Has Europe learnt from its great carbon price debasement?
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“Money, whether issued publicly or privately, is a public good. Those who create, manage and store it; and those who facilitate and record its transactions all bear special responsibilities to maintain trust in the system, for loss of confidence in one part of the system can undermine trust in the whole.”
- Mark Carney
In the early 16th century, the Spanish conquistador Francisco Pizarro ended the Inca Empire, killing Emperor Atahualpa.
After looting silver and other treasures, and destroying the Incan capital Cusco, Pizarro founded Lima, the present day capital of Peru. A convoys of ships – up to a hundred at a time – transported 170 tonnes of silver per year back across the Atlantic. The hoard of precious metals used by Spain to help finance its wars in Europe.
For Charles V and Philip II, the Spanish monarchs sitting on the throne during the 16th century, the realisation quickly dawned that an abundance of precious metal could be as much a curse as a blessing. Their navy had extracted so much silver from Latin America that the metal itself dramatically declined in value.
Currency debasement isn’t always accidental. Across history, governments have often betrayed their citizens long-term trust in exchange for short-term gains. The motivation to do so typically centres on the need to fund some ego-driven war overseas, or to pay off the debts built up by the rulers lavish lifestyle.
As in Spain, a sequence of currency crises across Europe during the 16th Century transformed economic life, resulting in a prolonged period of inflation that was to later become known as the ‘Spanish price revolution’, or more simply the price revolution.1
The track record for private money is no better. Banks began issuing their own money during the Renaissance, with private notes becoming increasingly prevalent during the 18th and 19th centuries. Institutions committed to maintain binding issuance rules and pledged assets as collateral. Over time the temptation to relax these structures and increase supply proved overwhelming. Trust in these private currencies, along with any credibility that was built up, quickly dissolved.
There are many parallels between the contrasting fortunes of currencies, and the far more recent emergence of carbon markets, their rise and fall, and rise again. Trust is the bedrock of both markets, currencies and carbon.
In the same way that trust in individual currencies supports investment, innovation and trade, trust in the carbon market helps to bring about the capital, skills and long-term planning that is required to help meet decarbonisation goals.
The carbon price is the ‘Currency of Decarbonisation’.
Two approaches to maintaining public trust in money and guarding against debasement include backing it with commodities including gold and silver, and backing by central banks, such as the Federal Reserve or the Bank of England. However, no approach is full-proof. Trust is hard won, but easily lost.
For the voluntary carbon credit market, asymmetric information means it’s very difficult for buyers to trust the veracity of the environmental claims made by a carbon project. A situation known as adverse selection. Various parties have come together (standards, measurement, and verification) to give buyers confidence that each carbon credit is backed by a tonne of CO2 abated or removed. But still, the incentive to debase remains.
Meanwhile, for compliance carbon pricing instruments such as emissions trading schemes, a commitment by the government (or some other institution) to a set of emission reduction targets, gives market participants the confidence to put a price on a carbon allowance.
Beginning in 2010, obligated emitters in the EU ETS were allowed to use international carbon credits - those generated under the UN’s Clean Development Mechanism (CDM) and Joint Implementation (JI) programme - to offset up to 4.5% of their verified emissions.
The measure was introduced with cost-containment in mind; rather than cutting their own emissions it allowed companies the flexibility to meet some of their compliance obligation by buying credits from carbon projects delivered elsewhere in the world.
There were two big problems.
First, the quantity limit of international credits turned out to be much too generous. The economic impact of the 2008/09 Great Financial Crisis (GFC), coupled with Japan’s retreat from its climate targets following the Fukushima nuclear accident in 2011 resulted in an enormous influx of cheap carbon credits, estimated to be in the region of 1.6 Gt CO2.
Second, the quality of the carbon credits was also found wanting. In 2016, Öko-Institut, the environmental research non-profit, estimated that only 7% of the potential 2013-2020 Certified Emissions Reduction (CER) supply was very likely to be additional; adding that the “large majority of the projects registered and CERs issued under the CDM are not providing real, measurable and additional emission reductions”. Their verdict: the CDM has “fundamental flaws in terms of overall environmental integrity”.2
The price of CER credits - remember they had monetary equivalence with EU emission allowances (EUAs) - dropped from €25 per tonne CO2 in 2008 to €10 per tonne CO2 in 2011, before then crashing to a low of €0.50 per tonne CO2 in 2012.
Until 30th April 2021 it was still possible to use international carbon credits to meet compliance (for calendar year 2020), but thereafter the EU ETS has been solely based on a domestic emissions reduction target. Nevertheless, the knock-on impact on the EU carbon market still lingers to this day, despite policy interventions such as the Market Stability Reserve (MSR) that have sought to curb the oversupply.
It’s different this time, or is it?
EU member states are legally committed to reach a 55% reduction in emissions by 2030, and net zero by 2050. However, the interim target for 2040 has yet to be determined and has proved contentious amid concerns about the competitiveness of European industry, and a broader political pushback against the blocs environmental rules. More details are expected to be published tomorrow - Wednesday 2nd July.
It’s clear that the European Commission wants to keep an emission reduction target of 90%, although there appears to be some wiggle room as to the trajectory, perhaps deferring the requirement for steeper cuts to late in the 2030’s. Governments are rightly concerned whether it's unrealistic to expect the industrial sector to shoulder so much of the burden, particularly given the steepness of their marginal abatement cost (MAC) curve.
The EC has indicated that member states may be able to allowed to use international carbon credits to meet the proposed 90% reduction in emissions by 2040 against 1990 levels. Only carbon credits generated under Article 6 are expected to be allowed. Early drafts of the EU's 2040 proposal reveal that member states may only be able to meet 3% of their target, but only phased in from 2036, and crucially, will not be allowed within the EU ETS.3
Nevertheless, the risk that poor quality carbon credits are used to meet Europe's climate targets remains. Remember, whether in the voluntary carbon market (VCM) or in the confines of a compliance scheme, there are several factors that determine whether a carbon credit will deliver on its claims. These include additionality (the reduction would have happened anyway), over-crediting (more credits are issued than warranted), and non-permanence (carbon avoided or removed is only temporary), among other factors.
A recent meta study evaluating the performance of 20% of all credits issued (representing almost 1 billion tons of CO2e), found that less than 16% constituted real emission reductions. Carbon credits generated under Article 6 may still suffer from the same problems that have plagued the VCM, even with (or perhaps despite) it being a regulated market and not just a voluntary market.4
Furthermore, there is a fundamental flaw in the Article 6 mechanism. Individual countries face a perverse incentive, that when multiplied across countries, will most likely fail to deliver the expected global emission reductions, and may even make things worse.
It’s rational for an individual country to deliberately set a weak nationally determined contribution (NDC), and then sell Internationally Transferrable Mitigation Outcome (ITMO) with corresponding adjustments to others when they overachieve it. This generates climate finance for themselves, but at the expense of weaker domestic and global emission reductions.
Outside of Europe many of the new and emerging ETS allow some degree of compliance need to be met by carbon credits. Out of the 38 ETS currently operational, 25 allow domestic carbon credits to meet compliance. While most ETS limit carbon credits to ~5% of compliance, others such as Australia’s Safeguard Mechanism and Vietnam’s proposed ETS allow much higher levels, of up to 30%. Only South Korea’s ETS currently accepts international carbon credits.
Allowing EU member States to meet future targets with carbon credits could open up Pandora’s Box, even if they're not directly allowed within the EU ETS. If Europe's politicians are prepared to signal a weakening in the need for domestic carbon abatement now, what might happen if things get really tough in 5-10 years time? It could lead to a situation where market participants anticipate that Europe will rely on carbon credits to an even greater extent in the future.
In this scenario the price of carbon will go down today, reducing the incentive for decarbonisation tomorrow. The delay in investment will bring about the very thing Europe would like to avoid in the future - the need for much higher carbon prices.
As Europe found to its cost before, loss of confidence in one part of the EU carbon market system undermined trust in the whole. The outcome was the debasement of its ‘Currency of Decarbonisation’. It cannot afford for that to happen again.
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England, also experienced a currency debasement in response to Henry VIII’s war expenses. There the episode was known as the Great Debasement.
https://climate.ec.europa.eu/system/files/2017-04/clean_dev_mechanism_en.pdf
Article 6 provides assurance to prospective buyers of carbon credits meeting the correct standard that their purchase and retirement can be counted under the framework of the Paris Agreement. A COP29 countries endorsed new standards, paving the way for a UN backed market under Article 6.4 of the Paris Agreement, now known as the Paris Agreement Crediting Mechanism (PACM). Countries also clarified the rules for bilateral carbon trading under Article 6.2, enabling the transfer of a type of carbon credit known as an Internationally Transferrable Mitigation Outcome (ITMO) between countries.
https://www.nature.com/articles/s41467-024-53645-z