What will it take to establish new carbon markets under the Paris Agreement?

As the global climate crisis looms, we look to the Paris Agreement to set countries on a new course to reduce global warming. One of the main measures of success will be limiting the global temperature from rising over 1.5–2 degrees Celsius in this century. To do this, we must incentivize countries to mitigate greenhouse gas (GHG) in a meaningful way. Robust carbon markets are one way to accomplish this.  

Article 6 of the Paris Agreement replaces previous forms of international carbon credits under the Kyoto Protocol and provides a new rulebook for governance. The unit of trade in these markets is coined “internationally transferred mitigation outcomes” or ITMOs. ITMO trading—which allows countries in under-compliance to purchase ITMOs from countries in over-compliance—opens the potential for the creation of new markets, large reductions in global GHG emissions , and could lead to more ambitious target setting as ITMOs can mobilize resources and reduce costs to participating countries. Our new paper, Prospects for Markets for Internationally Transferred Mitigation Outcomes under the Paris Agreement, examines issues related to how ITMO markets function, their impacts on potential ITMO-supplying countries, and their potential for reducing the cost of global GHG mitigation activity and increase the global ambition in climate policy.  

As exciting as these potential gains are, the question remains, will markets defined under the Paris Agreement be able to support extensive trading of ITMOs?   

Three types of markets may be relevant for trading ITMOs between parties to the Paris Agreement: 

• Forward contracts for ITMO transactions were standard under the Kyoto Protocol and could now play a similar role. These contracts provide certainty that future mitigation outcomes can be sold at a pre-agreed price or according to a pre-agreed price formula. They are particularly useful for lower income countries.  

• Spot markets could be especially useful closer to 2030. These markets make it possible for parties, uncertain whether their NDC commitments will be under- or over-fulfilled, to either buy or sell ITMOs when their NDC period is nearing its close. But their existence is in peril because banking of ITMOs is not allowed from one NDC period to the next. This raises concern that there may be very little supply of ITMOs near the end point of the NDC period, causing market non-existence or liquidity problems. Countries are therefore incentivized to work to achieve compliance to their Paris Agreement targets on their own, instead of buying and selling ITMOs. For example, a party that would have otherwise have aimed to sell ITMOs (by mitigating more than needed to meet its target), could worry that the marketplace for selling their ITMOs would no longer be available, and instead only reduce its GHG mitigation as needed to meet its own target. If most parties acted in this way, ITMO markets could “dry up” and become less relevant, or even cease to exist. 

• Option markets could then be helpful. They imply contractual commitments to either being able to sell ITMOs (through put options) when the party’s actual mitigation is in excess of its target or buying them when needed for NDC compliance (through call options). In our paper we show that availability of such options markets can be very attractive to parties, increasing their welfare and reducing their uncertainty. But options markets could face problems similar to those of spot markets, because even those parties that issue options, might fail to honor their (contractual) commitments to buy or sell ITMOs in 2030. It could also be that no such options contracts are actually offered.  

Donors and international financial institutions can reduce or eliminate much of this uncertainty by providing climate finance that is convertible to ITMO market transactions. For example, providers of climate finance could support mitigation activities in lower income countries through results-based climate finance (RBCF)—funding that is provided only when agreed-upon results are achieved. These host countries could then opt to sell ITMOs from these funded mitigation activities once they have sufficient certainty of achieving their own targets, reimbursing the RBCF received from ITMO sales proceeds. The reflow of RBCF could then be used by the climate finance providers to support a next generation of mitigation activities, thus becoming a revolving source of funding. 

Changing the trading rules under Article 6 of the Paris Agreement to allow banking of ITMO holdings beyond 2030 would greatly contribute to enable an ITMO market . It would make late ITMO market trading far more attractive to parties, and greatly facilitate the use of the Article 6 trading mechanisms. However, such a rule change might be difficult to achieve without stricter requirements on NDC targets and establishment of a binding compliance regime under the Paris Agreement. 

Efficient ITMO trading under the Paris Agreement has the potential to dramatically reduce the agreement’s overall implementation costs. Such cost reductions can translate into more ambitious NDC targets , and then lead to increased global GHG mitigation. The mechanisms discussed here have the potential to serve such purposes.