Category: Emissions Trading

Articles about emissions trading

How might Article 6 work in practice?

dchone October 11, 2019

This is a critical year for Article 6 of the Paris Agreement. The ‘rule book’ wasn’t agreed at COP24 in Katowice, so the focus of negotiations at COP25 in Santiago will largely be on Article 6. This is the section of the Paris Agreement that sets out the framework under which cooperative action can be organised between Parties with a view to achieving their Nationally Determined Contributions (NDC). While cooperative action could take many forms, Article 6 is being negotiated as a carbon trading framework. There are very significant benefits in doing this, as recently shown in new work from the University of Maryland.

There are a number of interpretations of how Article 6 should work, hence the lack of agreement in Katowice, but the text in the Paris Agreement is really very clear. As I recently discussed, the underlying issue is the implication of the rules. A simple illustration helps explain Article 6 and can show why it is so important, why robust accounting is essential and why it can help deliver an overall reduction in global emissions.

In the illustration below, we have three countries (A, B and C) and the aviation sector. They each have a goal of zero emissions, but that is not the current state they find themselves in.

County A still has considerable emissions (100 units) from its heavy industry sector, but with no local abatement opportunities. As such, it is stuck and unable to make further reductions.
Country B has reached zero emissions but has not developed local options to easily sequester carbon dioxide as it has no need to do so.
Country C is undeveloped and has no emissions, but needs to develop energy infrastructure.
The aviation sector still has emissions (200 units) despite efficiency improvements and perhaps some fuel substitution. It has no immediate opportunities for further reductions.

These countries and sector decide to make use of Article 6 of the Paris Agreement to achieve their goals, enhance ambition and achieve further reductions. Investors develop a large scale air capture project in Country B, with geological storage. Emissions for Country B fall to -100, but they transfer units to Country A using Article 6.2 which underpins the original investment. Both A and B adjust their inventories accordingly with each now achieving net-zero emissions.

A similar transaction is executed between Country B and the aviation sector, but this time using afforestation as a natural sink. Country B remains at net-zero emissions as it adjusts its inventory and the aviation sector emissions can now be reported as 100 units. The transfer of nature based units, again using Article 6.2, has delivered real reductions for the sector.

But aviation still needs to take further action and as such encourages project developers to implement an avoided emissions project in Country C using the mechanism under Article 6.4. The project investment delivers reduction units that are then sold to the sector, bringing emissions to net zero. However, because of the need for a corresponding adjustment to their own inventory under the rules of 6.4, Country C now finds itself with 100 units of emissions, despite having no physical emissions in the country itself. This is because of the strict accounting rules of the Paris Agreement that are designed to ensure an eventual net zero outcome.

So in this example, Country C opts for a transfer from Country B under Article 6.2, with Country B further developing its natural sink potential to allow the transfer to take place.

After making all the local reductions that were possible and then utilizing the cooperative trading approaches offered by Article 6, the overall outcome across the countries and the sector is net zero emissions, which aligns with their desired goals.

Article 6 has delivered in many ways;

An overall reduction in global emissions has been achieved, with emissions falling from 300 units to net zero.
Ambition has been enhanced, with the countries and the sector all able to confidently target a net zero emissions outcome instead of stopping short of that goal.
Economic activity across the countries has been enhanced, with jobs and investment resulting from the transfers and project activity. Importantly, no country or the sector has had to reduce its economic output to meet emissions goals.
No double counting has taken place and clear carbon emissions accounting has ensured that the actions are visible to all and pass the critical test of environmental integrity.
Project developers have made use of the capabilities of Article 6.2 and 6.4 and invested with confidence, knowing that the transaction and supporting accounting systems behind Article 6 would deliver a return on their investment, without delay and without withholding of units.
The transaction under 6.4 delivered valuable revenue to another developing country through its share of proceeds provision (Article 6.6).

While the above is a very simplified illustration, it nevertheless shows the importance of the market oriented aspect of Article 6 in delivering the goals of the Paris Agreement. In addition, there is Article 6.8 which will be used to deliver non-market oriented approaches, such as the Kigali Amendment to the Montreal Protocol. With regards the market provisions of Article 6, early and clear implementation of the rule-book, embracing the clear intent of the Paris Agreement as shown above, is the essential next step.

Looking again at carbon pricing

dchone September 23, 2019

It is Climate Week in New York and among the police barricades at the UN, the protests and traffic there is still the opportunity for new thinking and revisiting important subjects. Perhaps none is more important than the role that carbon pricing must play, yet its impact on the energy transition has been limited to date. One of the reasons for the modest uptake in carbon pricing (largely limited to the EU and a some parts of North America, but others now emerging, e.g. Singapore, South Africa and hopefully China) has been ongoing concerns relating to competition, be it for a single industry or more widely at national level compared to trading partners. By contrast, in the Shell Sky Scenario, government implemented carbon pricing emerges rapidly and robustly in the 2020s as part of a suite of critical policy measures to bend the global emissions curve and begin the long journey to net-zero emissions.

Following on from the Paris Agreement in 2015 the World Bank initiated a coalition to help usher in carbon pricing as a policy instrument. The Carbon Pricing Leadership Coalition (CPLC) brings together governments, civil society and industry and offers a forum to learn and share ideas. To that end, the CPLC created the High Level Commission on Carbon Pricing and Competitiveness and at the opening of Climate Week the Commission launched its report on the issue.

As the report discusses, those involved in the use of carbon pricing recognize the concerns that exist due to differential carbon prices between jurisdictions, currently ranging from zero (many places) to around $100 per ton of carbon dioxide (a few cases in some sectors in a handful of countries). There is the potential risk that high-carbon economic activity may move to regions without a carbon price or with a lower price. This could result in decreased profits and job losses. It could also exacerbate political push-back and undermine the intended environmental outcome of reduced GHG emissions. If this “carbon leakage” occurs, it would be a lose-lose: a loss of competitiveness or economic activity without an environmental gain.

But the report finds there is little evidence to date that carbon pricing has resulted in the relocation of the production of goods and services or investment in these products to other countries. This outcome is consistent with the economic literature assessing the competitive impact of environmental regulation more broadly. There may be several reasons for this, including the observation that carbon price levels have generally been moderate and existing programs include protection for at-risk sectors. In addition, tax rates, labour availability, and infrastructure may be more significant to investment decisions regarding location of production than environmental regulations.

While competitiveness remains a key concern for policymakers considering a price on carbon, the report argues that these concerns should not be overstated. Competitive risks exist primarily for highly emissions intensive and trade-exposed (EITE) sectors and jurisdictions that depend on such sectors. These risks can and should be addressed through a suite of locally tailored policy design choices intended to protect industry from unfair international competition even as they ensure that the incentive and support for low-carbon innovation remains.

The report points out that there are a variety of options to address competitiveness risks, including free allocation of emission rights and border measures. However, these should be based on a location-specific, data-driven evaluation of impacts. Once implemented, these measures should be periodically re-evaluated to ensure their effectiveness and usefulness. To that end, data transparency from industry, at least with government officials, is particularly important for assessing how and when intervention is necessary.

The report also revisited the broader carbon pricing subject for the sake of context and not surprisingly found that carbon pricing is an effective, flexible, and low-cost approach to reducing greenhouse gases (GHGs). Combined with other policies, carbon pricing can help accelerate and ensure a smooth transition to a low-carbon economy. Perhaps the more important context is that carbon pricing is intended to drive a shift away from high-emissions products to low-emissions products and processes. That intent may mean that some firms that compete against these low-emissions substitutes may experience a loss of market share and reduced profits even as others adapt, increase their profitability and develop new business models. That is the point of the instrument and more broadly, it is the point of the transition required to address the climate issue.

The CPLC isn’t the only organisation revisiting the basics of carbon pricing for Climate Week. The World Business Council for Sustainable Development (WBCSD) released its own report on the views of the business community on carbon pricing. The new WBCSD paper presents reasons why business supports carbon pricing as a critical enabler to raise climate ambition and calls for governments to put on a price on carbon and develop clear and consistent long-term carbon pricing policies as part of their national commitments and long-term strategies.

My own reflection on all this takes me to the movie Groundhog Day, but perhaps better phrased as Groundhog Decade when it comes to the climate issue. Ten years ago and in some cases more, I contributed to and was involved in the release of similar reports that came to the same conclusions and in some cases from the same organisations. Yet a decade later, the advance of carbon pricing as a preferred policy instrument has been modest at best and in the interim the largest implementation of carbon pricing (the EU ETS) spent much of the time languishing at very low levels and therefore having very little impact on the energy transition; fortunately in the case of the EU that has now changed. Not surprisingly, global greenhouse gas emissions have risen over the last decade.

But this time around something else has to change as there isn’t another decade to just discuss and think about the implementation of carbon pricing – in fact the decade just passed wasn’t thinking time either, it was the time during which all that had been discussed should have been implemented. Now there is no time for prevarication if the goals of the Paris Agreement are to be realised. The Sky Scenario and many other similar pieces of work make that abundantly clear.

Carbon pricing policy in 2018. Was it a year of progress??

dchone January 10, 2019

Carbon pricing remains at the centre of most government policy discussions on climate change, but in a year which saw the Intergovernmental Panel on Climate Change (IPCC) give an unambiguous warning on the need for mitigation action, carbon pricing policy development rather stumbled along.

Undoubtedly the highlight of the year was the restoration of the EU Emissions Trading System (ETS) to again become a meaningful mechanism, with prices rising to over €20 as EU growth gained momentum and allowance supply tightening. The recognition that the Market Stability Reserve would be a feature of Phase IV in the 2020s certainly contributed to this. Also in the EU, discussions opened around the need for an EU ETS floor price, following the successful example set by the UK which has seen coal almost vanish from the generation mix since their implementation of such a system.

Singapore also moved forward with the implementation of its carbon tax.

But outside the EU and Singapore it was hard to find any stellar examples of progress, although intent remains high in many jurisdictions. Rather, 2018 was a year troubled by a number of developments in the carbon pricing space;

In Canada, a new government was elected in the province of Ontario and true to their election manifesto the new Premier took rapid action to remove Ontario from the cap-and-trade system it had only recently joined with California and Quebec.
Also in Canada, the Federal government moved ahead with its backstop pricing mechanism which will kick in for individual provinces if they do not implement a price through some mechanism of their choice. While this was a positive development, the prospect of litigation from some provinces (either by the current provincial government or by an opposition in waiting) means that this program may have a bumpy ride in the years to come.
In Brazil there has been discussion for some time now on implementation of a carbon pricing policy, but this is unlikely to continue under the new administration.
In Australia, even the possibility of a carbon based policy being implemented seemed to create political turmoil. Nevertheless, Australia is not devoid of a mechanism in that the Safeguard Mechanism put in place with the Emissions Reduction Fund has created a secondary market for Australian reduction units on the back of some industrial facilities exceeding their safeguard cap.
In France, protests erupted late in the year on the back of a carbon tax implemented in the fuels market, although many other factors also lay behind the demonstrations. The government was forced to delay implementation.
Finally, the year ended with failure at COP24 to agree on the rule-book for Article 6 of the Paris Agreement. While the Article 6 mechanisms are not there to directly implement carbon pricing, their use would certainly help catalyze such developments in many economies.

In between the highs and lows of 2018, there was still progress. China announced further details of its upcoming cap-and-trade system and continues to make progress in implementing their plans and Kazakhstan is now looking to reboot their early system. The very long running discussion on a carbon tax continued in South Africa with the prospect of a system emerging in 2019, although the parliamentary process has yet to conclude.

But this is not the required profile of action for a world that is intent on reaching the goals of the Paris Agreement. That profile was illustrated by the May release of the Shell Sky Scenario which highlighted the extraordinary rate of progress required in this policy area in the 2020s. Whereas in 2020 Sky shows only modest uptake of carbon pricing, reflective of the situation today, by 2030 some form of carbon pricing is covering the bulk of the global economy at a level between $25 and $60 per tonne of carbon dioxide.

Sky Scenario carbon pricing profile (Source: Shell analysis)

Developments in this space need to pick up pace dramatically in 2019, but perhaps the transparency and reporting framework agreed at COP24 will help in that regard. While the Paris rulebook makes no specific demands on governments to implement policy, it will put a spotlight on the actions they choose to take and the mitigation they seek to achieve. Carbon pricing policy ought to see some uptick under such circumstances.

Overview of carbon pricing developments (Source: own analysis)

Note: Scenarios are not intended to be predictions of likely future events or outcomes and investors should not rely on them when making an investment decision with regard to Royal Dutch Shell plc securities. Please read the full cautionary note in http://www.shell.com/skyscenario.

What is a ‘mitigation outcome’?

dchone November 20, 2018

The potential for carbon market development was included in the Paris Agreement, as Article 6, at the very last moment of the negotiations in December 2015 and up until that moment the text flipped from being in, to out, to in again. Yet Article 6 is potentially one of the most important aspects of the Paris Agreement in that it is there to catalyze and support cooperative approaches towards meeting the goals of independently established so-called “Nationally Determined Contributions” (NDC). In a recent post I noted the importance of this Article in the years to come as the world looks towards the goal of net-zero emissions, or the ‘balance’ required under Article 4 of the Agreement.

As negotiators have tackled the development of the so-called ‘Paris rule book’ over the past two years, they have had to agree on the meaning of and then implementation strategy for the many short paragraphs of the Agreement. Article 6.2 is no exception. It simply says;

6.2 Parties shall, where engaging on a voluntary basis in cooperative approaches that involve the use of internationally transferred mitigation outcomes [ITMO] towards nationally determined contributions, promote sustainable development and ensure environmental integrity and transparency, including in governance, and shall apply robust accounting to ensure, inter alia, the avoidance of double counting, consistent with guidance adopted by the Conference of the Parties serving as the meeting of the Parties to the Paris Agreement.

This paragraph could be interpreted in a variety of ways, but the broad understanding of its meaning and the basis for its implementation has been trade of carbon units across borders. In recent weeks negotiators released draft text covering the options they have been discussing, which runs to 29 pages.

The options that are outlined will need to be pared down at COP24 in Poland to the final text, but one aspect that is currently missing is a clear definition of the term ‘mitigation outcome’. This is important in that it is apparent from the text as it stands that there may be a range of views as to what is a ‘mitigation outcome’.

For example, under the heading “Vintage” there is the proposal that says, “The year in which the mitigation outcome took place”, which implies that a ‘mitigation outcome’ is an event, such as an observable decline in emissions from some activity. Elsewhere, the form of a ‘mitigation outcome’ is referred to as a unit with a unique serial number, but also a net flow between participating Parties or alternatively emission reductions and removals or emissions avoided. In the section on characteristics it is variously defined as real, permanent, additional and verifiable. Later in the text there is reference to “an ITMO that is achieved in its jurisdiction”. Achievement again implies that something has taken place, such as a reduction arising from a specific project.

Interpreting a ‘mitigation outcome’ as an event or a specific measured reduction from a project will likely limit the effectiveness of Article 6.2 and therefore reduce the scope for cooperative approaches. A project/event-based definition of a mitigation outcome will be too narrow to allow for the system benefits that are achieved in a carbon market. Governance arrangements in Article 6.4 should ensure integrity of the project and Article 6.2 should focus on the integrity of the accounting of the units in the system.

One potential use of Article 6.2 is to account for the flow of allowances between the NDCs of two Parties which have in place linked emissions trading systems. An example of this is the linkage between Norway and the EU. Under the linked arrangement, allowances flow back and forth throughout the year as ETS participants trade to achieve compliance. There will be a net country level exchange for the year which can then be used to make the necessary adjustments to the national NDC. But there is no specific project taking place or clearly defined mitigation event, rather the net transfer is simply the result of the linked cap-and-trade systems functioning efficiently and may comprise millions of individually traded emission allowances. But an emission allowance can still be considered a mitigation outcome, in that the ability to sell the allowance stems from the seller not requiring it for compliance, presumably because emissions are lower than initially expected when the allowance was acquired. But even then, the allowance may date from a previous year, having been initially banked by the seller.

This discussion points to the need for a much simpler structure to the Article 6.2 rule book, which includes a broad definition of ‘mitigation outcome’ and excludes several clauses currently proposed by the Parties that narrowly define the accounting around the transfer as if it stemmed from a defined emission reduction project. While the use of 6.2 may, in some instances, relate to units arising from specific projects, in other cases this will not be so.

A definition of ‘mitigation outcome’ included within the rule book could be structured as follows and appear upfront in the current Section III – Definitions.

“Mitigation outcome” means units denominated as carbon dioxide that are held within the NDC and represent greenhouse gas emission, reduction or removal activities;

Such a definition, sitting alongside a clear but simple accounting framework that ensures adjustments are made to both the NDC emission accounts, would allow Article 6.2 to be used as a broad base for cooperative approaches.

After San Francisco . . . .

dchone September 27, 2018

In mid-September the climate change focused world turned its attention to San Francisco to attend, watch, listen and participate in the myriad of events surrounding the Global Climate Action Summit. The Summit was designed to show the extent of action taking place around the world to respond to climate change, but it was also a political statement of intent that the United States remained committed to the goals of the Paris Agreement through the actions of States, cities and the business sector.

There is no doubt that a wide range of actions are underway and that a major energy transition is in its early days of ushering in significant change. But does all this add up to a pathway that meets the goals of the Paris Agreement? Earlier this year Shell published its Sky scenario, which illustrates the depth and breadth of change required in the coming decades. One of the key drivers of the required change in Sky is the widespread use of policy mechanisms, both market based and mandated requirements. Within the mix, carbon pricing looms large, as shown in the chart below.

The exact nature of the carbon pricing mechanism is not specified in Sky, but it would include all the various forms seen around the world today, ranging from taxes, cap-and-trade, baseline-and-credit and so on. What is clear though in Sky, is that even by 2020 some form of carbon pricing is at least getting going in most jurisdictions and that by 2030 it is very well established, both in terms of coverage and impact.

Yet in the days after the San Francisco summit, the OECD released a report which showed just how large the gap is between where the world ought to be with this policy approach and where it actually is. The report looks at the use of carbon taxes, carbon allowance-based systems and specific fossil fuel taxes. The report notes that the latter have distorted the overall picture owing to the prevalence of gasoline taxes in various parts of the world. These taxes have led to greater efficiency in markets where they are imposed, but have not ushered in a transport transition.

Overall the report finds that the aggregate carbon pricing gap is declining at a snail’s pace. Using EUR 30 per tonne of CO2 as a benchmark, the gap for the 42 countries (OECD+G20 cover 80% of global emissions) as a whole dropped from 83% in 2012 to 79.5% in 2015, and is estimated to reach 76.5% in 2018. The authors note that new carbon pricing initiatives have the potential to significantly reduce the carbon pricing gap, with emphasis on the China ETS starting up soon. However, the report doesn’t include recent back-tracking such as in Ontario where the cap-and-trade system was halted. Even more recently, political disagreement has led to another setback in Australian climate policy.

Even as carbon pricing slowly grows in coverage, more companies adopt science-based targets and more cities pledge to use renewable energy and force certain vehicle types out of use, global emissions continue to rise. The sum of the parts is not yet close to adding up to a change of direction for the whole. This may be related to one salient aspect of the OECD report; the lack of carbon pricing coverage of industrial emissions. In the chart below extracted from the OECD report, industrial emissions are hardly touched by carbon pricing, yet as global development proceeds rapidly and GDP rises, it is industrial emissions that rise as cities are constructed, cars built and domestic appliances manufactured in the hundreds of millions of units.

For the most part industrial emissions are not covered by city pledges and looking at the list of companies with science-based targets, large industrial entities are a small subset of the ~500 companies that have adopted this approach. Even at national level, industrial emissions have been difficult to account for. Many OECD countries have moved industrial operations offshore, therefore seeing an apparent fall in domestic emissions even as they import embedded emissions in various goods and services.

San Francisco was a landmark event and a timely celebration of progress to date, but so much more remains to be done. At the heart of the effort must be a more comprehensive and joined up approach across national borders to carbon pricing. Voluntary and locally mandated distributed action is a worthy stopgap measure, but it is unlikely to put the world on a ‘well below 2°C’ pathway.

The future is carbon trading

dchone September 5, 2018

From time to time it is worth revisiting the rationale behind various initiatives, in part to better understand them but also to bring clarity to the benefits of implementation. Carbon emissions trading is one such practice.

Trading in goods and services has been at the foundation of human development for thousands of years. It introduces opportunity, cost efficiency and flexibility into society that in turn fosters economic growth. These benefits are well understood and have been proven many times over, but the idea that trade can successfully solve an environmental issue is again being challenged, to the extent that implementation of new trading systems is not welcomed by all parts of society.

Carbon trading involves the transfer of some form of carbon emission instrument between two parties in exchange for financial consideration. It has its roots in the mid-1990s, but its economic underpinnings go back into the 1970s and a related large-scale implementation in the United States to tackle sulphur emissions started operating in 1990. Emissions trading is also built on the back of commodity futures trading, which emerged in agricultural areas such as the mid-West of the United States to help balance supply and demand peaks and troughs, which in turn helped farmers manage their income over time.

To best understand carbon emissions trading, it helps to look forward to where we are headed, rather than back to where we started.

The Paris Agreement establishes the need for society to effectively reach zero greenhouse gas emissions in the second half of the century, with the Shell Sky scenario indicating a timeline to 2070 to give a high level of certainty (≥ 85%) that the 2°C goal of the Agreement will not be breached. As surface temperature warming is a function of cumulative emissions over time, temperature will not stabilize until the net addition of carbon dioxide to the atmosphere is zero.

The Sky scenario follows the guidance of Article 4 of the Paris Agreement due to ongoing societal use of oil, coal and gas for the delivery of energy services where non-emitting alternatives remain nascent or in some cases, non-existent. In Sky, society achieves net-zero emissions by balancing remaining emissions with the removal of carbon dioxide from the atmosphere at another location or even at another time.

Sky also illustrates the potential time spread for countries reaching net-zero carbon dioxide emissions. Some achieve that goal as early as the 2040s, but there is a long tail of emitting countries extending to the end of the century. Given the need for a global outcome around 2070, but faced with the reality of countries, sectors and industries only able to reduce emissions at different rates and some potentially not able to reduce to zero, the mechanism that emerges to achieve a balance and fairly distribute the cost of emission reductions across society and over time is carbon trading.

In Sky, emitters in 2070 would purchase carbon removal units from industries able to capture and geologically store carbon dioxide, or even use carbon dioxide to make certain products. This trade in carbon units underpins the journey to net-zero emissions while allowing economies to grow and prosper, making use of the energy services that are needed. But this requires the development of a large-scale industry to generate carbon removal units.

Today, the reduction journey is beginning but carbon emissions trading is just as important. For some emitters, even initial reductions may not be possible, particularly if they are part of an expanding sector. But for others, reductions may come more easily, for example by closing a coal fired power station which has been replaced by large scale implementation of renewables. The power generator can effectively share the reductions made with the sector that is growing, thereby achieving an overall reduction between them but without impinging on the growth prospects for the expanding sector. Trade in carbon units between these entities is the critical facilitator. A vibrant carbon trading market now will also give confidence to developers looking towards the supply of removal units in the future.

As the global economy heads towards large scale carbon emission reductions, implementation will be challenging for some and progress may be limited as a result. But as has been the case in all aspects of economic growth over many centuries, trade should be fully utilised to solve these issues and move forward.

The Role of the EU Emissions Trading System

dchone August 22, 2018

Over recent weeks, a number of media outlets have noted the launch of a new commission in Germany, officially known as the “Commission on Growth, Structural Change and Employment”. The initiative is a welcome development and is born out of two concerns;

That German emissions are not falling fast enough, with an apparent reason that there is continued reliance on coal in the power sector. Demand has not fallen significantly in recent years despite the emphasis on renewable energy through the Energiewende. However, it should also be noted that German nuclear output has nearly halved in ten years as that industry has been forcibly wound down.
That when emissions do fall, the impact on the personal welfare of those in the coal sector could have wider ramifications for the economy.

According to the Financial Times, the objective of the task force is to lay out a plan for the elimination of coal from the country’s energy mix and to report by the end of the year. In doing so, the task force must look at the employment and regional development issues associated with such a move, so as not to repeat the problems that manifested in other countries when coal use went into rapid decline. The FT concludes with the observation that chances are the outcome will be radical rather than minimal, with the commission perhaps even setting a date for the complete elimination of coal that is much earlier than many observers expect.

In the Shell Sky scenario released earlier this year where the goals of the Paris Agreement are met, coal use in the EU roughly halves from current levels by 2035. Over the same period, natural gas use rises, peaks and begins to fall, while wind and solar grow several fold. This would certainly involve significant change for Germany and the coal sector in particular, hence the need for the Commission to look at employment and structural impacts for such a shift.

But should the Commission also develop a plan for the elimination of coal itself, or should it focus on the societal impacts of such a change?

German power generation is covered by the EU Emissions Trading System (EU ETS) and has been since 2005. That system embodies an emissions trajectory that is now declining at 2.2 percentage points per annum (against a 2005 baseline), which implies an overall reduction of EU ETS emissions by 43% in 2030 relative to 2005. Extending that rate of change out further, the system will have no further issuance of allowances from 2056, or in other words emissions must be zero by then (or at least net-zero if the system allows for storage units via carbon capture and storage (CCS)). That system alone ought to be sufficient to guide the transition in terms of the energy mix.

But the EU ETS has been the subject of much criticism, in large part because of the low prices seen from 2008 through to 2017 (~€5 for much of that time). This isn’t to say that the EU ETS wasn’t working in that allowance allocation and surrender against emissions proceeded without a hitch. That is still the case today. The problem was a growing surplus of allowances and a market view that such a surplus would persist, leading to very low prices. That surplus initially grew for a number of reasons (i.e. the 2008+ recession, inflow of units from the Clean Development Mechanism of the Kyoto Protocol) but persisted for another reason; overlapping policies. These are actions taken by government which force emissions down at a rate faster than the EU ETS, thus throwing up allowances and adding to the surplus. Perhaps the most prominent of these policies was the EU wide push for renewable energy, which includes the German Energiewende.

Policies that overlap a cap-and-trade system will tend to do two things;

Lower the prevailing carbon price;
Raise the cost of emissions reduction across society.

These effects are illustrated in the charts above and this is exactly the impact that the Energiewende and other similar policies had on the EU ETS. This was eventually recognised and a correcting mechanism has now been built into the ETS, the Market Stability Reserve (MSR). The MSR removes and banks surplus allowances according to a formula built into its design.

With the MSR now starting to impact market perception, allowance prices are on the rise from a low of just €3 in 2015. Recently IETA noted in a tweet;

The EU ETS always was and remains the single most effective tool to push coal out of the power generation mix. For a period that will favour natural gas, but over time renewable energy, nuclear and possibly coal or gas with CCS will grow to dominate power generation. Coal would depart first. That is exactly what has happened in the UK, with that country bolstering the weak EU ETS with a floor price of £18 per tonne of CO2 (~€21). But it didn’t happen in Germany because of interventions on two fronts; the Energiewende favouring renewable energy and the national nuclear policy phasing out that technology.

Moving forward, the EU ETS is fully capable of shifting the EU power system (and industry) to an effective state of zero emissions in the 2050s. That date could even be brought forward by implementing more aggressive linear reduction rates from 2030 onward. A shift to 3% per annum from 2031 onward would deliver a zero emissions outcome by 2050. Notably, the system would deliver that outcome at lowest cost to society, an inherent design feature of the mechanism.

As the EU ETS bites, decisions will have to be made about the closure of individual generating stations and this is where the Commission could add value, ensuring that the transition is just and fair for various parts of the country. But if the Commission also proposes state intervention to force coal down an even faster exit route for Germany alone, there may be downwards pressure on allowance prices and the effectiveness of the EU ETS could be undermined, not just in Germany but right across the EU. While some of the surplus allowances will be absorbed by the MSR, others will flow out of Germany and underpin the longevity of coal in other EU member states. This means that the environmental benefits of early coal closure could be undermined as well.

But should the Commission land on a recommendation for accelerated phase out of coal, it could then advise on the use of newly introduced measures to cancel ETS allowances where governments take actions in addition to the EU ETS. This means that allowances can be cancelled in the case of deliberate coal phase out.

Directive (EU) 2018/410 of the European Parliament and of the Council of 14 March 2018, states;

In the event of closure of electricity generation capacity in their territory due to additional national measures, Member States may cancel allowances from the total quantity of allowances to be auctioned by them referred to in Article 10(2) up to an amount corresponding to the average verified emissions of the installation concerned over a period of five years preceding the closure. The Member State concerned shall inform the Commission of such intended cancellation in accordance with the delegated acts adopted pursuant to Article 10(4).

While the cancellation of allowances represents a further intervention in the ETS, it would at least address the issue of environmental leakage to other Member States. But the simple alternative is to leave the EU ETS to perform its job and phase coal out as part of a lowest cost driven transition. This might be the most prudent approach. The EU ETS is a robust, well designed system that will deliver on the required emission reduction goals.

After Bonn, is progress fast enough?

dchone May 17, 2018

The Parties to the Paris Agreement spent the first two weeks of May in Bonn, discussing amongst other things, the so-called rule book of the Paris Agreement. There was some progress, but the issues on the table are far from settled, to the extent that another negotiating session has been slotted in between now and COP24. That session will take place in Bangkok in early September.

The question on my mind is whether the pace is sufficient for setting out the conditions for countries to start ratcheting up their Nationally Determined Contributions (NDC) and shifting the current combined emissions trajectory from one that is potentially 3+°C to something that is closer to ‘well below 2°C’. The required changes are significant, as we noted in the recently released Sky scenario. For example, in the first 5-year period which is now opening with the Fijian inspired Talanoa Dialogue, we imagined a ratchet as sizable as China contributing a sharply falling emissions profile by 2030, rather than a peaking of emissions around 2030. Similarly, in the second NDC cycle from 2023-2028, a country such as India would contribute a clear peak in emissions in the 2030s. This would be a significant step up from the current contribution based largely on expansion of renewable energy in the electricity sector, efficiency and forestry, with a decline in emissions intensity of GDP, but no indication of absolute emissions limits.

While the formulation of NDCs isn’t necessarily dependent on the outcome Paris Agreement rulebook, the Paris Agreement still plays a critical role in driving the necessary changes. We identified the elements of this in the Sky scenario through the scenario framework within which Sky sits.

The elements of the framework are the necessary mechanisms to share common interests and the strength of leadership to take these forwards. The mechanisms start with the UNFCCC and the Paris Agreement at the top, but include various multilateral institutions and important initiatives such as the C40 and RE100. These then require strong leadership to function effectively and extract maximum value. In the runup to the Paris Agreement, the world occupied this space with many institutions rising to the challenge of formulating an agreement, propelled by very active leadership from the likes of the UNFCCC Executive Secretary, Christiana Figueres and many heads of government.

In Sky, the level of effort and action that delivered Paris should perpetuate for many years to ensure the Agreement takes root, yet it wasn’t apparent to me when I was in Bonn that this was the case. The discussions on Article 6 of the Agreement are reflective of the whole, although the negotiators discussing Article 6 have probably made more progress than most. Nevertheless, progress is slow and the big picture seems to be getting lost in the detail.

For example, one aspect of the discussion around the mechanism under 6.4 is focusing on provisions for projects that might be outside the scope of the NDC and how any carbon reduction units from such projects should be handled by receiving countries. But the discussion has missed a vital point, in that if there is broad application of such a provision then the Paris Agreement itself could be in trouble, because we should see the NDCs expand rapidly to cover all activities. As such, there shouldn’t be any projects outside the scope of the NDCs.

Part of the reason for considering projects outside the NDCs is that if they sit inside, then the movement of carbon units beyond the border of the host country for use by someone else will require a corresponding adjustment to the NDC – I discussed this in my previous post. This then opens another set of issues, around accounting. Corresponding adjustments should require full quantification of the NDC in CO2 terms, which takes the NDC into the territory of carbon budgets. Many countries don’t want this, but it is an inevitable outcome if the Paris Agreement is to work. So there is something of a Catch 22 building up, in that negotiators are avoiding the need for robust carbon accounting by negotiating a set of conditions that could undermine the Agreement itself, which in turn would undermine the value of the carbon units they are seeking to create. Unlike some Catch 22s, there is a simple way out here – embrace accounting and embrace the expansion of NDCs.

Moving forward requires leadership, which isn’t absent, but has certainly changed since 2015. There is something of a global trend back to nationalism and away from multilateralism, which potentially takes the world out of the top right region of the matrix. This in turn challenges the ultimate outcome of the Agreement, to limit surface temperature warming to well below 2°C. In Sky, we noted the following;

Achieving net-zero emissions in just 50 years leaves no margin for interruption, stalled technologies, delayed deployment, policy indecision, or national back-tracking. Rather, it requires a rapid acceleration in all aspects of an energy transition and particularly robust policy frameworks that target emissions. Success can be accomplished only through a broad process that is embraced by societies, led by governments, and lightly coordinated by organisations including the UNFCCC, the EU, ASEAN, and others.

In the context of the NDCs it means rapid expansion to cover all activities and full transparency through robust carbon accounting and quantification. But there is still some distance to travel before such an outcome is realised.

Note: Scenarios are not intended to be predictions of likely future events or outcomes and investors should not rely on them when making an investment decision with regard to Royal Dutch Shell plc securities. Please read the full cautionary note in http://www.shell.com/skyscenario.

Additionality and Article 6 of the Paris Agreement

dchone April 27, 2018

As negotiators gather in Bonn for another round of discussions on implementation of the Paris Agreement, various detailed issues are surfacing. One, which pertains to Article 6 of the Agreement, is the concept of additionality of actions implemented under the Article. In the Decision Text that accompanied the Paris Agreement, which is effectively the instruction manual for implementation, the need for additionality is referred to in relation to Article 6, Paragraph 4, the emissions mitigation mechanism. The Decision Text says;

Recommends that the Conference of the Parties serving as the meeting of the Parties to the Paris Agreement adopt rules, modalities and procedures for the mechanism established by Article 6, paragraph 4, of the Agreement on the basis of:

. . . .

(d) Reductions in emissions that are additional to any that would otherwise occur;

. . . .

The Article 6 negotiators have already grappled with this to some extent as the concept appears in the ‘Informal document containing the draft elements’, Annex XII.D, released in mid-March. In that document three possible definitions for additionality are considered, i.e.;

An Article 6, paragraph 4, activity to be additional by demonstrating that:

Option A {reference to what would otherwise have occurred}

(a) Emissions are reduced below those that would have occurred in the absence of the activity.

Option B {definition related to activity being beyond the NDC}

(b) The reduction of emissions goes beyond what would be achieved through the delivery of the NDCs of the host Party {further development may be required for implementation}.

Option C {definition linked to scope of NDC}

The concept of additionality stems from the Clean Development Mechanism (CDM) of the Kyoto Protocol, where Article 12.5 specifies that emission reductions are only to be certified under the CDM if they are additional to any that would occur in the absence of the certified project activity. In his 2009 paper ‘Additionality in the Clean Development Mechanism: Why and What?’, Benito Müller outlined a number of different ways in which additionality constraints under the CDM can be argued for. For example, there are arguments (i) from ‘environmental integrity’, (ii) from implementing Article 4.7 (of the Convention), and (iii) from the need to safeguard Annex I domestic mitigation efforts. Müller notes that the most important and widely used argument, is that additionality is needed to protect the environmental integrity of the regime. Being an offset mechanism, the CDM requires additionality to ensure that any ton emitted in developed countries against a CER must not increase the level of emissions permitted under the regime.

Under the CDM, additionality became something of a quasi-science, with baselines established for projects against which assessments could be made. The UNFCCC developed a toolkit, which recommended a scenario based approach for determination of additionality. But despite the effort put in, the analysis is largely subjective in nature. It all depended on what the assessor thought the future might bring, versus an objective numerical approach based on specific goals. The reason behind this is that developing countries didn’t have targets under the Kyoto Protocol, so environmental integrity could only be assessed, rather than measured.

Translating this concept to the Paris Agreement argues for new thinking on additionality in that the structure behind Paris requires all participating countries to have some form of target or goal embedded within their respective Nationally Determined Contributions (NDC). Paragraph 5 of Article 6 also specifies that emission reductions resulting from the 6.4 mechanism shall not be used to demonstrate achievement of the host Party’s nationally determined contribution if used by another Party to demonstrate achievement of its nationally determined contribution. This would happen if reduction units created under the mechanism were transferred to another Party without an accounting protocol. Doing so, would be classified as double counting. Within the Decision Text, there is a further requirement that double counting is avoided on the basis of a corresponding adjustment by both Parties for anthropogenic emissions by sources and/or removals by sinks covered by their nationally determined contributions under the Agreement.

The above discussion points to a more numerical and therefore objective approach to accounting for transfers under the Paris Agreement, in that corresponding adjustments are most easily executed when NDCs are quantified. I discussed this at length here. It also means that the more traditional complex assessment of additionality can be avoided, in that the corresponding adjustments ensure that environmental integrity is maintained.

If such a corresponding adjustment is made, then in the case of the host Party, the transferred quantity must be additional. This is because the host Party, having made the transfer, must find further, presumably lower cost, mitigation opportunities in their own economy to meet the stated goal of their NDC. This in turn means that the transferred actions were in addition to the requirements of the NDC, hence additionality can always be claimed. The quantification of systems is ideally done in units of CO2, but could even be in units of clean electricity or capacity in the case of renewable energy based NDCs.

Attempting any other assessment process to establish whether an activity goes beyond the NDC of the host Party is fraught with difficulty. In most instances this will be almost impossible to assess due to the difficulty of establishing the contribution of a single activity to the overall national emission pathway. Even if assessment is possible, it may be an extended period before the assessment can be made due to the need to collect and collate all the greenhouse gas data for the whole NDC. This will lead to any emission reduction units from the activity being untradeable in that they will carry considerable performance risk related to the outcome of an assessment that will be both uncertain and take a year or more to be delivered.

An extension of this approach to additionality is that units created under the 6.4 mechanism don’t require the same level of scrutiny as units created under the CDM. Should an activity produce an abundance of units which are then sold outside the host county, always a concern under the CDM through the application of a generous baseline, then the corresponding adjustment will act as a deterrent by demanding even greater mitigation efforts by the host. Although this isn’t a desirable way to operate the mechanism, it is nevertheless self-correcting.

The current informal text under consideration in Bonn doesn’t clearly identify the above route towards assessing additionality, but presumably Option B could fill this need. The text might then read;

The reduction of emissions goes beyond what would be achieved through the delivery of the NDC of the host Party. The host Party’s nationally determined contribution is adjusted numerically by an amount corresponding to any use of the emission reduction of said activity by another Party to achieve its nationally determined contribution, ensuring that additionality is established.

As the negotiators get down to their tasks in Bonn, they need to rethink additionality, jettison the model founded for good reasons under the Kyoto Protocol, and embrace a more quantified and objective approach to this subject.

It’s all in the numbers

dchone February 13, 2018

One of the noteworthy features of the 160+ nationally determined contributions (NDC) submitted to the UNFCCC following the adoption (and now ratification) of the Paris Agreement, is that no two are alike. True to the Paris Agreement, countries have submitted a description of their contribution, with most offering some indication of the emissions outcome, but the way this information is transmitted varies considerably by country.

In May 2016, the UNFCCC released a synthesis report of the NDCs, aggregating them in the only way that makes sense given the nature of climate issue, by cumulative emissions. Every NDC was turned into a cumulative carbon release to the atmosphere (i.e. quantification), which were then summed and compared to the ideal global carbon budget for a ‘well below 2°C’ pathway. Needless to say, the UNFCCC analysts almost certainly had to make numerous assumptions to do the calculations.

The problem that confronted the analysts was that not one of the NDCs was presented in the format they needed. Many offered an end goal in 2025 or 2030, such as the EU which is targeting a 40% reduction by 2030 against a 1990 baseline. Baseline years also vary across the NDCs. In most NDCs, little to nothing is said about what happens in the intervening years, so an assumption must be made about the likely trajectory. Others were presented as an expected reduction against a notional future emissions trajectory and some were presented without any emissions trajectory at all.

The variation in NDCs is now a well-known story, but the lack of quantification of NDCs has other implications which extend past the obvious analysis of the environmental outcome. It also limits the ability for carbon trade between the NDCs and potentially runs up against the accounting provisions of the Paris Agreement.

Those accounting provisions are dotted throughout the Agreement, but Article 4.13 is perhaps the most comprehensive. It states;

Parties shall account for their nationally determined contributions. In accounting for anthropogenic emissions and removals corresponding to their nationally determined contributions, Parties shall promote environmental integrity, transparency, accuracy, completeness, comparability and consistency, and ensure the avoidance of double counting, in accordance with guidance adopted by the Conference of the Parties serving as the meeting of the Parties to the Paris Agreement.

The above could be interpreted as a post-NDC (i.e. after the period for which the NDC applies) true-up of emissions, but even that requires summing all the emissions across all the years of the NDC, not just ticking off actions against a list or noting that emissions in the final year were as expected. Unless cumulative emissions are established for the whole period of the NDC, the environmental integrity of the NDC is questionable as it is cumulative emissions that determine the environmental outcome. Only a full assessment of the NDC in terms of cumulative emissions meets the other requirements of completeness, accuracy and comparability.

Further, post-NDC quantification of emissions is unlikely to be sufficient for trading purposes, or in the language of the Paris Agreement, internationally transferred mitigation outcomes. This is because transfers out of a country require a local corresponding adjustment. While this could also be done post-NDC, it should be done at the time of the transfer such that the country can determine the new trajectory it needs to be on and ensure policy measures are suitably modified to ensure compliance, particularly if transfers are large compared to national emissions (say, more than 5%). Of course, if both countries were operating economy wide cap-and trade systems the correction would be automatic, but that is hardly the case today.

The above makes quantification of NDCs an important and perhaps necessary step for the Paris Agreement, but agreement on this by the Parties appears to be distant. However, such a step is inevitable. As countries get closer to declaring full emissions compliance with the Paris Agreement, i.e. achieving net-zero emissions (NZE) or ‘a balance between anthropogenic emissions by sources and removals by sinks of greenhouse gases’ in the words of the Agreement itself, quantification becomes essential.

NZE will occur when the country in question has balanced the remaining emissions with sinks and there will likely be some remaining emissions well into the 22nd century. Those sinks will either be developed locally or purchased internationally via the transfer provision of Article 6. But both the buyer and seller of such sinks will have to implement careful accounting to ensure the integrity of the net-zero claim. This takes us back to the quantification discussion.

The Paris Agreement is rigorous in concept and the negotiators of 2015 should be commended for the thoughtfulness of their text. But as the delivery of the Paris ‘rulebook’ approaches, that same rigor does not yet appear to have the full backing of all the Parties.