Key Takeaways

• Article 6 of the Paris Agreement authorized countries to use two different forms of voluntary cooperation to implement their nationally determined contributions (NDCs).
• Article 6.2 enables a decentralized system, while Article 6.4 enables a centralized system.
• Private entities will be able to participate in both systems as well as voluntary carbon markets, but will have to consider which comes with the highest transaction costs.

Countries Indicate Increased Willingness to Use Carbon Credits

In the most recent round of nationally determined contributions (NDCs) submitted under the Paris Agreement, 102 of 124 countries indicated they would use or were open to using market mechanisms to reduce emissions. This is an increase from previous submissions, in which 79 countries signaled their openness. Clearly, market mechanisms, typically understood to mean the trading of carbon credits, are expected to help the world hold global warming below the Paris Agreement’s goal of 2 ℃.

How will carbon credits be utilized given the guidelines of the Paris Agreement? Article 6.2 (A6.2) and 6.4 (A6.4) of the Agreement are key to understanding how two different carbon markets will develop. Carbon market participants need to be aware of the significant differences between A6.2 and A6.4, and how these markets will effect voluntary carbon markets.

Differentiating Article 6.2 and 6.4 Markets

A6.2 creates a decentralized governance system for ITMOs. Countries can make bilateral or multilateral agreements with each other regarding how ITMOs will be used to achieve NDCs. Each country will be responsible for authorizing the issuance, transfer, and retirement of credits as well as monitoring, reporting, and verifying (MRV) the quality of the credits. This means that each country should host a registry of credits. Japan, Sweden, and Switzerland have already begun piloting these bilateral agreements and Bangladesh is developing an Article 6 engagement strategy.

The A6.4 mechanism is a centralized governance system administered by the Supervisory Body (SB), a group created at COP26. It will be responsible for keeping a registry of what will be called A6.4 Emissions Reductions (A6.4 ERs). Instead of individual countries being responsible for issuing, transferring, retiring, and conducting MRV of A6.4 ERs, the A6.4 mechanism will carry out these tasks. The A6.4 mechanism is still under development. A6.4 ERs will not be available until late 2023 at the earliest.

The most obvious difference between these parts of Article 6 is that ITMOs issued under A6.2 will be governed by the bilateral or multilateral agreements that countries make with each other while A6.4 ERs will all be held to the same set of standards created by the A6.4 mechanism. From the perspective of national governments, the most significant difference is that host countries for A6.2 ITMOs will need the governance capacity to administer this tool but for A6.4 ERs they will share the governance costs with the A6.4 SB. Countries are already concerned about developing the needed capacity for each pathway.

The Role for Private Entities and the Voluntary Carbon Market

Private entities that want to buy or sell carbon credits will be able to make use of either the A6.2 or A6.4 framework. Guidance for A6.2 developed at COP26 clarified this role for private entities while the A6.4 mechanism was always seen as a venue for private entities that want to buy or sell carbon credits. Buyers and sellers will have to determine if their interests are best served by working through bilateral agreements or through the A6.4 mechanism.

Alternatively, private entities could buy and sell credits through voluntary carbon markets. They might do this if they decide the cost of transacting through the bilateral agreements or the A6.4 mechanism is too high compared to the cost of transacting through a voluntary market. Standard-setting organizations for voluntary markets, such as the Integrity Council for the Voluntary Carbon Market, have already begun developing new standards that are intended to complement the Paris Agreement.

Analysis

Some of the factors that will influence the development of A6.2 markets, the A6.4 market, and voluntary markets are:

• The transaction costs of working with national governments for A6.2 ITMOs authorization vs. the transaction costs of the A6.4 mechanism vs. the transaction costs of voluntary markets. An entity that is seeking to buy A6.2 ITMOs from multiple countries would have to know the particulars of the agreements that its home government has with each country. If the same buyer transacted through the A6.4 mechanism or through a voluntary market, it would only have to comply with one set of rules.
• Whether or not governments offer financial or non-financial incentives for participating in one type of market.
• Whether or not a country is participating in an A6.2 framework. If a country has no bilateral agreements governing ITMOs, then private entities within the country looking to issue credits and private entities looking to buy credits from mitigation projects within the country will have to work with the A6.4 mechanism or voluntary markets.
• The levies applied to transactions in each framework. The A6.4 mechanism is required to levy a share of proceeds for administrative costs and to finance an Adaptation Fund. A6.2 does not stipulate any levies but recent guidance recommends levies.