By Fabrice Mattei
Following the adoption of the Rules Book of the Paris Agreement on Climate Change at the COP 26 (Decision CMA/3) establishing the long-awaited International Carbon Market, a fresh look about carbon pricing instruments and their interaction with green innovations to tackle climate change is needed.
With the operationalizing of the International Carbon Market all Parties to the Paris Agreement can engage with one another to reduce their greenhouse gas emissions through the international transfer of green innovations, generally known as Internationally Transferred Mitigation Outcomes (“ITMO”). It is estimated that the International Carbon Market has the potential to reduce to total cost of implementing Nationally Determined Contributions by more than half or USD 250 billion per year from 2030 or help the removal of approximately 50% additional greenhouse gas emissions in 2030.
The effectiveness of the new market at generating meaningful Credits Emissions Reductions (CERs) obtained from ITMO depends on (i) the access and diffusion of green innovations and (ii) the possibility of offsetting CERs obtained from those innovations against carbon pricing initiatives especially carbon tax and Emission Trading Scheme (ETS). As of now, only few countries (e.g. Columbia) allow the offsetting.
Then, buyers of ITMO will be able offset their CERs if the the price of a carbon tax or the value of a ton of CO₂ traded at the ETS is higher than the actual cost of developing and transferring their green innovations.
This raises a further question of which instrument between a carbon tax or ETS is best suited for offsetting CERs.
Offsetting CERs against a Carbon tax:
An offsetting component in a carbon tax allows entities to fulfil part or all of their climate change compliance obligations by surrendering CERs generated outside the scope of the carbon tax. Instead of paying a carbon tax, taxpayers may surrender CERs for a certain % of their tax obligations.
Offsetting CERs against Emission Trading Scheme:
In an ETS the mitigation goal is predefined through the overall cap that is set for the emissions covered while the price for emission allowances is variable according to demand and supply in the market. Participants can submit CERs instead of, or in addition to allocated permits. Offsets allowed in an ETS should not increase or decrease the overall mitigation outcome.
The characteristics of the carbon tax and ETS lead to conclude that offsetting CERs against a carbon tax is preferable because of the predictable price level and unlimited liquidity due to uncapped volume. However, using offsets for complying with a carbon tax would only be attractive to buyers of ITMO if it results in lower costs than the actual rate of the carbon tax. This requires to not only evaluate the development and diffusion cost of green innovations but also estimate their carbon value as translated into CERs.