoral crediting mechanisms come in a variety of flavours. The typical formulation envisages participating countries agreeing to unilateral mitigation efforts in a particular sector (ideally aligned with their unconditional Nationally Determined Contribution (NDC) pledges) and a second, more stringent baseline. Emission reductions achieved below this more stringent baseline are converted into carbon credits that can then be sold on the (or, more likely, a) carbon market.

The baseline can be defined in terms of absolute emissions (tCO2e) or an alternative metric (for example, tCO2e/unit product or tCO2e/kWh). But it’s likely that the credits would be issued in terms of tCO2e so that they are comparable – and potentially fungible – with carbon units issued by other instruments.

A stylised summary of how the Article 6.4 mechanism might work

Sectoral crediting is thus a means of incentivising more ambitious mitigation efforts. It’s typically envisaged as being a ‘no-lose’ mechanism: ambition is rewarded but failure to reach the target is not penalised.

Sectoral crediting ticks a number of interesting boxes.

It operates at scale and, depending how ambitiously the baseline is set, can be genuinely transformational. It avoids the ‘awkward scalability’ problem of the CDM’s project-by-project approach, as well as the CDM’s perennial problems with assessing additionality.

It is agnostic about how sectoral emission reductions are achieved, allowing policy stacks involving facility-level investments (along the lines of the CDM) as well as sectoral policies and measures (PAMs, along the lines of NAMAs and the GEF).

It uses a standardised baseline (along the lines of REDD+) and, because the issue is whether emission reductions are brought below the baseline, rather than how they are brought down, the complexities confronted by the GEF (and increasingly the GCF) with regard to direct and consequential emission reduction accounting generally do not arise.

Finally, it is not only intrinsically transformational (at sectoral scale) but is evolutionarily so as well, marking a natural waypoint between project-level mitigation and economy-wide mitigation (such as through an emissions trading scheme). Countries are able to bring a fraction of their economies under a cap without necessitating a wholesale – and potentially premature – transition to a full cap.

Moreover, ambition within the covered sector can be enhanced over time: the baseline can be progressively tightened, a no-lose target can transition to a mandatory cap or sectoral crediting can give way to sectoral trading.

Given that 25% of global emissions derive from the electricity and heat production sector, 21% from industry and 24% from agriculture and land-use change, and given that the G20 countries alone account for 80% of total emissions, it is clear that mitigation can be tackled very effectively by adopting a focused sectoral and geographical approach. Sectoral crediting is ideal for such precision abatement.

Greenhouse gas emissions by economic sector. Credit: IPCC

Now, of course, there are a lot of assumptions here that could lead us astray.

An easily-overlooked, but rather fundamental, issue associated with sectoral crediting is how to define the sector in question. The sectoral scope can be defined in terms of product or output, feedstock or input, the age (vintage) of production facilities, the industrial process, the types of technology used or other factors.

Pinning down a workable definition can prove surprisingly difficult. Consider, for example, the chemicals industry, where similar facilities can produce a diverse range of products (often from the same feedstocks). How, then, is the sector to be defined?

The EU Emissions Trading Scheme (EU-ETS) avoids such definitional quandaries by employing product benchmarks (52 of them), standard emission factors expressed as tCO2e per tonne of product. Each product has only one benchmark, regardless of the feedstock, process and technology involved. However, such an approach merely generates an alternative set of challenges, not least how to select the products for which benchmarks are needed.

Furthermore, there is an implicit assumption that a sector is typically homogeneous. But sectors sometimes – actually, surprisingly often – consist of efficient, large firms alongside large numbers of inefficient, small companies. Setting a single sector-wide target in these circumstances then runs the risk of putting the small firms at a disadvantage. The target may be ‘no lose’ but the high mitigation costs faced by the small firms could make it just as much ‘no win’ as well.

A key concern relating to sectoral crediting is incentivisation of the private sector. Since the emission reduction target is set at the aggregate sector level, it is possible that the mitigation actions of proactive firms could be cancelled out by the indifferent efforts of laggard firms, resulting in few (or no) credits being issued.

One way of addressing this problem is for a government to ensure that those credits that are issued are channelled to the appropriate firms. An alternative approach is for the government to guarantee credits for those firms that out-perform the target, with the government assuming the liability of making up the difference (by purchasing credits from elsewhere, for example) if there is a shortfall at the aggregate – sector – level.

But both these approaches require facility-level emissions monitoring, which is clearly more demanding (and expensive) than sector-level monitoring.

Setting the crediting baseline is, as one would expect, crucial to the success or failure of the mechanism. Baseline-setting requires detailed data relating to firms’ business-as-usual emissions (and how they are likely to evolve in the future), a good understanding of the mitigation costs that firms will face and a good inventory system that is capable of tracking at least sector-level, and very possibly facility-level, emissions.

If the baseline is too unambitious, large volumes of credits will be generated, swamping the market and driving down the price – and hence undermining the very mitigation incentive the mechanism is intended to create. If the baseline is too ambitious, disillusion and apathy will soon set in amongst firms and, again, the rationale of the mechanism will be lost.

Data-collection programmes such as the International Energy Agency’s benchmarking efforts and the Cement Sustainability Initiative’s ‘Getting the Numbers Right’ database can certainly inform baseline-setting; participating countries do not need to start from scratch. Nonetheless, detailed sector characterisation is inevitably needed to account for national- and even facility-specific peculiarities, and this necessitates considerable design and preparation work prior to the mechanism going live.

Moreover, external factors – such as international fuel prices, macroeconomic shocks and technological change – can exert considerable influence over a sector’s emissions, regardless of the mitigation actions adopted (or not adopted) by firms within the sector.

As evidenced by the IMF’s rather lacklustre track-record of GDP forecasting (or, indeed, carbon analysts’ repeated revisions of predicted CER prices), predicting the future is extremely challenging. Almost inevitably, a sectoral crediting mechanism needs some sort of dynamic adjustment facility, whereby the baseline can be periodically ‘tweaked’ to maintain a roughly stable level of ‘practicable ambition’. Such tweaking could potentially be linked to the 5-yearly NDC global stocktake process under the Paris Agreement.

Secondary CER price forecasts made by Point Carbon over a 14-month period. Credit: Axel Michaelowa

And the viability of such a mechanism of course depends on there being sufficient demand for the resulting credits.

The statements provided in NDCs to date do not provide much confidence in this regard: although two-thirds of NDCs, representing 58% of global greenhouse gas emissions, state that Parties are considering the use of carbon pricing, only 13 NDCs indicate an interest in acquiring international units to assist with meeting NDC targets. This may change, of course, particularly as the details of Articles 6.2 and 6.4 become clearer, but the CDM provides a sobering reminder of the impact of insufficient demand.

Given these complexities, it is likely that a sub-group of like-minded and more advanced Parties will at first participate, with membership expanding over time. There are plenty of contemporary examples of such ‘carbon clubs’, such as the members of the EU-ETS and the countries participating in Japan’s Joint Crediting Mechanism (JCM). Obvious candidates for initial participation would be countries with shared sectoral priorities, NDC targets denominated in tCO2e, and the inventory systems and capacities required for facility- or sector-level MRV.

Where this all leaves us rather depends on one’s perspective.

On the one hand, a sectoral crediting mechanism combines many of the positive features of today’s mitigation armoury whilst avoiding the negatives: the scale and flexibility of NAMAs and the GEF (and, increasingly, the GCF) are combined with the baseline-setting and MRV rigours of the CDM and REDD+.

On the other hand, such a mechanism is susceptible to the same weaknesses confronted by contemporary carbon instruments – poor calibration of the cap (often driven by industry lobbying), uncertain and potentially volatile credit prices, and a high level of complexity (and resulting transaction costs).

What’s clear is that if the Paris Agreement is to live up to its commitment to pursue efforts to limit global temperature increase to 1.5°C, not only must the NDCs demonstrate a commensurate level of ambition but so must the tools made available to Parties. With genuine determination from Parties and intelligent design decisions, the Article 6.4 mechanism has the potential to deliver the needed transformational change.