The Cap and Trade Market Is Going Global—If Politics Are Put Aside

Delegates at UN Climate Change Conference COP25 have been gathered in Madrid for nearly two weeks in hopes of finalizing the remaining articles of the 2015 Paris Agreement.

Their work is spurred on by massive youth protests led in part by Swedish student activist Greta Thunberg, who has called for heightened urgency around climate change. A UN Environment Programme report warned last month that as greenhouse gas emissions continue to rise, “deeper and faster” cuts will be required in the years ahead to keep global temperatures at most 1.5°C above pre-industrial levels.

Current efforts are not enough to avoid the worst impacts of climate change, experts have said. According to The Truth Behind the Climate Pledges, a November study conducted by climate scientists, failure to reach climate goals could result in extreme weather events leading to economic losses of at least $2 billion per day by 2030—not to mention the devastating effects on livelihoods, food, and water supplies.

Thus one of the most poignant decisions to be made at COP25 pertains to Article 6, the section of the Paris Agreement relating to an international cap and trade carbon market.

“Fundamentally, it’s about international cooperation,” Nathaniel Keohane, senior vice president for climate at the Environmental Defense Fund, said of Article 6. He spoke with Fortune from Madrid, where the EDF is advising negotiators.

“We need international cooperation,” he continued. “Countries need a mechanism or a means—a pathway—to work together effectively, and a market can be a really vital pathway to do that. That’s why Article 6 is so important.”

Driving ambition with carbon markets

In a carbon market, also known as cap and trade, the overall amount of greenhouse gas emissions permitted in a certain time period would be limited. Polluters would need permits to account for their emissions, but those with lower emissions could sell excess permits to others struggling to meet their goals. This allows those succeeding in lowering greenhouse gas emissions to be rewarded while placing the cost of climate change on the major emitters. Regulated entities could also offset a portion of their emissions by funding emissions-reduction projects.

Carbon markets already exist in a number of spaces around the world, including the European Union and Switzerland. In the state of California, cap and trade has been a massive success.

California’s legislature in 2006 called for the state to reduce greenhouse gas emissions to 1990 levels by 2020. With a carbon market and other complementary programs, California reached its target in 2016—four years early.

“During the same time period, our economy grew faster than the economy of the rest of the U.S.,” a representative of the California Air Resources Board told Fortune, “and our per capita and per GDP emissions year over year continue to decline.”

The amount of progress California has had so far with its carbon market is thanks in part to its floor price for emissions permits. Not only do the number of permits distributed each year decline, but this minimum price goes up by 5% plus inflation each year, encouraging businesses to invest in cleaner production early on to avoid higher costs of compliance later.

And it worked. Covering around 450 businesses in the state, the ARB has seen near 100% compliance each year in the program. Permit auctions have raised $12 billion since 2013, with all funds reinvested into emissions reductions and disadvantaged communities. In addition to the health and safety engineers who historically handle environmental law and regulation, more financial officers are coming to consult ARB as well.

“It shows that companies have adapted and learned that cap and trade and the carbon price signal need to be something that is incorporated and considered in all business decisions,” said the ARB representative.

Prolonged International Negotiations

A similar sort of market could be implemented on an international scale. Delegates at COP25, however, are struggling to reach a consensus on how exactly to do that. Article 6 was the only piece of the Paris Agreement rulebook left unfinished at last year’s conference, and the same issues that held up agreement are persisting this year in Madrid.

The main problem? Double counting.

If a company in one country builds a renewable energy plant and sells the offset credits to another country, the reductions could count for both the country where the plant resides and the country who bought the offset credits. This is called double counting, and if the final rules of Article 6 permit it, the effects could be disastrous.

“The atmosphere only sees those emissions reductions once,” said Keohane. Therefore, it’s paramount “that every ton of emissions reductions that’s achieved only gets counted towards one country’s target.”

A group of countries—including Brazil, India, and Saudi Arabia—disagree.

“They don’t want the same kind of really rigorous accounting to be applied to all carbon credits,” said Keohane. Instead, they believe “a country shouldn’t be held responsible for what companies are doing.”

“It’s really a political issue,” said Keohane. “We know how to do it technically, but politically it’s proving to be a sticking point.”

Without this loophole, a carbon market could have a massive impact on emissions reductions. According to an EDF study, cap and trade would reduce the total mitigation cost of meeting current Paris pledges by 59% to 79%. If these savings are then reinvested into lowering greenhouse gas emissions, a carbon market could nearly double expected global emissions reductions between 2020 and 2035.

In California, a carbon market has proven to be “the most cost effective way to reduce emissions in the state when paired up with all of our other policies,” said the ARB representative.

Another point of contention at the UN involves offset credits left over from the Clean Development Mechanism of the Kyoto Protocol. Unlike the Paris Agreement, this system did not require every country to reduce emissions. Instead, developing nations could create a renewable energy plant or another emissions-reducing project and then sell credits to regulated countries to offset their emissions.

Many believe the new cap and trade system should override the CDM system, but some—largely the same countries opposed to stricter accounting—believe the leftover credits should be useable. Compared to the double counting loophole, this issue is less black and white, said Keohane.

“Either you have accounting rules that prevent double counting or you don’t. It’s a pretty clear yes or no question. With the CDM credits you could imagine it being a transition,” he explained.

Either way, the conference of the parties at COP25 is running short on time to make a decision. This is the year for action, as next year’s discussions will be dominated by the update and renewal of reduction targets.

“Either you get it done this year and you get a good deal that has environment integrity, or countries that want to use markets in bilateral transactions can just go ahead and work together to set standards for integrity,” said Keohane. “If they can’t reach agreement on a good deal, then no deal is better than a bad deal.”

Draft decisions on Article 6 were sent to the CMA—the parties conferring on the Paris Agreement—this past weekend, but no final decisions have been made. The parties do not need a unanimous vote in support, but they do have to meet a consensus. With multiple countries remaining unsatisfied, negotiations aren’t yet there.

Even if the UN is not able to form a carbon market blueprint, countries can decide on their own to work together. These bilateral transactions have similar potential for success, and it’s already been done: the EU and Switzerland linked their cap and trade systems in 2017.

This cooperation allows countries to go “beyond what they would otherwise be able to do to achieve more ambition by working together,” said Keohane. “That’s the promise of markets.”

The next UN climate conference, COP26, will take place is Glasgow, United Kingdom, in November 2020.