Emissions Trading: As COP26 is delayed by COVID-19, some thoughts on the international linking of domestic schemes

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Introduction

Last month, the COP26 UN climate change conference set to take place in Glasgow in November 2020 was postponed due to COVID-19.  One consequence: agreement on the rules for a global emissions trading scheme under Article 6 of the Paris Agreement will be deferred again, to at least 2021.  As agreement under Article 6 has been delayed in the past, various groups – including the International Carbon Action Partnership (ICAP) and Carbon Market Watch – have advocated for increased linking of domestic schemes.  The thinking is that this would encourage the creation of a global carbon market and thus the harmonisation of regulatory standards, and that it would also lower the costs of reducing emissions globally.  In that context, this post briefly considers existing international and domestic schemes, as well as the risks to market actors as those schemes evolve and interact, before suggesting how these risks can be mitigated, thus maximising the intended benefits of internationalisation.

Emissions trading schemes

In an effort to reduce emissions of carbon dioxide (CO2) and other greenhouse gases, a number of states have introduced so-called “cap and trade” schemes.  These schemes impose a limit (the “cap”) on CO2 and other greenhouse gases that can be emitted in defined sectors; the cap then typically decreases over time.  Subjects of the scheme receive emissions allowances, typically expressed in units of emissions, where each unit allows the holder to emit one tonne of CO2 or its equivalent in other gasses.  Subjects without enough allowances can buy allowances held by other subjects, or offset their emissions by earning or buying credits generated through projects that reduce emissions (the “trade”) – otherwise, they are sanctioned in some way (e.g. they pay a fine). 

The first scheme applicable to private actors was introduced by the European Union (EU) in 2005.  There are now at least 20 schemes globally, and ICAP reports that 6 more are scheduled for implementation, and a further 12 under active consideration. 

An international scheme – applicable to states – was introduced by the Kyoto Protocol, which was agreed under the UN Framework Convention on Climate Change (UNFCCC) and entered into force in 2005.  It required developed countries to cap their emissions at agreed levels; allowances were allocated to those parties in amounts equivalent to their cap.  Parties requiring more allowances could either acquire them from other participants, or earn credits through emissions reducing projects, whether in other developed countries (Joint Implementation (JI) projects) or in developing countries (Clean Development Mechanism (CDM) projects).

In 2015, the UNFCCC parties concluded the Paris Agreement, which established a new regime requiring all parties (not just developed countries) to set caps. Article 6 contemplated a new global emissions trading scheme, but the UNFCCC parties were not then able to agree on its details.  Nor were they able to agree on its details at COP24 in 2018, during which the implementing details of the Paris Agreement were agreed in part, or at COP25 in 2019. 

Risks in the current landscape of emissions trading schemes

The landscape of international and domestic trading schemes is evolving rapidly.  Beyond the proliferation of schemes noted above: 

  • The scope of schemes is expanding. For example, the EU Emissions Trading Scheme (EU ETS) has been introduced in phases, with each phase increasing the activities covered: Phase I covered energy, ferrous metals and minerals; Phase II added intra-EU aviation; and Phase III added, inter alia, carbon capture and storage, non-ferrous metals and petrochemicals.  The phasing in of schemes can be controversial, for example where subject companies compete with non-subject companies (as ArcelorMittal argued before the European Court of Justice (ECJ)).
  • Allowances will typically be decreased within a scheme over time – to the extent that the rate of decrease is not set out in advance, there is a degree of risk involved.
  • The means of approving and regulating credit-generating projects may change within the scheme (as may be the case for CDM projects, whose status after 2020 is still uncertain); or regulatory bodies may take actions in relation to those projects that affect their ability to generate credits (as was the case in Guaracachi v. Bolivia and a case brought by Core Carbon against Rozgas).
  • Measures are still being honed to ensure security, including to protect against theft from registries: the 2010 theft of Holcim Ltd.’s allowances from Romania’s national registry was, for instance, the subject of proceedings in the Romanian civil courts and before the European Court of Justice.   

In addition to these risks – which are in a sense “domestic” to any given scheme – there are the further risks that arise as a result of interactions between schemes, and that are the subject of this post. 

Those interactions can take various forms:

  • The past few years has seen “linking” between domestic schemes. The Japanese cities of Tokyo and Saitama agreed to link their schemes in 2011; California and Québec in 2013, with Ontario joining in 2018; and the EU and Switzerland in 2017.  The key feature of the “link” is that one scheme will recognise allowances or credits granted by the other.  Thus, for example, according to Article 4(1) of the EU-Switzerland Agreement, the EU will recognise allowances granted by Swiss authorities, and vice versa. 
  • One scheme may also recognise allowances or credits granted by another scheme unilaterally. Under the EU ETS rules (Article 11(a) of Directive 2004/101/EC), credits earned from JI and CDM projects under the Kyoto Protocol are recognised. 

In these circumstances, market actors may be subject in some way to the regulatory authority of not just one state, but also that of another state or some manner of joint body.  Staying with the EU-Switzerland example: a company subject to the EU ETS may have a project that generates credits under the Swiss scheme (or have purchased credits from such a project); because the EU ETS and Swiss scheme are linked, the EU authorities will recognise that credit and add it to the company’s allowance in the EU; but the company is as a result subject to some degree to both Swiss law and EU law. In the EU-Kyoto Protocol case, the EU company would also be subject to some degree to the relevant international authorities – for CDM projects, the CDM Executive Board under Article 12.9 of the Kyoto Protocol.

That in itself gives rise to increased regulatory risk, which is compounded by the possibility that the “link” or other manner of recognition may be revoked for some reason.  This is not an abstract concern.  EU recognition of Kyoto Protocol credits will expire at the end of this year due to a large surplus of EU allowances already in circulation.  The rules regulating UK credits post-Brexit have yet to be developed.  Joint regulatory agencies may alter the applicable rules of recognition.  And schemes may be de-linked: that effectively happened to Ontario’s link to California and Québec when the Ontario government dismantled its scheme; it is also contemplated under Article 16 of the EU-Switzerland Agreement

Recommendations for mitigation

As noted, links between domestic schemes are advocated because it is thought that they will lower the global cost of reducing emissions.  The idea is that costs will be lowered because emissions-reducing projects will be performed where most cost-effective, including potentially outside of the jurisdiction in which a credit is used.  But if linking is to encourage this type of cost-effective behaviour, market players will need (1) some manner of clarity as to who will bear the above-noted risks of internationalisation, (2) backed up by an ability to enforce that allocation of risk. 

As to the first, Article 10(1) of the EU-Switzerland Agreement states that it is “without prejudice to the right of each Party to amend or adopt legislation of relevance to this Agreement, including the right to adopt more stringent protective measures.”  Thus, our company subject to the EU ETS with a project that generates credits under the Swiss scheme may be subject to a change in Swiss legislation, unless there is some manner of stabilisation commitment elsewhere.  The Agreement does not, though, say what would happen if that change in legislation allowed the EU to cease to recognise Swiss allowances.  The company would argue that it had acquired rights to the allowances, whether under Swiss law or international law, but additional clarity would be helpful.

As to the second, international linking agreements tend to provide how disputes between their state parties will be settled, but not to address disputes between market participants and states.  Thus, Article 14 of the EU-Switzerland Agreement gives each party the right to take the other party to arbitration; it does not, however, allow our EU company to initiate arbitration against Switzerland for breach of the Agreement.  To the extent that the linking states have strong judicial systems, that may not be a problem.  But where links are created with countries with less developed judicial systems, it could be.  In that context, recourse might be sought under an investment treaty if one is available. (My recent ICSID Review article considers issues that might arise in seeking such recourse.)  Again, though, greater clarity will no doubt be helpful.

It is unfortunate that COVID-19 has further delayed agreement on the rules for a global emissions trading scheme under Article 6 of the Paris Agreement.  But if global efficiencies can be created by other means in the meantime, that may be some consolation. 

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