Law, Policy & Markets
Law, Policy & Markets
How to Improve Carbon Credit Markets: “Trust but Verify”
Use Left/Right to seek, Home/End to jump to start or end. Hold shift to jump forward or backward.
In this episode, host Allan Marks speaks with Alexia Kelley, managing director of the Carbon Policy & Markets Initiative at High Tide Foundation, and Josh Sterling, a partner in Milbank’s Litigation & Arbitration and Derivatives Groups based in Washington, DC and former federal regulator of commodity futures markets. They discuss carbon credits in voluntary markets and in mandatory or compliance markets. They also explore how new rules in the US and globally aim to boost the integrity of voluntary carbon markets, how to get more “bang for the buck” in carbon trading, and how nature-based projects and other decarbonization investments funded by carbon credits—such as reforestation, agriculture sector improvements, and renewable energy projects—help support climate goals.
About the Speakers
Alexia Kelly has nearly 20 years of experience dealing with high integrity carbon and environmental services markets. She is managing director of the Carbon Policy & Markets Initiative at High Tide Foundation and was previously director of NetZero and Nature at Netflix, on the board of ICVCM setting global standards for voluntary carbon markets, and the US State Department’s lead negotiator on Article 6 of the Paris Agreement to the United Nations Framework Convention on Climate Change.
Josh Sterling is a Milbank partner based in Washington, DC and a member of the firm’s Litigation & Arbitration and Derivatives Groups. In DC, he served for many years as Director of the CFTC’s Market Participants Division overseeing over 3300 banks, intermediaries and registered asset managers trading derivatives, among other federal regulatory duties. He specializes in representing banks, trading firms, derivatives markets, and other institutional clients in high-stakes investigations, enforcement matters and other regulatory proceedings before the CFTC.
Allan Marks is one of the world's leading project finance lawyers. He advises developers, investors, lenders, and underwriters around the world in the development and financing of complex energy and infrastructure projects, as well as related acquisitions, restructurings and capital markets transactions. Many of his transactions relate to ESG and sustainability, innovative clean technologies, and sophisticated contractual risk allocation. He is a Senior Fellow at Columbia University’s Center on Sustainable Investment and serves as an Adjunct Lecturer at the University of California, Berkeley at the Law School and previously at the Haas School of Business.
For more information and insights, follow us on social media and podcast platforms, including Apple, Spotify, Amazon Music, iHeart, Google and Audible.
Disclaimer
Law Policy and Markets. I'm Alan Marks. Today I'm joined by Alexia Kelly, the Managing Director of the Carbon Policy and Markets Initiative at High Tide Foundation, and Josh Sterling, a partner in Milbank's Litigation and Arbitration Group, based in Washington DC.
Speaker 2We're about to see, I think, massive implementation globally of international emissions trading at scales that we've really never seen before, and it's exciting because what that offers is an opportunity for us to mobilize in a more structured way significant amounts of capital on carbon finance that we just didn't have access to before these rules were agreed.
Speaker 1Let's get to it agreed. Let's get to it. In the run-up to the COP29 UN Climate Conference starting November 11th in Baku, azerbaijan, expect more discussion around carbon credits and Article 6 of the Paris Agreement. Carbon credits, or offsets, are a market mechanism to reduce greenhouse gas emissions, which cause climate change, while bringing capital to fund environmental remediation projects around the world. Do carbon credits really work? Basically, yes, but how well and at what cost depends on lots of factors. Critics link them to greenwashing or abatement that is ineffective or inefficient. Others note that carbon credits are an imperfect but needed stopgap for what is basically a worldwide regulatory and market failure to mandate emissions reductions or to internalize an economic cost on atmospheric pollution.
Speaker 1Carbon credits come in two flavors. In voluntary markets, companies buy credits to support non-binding decarbonization pledges. In mandatory or compliance markets, emitters need to buy emissions allowances to emit over defined limits. In either case, the sellers of the credits receive money that can fund the reduction, sequestration or avoidance of greenhouse gas emissions. Projects funded by carbon credits are often nature-based projects, such as reforestation or afforestation or agriculture sector improvements or renewable energy projects. Though they are called carbon credits, they apply to the whole range of greenhouse gases carbon dioxide, methane, hydrofluorocarbons and so on, with different methodologies used to measure and verify their value. New rules in the United States and Europe aim to boost the integrity and transparency of voluntary carbon markets.
Speaker 1With me today, to unpack all of this are Alexia Kelly and Josh Sterling. Alexia is Managing Director of the Carbon Policy and Markets Initiative at High Tide Foundation and was previously a State Department negotiator for Article 6 of the Paris Agreement. Josh Sterling is a partner in Milbank's Washington DC office and a member of the firm's litigation and arbitration group. He also works on derivatives and was previously a senior regulator at the Commodity Futures Trading Commission. Josh Alexia, thank you very much for joining me today. Thank you.
Speaker 2Thanks for having us.
Speaker 1So I wonder if you could each maybe just give a quick snapshot of how you come to this area of carbon credits and associated regulation and market compliance. Josh.
Speaker 3Sure, alan, thanks for that.
Speaker 3I'm very happy to be here today speaking with you both.
Speaker 3It's great leadership at the CFTC, commodity Futures Trading Commission, which is the leading regulator for derivatives and commodities transactions in the world.
Speaker 3It's unique, it's a special feature of our US regulatory regime and in that connection the CFTC has a very broad remit, and one of the commissioners there at the time, rostan Benham now Chairman Benham wrote a white paper on climate risk in the financial system and in our financial markets and part of that was thinking about voluntary carbon credits and other developments in carbon markets. So that's as hard as it might be for some to understand, a carbon credit or an emissions allowance or anything like that is what's called an intangible commodity, commodity being a very broad term that picks up interest rates, exchange rates, events beyond things like copper and coffee and cocoa, and a whole lot of markets began to be developed and continue to be developed around those, and since I'm a practitioner of regulatory and enforcement matters in commodities markets, I became interested in that area, worked with some folks. We're trying to put together a swaps market, a derivatives market, for certain green energy contracts. That's how I sort of came into this area.
Speaker 1Thank you and Alexia, I know you've got a very longstanding history both in and out of government working with carbon credits and carbon offsets and all of the things to go around that. Going back to the negotiations of the Paris Agreement, tell us how you come to this.
Speaker 2Yeah, thanks, alan, and thanks for the invitation to join you here today, Always happy to be chatting about carbon markets and where we are and where we're going.
Speaker 2I've worked for the better part of two decades it's about 2006, in a variety of capacities in and around climate policy carbon pricing, climate finance mobilization and carbon regulation, united Nations Framework Convention on Climate Change between what was COP 10 and COP 16, copenhagen, through to Paris, and negotiated Article 6 provisions, which are the international emissions trading provisions of the Paris Agreement, which, of course, are being implemented now and one of the topics we'll talk about today. Also spent some time in the private sector, working on private finance mobilization and voluntary corporate program design and implementation, and my last role at Netflix as the director of Net Zero Plus Nature. Now I lead a program called the Carbon Policy and Markets Initiative at the High Tide Foundation. The High Tide Foundation is a private family office philanthropy focused exclusively on the climate crisis, so we do a lot of work around standards and emerging standards in a variety of markets on this set of really important issues.
Speaker 1So thank you both very much for that, and, alexia, I want to jump right into it, because we talk about markets. People usually figure, ok, fine, we have supply, we have demand. There's some equilibrium based on how those two things fluctuate over time, so that you get some kind of a price discovery, if you will, and then things can change and supply and demand themselves will change, and so you get together with new technologies and new policies. You'll have this constantly dynamic, evolving process here, the first fork in the road when we're talking about carbon and, in particular, the goal of reducing greenhouse gas emissions globally, because we're all on the same small blue marble right, three planets out from the sun. That's the goal, and what we're really talking here, of course, is about avoiding CO2 or CO2 equivalent greenhouse gas emissions, perhaps reducing them, perhaps sequestering them if they are produced. How do markets play a role in that, and what's the difference between a voluntary market and a compliance market?
Carbon Market Regulation and Oversight
Speaker 2Yeah, I think, at the most basic level, the way to think about carbon markets is as a carbon pricing instrument. So what carbon markets do is they put a price on the externality of the environmental impact of all of these activities. And, as anybody who did a basic economics course, we have a market failure and climate change is perhaps the greatest market failure of all time which is that we have an entire economic system that's built on cheap, abundant, readily available fossil fuels that have now touched and underpin almost every part of the global economy and, as you all know, about 30 years ago, we figured out that this is actually not a great thing from a stable, habitable planetary perspective and that it was causing this thing called climate change. So carbon markets have always been part of our regulatory approach and increasingly also a voluntary approach, as we have consistently failed to put in place comprehensive regulation in some of the world's leading economies, like the United States, and so we have this funny kind of mishmash of both voluntary and regulatory systems that have emerged as a result of the fact that we have not been able to agree one unified global approach to how we price carbon and how we begin to bring down and stabilize and, frankly, wean ourselves off of the fossil fuels that we know do so many wonderful things in the world and are also causing significant damage through climate change and their climate impacts. So currently, about 25% of the world's emissions are covered by some sort of price on carbon.
Speaker 2That's up. It's been increasing steadily, but it's clearly still not enough. We have about 75 different carbon pricing regimes in place and the total value of regulated emissions trading markets is just south of a trillion dollars about $800 billion a year. So that includes things like the European Union Emissions Trading System and the Regional Greenhouse Gas Initiative and the California cap and trade market, of course, which are some of the largest and most successful examples of carbon pricing and carbon regulation in the world. The voluntary market is much smaller, so it reached a peak in 2020 of about $2 billion.
Speaker 2Last year. Due to a variety of factors, we're down to about $750 million and cumulatively, all told, the voluntary carbon market has mobilized about $10 billion. So all of these markets are still much smaller than they need to be and they're all really in their infancy. We're still very much in a learning by doing, and we've really only been doing this for the past 25 years or so, but the pricing, carbon and building these systems and getting them implemented and scaled effectively is just a non-negotiable part of the way in which we address the climate crisis and get folks moving towards, hopefully, a safe and stable atmosphere.
Speaker 1So if you look at carbon pricing, like what the price of carbon is, you're going to get a different answer depending on where you are and which market you're looking at. So if you're in my home is in California, so we have under AB 32, we have cap and trade, we have linkages with other jurisdictions Quebec, for example, in Canada and others. You mentioned Reggie, which is the Northeast United States market, which is a different approach. It's not quite as sophisticated or as market-wide as California's is. You mentioned Europe. So in those regulated markets there's some requirement compliance to reduce emissions across the whole economy or a sector of the economy like, say, energy generation, and that helps to discover what the price is. In voluntary markets, I suspect it's a little more difficult because the demand for these things is fluctuating in ways that are independent, if you will, of what's generating supply.
Speaker 2Yeah, absolutely, and the voluntary market is a really interesting sort of animal because it's precisely arisen out of our failure to regulate, and so what's happened is we've had a bunch of nonprofit voluntary buyers step up and say, hey, I think this is important, I want to do something about climate change, this is one way I can do it. And we've had a bunch of nonprofit intermediaries step in and say somebody should really write some rules about how you do this accounting, because I think, unlike commodities that are underpinned by pork bellies or grain, you can't actually ever go out and really weigh and transact the ton of carbon that you're looking at, and so it is a commodity created by policy fiat. Right, we say it has value, we give it value because we say it has value, and that results in a really complicated and pretty interesting challenge from a regulatory and oversight perspective, because in many instances, what you're regulating is the absence of something having occurred, or it's something that's defined in a way that's very difficult to directly measure and weigh in the way that you would another commodity.
Speaker 1Yeah, I want to come back to methodologies and quality of these things in a moment, josh, I want to stay with carbon price for a second, because one of the ways that markets discover price is most effectively with arbitrage, and derivatives play a very important part of that. What's the connection between carbon markets and derivatives in carbon credits or carbon offsets, right?
Speaker 3So right now in the United States, at a federal level, the only instrument you could have that has anything to do with voluntary carbon credits per se. Then I would tend to think that the derivatives on top of that are smaller in terms of the outright cash spent to set up those positions. And then the notional value of the contract is also in the E for two. That matters much less than what people are expending on it. So I will just say I think that regulatory tools to force outcomes are interesting. They're interesting in a market dynamic which is supposed to reflect legitimate prices for supply and demand of given goods. I think the purpose by the way of the CFTC guidance, which will's really the only way to do it, which is to say, well, sure, we can police the underlying market for carbon credits themselves for fraud, manipulation, in terms of actually having a regular on the beat looking at it, would be for the derivatives. And so to the extent a derivative is the second order aspect of a commodity, rules for those derivatives are a second order effect and they make you, if you want to list a derivative, look at the credibility of the registry and underlying mechanisms of the spot market or the markets for the credit itself.
Speaker 3I don't know if it's going to change them that much. I think it would require a lot of money flowing in to those markets first. I don't know, I don't know, I haven't. I haven't surveyed the world and worked the policy and negotiated anything at the UN, of course. But it's hard for me to see how these rules. I think it's sort of like well, here's the lane you could drive on, but they're going to drive anything in themselves. And it took, I think, about four years to get them written, a lot of time. And here we are with that.
Speaker 1Well, let me say, let me stay with that for a second, because if you look at the authority that CFTC has under the Commodities Exchange Act to regulate voluntary carbon credits derivatives right on designated contract markets, that's one piece. But you also mentioned anti-fraud and anti-manipulation, which is broader authority CFTC has, even independent of derivatives.
Regulating and Standardizing Carbon Markets
Speaker 3Well, that's correct, and even state attorneys general can sue under the Commodity Exchange Act. The key word is sue or investigate. And so, while you can have rules to say, okay, a contract market, a futures exchange, and A plus to you, alan, for knowing what a designated contract market is, a futures exchange, and A plus to you, alan, for knowing what a designated contract market is. I love it. They are comprehensively regulated, just so everything they do, I dare say. In reality, they're almost prudentially regulated, the way that government treats them day to day, and that's a thing.
Speaker 3That's where the maximal regulation is over how you list contracts, how you surveil the markets, how the information is reported.
Speaker 3You list contracts, how you surveil the markets, how the information is reported, the types of system safeguards and technology you need to have to list trade and clear derivatives, how much you margin them, whether you have a limit on positions or not probably not for a nascent market, I don't know. That's all very clear. But in terms of the underlying, hey, we're not going to do this under a futures contract or a swap instrument. I'm going to pay you, alan, $5,000 for 10 credits and you're going to deliver them to me in whatever form that is inside of a magic number and derivative land of 28 days to spot trade and next week keep it simple. That activity of me buying and you selling is at whatever price. There's no federal regulation on that. It's willing to buy or willing to sell, then you give them to me and it's not like the terms of those contracts are established and put through a federal regulator, they're just freely negotiated. So much less regulation there. Just they can go after bad actors.
Speaker 1Okay, I want to come back, then. Really, I'd like to see to you on the quality, then, of what's undergoing here, because in markets, we look at integrity, we look at quality, we look at transparency of the market, and I want to use an analogy, if I may. If I want to go out and buy oranges, let's imagine my oranges are my proxy for a carbon offset right. Some oranges are fresh and beautiful. They come from California.
Speaker 2You want to eat them.
Speaker 1There are other oranges that are either green when they're picked and so someone paints them orange, and they're not really great, but they're still oranges. Some oranges are old and rotten and if I tell you they're super fresh, that's an ethics issue. Suddenly we're bleeding into that, but they're still oranges. Now if I tell you it's an orange, it's really a lemon. Now I'm lying, so that's different. So if we distinguish greenwashing, which is, I'm going to say, the lemon just pretending to be an orange, from what's the bulk of these markets which are actual, real money really is being used to remove or avoid or sequester emissions, but there's varying qualities of that, and that gets us, of course, then into verification and monitoring. What's the range of quality and the safeguards, and do voluntary versus compliance markets differ as far as the quality of what's being traded?
Speaker 2Yeah, thanks. So a couple of thoughts. One most of the market today just to Josh's good points are over the counter, right. Almost everything is bespoke bilateral contracts between a buyer and a seller. There's very little visibility. There are a few exchanges that are specialized and have trading capacity, but for the most part this market is largely just happening all over the counter, which has been interesting because it means that we don't have a lot of the standardized kind of universally agreed and templatized emission reduction purchase agreements, for example, and just standard contracts that are going to be necessary in order to really know that if I say this is an orange, it's really an orange. And so that work is very much underway as we speak and has been for the last few years, predominantly through the work of both regulators who are starting to look over the transom and say, huh, this little market is pretty interesting and maybe we should start thinking in a more systematic fashion about how it should be regulated and overseen, which we very much welcome, encourage and are thankful for. But a lot of that is informed by work that's happening in both the voluntary and emerging compliance markets.
Speaker 2So about four years ago, a group of bankers got together and established the Task Force for Scaling Voluntary Carbon Markets, which brought together many of the world's preeminent carbon market experts to start putting together some of that standardized infrastructure, including a threshold definition for quality. So, because of what I said earlier about these instruments really having the value that we give them, getting the rules right is really important, and getting the rules right is also very difficult. These are intangible commodities, which means that we need we're using a lot of proxies, we're using a lot of estimates and we're using a lot of data from a wide variety of sources to cover a huge range of what we call mitigation interventions things we're doing to reduce, sequester or avoid emissions. So think about installing new energy efficiency boilers or planting trees in a specific place, or even now pulling carbon out of the atmosphere and storing it underground. There's a wide range of things that we're doing, and all of them are different, and so we're working towards putting in place standardized sets of methodologies that really enable us to represent and reflect the best of the science that we have available, the best data we have available and the methods we have for measuring and tracking and monitoring the carbon as we're removing it.
Speaker 2So the task force morphed into and became a fully fledged independent nonprofit that's actually chaired by a former SEC regulator, annette Nazareth, and we are working systematically to design standardized threshold benchmarks for quality for the carbon market which mean that we know that if I tell you it's an orange, it's really an orange, because it's going to have a label from the ICBCM that says you're an orange, and so that we call those our core carbon principles, and they cover a range of core quality criteria and we're in the process of systematically assessing everything in the carbon market right now, or almost everything in the carbon market, to understand whether or not it conforms with this threshold quality benchmark that we have now established.
Speaker 2We also review the governance systems of the registries that administer and issue these credits, and so that looks at just good basic governance things, and the CFTC guidance points to many of the ICBCM core criteria and requirements throughout its documentation, as did the US Treasury Department's statement on voluntary carbon markets that it released last May. So we're really starting to see what I think of as a virtuous cycle between regulators and the voluntary market as we move forward with establishing these global threshold quality benchmarks so that we can really agree on what best practice looks like and start to scale, so that it's not an artisanal, bespoke baby market. It actually grows up to be a full-fledged contributing member of society, helping us solve this existential crisis.
Speaker 1Right Because one way the market participants deal with this asymmetric information right existential crisis. Right Because one way the market participants deal with this asymmetric information right is by, if you get a third party to certify and verify which is ICBCM, or you have a regulator that says what it's supposed to be California Air Resources Board, for example, for cap and trade under the California market, carb tells you what their methodologies are or you just have market participants that are big, do their own diligence, which in bespoke transactions is not impossible. But why reinvent the wheel? So when Josh, when the CFTC looked at this, why did they defer to things like ICVCM and not look at, for example, what Europe is doing or other areas that maybe were taking a slightly different tack, that maybe we're taking a slightly different tack, although I think now they've frankly come back to realizing that one set of scientific standards and non-governmental bodies doing this might actually be a pretty workable solution.
Speaker 3Right. Well, in my heart of hearts, I wish I could tell you. The answer was well, the CFTC woke up one morning and said my God, what are we doing? We don't have any scientists. I would like to think that's the answer. Because there aren't any there. I know she used to work there and help run it, but I think it's because I think probably a more realistic answer would be there's really only so much you could do with guidance, and there's really only so much you could do in the derivatives market. And, importantly, there's really only so much you can do without legislation that elected representatives of the people vote into law. That says agencies must do something, and the president of the United States, as the leader of the executive, says we will do that because there is popular support for this. There isn't any of that in America. I think the Inflation Reduction Act is a little bit different than we're talking about here. I may be wrong about that, but my sense is there were some political constraints. And then, frankly, I think there were some expertise constraints, and that's not a criticism of the lawyers, risk analysis, data scientists and economists there. It's just none of them are hard scientists, so I would say that are hard scientists. So I would say that One thing that I find interesting about efforts to create I'll call them private standards well-intentioned, of course, it can be applied in a variety of contexts, to a variety of different assets, a variety of different jurisdictions, to harmonize, homogenize how we measure a thing I was reminded in hearing Alexis speak about that.
Speaker 3I was at a Harvard Law School how Scott program a few years ago. I remember pointedly in the open discussion. There's a gentleman there from a ratings agency talking about how, with their new and enhanced tools, they could look into individual bonds in some stack of structured assets and identify the precise amount of carbon reduction being funded by that particular bond. Now, having been a regulator, I said to myself, get real. And I couldn't help but think of and you'll forgive me for being just a touch contrarian here another time in our history not too long ago, where we had wonderful public-private partnership.
Speaker 3There was a conviction about the certainty of one thing the price of something called housing never would go down, it only goes up. And we had rating agencies, consultants, accounting firms, law firms all looking at the problem. We had a commercial industry developed around a thing to financialize it Fine, and we had private risk taking, with the public backstop in the form of GSEs and federal policy that enhanced all that. And I look around and carbon is in everything. It's in nearly every large scale energy source we have I can think of. Obviously, and if you're going to take something and measure it in a particular way and create financial assets around it, what you have is similar patchwork of gaps that we had in another financial crisis. Not suggesting one will happen. I would like to think that people could step back and say do we have the right regulatory approach or are we just following the pattern? We know because we know it. So just something to think about.
Speaker 1Well, let me then turn it back to you, alexi, on that, because I personally do think there's a pretty big difference between financial ratings of securities or strips of mortgages within a securitized vehicle, where you're really depending on market dynamics. As opposed to physics, chemistry, biology, biodiversity, there is more science, of course, involved in looking at the quality of some of the offsets and some of the projects that are being funded by the sales of credits to companies that either need or want to buy them, but of course, it can vary by sector. Can you give a sense of how those methodologies to look at the quality of some of these credits vary, say, between forestry or agriculture or other areas where they're being used?
Speaker 2Yeah, there's a really wide range of methodologies and methods we use to quantify and assess the impact of the mitigation interventions, the actions we're taking to reduce emissions across the market, and one of the really interesting things about the work we've been doing at the ICBCM is systematically looking at the methods that have been, the methodologies that have been under development and determining.
Speaker 2We think that this conforms with what we consider to be best practice, and we think this doesn't, and it is not an easy thing to design a kind of credit category, specific but standardizable and universally applicable rule set for measuring what is an almost infinite number of individual and unique implementation circumstances, and so the last 20 years has really been about trying different methods out to see what works best. There's a couple of things that are changing relatively rapidly that give me much more confidence, and one of the biggest is digital and remote sensing and monitoring systems. So we can now measure using satellite imagery, using LIDAR, using machine learning and AI, using the Internet of Things, like we are much, much, much better at measuring and managing huge amounts of data that we just simply didn't have when we were writing these methods the first time around.
Speaker 1And does that work as well for something like, say, reforestation or afforestation, as opposed to say, fugitive emissions from methane leaks? That can then be capped.
Speaker 2All of the above.
Global Carbon Market Regulation and Coordination
Speaker 2So we've seen just absolutely incredible advances in these technologies Just in the last five years, and actually the Hightide Foundation is a huge supporter of these remote sensing technologies.
Speaker 2So we funded Carbon Mapper, which actually just successfully launched its first satellite in partnership with Planet, and we've also funded SeaTrees, which is a nonprofit that spun out of NASA JPL that specifically looks at how do you do very precise measurement of the amount of carbon that's stored in the forest globally, and so this is not a panacea, to be clear, but we are way, way better than we've ever been at being able to accurately measure the amount of carbon in a given tree or that's being emitted from a particular pipeline. Like that, data transparency and information is orders of magnitude improved, and so a big part of what we're doing right now in the carbon market is figuring out how do we integrate all of that into these very kind of analog paper-based methodologies and measurement systems where we literally send teams of people on the ground for four days to go trek through forests to randomly appointed plot points and go out and do allometric measurement and stratification of the tree species and the size of the trees, and this just like incredibly labor and time intensive process.
Speaker 1Density of the canopy leaf, size, all that.
Speaker 2All of the above, yeah, and so that gives me a lot of hope and confidence that as we move forward, we're not going to see the same kind of headlines that you've probably been seeing coming out of the Guardian and other places where we just mismanaged or we mismeasured these systems.
Speaker 2So those pieces, I think, are definitely areas to watch, as well as increasing convergence and alignment around what right looks like, as we're thinking about the underlying quality of the various projects.
Speaker 2So watching what's happening coming out of Article 6.4, which, ellen, you and I were talking about earlier under the Paris Agreement, article 6 are the emissions trading provisions that govern countries' international exchanges of emissions, and there's three provisions Article 6.2, which is bilateral trading between countries, countries that wish to trade their emissions, between cap and trade systems or other ways. There's Article 6.4, which establishes a new UN-administered body to oversee and approve rules and methodologies, and so those folks have been working literally since we finished the Paris Agreement a decade ago to write the whole new rule set for how this market is going to work. And then Article 6.8 is things that are non-market-based mechanisms, which separate story we won't get into, but also interesting. So we're about to see, I think, massive implementation globally of international emissions trading at scales that we've really never seen before, and it's exciting because what that offers is an opportunity for us to mobilize in a more structured way significant amounts of capital and carbon finance that we just didn't have access to before these rules were agreed.
Speaker 1So, looking at those discussions around Article 6, I know when I was at COP 27, so that's now two years ago in Egypt, there was a lot of discussion and the failure at the end of the day really to agree, coming out of that on how to set up some of these mechanisms under 6.4 in particular. But you're right on the broader ones, as well as Article 8 on loss and damage, where there was work, positive work done, there was progress made, but way short of where we want it to be, given that Paris, the Paris Agreement, is non-binding, as opposed to say the earlier Kyoto Protocol that would have been binding had people like the United States actually signed on to it. How will that be implemented, even if they can agree on the rules? I doubt frankly, personally, that the COP this year will do that, but maybe next year in Brazil it might.
Speaker 2Yeah, and depending on where they land from a procedural decision perspective, they may not need to right. Procedural decision perspective, they may not need to right. The CMP issued the standards just a couple of weeks ago after, as you noted, years of failure to agree at the bigger COP process, and so the assumption is that the Article 6.4 supervisory body will start moving ahead approving methodologies for use under 6.4, unless there is a huge kind of blow up at COP and we're not anticipating that that will be the case, because I think folks recognize that we just need to get on with the business of putting these systems in place and starting to deliver emission reductions through them. But your point about non-binding is really important, because that is the nature of the Paris Agreement. Right, that was the only way that we could get everybody to sign on and for both developed and developing countries to basically self-determine what it is the contribution they wanted to make to fighting global climate change. Is this optimal? Absolutely not. Is it the best we could do, given the geopolitical constraints we were operating under? It was, and so the fact that you have China and India and the United States and Europe all standing up and saying, yes, we're willing to take some responsibility for this problem and do something to address it is enormously important, and that's what led to the nationally determined contributions, which are the kind of individual contributions that each country decides it wants to make.
Speaker 2But that also means that we do not have as much regulation or top-down oversight from the UN as we did under the Kyoto Protocol, which you mentioned, alan, and so the work of governing bodies like the self-appointed voluntary governing bodies, like the Integrity Council for Voluntary Cover Markets, become much more important, because they then become sort of the flywheel in what we hope will be a virtuous sidebar and making sure that everybody has that political pressure to meet that bar, even though they don't have to.
Speaker 2And transparency is really the thing that we rely the most heavily on under Paris, and my hope is that and we will need to put some pressure on countries to make sure that they are adhering to that kind of agreed minimum bar for quality globally, because we don't have a lot of enforcement capacity under Paris Do I wish that we could come up with a uniform, globally binding, strict emission reduction regime that applied to everyone equally and got us on the trajectory which you can't see my arm, but it's pretty close to a 90 degree pathway at this point that we need to be following in order to avoid two to three degrees of warming between now and the end of the century. I sure do, but is it realistic? It's not. So we're stuck in this world where voluntary action ends up playing, both under Paris and out there in the world more broadly, a really essential role in helping us get going on reducing global emissions, which, to be clear, we haven't even started to do yet meaningfully. We have not bent the curve.
Speaker 1No, in fact, emissions are still going up year on year.
Speaker 2Yeah, emissions intensity in emerging economies are definitely going down. We have seen in Europe and the US decoupling of economic growth from emissions intensity, which is hugely important and very encouraging. But most of the major emerging economies we haven't yet seen that decoupling and so that really is the work of the next 20 years. It's like can we get out ahead of that and push that enhanced efficiency as quickly as we possibly can?
Speaker 1Yeah, especially if you see increasing electrification and air conditioning when it's getting hotter, which is, in equatorial regions and especially in the global south, a huge issue going forward. But I want to come back to you, josh, on something Alexia was talking about here, which is coordination, or the lack of it, internationally. Now, within the US government, regardless of who's in office, there is still within the agencies, within the executive branch, in order to implement whatever the executive's goals are from time to time, right every four years, there is a need for coordination, the science and economic things that could influence regulation, so that markets are in fact doing their job of not being manipulated, of being fair, of people in them doing the appropriate disclosures and selling what they say they're selling.
Speaker 3Yeah Well, I think you described at the beginning of that, Alan, very well what does work, and it is certainly in the area of enforcement in cases of suspected wrongdoing or potential criminality. I think the coordination between both market regulators, sec and CFTC, are strong and DOJ is involved. They have appropriate task forces, including main justice, for things like commodities fraud and very serious cases. Particularly, in fact, patterns will sustain foreign corrupt practices or wire fraud or other favorites, even money laundering in some extreme cases. Particularly, in fact, patterns will sustain foreign corrupt practices or wire fraud or other favorites, even money laundering in some extreme cases. So that's all for sure. In terms of overt climate-related coordination, I don't know that there is any, I think. To my way of understanding in America anyway, the climate response has been the Inflation Reduction Act, which is in some ways a form of industrial policy that will have outcomes. We'll see how that goes. It's obviously having a huge impact on some of the work we're doing for clients.
Speaker 1It tends to be the carrot, which my clients love, but not the stick.
International Carbon Market Regulation Discussion
Speaker 3Right, yeah, the stick thing is interesting. I'm aware of mandatory regimes I'm not sure if that's the right term, but the opposite of voluntary and one of these events, again under Chatham House rules. I did ask the question. My experience and I'm a student in history, I've studied markets from the beginning. There's some archaeological evidence that bartering came before lending, which is interesting for a market species, and I've not yet encountered in my life until now a market that ever existed with the purpose of making something more expensive and more scarce.
Speaker 3Usually, markets exist to increase supply or at least appropriately align supply and demand, and so I sometimes think of these mandatory regimes and they could be in anything. It just happens to be carbon right now. There's really more way to tax people without calling it that, and I understand the political expediencies of that, and I may be wrong about that, but I guess that's all to say from a regulator's point of view former regulator, excuse me. You can do what the law says. You can go a little bit beyond it where you have broader authorities, like anti-manipulation and anti-fraud, but sometimes when you're talking about significant investments, of interagency efforts, under US law, that often has to be directed or required. Every agency department likes to do its own thing typically, and then obviously, for anything to come through from from the international regime basically needs to be have the force of the us law, so a treaty or something like that with binding commitments. I don't think we have that.
Speaker 3I'll tell you, when I was in government, we're at the tail end of trying to integrate oversight of things like derivatives, clearing houses towards the tail end and implementing the Dodd-Frank laws for that financial crisis, and there was strong interest by the Europeans to substantively regulate our clearinghouses, which we didn't like, the clearinghouses didn't like, and the elected representatives of Congress and the right committees got involved. And at some point some representatives of the European Union were told and this is true, they're France, if it weren't for us, you'd be speaking German right now. Now, get out of here. That's almost a direct quote and they left and the Europeans didn't get to regulate the US clearinghouses. And so there is sometimes a tendency in US law. I don't necessarily endorse that, I'm just saying it could be a tendency in US law.
Speaker 3I don't necessarily endorse that, I'm just saying there could be a tendency in US law. Even amongst elected representatives, their backs up a little bit when they're told something from outside America is going to direct what goes on here and I say that because it's an important political reality or constraint on concerted global efforts to adopt and implement standards that can be well-intentioned. You're going to hit the wall of a country's border and have to deal with the political context within it, which I think can be challenging. I think in this area it's acutely challenging for a number of reasons, including the fact that we are a resource-rich country with a lot of supplies of carbon-intensive materials I don't have to tell that to you experts and it's really hard to stop using that if it's economically efficient to do it. You know what I mean. So it's hard to force that from outside America, at least from my point of view, having been in the trenches of the government.
Speaker 1So you bring some good points up and I think, from the point of view of globalization and I know there's de-globalization geopolitics in the background here, but set that aside, because at the moment, right now, we are still in a world where international trade dominates so if you look then at how that trading power can be used for, I'm going to say, for good so, for example, to turn these externalities into costs, maybe not as a tax, not as a direct cost, but maybe indirectly through tariffs. So, for example, alexia, if you could speak to how the EU has a new carbon border adjustment mechanism that really plays this role. So if you're not trying to reduce emissions and you're outside of Europe and you want to sell your stuff into Europe, well, there's going to be an adjustment to what you're selling it for, based on how good or bad a job you're doing, broadly speaking, on your carbon intensity. How effective is that?
Speaker 2State Department diplomat, but it is true they have honestly been leading the charge. They have the most comprehensive and legally binding set of regulations on the planet related to climate, and what's happening is as their cap, and so the way that works right is you start with a lot of other allowances and over time, you reduce allowances and that scarcity makes it more expensive to emit, and so it gives industry that transition, that glide path to actually invest in the new technologies and do the things that they need to do to put the carbon control technologies in place. But it also means that the rest of the world has not moved as fast as Europe has, and so European industry is in a difficult position, because they bear a carbon price that is coming up on 100 euro a ton now, and most of the rest of the world does not, including the US economy, and so from a competitiveness perspective, that makes it really challenging.
Speaker 3Oh no, I was going to say yeah, it's striking, and I was thinking of some recent news on that regard where VW, the national champion of Europec I own two Audis myself with big engines they're talking about closing plants and laying off people for the first time, the plant closures in many decades, and other people in leadership in Germany, which is the beating industrial heart of Europe as I understand it, talking about what would be necessary in terms of change in lifestyles to achieve the degree of required carbon reduction, under whatever team the German government has made. It's substantial and it's great to see Europe leading in that. I think it can set some examples and maybe inform other ways to get at it. These are just bits of news as a broader context, but as a casual reader, not someone in the climate policy area as you, I take note of these things when I hear you speak about it. This is a challenging time and really plowing ahead.
Speaker 2It is a challenging time, for sure, and I think really ensuring that orderly transition as we seek to decarbonize the economy is going to be incredibly important.
Speaker 2And so the European automakers have been actually quite slow to the game on electrification, and that's hurting them, because I drive a Tesla proudly, it's amazing and my husband drives an F-150 Lightning. So the American automakers and the American auto industry are actually starting to really lead on the electric vehicle transition, and in my mind, they're significantly superior vehicles. But what it does mean from a geopolitical perspective is that we are in a moment in time where the leaders are starting to feel the fact that they are leaders. Right, it is having an impact on European economy and they're needing to respond to domestic political pressure, hence the carbon border adjustment mechanism that Alan was talking about. And so how is going to be really interesting to watch, because it's going to impact a whole bunch of countries and industries in a much less direct way than if cement producers in Turkey, for example, regulated to start thinking about how they're going to reduce their emissions by their governments.
Speaker 1So let's say, if you could wave a magic wand and come up with a system, maybe under the UN offices, under Paris 6.4, what have you? Or by international collaboration, or maybe more clearinghouse regulation, market coordination we do actually coordinate on other markets internationally, currency markets in particular, where there's certainly behind the scenes huge role among central bank coordination on monetary policy globally in ways that are actually very good for market stability and price signals. So my question, coming back to it, is if you could wave a magic wand, what would you do to design a carbon credit market that drove investment into the projects with the lowest marginal cost to get the biggest bang for the buck in reducing greenhouse gases?
Speaker 2A global cap-and-trade system would be lovely, which is where we would set legally binding, internationally enforceable emissions caps, essentially for every country, and you allocate allowances to whomever the regulatory burden sits on so in the? U and in California that tends to be large emitters electricity generators, oil and gas producers and they then can trade and price and move forward. That's obviously not going to happen. The kind of second best option would be to impose a relatively high and steadily increasing carbon tax on every ton of emissions everywhere in the world that you can measure them. That would enable us to really start finding those low cost ab abatement opportunities, of which there are many, and so that's also probably not going to happen.
Speaker 1I would dig deeper into that one for a minute. So let's say we had an international carbon tax and carbon is now I don't know $1,000 a ton.
Speaker 2It wouldn't seem to be that high. Even $25 a ton would make a huge difference.
Speaker 1So I have a $25 a ton carbon tax. Is it the same tax that I apply in wealthy countries that are highly developed that probably can afford to pay that, as it is in emerging markets? And if it is, do the emerging markets tend to get some kind of a net benefit? Because, oh, by the way, the proceeds of this tax are going to be reinvested there in order to deal with either mitigation and abatement or maybe also with loss and damage that might get conflated. I can see where that could be a problem, but how do you deal with that?
Speaker 2Well, you just hit on the reason why, you know, despite all the negative headlines we may be seeing, this exercise of designing international emissions trading systems is really, really important, and the thing that I think carbon markets offer that is so incredibly exciting is that ability to do that wealth transfer in a structured and orderly way and to enable Global South rich companies in the Global North to fund mitigation in the Global South that not only reduces emissions and helps us combat climate crisis, but also enables us to make sure that we are adapting and responding to changing climates the things that we need to be doing per the loss and damage agreements, but also really looking at livelihoods and making sure that we are maintaining geopolitical stability, because in countries in the global south that live much closer to the land than we do, climate change is causing migration, it's causing significant disruptions to local economies, water scarcity is increasing conflict among tribes, among communities, and so making sure that the global South remains safe and habitable for the billions of people who live there, while we are charting this course to reduce emissions in more developed economies and helping those developing economies leapfrog to the cleaner, greener, frankly superior next generation technologies that we're seeing emerge out of this transition, like electric vehicles, like renewable energy, is going to be really, really important in order for us to have it all hang together as things continue to unfold over the course of the next 50 years or so.
Speaker 1Good. Alexia and Josh, thank you very, very much. I really appreciated your taking the time and sharing your expertise. Thank you.
Speaker 2Thanks for having us, it was fun.
Speaker 1Thank you for joining us on another episode of Law Policy and Markets Milbank Conversations. Follow us on your favorite podcast platform and learn more at millbankcom.
