Carbon Markets: An Opportunity for India and the Planet - Part II
The atmosphere doesn't distinguish between CO2 emitted in New Delhi and New York. But while carbon impact is global, carbon markets are not. Can international carbon trading do something about this?
6 Takeaways in 60 seconds
Following the introduction to India’s developments in carbon markets in the last issue of Indian Energy Quadfecta (IEQ), this week we will go global and look at fast developing world of international carbon trading. First, here are 6 takeaways in 60 seconds:
Universal Problems, Non-Universal Solutions: A ton of carbon is just as damaging to the climate regardless of where it comes from; the atmosphere doesn’t distinguish between emissions from New Delhi and New York. But while carbon impacts are universal, carbon markets are not. Article 6 of the Paris Agreement allows for emissions trading and the establishment of carbon markets to help countries meet their nationally determined contributions (NDCs). But NDCs themselves are moving targets, as are the approaches various countries take to meet them. Buying or selling carbon credits through Article 6 also increases the need to ensure consistent rules and avoid “double counting”.
A Patchwork of Standards: The world of compliance carbon markets is fragmented to say the least. The EU Emissions Trading System (EU ETS) is the largest by far. California has its own market, which it subsequently linked to Quebec. 12 states on the East Coast of the US have formed a combined market, but have limited it to only cover power sector emissions. Meanwhile, China has a national market, but doesn’t actually put a cap on emissions and instead deals with emissions intensity. A key challenge will be to translate this patchwork into a global or near-global framework.
Pricing Goldilocks: Carbon credits that are too cheap give the dangerous signal that the market-determined cost of pollution is low. In contrast, when prices are perceived to be too high it generates significant public backlash. This highlights a key role for price stabilizing mechanisms: to ensure that carbon trading advances overall emissions reductions, even if prices don’t always meet Goldilocks’s standard of “just right”.
Border Checkpoints: The EU, home to the largest compliance carbon market in the world, recently announced that it was establishing a border adjustment mechanism (CBAM), which will have a material economic impact. The CBAM would mandate that products imported into the EU be subject to emissions charges according to the carbon prices set by EU ETS. The details are still being ironed out, but for countries like India, which don’t yet have a meaningful domestic carbon tax, this could present a meaningful trade issue for exported products.
A Wishlist: The Indian government recently published a list of eligible technologies that can earn carbon offsets for the purpose of sale in international carbon markets. This includes offshore wind, green hydrogen, energy storage for renewables, sustainable aviation fuel, and carbon capture, among others. This is smart policy, as it aligns the development of carbon markets with the development of ‘Make in India’. It uses the carrot of potential carbon credits to incentivize development of next generation technologies that are not currently manufactured at a large scale in the country.
Unwritten Rules: The rulebooks for carbon markets are literally being written. This presents an enormous opportunity for India – who is a relative newcomer to compliance carbon markets, but will be a significant source of credits and emissions. India can help shape the rules of the road, which can include influence in multilateral conventions like COP, but will need to start with domestic carbon tracking and trading initiatives.
A Deeper Dive
Fundamentals of International Carbon Trading
Article 6: The Origins
International emissions trading traces its origins back to the Kyoto Protocol in 1997, which permitted countries to sell emission “units” that are permitted but not used to other countries. Since then, emissions markets have experienced a resurgence through the landmark Paris Agreement in 2015. Article 6 of the Paris Agreement allows for carbon trading between countries by creating a special kind of credit. It therefore creates a framework by which countries can not only strive to meet their own National Determined Contributions (NDCs), but can also sell surplus emissions units to other countries that need to meet their NDCs.
In the context of international emissions trades, remember we are talking about compliance markets – where a cap is placed of carbon emission by regulators, and then carbon “allowances” are permitted to be traded between companies as needed. This is distinct from voluntary markets where companies buy carbon offsets to meet their own net zero targets (for a refresher, check out the previous edition of IEQ).
A Patchwork of Standards
The world of carbon emissions markets is fragmented to say the least. As of 2021, there were 64 jurisdictions with carbon taxes or emissions markets, covering about 21% of global emissions. Even though carbon markets are conceptualized to cover one-ton “units” of carbon, each jurisdiction covers different regions and measures things differently. Here are a few examples:
EU Emissions Trading System: Largest carbon market (by far) in the world, representing 87% of the aggregate market value of carbon markets in the world
China: Market that does not put a cap on carbon emissions, but rather emissions intensity of industries. Limited to the power sector. Doubts raised over the data validity underpinning the market.
California: Independent cap-and-trade carbon market for the State of California
Regional Greenhouse Gas Initiative: 12 states in the Eastern Seaboard of the US have a combined carbon market. Only covers power sector.
Connections: California and…Quebec?
Carbon markets are most effective when they cover larger regions. This ensures greater liquidity as well as greatest aggregate potential for limiting emissions. To that end, there have been some interesting market linkages across geographies. California’s cap-and-trade was linked with Quebec as part of the Western Climate Initiative. Switzerland’s carbon market merged with the EU ETS in 2020. I would similarly bet on more such market linkages across the world as both the depth and breadth of carbon markets increase.
Double Counting
Article 6 stipulates that countries that sell carbon credits to others must adjust for this sale in their own emissions inventory. For example, if India sold carbon credits through the Article 6 mechanism, these credits wouldn’t be counted towards India’s NDC, but rather towards the buying country’s. In practice, avoiding this double counting is more nuanced and will require tailored regulatory mechanisms. This places India’s experiment with restricting exports of carbon offsets in context. Prioritizing credits for meeting its own national NDC meant limiting the number available to be sent overseas.
Another form of double counting is between the credits eligible for Article 6 (international carbon trades) and those sold in the voluntary markets to international companies. The general consensus here is that credits should be prioritized for compliance markets – those required by governments – over voluntary markets. Carbon offsets for voluntary markets should be additional over and above the emissions reductions required by governments.
Pricing Goldilocks: The Difficulties of “Just Right”
The most effective market design for carbon emissions trading is one that is broad, liquid, and sufficiently high priced. A high price on carbon in a compliance market is typically one where there is a low cap on emissions, which limits the supply of emissions credits. In practice, it has been difficult to achieve sufficiently high and stable pricing. Of the 64 carbon taxes and emission trading systems that that existed in 2021, only a tiny minority covering ~4% of emissions priced carbon above $40/ton, which is estimated to be the minimum social cost of carbon. A market with too low of a carbon price essentially renders it useless, because pollution is no longer expensive.
On the other hand, a market with carbon prices that are too high contains other risks. In response to perennially low prices in the EU ETS prior to 2021 (see chart above), the EU cut the supply of credits. Price volatility was further exacerbated by the Russian invasion of Ukraine, which sent energy availability into a tailspin. High carbon prices impacted energy bills, generating significant public backlash, which forced politicians to increase the supply of credits to manage price rises.
EU: Border Tax Adjustments
The EU is considering a “carbon border-adjustment mechanism”, which would require importers into the EU pay the difference between relevant foreign carbon price and the EU’s. The details of the mandate are not finalized, but current estimates suggest that products imported into the EU would be subject to emissions charges according to the carbon prices set by EU ETS. There is also an open question of which industries will be subject to the border adjustment. It is reasonable to expect that products in harder-to-abate sectors will be subject to more lenient requirements at first. For countries like India, which don’t yet have a meaningful domestic carbon tax on products, this could present a meaningful trade issue for exported products. Over time, this could encourage countries that want to export to the bloc to bring their carbon prices closer to the EUs.
A Wishlist
In addition to a temporary restriction on carbon credit exports, India has also experimented with other approaches to ensure its carbon markets are serving its own national interests. The government recently published a list of eligible technologies to earn carbon offsets for the purpose of selling them in international carbon markets, which includes the likes of offshore wind, green hydrogen, energy storage based on renewables, sustainable aviation fuel, and carbon capture among others. This is smart policy, as it aligns the development of carbon markets with the development of ‘Make in India’. It uses the carrot of potential carbon credits to incentivize development of next generation clean technologies that are not currently manufactured in India.
Unwritten Rules
Despite the early infrastructure having been set up, we are still in the very early days of international carbon trading. COP 27 represented progress, and we are likely to see more international trades soon in 2023. However, major rules and agreements – both bilateral and multilateral – are still being written. Given the early stages, India has an opportunity to shape the rules of the road in a meaningful way.
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