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With an increasing awareness of the cost of climate change, efforts have been made globally to mitigate its effects. Greenhouse gas (GHG) emissions contribute significantly to global warming, and the realization has dawned that the world needs to reduce them immediately. Carbon markets are a step in this direction. These markets operate with the help of carbon credits that can be bought and sold, creating financial incentives by rewarding nations that reduce emissions. The World Bank has explained the importance of carbon markets, stating that “Carbon markets help mobilize resources and reduce costs to give countries and companies the space to smooth the low-carbon transition.”
Carbon markets can be either compliance-based or voluntary. Compliance based markets are mandatory and set up by governments or multi-governmental bodies. On the other hand, voluntary markets are based on voluntary participation in the trading of carbon credits known as Verified Emission Reductions (VER).
With COP28 here the carbon markets are again a point of focus. How efficient have they been? What shortcoming do they suffer from? Is there a way for their standardization? This article discusses the risks associated with the carbon market and how India is progressing in this market.
EVOLUTION OF CARBON MARKETS: FROM PARIS TO COP 28
In 1997, the Kyoto Protocol was adopted, which set greenhouse gas (GHG) emission targets for industrialized nations and economies in transition. No targets were set for developing countries. The Clean Development Mechanism (CDM) was devised, which enabled countries to emit more than the target emission level if they helped countries without targets set under the Kyoto Protocol to reduce emissions. Under this mechanism, certified emission reductions (CERs) could be purchased from another country to offset the obligation set out.
The Paris Agreement in 2015 was another fundamental step in the world's climate mitigation efforts. Paris Agreement marked a key departure from the Kyoto Protocol by including all countries in setting climate mitigation targets, with an expectation put on all countries to move towards economy wide reduction or limitation targets over time. Mitigation targets were drawn up in the Nationally Determined Contributions (NDCs). Together they aim at keeping the average global temperature rise less than 2℃ above pre-industrial level and limiting the temperature increase to 1.5℃. Article 6 of the Paris Agreement builds on the experience of market approaches under the Kyoto Protocol.
At COP26, held in 2021, Article 6 of the Paris agreement form a central part of the negotiations and debate. Later, COP27 led to the publication of a draft document which outlines the functioning of carbon trading under a two-tier system. It introduced a new kind of carbon credit referred to as the “mitigation contribution” unit under Article 6.4.
With COP28 here, there could be efforts to standardize the voluntary carbon markets. COP28 could be a step in the direction of accelerating climate action by making progress with regard to carbon markets, working towards making them credible and increasing their functionality.
CHALLENGES IN CARBON MARKETS
Carbon markets have faced its fair share of challenges and criticism. At the outset, there is a lack of standardization and governance when it comes to carbon markets. NDCs vary in terms of their sectoral coverage and the types of GHG included in their targets defined. Additionally, some countries use other metrics to define targets such as renewable energy targets along with some others only formulating non-quantitative actions. The NDCs are self-determined with a mandate put on countries to supply sufficient information to allow “clarity, transparency and understanding” about the nature of the contribution. The NDCs are not legally binding, and enforcement mechanisms are non-adversarial and non-punitive.
In case of cap-and-trade systems, research has shown that they would successfully achieve the aim of meeting target emission reduction cost-efficiently only if they are well-designed and appropriately implemented. These systems are not sufficient on their own; their effectiveness depends on the economic environment in which they are implemented.
Voluntary Carbon markets face a higher share of criticism. There have been claims that the offsets often do not achieve the claimed results. This makes the effectiveness and integrity of voluntary credits questionable. As an extension of this problem comes the issue of greenwashing, which refers to a company deceiving people into thinking they have environmentally friendly products, exaggerating the positive impacts on the environment, or overemphasizing the sustainable efforts of the company to mask practices that cause environmental damage. Thus, companies often do not take adequate steps toward reducing their carbon footprint and hide behind the garb of carbon credits.
There is also want for transparency regarding voluntary carbon markets as was pointed out in a 2023 report of the World Economic Forum. The report also stated that there is a need to ensure that the action resulting from the carbon credit should not have happened without it and should be permanent.
On a similar note, reports have pointed out that investors are sceptical about whether a voluntary carbon credit is high or low-quality since there have been allegations of overrepresentation of the amount of carbon reduction being caused by carbon standard providers. On the flip side, companies have also become reluctant to engage with the carbon market for fear of being accused of greenwashing. This is evident from a survey in 2022 where 40% of the corporate respondents shared that they were concerned about “reputational risk” given the rising criticism of carbon offset projects. There has also been a decline in the demand for offsets and issuances of new credits is estimated to slow down. There has been a rising trend of companies being more cautious of claims of emission reduction that aren’t genuine.
CONCERNS REGARDING CARBON MARKET
Carbon credits, distinct from physical goods in traditional markets, lack a tangible form, raising complexities in their legal characterization and fostering confusion among participants in the carbon trading arena. This intangibility has created a breeding ground for fraudulent activities and illicit practices, exposing the market to exploitation risks reminiscent of those witnessed in other financial markets. The intricate nature of carbon markets, which extend beyond direct credit trading to encompass derivatives and various financial instruments, further compounds the challenge of effective regulation and compliance assessment. The global financial crisis underscored the inherent difficulties in overseeing markets involving intricate financial products, with the carbon market facing similar risks if regulatory capacities are not strengthened.
Identified illicit activities in carbon markets span a spectrum of fraudulent practices, ranging from the deceptive manipulation of measurements to unauthorized sales of non-existent or third-party-owned credits. These malpractices extend to misleading claims about environmental and financial benefits, exploiting regulatory gaps for financial crimes like money laundering and securities fraud, and engaging in computer-based crimes such as hacking and phishing to pilfer carbon credits and personal information. Forecasts anticipate a future where carbon credits traverse multiple countries, complicating efforts to trace their journey and providing fertile ground for criminal exploitation.
Looking ahead, the foreseeable future of carbon credits may be influenced by the framework of the Kyoto Protocol, involving the establishment of national registries to monitor these credits. Transactions within these registries, connected to the International Transaction Log, aim to validate and track the movement of units. However, vulnerabilities in internet security have been ruthlessly exploited, as exemplified by the cyberattack in November 2010, where 1.6 million carbon credits were stolen from the Romanian registry account of Holcim Ltd., a major global cement manufacturer. The incident highlighted the susceptibility of carbon trading to technology-related crimes, emphasizing the need for robust cybersecurity measures in this evolving market.
INDIA AND CARBON MARKET
India stands prominently among the contributors to global greenhouse gas emissions, underscoring its crucial role in addressing climate change. Demonstrating commitment to reducing carbon footprints and achieving sustainable development goals, India has unveiled significant opportunities for carbon credits within its borders. In June this year, the government introduced the framework for the Indian carbon market through the Carbon Credit Trading Scheme, 2023. This marks a noteworthy stride as the generation, sale, and purchase of carbon credits will now occur within the country, employing the cap and trade mechanism.
The Ministry of Power is entrusted with identifying sectors and obligated entities, establishing emission intensity targets, and notifying the Ministry of Environment, Forests, and Climate Change. Regulatory oversight will be conducted by the Central Electricity Regulatory Commission (CERC), with trading activities supervised by POSOCO. The Bureau of Energy Efficiency (BEE) will administer carbon credits, supported by a National Steering Committee comprising officials from the Ministries of Power and Environment. Despite this substantial move towards an Indian carbon market, details such as sector identification, entity naming, emission targets, and verification procedures require further refinement.
The commendable efforts of the Indian government face challenges, primarily centred around the delicate balance between supply and demand. While emission reduction obligations are set to generate a substantial supply of carbon credits, uncertainties persist about the demand side, risking plummeting carbon credit prices. Harmonizing supply and demand is crucial to avoid discouraging companies from engaging in emission reduction activities. Challenges also extend to determining emission limits, potential inclusion of a secondary market, and establishing a robust regulatory framework. A major challenge lies in determining emission limits, a potentially contentious task given diverse technologies among companies. Concerns also arise over potential speculation in a secondary market, necessitating careful regulation to prevent adverse consequences. The successful establishment of a thriving carbon market in India hinges on addressing these multifaceted challenges while ensuring a robust regulatory framework.
PROSPECTS FROM COP 28
COP28 stands at a crucial juncture where the discourse on climate action, carbon markets, and finance must transcend mere pledges to concrete, impactful measures. The framework of the Indian carbon market, as outlined in the Carbon Credit Trading Scheme, 2023, plays a crucial role in this landscape, although it excludes voluntary markets. To signal a definitive commitment to genuine action, COP28 needs to simplify the rules for carbon accounting, particularly those under Article 6 of the Paris Agreement. Establishing coherent accounting rules is akin to architecting the market infrastructure essential for implementing decarbonization plans globally.
Amidst the complexities, COP28 should acknowledge and enhance existing standards, endorsing independent regulatory bodies like the Integrity Council for the Voluntary Carbon Markets (ICVCM). These bodies work towards ensuring a minimum quality standard for carbon markets, learning from the lessons of the UN's Clean Development Mechanism. By setting a fair minimum price for carbon, COP28 can amplify the effectiveness of carbon pricing signals. This step would motivate companies to undertake impactful emissions reduction measures, providing financial certainty for projects on the ground. Encouragingly, the Voluntary Carbon Market Integrity initiative offers companies a secure space to participate without fear of unwarranted criticism or legal challenges. It is a vital step in urging companies to contribute substantively to climate solutions.
As the world keenly observes, COP28 holds the responsibility of transforming rhetoric into actionable strategies. Recognizing the interconnectedness of capital flows, carbon markets, and climate goals, these proposed actions outline a roadmap for COP28 to lead by example, fostering genuine and impactful climate action.
This blog has been authored by Aayush Pandey and Sudarshana Mahanta from Gujarat National Law University.
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