The EU’s Dilemma on International Carbon Credits
by Kateryna Holzer, Senior Researcher
This blogpost is based on research under the project ‘Voluntary carbon offsetting in (climate) action: Perception coalitions, representations, and regulation (OFFCORR)’, funded by the Research Council of Finland (grant 355944). Opinions expressed are however those of the author only.
With the adoption of additional decisions on registries and standards for methodologies supporting the generation and cross-border transfer of international credits, the 29th Conference of the Parties (COP) to the United Nations Framework Convention on Climate Change (UNFCCC), held last year in Baku, achieved full operationalization of Article 6 of the Paris Agreement. This was an important milestone paving the way for the global carbon market. However, uncertainties and obstacles remain in the future implementation of cross-border transfer of international credits. A key challenge lies in the low demand for these credits and the national regulatory barriers that discourage it, hindering the expansion and linkage of carbon markets. Questions remain, in particular, regarding the participation of EU public bodies and companies in developing climate mitigation projects registered within the framework of Article 6, and also their ability to acquire credits generated from such projects. The EU has not yet created incentives for this, choosing to keep international credits outside its mandatory emissions reduction schemes and targets. EU legislation also does not permit the generation of Article 6 credits within its territory to be available for transfers to non-EU countries.
As the EU prepares to adopt its 2040 emissions reduction target, an intense debate is underway on whether to open the EU carbon market to international credits by allowing their use as offsets. With a decision on this issue anticipated in the coming months, this blog post discusses the opportunities and challenges of a potential shift in the EU stance on Article 6 cooperation.
Understanding credit-based cooperation under Article 6
Article 6 of the Paris Agreement enables voluntary cooperation between countries in achieving their nationally determined contributions (NDCs). This primarily involves cross-border transfers of credits between host countries implementing emissions reduction projects, on the one side, and governments or companies willing to acquire credits generated from these projects, on the other side. The motivation to acquire credits may be driven by multiple factors. Buyers may use these credits for compliance with national emissions reduction schemes – those which accept Article 6 credits as offsets (e.g. the Swiss carbon tax on transport fuels). They may also want to purchase credits to achieve compliance with emissions reduction obligations under international compliance frameworks, such as the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) in the aviation sector. Moreover, companies may want to purchase Article 6 credits on their own initiative as part of their corporate social responsibility strategies, to be able to make claims of offsetting emissions in their value chains or claims of contribution to result-based climate finance.
Article 6 cooperation can significantly reduce the cost of mitigation, enabling more efficient implementation of NDCs. Some estimates suggest that such cooperation could reduce mitigation costs by USD 250 billion per year by 2030. No wonder that over 120 countries have signaled their willingness to use Article 6 for their NDC implementation since COP26 in Glasgow. Moreover, by attracting foreign investment in mitigation projects, Article 6 cooperation serves as a vital source of climate finance. A country can decide whether to attract climate finance through Article 6 or other projects. On the one hand, attracting finance through Article 6 comes at a higher cost for the host country, as this requires corresponding adjustments in the country’s emissions budget and finding alternative sources for emissions reductions to remain on track with its NDC. On the other hand, it can be easier to attract investments through such projects because Article 6 credits issued under UN-approved rules promise to be perceived of higher value than credits from the same kind of activities issued by some private crediting programs.
While participation in Article 6 credit-based cooperation is voluntary, if a country decides to participate, it has to follow rules adopted by UNFCCC parties. Article 6 foresees two kinds of cross-border credit transfers – under bilateral/plurilateral agreements (Article 6.2) and through a centralized mechanism called the Paris Agreement Crediting Mechanism (PACM), the successor to the Kyoto Protocol’s Clean Development Mechanism (CDM). Whereas the PACM is still under development, the bilateral transfer of credits – Internationally Transferred Mitigation Outcomes (ITMOs) – has been under way for several years. Such countries as Switzerland, Singapore, Japan and South Korea have entered into agreements with other countries to be able to invest in mitigation projects in those countries and acquire credits. For instance, Switzerland has already concluded agreements with fourteen counties, including Peru, Ghana, Uruguay, Thailand, Morocco, Chile etc. These credits are bought, for instance, by importers of fossil transport fuels who are obliged to offset certain amount of carbon emissions. The offsets are then counted towards compliance with the Swiss NDC. Singapore also plans to use 30% of ITMOs authorized under its emissions reduction implementation agreements with third countries for compliance with its NDC.
The EU cautious stance on the use of international credits
So far, the EU has not been rushing to conclude agreements on transfers of credits with third countries under the Article 6 framework. This is despite the EU’s promotion of cooperative approaches in the UNFCCC negotiations. Not to engage in cross-border credit transfers was a conscious choice: in achieving its NDC target of 55% of emissions reductions by 2030 compared to 1990 levels, the EU decided to rely only on domestic sources of emissions reductions. Such a decision stems from the EU’s negative experience with international credits in the past. Till 2021, credits stemming from Kyoto Protocol’s CDM and JI projects were accepted for compliance with the EU Emissions Trading Scheme (ETS). At that time, being the largest carbon market in the world due to its ETS, the EU also became the biggest source of demand for CDM and JI credits and, in parallel, the main provider of clean energy investment in developing countries and economies in transition. But the EU failed to prevent an inflow of cheap low-quality international credits to its carbon market contributing to a collapse in the carbon price in the second phase of ETS (2008-2012). Consequently, the EU refrained from accepting international credits for compliance with the ETS in the fourth phase (2021-2030) and hence also from engaging in credit-based cooperation under Article 6 for the implementation of its 2030 NDC.
That said, while the EU as a whole has not been involved in carbon transactions under Article 6, some EU member states (e.g. Sweden) have started investing in Article 6 credits. EU legislation does not prohibit EU member states to acquire Article 6 credits if these credits are not used for the 55% joint 2030 emissions reduction target in the EU NDC. Article 6 credits can be used for the achievement of EU member states’ national targets that go beyond their contribution to the joint EU-wide NDC and for other purposes not related to the EU NDC commitments. EU companies, for instance, can buy Article 6 credits to be used for compliance with obligations under CORSIA or in fulfilment of their corporate responsibility pledges. EU member states cannot, however, host credit-generating projects and authorize cross-border transfers of credits generating from these projects, not to disturb the EU’s joint emissions balance and hence the EU NDC.
Looking beyond 2030: time for a strategic reassessment?
While the use of Article 6 credits for achieving compliance with EU mandatory emissions reduction schemes and targets is currently not allowed, this may change in the future. The goal of 90% emissions reductions by 2040 as a key step towards achieving climate neutrality by 2050 presents a significant challenge, especially under the changing circumstances marked by the political pushback against climate policy, internal struggles to reconcile climate policy goals with other priorities emerging from geopolitical and economic instability, the risk of war etc. The EU may not be able to achieve this goal without undermining the competitiveness of its producers if it does not use flexibilities offered by the Paris Agreement to offset some small percent of hard-to-abate emissions. Thus, the use of international credits is back on the table. As the EU has yet to make its final decision, what are the pros and cons of the EU’s engagement with Article 6 mechanisms?
Seizing opportunities
Engaging in carbon credit transfers under Article 6 may be beneficial for the following reasons. First of all, it would allow the EU to achieve its ambitious emissions reduction goal, if domestic emissions reductions are not sufficient. The costs of emissions reductions would be lower compared to complete reliance on domestic measures and the emissions reduction goal can be achieved in a more efficient way. Second, it could add flexibility to the EU climate regime and help overcome resistance of opposing political parties in the upcoming vote for the adoption of the 2040 90% emissions reduction goal in the European Parliament and Council. Third, the EU engagement in Article 6 cooperation could open new markets for EU companies and increase their export opportunities in connection to the development of climate change mitigation projects abroad. This would also have geopolitical significance preventing China’s monopoly on filling the gap left by the US as a provider of green technology and partnership. The acceptance of international credits for compliance with EU emissions reduction schemes and targets could also help address the integrity problem of carbon credits, provided that the use of credits for compliance is subject to strict control of integrity, steering demand towards high-quality credits. Last but not least, the EU-wide participation in Article 6 credit-based cooperation would increase climate finance and hence the EU’s leverage in setting global climate policy.
Avoiding pitfalls
Based on past experience, the EU’s acceptance of Article 6 credits for compliance with its emissions reduction targets would need to be subject to very strict quantitative and qualitative restrictions. This requires a robust system with a swift self-correction mechanism. Not to undermine its climate policy ambition, the EU cannot allow a large percentage of emissions in its post-2030 emissions budget to be offset by Article 6 credits. Offsetting emissions through Article 6 credits should only be allowed in some hard-to-abate sectors, including aviation, steel, cement, chemicals, agriculture, and only for residual emissions (that is, those emissions that remain after a company has implemented all technically and economically feasible opportunities to reduce them). The EU might also consider allowing transfers of ITMOs generated within its territory to other countries in order to attract investments in valuable technologies, such as bioenergy with carbon capture and storage (BECCS). Such transfers, however, would require adjustments in the EU emissions balance taking away a chance to count these mitigation outcomes towards the achievement of its own NDC. Article 6 credits could also be recognized as part of sustainability criteria for assessing bids and awarding contracts in public procurement in the EU. Even though this would not be directly linked to the fulfilment of NDC, it would create an incentive for companies to invest in mitigation projects. Article 6 credits could also be considered for compliance with the EU Carbon Border Adjustment Mechanism (EU CBAM), which extends the EU ETS obligation to imports of some carbon-intensive products. Acceptance of Article 6 credits for compliance with the CBAM would mean that importers possessing these credits would receive a rebate on the CBAM fee. But in that case again, acceptance needs to be subject to quantitative and qualitative criteria not to undermine the very purpose of the CBAM aimed at ensuring a level playing field for domestic producers and thereby preventing carbon leakage.
That said, the main question is how to ensure that the quality of international credits accepted for compliance meets high integrity standards. This question is especially relevant in light of the COP29 decision allowing transfers of former CDM credits to the new PACM under Article 6.4. UNFCCC parties can now request a transfer of their CDM credits to the PACM registry to be registered and authorised as credits issued under the PACM (A6.4ERs). This raises serious concerns of integrity. According to some estimates, ‘nearly 1 billion repackaged CDM credits with questionable credentials could flood the nascent Article 6 market’ and only one in 26 former CDM credits will represent real emissions reductions. The problem with CDM was questionable emissions reduction quantification methods (inflated baselines, lack of additionality etc.). However, it is also not clear whether the PACM standards for methodologies (currently under development by the PACM Supervisory Body) will meet higher integrity standards compared to CDM. This raises concerns about the credibility of international carbon credits and puts in question the appropriateness of using these credits for compliance with the EU NDC.
A possible safeguard against an inflow of low-quality carbon credits to the EU carbon market is to constrain the use of international credits for compliance only to those credits that are authorized for transfer under Article 6.2. Accepting only credits generated from projects approved under bilateral/plurilateral agreements would enable the EU to ensure a strict integrity control over credits it intends to use for compliance with its NDC. This is because the rules under Article 6.2 allow countries to decide themselves under which conditions they wish to participate in cross-border transfers of mitigation outcomes. Bilateral agreements with partner countries may include additional requirements for validation and verification of credits that go beyond the basic requirements, ensuring accuracy and reliability of ITMOs. Moreover, they may include requirements related to protection of human rights and social justice.
To conclude, in the present situation marked by unprecedented geopolitical challenges requiring additional spending on defense, energy security and strategic sectors, the EU’s potential engagement in carbon offsetting under Article 6 may be a pragmatic necessity. There is a risk, however, that by accepting Article 6 credits as offsets, the EU will not remain on track to reach its 2040 emissions reduction goal. Much depends on safeguards that can be put in place against oversupply and low quality of credits. This means that the EU faces a critical strategic choice – one that may determine the success of its mid-century net-zero ambition.