Climate Finance: How Countries Can Develop National Strategies for Carbon Markets

Carbon markets can be a crucial tool in the effort to address climate change. Photo: Francesco Ungaro
Carbon markets can be a crucial tool in the effort to address climate change. Photo: Francesco Ungaro

By Virender K. Duggal

Governments face risks and opportunities when developing national strategies for using carbon markets to transition to a low-carbon economy.

Carbon markets are increasingly being recognized as a pivotal mechanism to channel financial resources into initiatives combating climate change. As integral components of the climate policy architecture, these markets play a crucial role in reducing greenhouse gas emissions cost-effectively and promoting the adoption of low-carbon technologies.

The landscape of carbon markets is evolving and diverse. They are primarily driven by demand at both the international and domestic levels, either for the fulfilment of voluntary climate commitments or to meet compliance requirements established by laws or international agreements.

The international carbon market under Article 6 of the Paris Agreement is gaining traction, with several countries actively preparing for transactions through bilateral agreements and development of technical and institutional capacity.

 If Article 6 is used to its full potential at the system level, potential cost savings are estimated to achieve nationally determined contributions through Article 6 at around $250 billion annually in 2030. But the figure currently is nowhere close to this with the first transaction agreements coming into place this year. Meanwhile, the voluntary carbon market is at just under $2 billion amid strong demand for higher integrity and increasing convergence with Article 6.

With a range of options available that bring opportunities and challenges, governments are faced with determining their scope and level of participation and defining the objectives behind engaging in specific carbon markets. Policymakers should understand the wide-ranging possibilities and pitfalls within carbon markets and how high-integrity carbon markets can underpin the transition towards a low-carbon economy as countries transition towards net zero.

This calls for strategic thinking in devising national strategies for international carbon markets under the Paris Agreement.

Navigating the challenges of domestic and international carbon markets requires an in-depth knowledge of current trends, the international landscape, and related policy requirements. As international carbon markets started expanding, two major issues have emerged: doubts about whether these markets truly benefit the environment (environmental integrity) and concerns about the reliability of the carbon credits (credit quality).

This has led to questions about the legitimacy and long-term effectiveness of the claims made by these markets. These issues need to be addressed for carbon markets to be an effective environmental policy instrument.

For many countries, participation in international approaches under Article 6 will require new domestic regulations and legal frameworks to support compliance with the Article 6 guidance and rules. Participation will also require countries to weigh several considerations, including the impact of participation on the long-term achievement of their nationally determined contribution targets.

This will require a decision-making framework to determine which mitigation outcomes to authorize for international trade as well as administrative capabilities to facilitate credit authorization. While voluntary markets typically run independently of government regulation, they have always existed in the context of national legal and regulatory frameworks, and governments may consider what actions can be taken to support or constrain voluntary activities in their jurisdiction. 

 An Article 6 policy framework, comprising of both strategic and operational elements, will ultimately be necessary for involvement in international carbon markets.

Establishing a long-term strategy and framework on engagement with carbon markets with the objective to achieving the nationally determined contributions and raising ambition should be considered one of the first steps. This requires a detailed identification of priorities, considering specific country circumstances and development needs.

Within this strategy, regulatory and legal structures as well as taxation requirements should be identified and adapted.  Specifically for the engagement under Article 6, strategic objectives must be prioritized for mitigation outcomes to be eligible for international transfers. 

Policymakers should understand the wide-ranging possibilities and pitfalls within carbon markets and how high-integrity carbon markets can underpin the transition towards a low-carbon economy as countries transition towards net zero.

Identifying the right balance in the strategy concerning attracting international finance without the risks of ‘over-selling’ credits at the expense of achieving domestic nationally determined contribution targets will be critical.

Finally,  international carbon finance should be additional and support otherwise challenging sectors, ensuring appropriate revenue-sharing among beneficiaries.

It is essential to develop a strong governance system, as well as robust and transparent national frameworks and strategies that encompass environmental, social, and financial accountability. Maximizing engagement with local communities, civil society, indigenous people, and youth as partners and rightful beneficiaries in the design of such a strategy will be critical. Governance structures and safeguards should be streamlined along with decision-making processes.

Operationally, effective participation in carbon markets entails implementing transparent processes for authorizing international transfers of carbon credits and formalizing roles and responsibilities across governments to operationalize Article 6. This goes hand in hand with developing procedures for transitioning projects from the Clean Development Mechanism to the Article 6.4 mechanism aligned with the decisions under Conference of the Parties.

Additionally, countries should consider instituting accounting and reporting capabilities under Article 6 requirements while also establishing clear contact points for negotiation, bilateral Article 6 agreements, and inter-ministerial or inter-agency approval processes.

It is also beneficial for countries to align Article 6 transactions with their domestic carbon market policies and activities. For example, domestic emission trading systems can be directly linked to international carbon markets. and guide voluntary purchasers to ensure alignment with crucial carbon market integrity initiatives.

Options are plenty, so policymakers should not wait. They should start evaluating opportunities for engaging in carbon markets, consulting domestic and international stakeholders, and preparing frameworks and instruments to underpin the transition towards a low-carbon economy.

Ultimately, it is imperative to remember that despite the opportunities presented by carbon markets, they are not a panacea for climate action.

 The effectiveness of carbon markets can only be optimized if seamlessly integrated into the broader climate policy framework and aligned with complementary policies. This is particularly important in the new era of carbon markets under the Paris Agreement.