Formulating an Article 6.2 transaction

While Article 6 of the Paris Agreement remains in negotiating limbo, the text that emerged from Madrid for Article 6.2 gives a very strong indication of how countries view this mechanism and what will be required between Parties to see transactions begin to emerge. This includes the need for a carbon budget based Nationally Determined Contribution (NDC) or an NDC for which a budget can be formulated and a corresponding adjustment of NDCs to ensure environmental integrity and the avoidance of double counting. This is clearly spelled out in the Madrid text – III. Corresponding adjustments / B. Application of corresponding adjustments, paragraphs 8 to 13.

However, the actual buyer and seller will likely be private entities operating in the two countries making use of Article 6 and while the Paris rulebook is an important consideration in their transaction, the requirements of the rulebook will not be met by the transaction itself. Rather, the transaction of units between the buyer and seller must trigger a set of actions by the respective governments such that the Paris Agreement rules can be adhered to. This means that a link must exist between the inflow and outflow of carbon units within each economy and the implementation of the respective NDCs. Without such a link, the transaction effectively sits in the global voluntary market, which in turn means that the transaction cannot be used to meet compliance obligations that are crafted to guide the economy towards the goals described in the NDC.

The simplest such link that currently exists is where two emissions trading systems are joined, such as between Switzerland and the EU. Private entities operating within these systems can trade EU ETS allowances and Swiss ETS allowances, use the allowances for compliance in their respective country and know that there is some cascade upwards to the EU and Swiss NDC accounting. The approach is very simple, transparent and effectively a non-issue for the participants in the transactions. But what happens when there isn’t an existing trading system in place?

In the case of the Clean Development Mechanism (CDM) under the Kyoto Protocol, a project could be implemented in a developing country and upon agreement of the host country, the CDM Executive Board and a verifier, certified emission reduction units (CER) were issued. Apart from the checks already mentioned, these units were issued without context in that they didn’t relate specifically to a national plan to reduce emissions or have any economic bearing on the project host country other than bringing in valuable foreign investment. In the case of the buyer, the transaction was managed through the accounting rules of the Kyoto Protocol because the CERs would be added to the national inventory of assigned amount units (AAU) and then could be used for compliance against the national target. There was still a need for a system to cause the buyer to make the purchase, which in the case of the EU was the compliance requirements of the EU ETS.

But in the case of an Article 6.2 transaction, there is an impact on the national economy where the seller resides. Firstly, the requirement for a corresponding adjustment to the NDC means that an NDC carbon budget must be established. Secondly, the adjustment means that further reductions in country must be made to compensate for the sale, so a mechanism should ideally exist to ensure that those reductions are made and that they don’t cost more to implement than the proceeds from the sale. In the case of linked emission trading systems, the inherent design of the trading system provides this mechanism. A similar problem could exist at the buyers end, but the issue is often simpler. For example, the buyer may be using the units as an allowable alternative against payment of a carbon tax, in which case the decision to buy is based on the cost of available units from the recognized sources versus the payment of the domestic carbon tax.

Without an emissions trading system in place, the host country looking to generate income through the sale of units under Article 6.2 (ITMO or Internationally transferred mitigation outcome) has the perplexing problem of both tying the sale to the NDC and establishing whether the sale is of economic interest for the country. Depending on the eventual structure and agreement on Article 6.4, the same problems could also emerge. This means that the implementation of Article 6 will have a profound impact on the shape of mitigation policy in participating countries. It may be the case that the only way of solving this problem is through the implementation of a domestic emissions trading system, which makes Article 6 a catalyst for further uptake of cap-and-trade architecture (i.e. emissions trading systems). That would be a good outcome for all concerned.