After COP26: The interplay between Article 6 of the Paris Agreement and the Voluntary Carbon Market

Article 6 of the Paris Agreement provides a framework for international cooperation on emissions reductions, intended to accelerate global efforts in fight against climate change. However, without specific guidelines for implementation Article 6 has been inoperative since its adoption six years ago. One of the major achievements of COP26 in Glasgow was to finalize the Paris Rulebook - a set of decisions  providing details around implementation of the Paris Agreement. The Rulebook’s decisions relating to Article 6 are now expected to unlock the potential of international emissions trading and contribute to the exponentially growing $1 billion market of voluntary carbon credits[1]. 

Why Article 6 was a central discussion point in Glasgow?

To understand why a provision of an agreement adopted six years ago is gaining momentum now let’s outline its content:

• in paragraph 1, the Parties recognize the need for “voluntary cooperation in the implementation of their nationally determined contributions ” to decarbonization effort;

• paragraph 2 requires the Parties to promote sustainable development, environmental integrity, transparency, and avoid double counting, when engaging in the cooperative approaches;

• paragraph 3 highlights the fact that international cooperation should be voluntary;

• in paragraph 4 the Parties enact a mechanism to facilitate the cooperation under Article 6;

• paragraph 5 prohibits double counting of emission reductions;

• paragraph 6 addresses the expenses of the mechanism and provides for financial assistance for developing countries;

• under paragraph 7, COP should adopt rules governing the mechanism established in paragraph 4;

• finally, paragraphs 8 and 9 refer to non-market approaches for emission reductions.  

During COP26, after six years of negotiations, the Parties fulfilled the requirement of paragraph 7 of Article 6 by adopting i) Guidance on cooperative approaches referred to in Article 6, paragraph 2, of the Paris Agreement (“Guidance on cooperative approaches”), ii) Rules, modalities and procedures for the mechanism established by Article 6, paragraph 4, of the Paris Agreement (“Decision on rules, modalities and procedures”) and iii) other rules implementing the provisions of the Paris Agreement.  

Definitions of a carbon credit in the voluntary carbon markets and under Article 6 

As explained in our previous article on the Voluntary Carbon Market[2], there is no single definition of an instrument that certifies the reduction or sequestration of a certain amount of carbon emissions equivalent. In the voluntary carbon market these instruments are commonly referred to as carbon credits, carbon units or carbon offsets. One carbon credit represents 1 tonne of CO2e emission reduction.

The Paris Agreement Rulebook introduces the following instruments that bear resemblance to VCM’s carbon credits:

• internationally transferred mitigation outcomes (“ITMOs”) and

• Article 6, paragraph 4, emission reductions (“A6.4ERs”).

Under the Decision on rules, modalities and procedures A6.4ER represents a reduction of 1 tonne of CO2e. Under the Guidance on cooperative approaches, A6.4ER becomes an ITMO when it is “authorized for use towards achievement of NDCs and/or authorized for use for other international mitigation purposes”. Further, the Guidance on cooperative approaches provides that ITMO must be “real, verified, and additional”, that it stands for emission reductions and removals, and has been generated on or after 2021 or represents a mitigation that occurred at that time.

While voluntary carbon credits are most often issued based on standards of non-profit organizations, ITMOs will be issued by the states that are Parties to the Paris Agreement. Just like voluntary carbon credits, ITMOs will be used to offset emissions by various entities, but they will have to be also authorized for use towards Nationally Determined Contributions.

The Mechanism under paragraph 4

The Decision on rules, modalities and procedures governs A6.4ERs issuance. This process will be overseen by a Supervisory Board and managed by designated national authorities. The Supervisory Board will consist of 12 members elected for two-year term: two members from each of the five United Nations regional groups, one member from the least developed countries, and one member from small island developing States.

Countries that wish to participate in the mechanism need to be Parties to the Paris Agreement, must have a Nationally Determined Contribution set according to Article 4 paragraph 2 of the Paris Agreement, and must designate a national authority managing the procedures of the mechanism. Countries participating in the mechanism are called “host Parties”.

Under the Decision on rules, modalities and procedures the activity generating removals or reductions must be:

•       additional;

•       designed to achieve emission reductions in the host Party;

•       deliver real, measurable and long-term benefits related to climate change;

•       minimize the risk of non-permanence of emission reductions; v) minimize the risk of leakage; and

•       minimize and where possible, avoid negative environmental and social impacts.

Methodologies implemented under this mechanism shall be real, transparent, conservative, credible, below ‘business as usual’ and avoid leakage.

After the activity and methodology are set, the host Party provides information to the Supervisory Board whether it approves the activity and the authorization of A6.4ERs for the activity in question. As a next step an independent entity should validate the activity and, if the outcome of the validation is positive, submit a request for registration with the validation outcome to the Supervisory Body. The Supervisory Board registers the activity, if it decides that the activity meets all relevant requirements.

After the registration, but before A6.4ERs may be issued, there is a pilot phase referred to as monitoring and verification. In this step, an independent entity is monitoring whether reductions stated in the methodology have been achieved in a given timeframe. If the outcome is positive, the independent entity submits a request for A6.4ERs issuance with the verification outcome to the Supervisory Body. That is when the Supervisory Board can certify the activity and A6.4ERs can be issued.  

How the Mechanism under paragraph 4 differs from VCM

The Decision on rules, modalities and procedures maps out the process of A6.4ERs issuance and sets the rules that govern it. Interestingly, the steps required to produce A6.4ERs are very similar to the procedures set by standards in the voluntary carbon market. There are two key characteristics of A6.4ERs that differentiate them from VCCs.

The fundamental difference between VCCs and A6.4ERs is a mandatory default cancellation of 2% of any A6.4ERs issued. While the VCM offset project developers can sell as many carbon credits as the total volume of CO2e sequestered or their emissions reduced, investors in Article 6 paragraph 4 activities will need to subtract 2% of the total emissions reduced from the total number of A6.4ERs they could sell.

Secondly, 5% of proceeds from A6.4ERs transfer will be paid to an adaptation fund supporting climate change adaptation efforts of developing countries. COP26 is the first summit after the adoption of the Paris Agreement that truly confronted the issue of the challenges faced by the developing countries. Harnessing Article 6 paragraph 4 mechanism for the purpose of leveling global adaptation efforts elevates its significance and sets up new expectation for similar measures coming from the Voluntary Carbon Market.

Both cancellation of 2% of A6.4ERs and contribution of the proceeds from the additional 5% of A6.4ERs to the adaptation fund happen at their first transfer from the mechanism registry, that is right after A6.4ERs are issued.

The issue of double counting and the mechanism of corresponding adjustment

One of the greatest risks which might stifle the success of the emission reduction mechanism under Article 6 is the issue of double counting. Double counting occurs when the same reduction is counted towards achievement of two separate goals. For example, if the national government counts 10 tonnes of CO2e emission reduction towards the realization of its NDC, and simultaneously sells the rights to claim those 10 tonnes of CO2e emission reduction to an international corporation, this is double counting.

To prevent double counting, the Guidance on cooperative approaches proposed a procedure called corresponding adjustment. Through a corresponding adjustment participating host Parties will monitor and deduct the amount of ITMOs transferred to other entities from  the total number of ITMOs produced in the host Party’s territory, that otherwise would be counted towards its Nationally Determined Contributions.

As noted by Voluntary Carbon Market Integrity Initiative[3], it has not yet been decided how voluntary use of carbon credits will be accounted for the purpose of a corresponding adjustment in a situation when credits acquired are not used to meet the buyer country’s Nationally Determined Contributions.

What do the new rules mean for VCM participants

In general, the outcome of COP26 is a positive sign to all voluntary carbon market participants. Proposed decisions on paragraph 2 and 4 of Article 6 of the Paris Agreement should bring more credibility and stability to the market. More frequent reviews of the Nationally Determined Contributions can also fuel decarbonization ambition and generate a higher demand for instruments like carbon credits.

Before VCM stakeholders will harvest the fruits of what have been agreed at COP26, everybody needs to revisit the current standards and align their market practices with the Paris Agreement Rulebook. At EY, we are ready to tackle these challenges with our clients and together be at the forefront of the decarbonization journey.

[1]Voluntary Carbon Markets Top $1 Billion in 2021 with Newly Reported Trades, Ecosystem Marketplace, 10 November 2021

[2] Voluntary Carbon Market: Challenges and Promises of the Green Transition Tool, EY Law, 20 August 2021

[3] VCMI response to agreement of Article 6 rulebook, VCMI, 15 November 2021