103280 This Discussion Paper was prepared by the author for the World Bank Group’s Networked Carbon Markets (NCM) initiative. It describes the rationale, objectives and key elements of the NCM initiative. It is expected that the proposed concepts and components outlined in this Paper will evolve based on discussions with stakeholders, further technical work, and negotiations under the United Nations Framework Convention on Climate Change. As such, this Paper is ‘live’ and will continue to be updated to capture the evolution of the NCM initiative. Table of Contents 1. Introduction ................................................................................................................................... 1 2. Review of the subject matter – a quick reminder of the heterogeneous pricing mechanisms ...................................................................................................................... 2 3. Background framework concepts .................................................................................................. 3 4. Glossary of Key Definitions ........................................................................................................... 9 5. Key roles and available tools ....................................................................................................... 14 6. Guidance and regulatory supervision of mitigation value assessments ....................................... 20 7. Relationship between mitigation value and compliance value, settlement platform; and ITUs and the Index ............................................................................... 24 8. Recommendations for Next Step................................................................................................. 29 Glossary of acronyms .......................................................................................................................... 32 ANNEXURE “A” ................................................................................................................................... 34 ANNEXURE “B” ................................................................................................................................... 37 ANNEXURE “C” ................................................................................................................................... 42 ANNEXURE “D” ................................................................................................................................... 47 Introduction 1 1. Introduction 1] The Networked Carbon Markets (NCM) initiative of the Group (Kevin Bourne, Gordon Morrison) and Mike Wilkins World Bank Group aims to enable comparison of different of S&P. Account has been taken also of papers by: carbon pricing systems and trade across different carbon IISD/New Climate Institute (Frédéric Gagnon-Lebrun, assets with efficiency, transparency and integrity. It is Seton Stiebert) ‘Scorecard to Assess Carbon Integrity founded on the assumptions that, firstly, the linking of Risks’; Grantham Research Institute on Climate Change diverse and heterogeneous carbon markets is desirable; and the Environment (Luca Taschini and Corina secondly, that governments and market participants need Comendant): ‘A Comparative Assessment of Design information about the schemes with which they enter Options for an International Carbon Asset Reserve’; transactions and the carbon assets they acquire through Climate Transparency Initiative: ‘A Guide to Climate those transactions; and thirdly, that governments should Performance Assessments for the G20’. retain the sovereignty to act on the information about [4] This paper builds on the findings of an earlier those other schemes and assets as they see fit. An NCM unpublished discussion paper titled ‘Designing a Model for system seeks to provide the information necessary to Networked Carbon Markets’,1 with its objective being to enable comparability of carbon pricing systems and describe key elements of the mitigation value assessment fungibility of assets. In doing so, it seeks to reduce process. The outcome of this paper will inform a model for regulatory risks and delays, address market barriers, the Networked Carbon Markets concept, to be prepared at catalyze large-scale private investment and achieve the a later date. benefits of a single carbon market. The services and institutions developed through the NCM initiative might be [5] The following Section 2 acknowledges the subject introduced in a phased manner, initially facilitating linking matter of the NCM initiative, namely the diverse and of markets within countries and then bilaterally, before heterogeneous trading schemes and other carbon pricing being extended to markets on a regional basis – perhaps mechanisms that are being put in place by jurisdictions through carbon clubs – and in the long term helping around the globe. As this is the subject of another World markets to link on a global basis. Bank paper, only a brief reference is included. Section 3 sets out a conceptual framework within which to consider [2] A key element of the NCM concept is a risk-based the key elements described in the glossary of terms, approach to assessing climate change mitigation value addressed in Section 4 and Annexure “C”. This section across heterogeneous carbon asset classes. The idea is also looks at different transaction scenarios, introducing that mitigation efforts by jurisdictions have a mitigation the concepts of an international transaction unit and an value, which will translate into the rate of exchange, or the index. price, or the ratio, at which a carbon asset generated by the trading scheme in that jurisdiction, will be exchanged [6] Section 5 turns attention to the types of institutions that or purchased. might be suitable to participate in the mitigation value assessment process, providing practical examples, and [3] In preparing this paper, informal discussions have considering the types of expertise and tools those occurred and feedback has been obtained from a series of institutions might leverage. Section 6 considers options for partners also working on various elements of Networked regulatory supervision of the MV assessment process. Carbon Markets concept or who have expressed interest Section 7 looks in more detail at the relationship between in it. In particular, account has been taken of the concepts mitigation value and the compliance value that might be and ideas set out by Andrei Marcu in the paper ‘NCM and attached to carbon assets and, in so doing, considers the the Post-2020 Global Climate Change Regime’, the role and function of the settlement platform. This section relevant sections of which are copied in Annexure “A”. also considers the feasibility and potential benefits of an Others include: Jennifer Austin, consultant on NCM; index. The concluding Section 8 looks at the next steps Clayton Munnings, consultant on NCM; CMIA (Adrian that might flow from this work Rimmer, Fenella Aouane); EEX/Eurex (Manuel Möller, Steffen Löbner); London Stock Exchange Group, FTSE 1 Annexure “B” sets out the findings of the earlier of three comparable financial markets, namely the discussion paper titled “Designing a Model for Networked bond/debt market; the foreign exchange market; and Carbon Markets”, which draw on a high-level examination physical commodities markets. Review of the subject matter – a quick reminder of the heterogeneous pricing mechanisms 2 2. Review of the subject matter – a quick reminder of the heterogeneous pricing mechanisms [7] It is important not to lose sight of the reason for, and [9] Equally importantly, these emissions trading schemes subject of, the NCM initiative, namely the diverse and differ in many key design aspects, including in areas such heterogeneous trading schemes and other carbon pricing as: mechanisms that are being put in place by jurisdictions around the globe.  the nature of the asset traded, and base unit of its measurement; [8] As of 2014, there were approximately forty countries and twenty sub-national jurisdictions putting a price on  jurisdictional level of implementation; carbon. Of these, there were about twenty existing,  number of compliance entities under the scheme; emerging or potential emissions trading schemes at national or sub-national levels globally. 2 These included in  banking and borrowing rights of compliance entities; Canada, schemes in Alberta and Québec; in the United  distribution of assets – grandfathering, auctioning; States, the California Cap-and-Trade Program and the Regional Greenhouse Gas Initiative amongst nine north-  lifespan of asset, surrender obligations of compliance eastern states; planned or existing emission trading entities; schemes, at a national level, in New Zealand, Switzerland, Korea and Kazakhstan; and, at a sub-national level, in  use of offsets/credits with in the scheme, permitted seven city-regions of China; in Japan, three regional ETS, sources of those credits/offsets. as well as various other voluntary crediting or offsetting [10] These schemes are the subject of a detailed paper instruments, with a national ETS under consideration; and prepared by the World Bank.5 Mention is made of them a carbon price mechanism in Australia.3 In addition, there here solely to help keep them in mind while consideration were at least a dozen national and sub-national is given to the issues and proposals described in this jurisdictions where a carbon tax applied, with others paper. considering the introduction of such instruments.4 2 4 World Bank, 2014, State and Trends of Carbon Pricing Note 2 supra, chapter 5 5 2014, Washington, DC: World Bank, chapter 4 Reference paper prepared by Mandkhai Bayarsaikhan, 3 ibid NCM Initiative, Carbon and Climate Finance Unit Background framework concepts 3 3. Background framework concepts [11] Before setting out a proposed glossary of terms that  Some states and the EU gave further application to might be applied to the mitigation value assessment the market concept by creating corresponding process, this section aims to provide a framework within obligations on domestic economic actors and which those terms might be considered. In so doing, the establishing schemes for trading between these aim is not only to reach some level of consistency of entities (e.g. as in the EUETS). understanding of the concepts and terms, but also to flag some of the areas that will need further investigation.  While the EUETS has had success in reducing emissions of the entities on which it places compliance obligations, the top down model has A. Carbon markets as a creation of policy – failed, inter alia, because: compliance drives demand o the idea of a top down, compliance-driven model  The UNFCCC/IPCC position, that is, the generally is flawed due to the inability to impose and accepted position of most governments globally, enforce compliance commitments on sovereign based on scientific research, is that GHG emissions states (in a regulatory command and control must be reduced to avoid dangerous anthropogenic sense); and climate change. o politically and economically, national  To achieve these reductions requires fundamental governments of sovereign states will always act changes in the structure of the way in which to protect the national self-interest, hence economies are organised, away from activities that voluntary commitment is not an adequate generate such emissions or in the way those activities substitute for the ability to enforce compliance. are carried out. C. Bottom up model  Pricing mechanisms and, in particular, markets, were introduced to facilitate an economically efficient  A response to the failure of the top down model has transition to a low carbon emission economy – carbon been the growth of individual jurisdictions, both at the trading is only a tool for achieving the policy objective sovereign state and sub-national levels, implementing of reduced emissions. or developing their own carbon pricing systems, including trading mechanisms.  There is no natural market for avoided/reduced/sequestered GHG emissions, that is,  Differences in the design and other elements of these no natural demand. Demand is generated by the mechanisms, while reflecting local preferences and imposition of obligations on the economic actors circumstances, have resulted in fragmentation and responsible for the emissions – these obligations take heterogeneity. the form of requirements on emitters to reduce their emissions profile over time.  In order to improve the liquidity and depth of these markets, and help them leverage new low carbon  Hence demand in the carbon market in primarily financing and investment, ways are being explored to compliance driven. facilitate fungibility of the carbon assets traded in these heterogeneous markets. B. Top down model  Fungibility of the carbon assets being traded  The Kyoto Protocol includes an attempt by the presumes either (i) the carbon assets are all the signatory Parties – national governments of sovereign same, which cannot be the case here unless all the states – to put in place such a compliance driven heterogeneous trading schemes are made the same; market. or (ii) that there is a way of evaluating and comparing the relative values of the diverse carbon assets being  Parties listed in Annex B made quantified emission traded, e.g., by applying exchange rates or ratios. limitation and reduction commitments (QELRCs) to reduce their emissions by the stated percentage  It is proposed to bring about an evaluation and amounts over a fixed five year period (First comparison of the various diverse carbon assets by Commitment Period 2008-2012), with the intention assessing the ‘mitigation value’ (‘MV’) of the that there would be subsequent commitment periods. jurisdiction within which the carbon asset is generated: it is proposed that the MV assessment process will translate into rates of exchange, or ratios, Background framework concepts 4 at which carbon assets can be traded between initiative, seeks to take account of the different schemes. respective circumstances in which climate mitigation efforts are made, rather than excluding some D. What is ‘mitigation’ and how is a value countries due to domestic choices or inability to meet attached to it? potentially unattainable standards.  Mitigation means stabilising GHG concentrations in  Not only can jurisdictions have their mitigation efforts the atmosphere at a level that would prevent ranked relative to each other, but those efforts – the dangerous anthropogenic interference with the jurisdiction’s performance in carrying out mitigation climate system, which is the ultimate objective of the actions – might also be assessed against what that UNFCCC (Article 2). jurisdiction has stated it will achieve in that respect, i.e., its level of ambition.  According to the IPCC, this means keeping average global temperature increase to less than 2° above  The jurisdiction’s ‘level of ambition’ might be pre-industrial levels. compared, also, against a ‘view’ as to what the level of ambition for that jurisdiction should be (taking  Mitigation can be achieved in two ways: (i) limiting or account of its circumstances) in the context of reducing anthropogenic GHG emissions by sources to achieving the ultimate objective of the UNFCCC (that the atmosphere, or (ii) preserving or enhancing sinks is, keeping average global temperature increase to or reservoirs of GHGs. less than 2° above pre-industrial levels). This ‘level of expectation’ might be formed by an independent,  The commitments of Parties under the UNFCCC to unbiased, expert group. If this approach were mitigate, are qualified in terms of (Article 4.1) followed, how such a group might be constituted and “common but differentiated responsibilities and their how it might form its views would need to be specific national and regional development priorities, addressed, however, these issues are beyond the objectives and circumstances” and in terms of (Article scope of this paper. 4.2) “the differences ... in starting points and approaches, economic structures and resource  Having, as part of the MV assessment, a level of bases, the need to maintain strong and sustainable ambition for a jurisdiction’s mitigation actions and that economic growth, available technologies and other level of ambition being assessed for its adequacy in individual circumstances”. global terms could tie a jurisdiction’s MV back to the ultimate objective of the UNFCCC.  Hence, mitigation relates to the actions (in the context of the UNFCCC, taken by a Party (sovereign state),  However, while theoretically any jurisdictional level but in broader terms, taken by any economic actor), to (i.e., national, provincial, local) can state a level of limit or reduce its GHG emissions by sources to the ambition for its mitigation actions, it is unlikely that all atmosphere or to enhance removals of GHG jurisdictions will have done so. Furthermore, it may emissions by sinks from the atmosphere. not be realistic to try to gather all the data necessary to make valid assessments of whether a jurisdiction’s  Taking account of the qualifications in UNFCCC level of ambition is adequate, in global terms, for Articles 4.1 and 4.2, mentioned above, mitigation jurisdictions other than at the sovereign level (i.e., for actions need to be seen in their proper context. sub-national jurisdictions).  Accordingly, in developing technical and analytical  Nevertheless, in developing an MV assessment foundations for a framework to assess and compare process, the relationship between a jurisdiction’s MV different climate change mitigation efforts (the aim of relative to other jurisdictions, and its MV when the NCM initiative), it is important to ensure that compared to (a) its level of ambition and (b) the level framework is able to take account of the different of expectation as to its ambition, will need to be respective circumstances in which the mitigation explored and determined, as well as the level of efforts are made, in ranking those efforts relative to each other.  While there is no finally accepted definition yet of what mitigation value is, for the purposes of this discussion paper, mitigation value is proposed as a relative measure, as between jurisdictions, of the effectiveness of their emission reduction programs in ‘mitigating’, which takes account of their respective jurisdictional ‘circumstances’. In doing so, the NCM Background framework concepts 5 jurisdiction at which (a) and (b) should be taken into Parties also have to submit National account.6 Communications); both the IPCC and the UNFCCC have issued guidelines; methodologies have been E. How is mitigation value measured? approved also by the CDM Executive Board; and there is also the GHG Protocol (WRI/WBCSD) and  The most common standard unit for measurement of ISO 14064, for GHG accounting and reporting GHG emissions is a metric tonne of CO2-equivalent principles and methodologies.7 gas, pursuant to the conventions adopted under the UNFCCC and IPCC Guidelines.  A jurisdiction’s mitigation effort will be a function of the programs, policies and pledges (‘PPPs’) that it has in  While the heterogeneous carbon pricing and trading place to limit or reduce its GHG emissions by sources mechanisms that are springing up in diverse to the atmosphere or to enhance removals of GHG jurisdictions may vary in the basic unit of emissions by sinks from the atmosphere. measurement they provide for, most of the differences (at least between the trading schemes) seem to be  To determine the effectiveness of the jurisdiction’s between metric tonnes or US short tons, or as to the PPPs, it will be necessary to make types of gas emissions, e.g. CO2 only, or a number of measurements/estimations of the emissions (a) with GHGs. As such, there should not be any difficulty in the PPPs in place; and (b) without them in place (the reducing all of these to a common unit of business-as-usual (“BAU”) scenario). There are also measurement. Similarly, mitigation by schemes based other considerations, for instance, how well the PPPs on energy intensity, fuel substitution, or ratios per unit are set up: see the IISD risk categories e.g., program of production (or similar), or other such measures, boundaries/leakage; funding to fully implement; should (in most cases) also be capable of being enforcement; accounting, monitoring, reporting, etc.8 reduced to a unit of measurement common to other schemes, e.g., metric tonnes CO2-equivalent gas.  It is relevant also whether this assessment of a jurisdiction’s mitigation effort is being made:  However, physical measurement of GHG emissions, reductions, avoidance or removals is impractical at o ex-ante, that is, forward looking and on a best, and possible for only a limited suite of point predictive basis as to whether the PPPs will sources: for example, the USEPA Acid Rain program, deliver the anticipated results, in which case, it is in providing for trading in SO2 emission allowances, more an assessment of the robustness of the benefitted from continuous monitoring of stack PPPs in place, and factors such as IISD risk emissions of regulated sources: this sort of approach categories e.g., program boundaries/leakage; is simply not possible across the board in the case of funding to fully implement; institutional strength; broader, economy-wide schemes that provide for enforcement; accounting, monitoring, reporting, GHG emissions and reductions, etc, from diverse and so on, will be more significant; or sources, more generally. o ex-post, that is, looking back at the relevant period of emissions, in which case,  Hence both volume of emissions and the extent of measurements and proxy-based estimates9 their mitigation often will need to be derived as should be available and will be more significant; estimates, or indirectly through measurement of and proxies. There are well-developed methodologies and a considerable body of data and experience in making o it is conceivable that over time, assessments of such estimations: for example, since 1996, UNFCCC a jurisdiction’s MV will change in emphasis to Annex I Parties have been required to submit to the take more account of the ex-post components secretariat an annual inventory of their emissions by as the PPPs build a track record. sources and removals by sinks of all GHGs not controlled by the Montreal Protocol (non-Annex I 6 NB: if comparing one jurisdiction with another, they need 8 IISD/New Climate Institute: ‘Carbon Integrity Assessment to be assessed in the same way: so if one is a city or at the Program Level – Scorecard to Assess Carbon province (i.e., sub-national), and the other is a sovereign Integrity Risks, Supplementary Note’, Frédéric Gagnon- state (i.e., national), the same criteria must be applied to Lebrun, Seton Stiebert, July 2015 9 For example, levels of production using a particular each in arriving at their respective MVs; cannot look at the level of ambition for the sovereign state, but not for the process for which % emissions, level of energy use, province, especially if they both operate a trading scheme efficiency are known, types of energy used, efficiency of generating carbon assets they wish to be fungible production and emission factors for that type, etc. 7 See also, for example, Climate Action Tracker methodology: http://climateactiontracker.org/ Background framework concepts 6  If a jurisdiction has a number of PPPs in place, each o Geographic profile – size, population, one will need to be evaluated individually for demography, building stock profile; effectiveness then, collectively, they would contribute o Financial profile; to the MV of the jurisdiction; so at the jurisdictional o Institutional structures; level, the MV would be a matter of: o Political profile. o mitigation performance of each individual PPP,  Account will also need to be taken of the level of considered together (that is, the sum of the PPP government: is the jurisdiction regional (e.g., EU), MVs); and national, sub-national, provincial, local – are the o collectively, how do the PPPs fit and work emissions and their mitigation particular to the together (do they complement each other? Are jurisdiction; what degree of independence is there there gaps? Overlaps? Inconsistencies? from the next higher level of government (principle of Conflicting elements?); and subsidiarity)11 – this may dictate the applicability of o any other overriding factors – political will of the any of the factors listed in the preceding point in the government, strength of the supervising case of any particular sub-national jurisdiction; and institution and so on. the operation of internationally binding commitments and principles (e.g. principle of supplementarity)12.  If one of the PPPs that a jurisdiction has in place is a carbon trading mechanism generating carbon assets F. What determines compliance value for trading within the scheme but which, by participating in NCM, might also be traded into (‘CV’) of a carbon asset? schemes in other jurisdictions, then not only will that  Under carbon trading schemes, carbon assets particular PPP be evaluated, but it will be evaluated in ultimately have to be surrendered against compliance the context of the jurisdiction overall, the resulting obligations imposed on the economic actors who MV10 being translated into an exchange rate, or ratio, must reduce emissions (‘compliance entities’), so for its carbon assets when they are traded between those assets have a value for compliance purposes: schemes. The form and practicality of a carbon the compliance value (‘CV’). The form and exchange rate is still being explored. practicability of how CV is taken into account is still under consideration.  The extent to which estimates, indirect measurement through proxies, or direct measurement, are  The scheme administrator/regulator will determine the applicable, will vary depending on the size and nature amount of compliance obligation to accept, as having of emissions, the PPP and the jurisdiction. been acquitted against the carbon assets surrendered by a compliance entity. In so doing, they determine (at  As noted earlier, consideration of the effectiveness of the time of surrender) what is the CV of those carbon a jurisdiction’s mitigation needs also to take account assets. of its circumstances, which might include factors such as:  For any scheme under which allowances are issued o Level of emissions; to compliance entities13, it is most likely that the o Economic structure – energy resources, scheme administrator/regulator would assign a value transport, industry, agriculture, waste of CV=1, for allowances issued by it in the first place management; (i.e., domestically). 10 thisis the MV of the trading scheme, in the context of States: the jurisdiction, overall, taking into account all PPPs it has http://www.europarl.europa.eu/aboutparliament/en/displayFtu.html in place. The MV assessment process itself is yet to be ?ftuId=FTU_1.2.2.html, accessed 3 August 2015 defined, including whether it is the jurisdiction, the trading 12 ‘… the use of the mechanisms [International Emissions mechanism program, or the carbon asset itself, whose MV Trading, CDM, JI] shall be supplemental to domestic is being assessed. By analogy, when corporate or public action and that domestic action shall thus constitute a debt is issued, both the issuer and the instrument may be significant effort made by each Party included in Annex I rated by credit rating agencies. [NB this needs to be to meet its quantified emission limitation and reduction considered further] commitments under Article 3, Paragraph 1.’ (Article 1 Draft 11 The general aim of the principle of subsidiarity is to Decision -/CMP.1 (Mechanisms) contained in Decision guarantee a degree of independence for a lower authority 15/CP.7, Marrakech Accords). NB to be considered further 13 in relation to a higher body or for a local authority in whether by grandfathering (i.e., for free) or by auction relation to central government. It therefore involves the (i.e., at a price) sharing of powers between several levels of authority, a principle which forms the institutional basis for federal Background framework concepts 7  The question will be what CV the scheme less relevant consideration in relation to price, for administrator assigns to, say, project generated buyers in that jurisdiction. credits/offsets accepted under the scheme, or carbon assets from another jurisdiction? In the case of the  Whatever level of significance attaches to the MV credits, a risk-based rating could provide guidance to exchange rate, or ratio, between two jurisdictions, as the administrator/regulator as to the CV to assign. a result of the approach to CV taken by the Similarly, the MV of the other jurisdiction could administrator/regulator, market factors such as translate into a rate of exchange, or ratio, applicable demand and supply, liquidity, and depth of the to carbon assets traded from that jurisdiction: this market, will remain important in determining the FV of would provide guidance to the administrator/regulator the carbon asset traded. It will always be up to the as to the CV it should assign to those traded carbon buyer to decide what price they are willing to pay, in assets.14 the overall circumstances.15  The design of NCM trading will have an influence on G. What determines financial value (‘FV’) of the relative significance of the MV exchange rate, or a carbon asset? ratio, in the decision-making process: for example,  The financial value (‘FV’) of a carbon asset is the o if the exchange rate was published as an ‘official price a buyer is willing to pay for it. As such, FV will rate’, by a recognised body, or by entities depend on a number of market factors, including officially recognised to do so, as opposed to demand and supply, market liquidity, and depth of the being just the unofficial difference between the market, as well as marginal cost in a jurisdiction of MVs of the two jurisdictions; or mitigating emissions as opposed to buying carbon assets in order to acquit compliance obligations o if the administrators/regulators of schemes that (marginal abatement cost). participate in NCM trading were encouraged, or even required, to signify their acceptance of  When a carbon asset generated under a scheme in officially-quoted MV exchange rates for the one jurisdiction, is traded into the scheme in another purposes of setting CVs; or jurisdiction, the relative MVs of the two jurisdictions are relevant, as they can translate into a rate of o if the exchange rate were to be built into the NCM exchange, or ratio, for the carbon assets of each transaction process, by providing for conversion jurisdiction. of traded carbon assets, either into the domestic units of the buyer’s jurisdiction, or by introducing  As noted above at F, the exchange rate, or ratio, of the concept of an index and a transaction carbon assets traded across jurisdictions, might currency in the form of ‘International Transaction provide guidance to the administrator/regulator of the Units’. jurisdiction into which they are traded, then Consideration is given to design of the NCM surrendered, as to the CV it should assign to those transaction process in Section 4 following. carbon assets on surrender. [12] While the concept of MV can be described as above,  If the administrator/regulator of the scheme where a finally agreed definition is yet to be settled, but it is these carbon assets are surrendered does give a CV important to note that there will be a range of ways in to those assets based on the MV exchange rate, then which the concept of MV can be applied.16 Similarly, while since the value to the end user is ultimately the elements of the MV assessment process can be proposed asset’s use for acquittal of compliance obligations by as above, many issues remain to be resolved and the surrendering the assets, the likely effect will be that mechanics and structure of any assessment process are buyers in the market will be more inclined to take yet to be determined. Nevertheless, elements of the account of the exchange rate, or ratio, when entering concept, by whom the assessment process might be trading transactions. carried out and how they might be regulated can all be  Conversely, if the administrator/regulator of the considered and are, in this paper. In doing so, it is trading scheme in a particular jurisdiction does not important to keep in mind that for there to be any value in base its decision concerning allocation of a CV to a the process these elements seek to inform, the design carbon asset traded into its scheme on the MV must ensure that environmental integrity is maintained and exchange rate, then the MV exchange rate will be a promotes the objectives of the UNFCCC, but equally, that 14 15 This question explored more in Sections 4 and 7 of this MV:CV:FV relationship considered more in Sections 4 paper and 7 of this paper 16 see [35] following Background framework concepts 8 design should afford certainty, clarity and operational efficiency such that the market can perform the role for which it is intended. Figure 1. How Mitigation Value protects the environmental integrity of trade of carbon allowances  Scene: 10 million x ‘Country A’ carbon allowances are purchased by Country B. The actual mitigation value of each ‘Country A’ asset is 0.5 tonne Mitigation Value is intended to preserve the environmental integrity of the trade Glossary of Key Definitions 9 4. Glossary of Key Definitions [13] This section explores in more detail the carbon asset, o depending on the rules of the relevant its compliance value, its financial value, and the compliance scheme, may also be able to be relationship between these elements. It introduces the surrendered in respect of compliance obligations; concepts of an international transaction unit and an index against which the mitigation value of carbon assets might  other forms of carbon asset might include any sort of be assessed. A proposed glossary of key definitions is set units issued pursuant to an INDC, for example, out in full at Annexure “C”. However, the relevant energy intensity units, tax credits, etc. under other definitions for the purposes of this section, extracted from carbon pricing mechanisms. the glossary are as follows. However, for the purposes of this paper, the concept will be confined to allowances issued pursuant to an ETS. Selected definitions [14] Carbon asset: [15] Compliance value: The value ascribed by the administrator/regulator of an A carbon asset is an instrument generated as part of a ETS, to a unit of a carbon asset, at the time it is scheme, project or program the purpose of which is surrendered for compliance purposes under that ETS. mitigation of carbon emissions. In some jurisdictions, the This will drive demand for the carbon asset and hence it is legal system may classify a carbon asset as a ‘chose in expected would be directly relevant to the price. If the action’, meaning that it confers a right enforceable at law. carbon asset has been issued by the administrator under It may be classified also as a ‘financial instrument’, that scheme, it would be usual for it to be given a value depending on application of financial regulations in the CV=1; if the carbon asset has been issued under the particular jurisdiction. Carbon assets are usually measured scheme of another jurisdiction, the administrator might be in base units of a tonne of carbon dioxide equivalent guided by the MV of that other jurisdiction in ascribing a greenhouse gas (CO2-eq GHG), whereby Global Warming CV to that scheme’s carbon asset at the time of surrender. Potentials of other GHGs are used to give the equivalent number of tonnes of CO2, and GWP CO2 = 1. Carbon [16] Financial value: assets can take a variety of forms: The price a buyer is willing to pay for a unit of a carbon asset. It will depend on a number of market factors,  Allowances: including demand and supply, market liquidity, and depth o are usually issued (either free or by auction) by a of the market; it will be influenced also by the respective compliance scheme (ETS) administrator to marginal abatement costs in the two jurisdictions to the scheme participants (‘compliance entities’) – trade; and will also be influenced by the carbon asset entities emitting GHGs who have obligations exchange rate between the relevant jurisdictions. under the scheme to mitigate their emissions; [17] International Transaction Unit: o compliance entities will be required to surrender The unit of a ‘transaction currency’ introduced for the allowances equivalent to their GHG emissions for purpose of facilitating trading between schemes in diverse, the compliance periods determined under the heterogeneous jurisdictions. The nature and scheme (e.g. annually); characteristics that such a unit might have are discussed in more detail below at [28] and [29] and in Section 7.  Credits/offsets: [18] Index: o are generated by projects which avoid or reduce A statistical composite that measures changes in the emissions that would otherwise occur, or which economy or a financial market, often expressed as sequester GHGs from the atmosphere, in both cases, compared to a baseline; changes from a base year or a preceding month. Each index has its own method of calculation;17 components o need to be real, measurable and verifiable, as may be weighted according to certain characteristics, e.g., well as additional to BAU; stock index weighted for market cap. o can be surrendered on a voluntary basis, by Design differences and fungibility entities that do not have compliance obligations; 17 this might include an index based on reference to a global emissions budget, or similar concept. These are discussed in Section 7. Glossary of Key Definitions 10 [19] Carbon trading schemes have differences in design (ii) foreign unit imported model; aspects, such as those mentioned above at [9], which mean that the carbon assets issued under them will differ [23] In both these scenarios, units from the scheme in from one jurisdiction to another. There are also important Jurisdiction A (A units) are being sold by Seller A to Buyer similarities, such as the fact that the schemes under which B, who has compliance obligations in Jurisdiction B, which the carbon assets are issued all have the same purpose, trades B units. In scenario (i), upon the transaction taking namely mitigation of GHG emissions; and that the carbon place, the A units purchased by Buyer B are converted assets are intended to be tradable, and are surrendered into the equivalent number of B units by the Jurisdiction B against compliance obligations, under the respective scheme administrator, at the prevailing exchange rate, schemes. and the A units are cancelled. In scenario (ii), the A units are not cancelled but credited to Buyer B’s registry [20] As noted in Section 3, the fact that these schemes account in Jurisdiction B as A units. have a common purpose, namely mitigation, provides the means to evaluate the differences between them and, [24] In scenario (i), the Buyer B account in the Jurisdiction thereby, to arrive at a relative measure of their B registry only ever receives B units. The Jurisdiction B effectiveness in achieving that purpose.18 scheme administrator cancels the A units and credits Buyer B with the relevant number of B units. This [21] The NCM initiative aims to enable comparison of contrasts with scenario (ii), in which A units are transferred different carbon pricing systems and trade across different into Buyer B’s account in the Jurisdiction B registry. It then carbon assets by providing for fungibility of carbon assets. becomes a matter for the Jurisdiction B scheme To be ‘fungible’, means that a thing is mutually administrator to determine how to ascribe value to those A interchangeable with another thing that is, for all intents units in the Jurisdiction B scheme, bearing in mind that and purposes, identical to it. The comparison of carbon there are differences between A units and B units (due to assets across jurisdictions will be a function of the extent differing scheme design aspects – see [9]). Further, under to which differences in the trading schemes can be this scenario compliance entities in Jurisdiction B (as in all reduced to relative values in terms of mitigation. The trading jurisdictions) would need to have accounts for units actual carbon assets themselves, will retain their from all other trading jurisdictions from which they might differences (due to scheme designs) and, not being possibly acquire units. If this applied across all identical, will not be interchangeable with, or able to be transactions and all jurisdictions engaged in NCM, it would substituted for, each other, per se: that is, they are not make administration more complex and may lead to ‘fungible’, in the full meaning of the word. Rather it will be inconsistencies. their relative value – in mitigation terms – that will be capable of being traded into another scheme. This is [25] These transaction scenarios illustrate how MV, achieved by deriving an exchange rate, or ratio, for the translated into an exchange rate for the carbon assets, carbon assets issued under the schemes of different interacts with the CV and the FV of the carbon assets.19 jurisdictions, based on the respective mitigation value [26] In scenario (i), as it is B units that are credited to assessment outcomes of those jurisdictions. Buyer B’s account in the Jurisdiction B registry, the CV of the purchased units is whatever the Jurisdiction B scheme Transaction scenarios administrator has set under that scheme for B units (e.g., [22] The form that transactions take will have implications probably, CV = 1). As such, the FV of the carbon assets for how key elements interact. To illustrate this, three should be substantially influenced by the exchange rate on scenarios are set out in Annexure “D”. It is presumed that the transaction date. Hence the relative MVs of the each of these transactions will be via an intermediary, respective jurisdictions should be a factor in the price paid. namely a settlement platform. The form, role and functions of the settlement platform are considered in Section 7. [27] By contrast under scenario (ii), on the transaction date However, all transactions will need to be settled and Buyer B will not know what CV the Jurisdiction B scheme cleared, so it is reasonable to assume that there will be administrator will place on the A units. This decision may such an intermediary in all transactions. The first two be influenced by a number of factors, including the way scenarios are: NCM trading is designed, for instance, whether exchange rates are ‘official’ or ‘unofficial’; the degree to which (i) foreign unit converted model; scheme administrators agree to apply them; and also the period of time between the transaction and surrender of 18 19 What mitigation is and how a value is attached to it, and When a carbon asset is to be traded between two how mitigation value is measured, have been considered jurisdictions, what determines the compliance value and in the preceding Section 3, at sub-sections D and E, what determines the financial value have been considered respectively. in the preceding Section 3, at sub-sections F and G, respectively. Glossary of Key Definitions 11 the A units, by Buyer B, for compliance purposes under at the applicable exchange rate. The B units are the Jurisdiction B scheme: the longer the time between the transferred to Buyer B’s account in the Jurisdiction B two events, the greater the chance that the exchange rate registry, relieving the Jurisdiction B scheme administrator will change, which may affect the decision of the of the need to make the conversion by issuing B units and Jurisdiction B scheme administrator. Under this scenario, cancelling A units. The exchange rate for A units this risk is carried by Buyer B. It could be a powerful converted to ITUs21 would be derived from the MV of disincentive to purchase from another scheme. Jurisdiction A relative to the Index. Similarly, the exchange rate for the conversion of ITUs to B units, would be International Transaction Unit derived from the value of the Index relative to the MV of [28] The introduction of a ‘vehicle’ for transactions in the Jurisdiction B. NCM could greatly simplify the process. In foreign [31] The purpose served by the Index in scenario (iii) is to exchange transactions, use of a vehicle currency ($USD) provide a way of comparing the relative MVs of the greatly reduces the number of exchange rates that must jurisdictions. In this example, the MV of each jurisdiction is be dealt with in a multilateral system. For example, in a measured against the weighted average for all trading system of 10 currencies, with one a vehicle, 9 rates need jurisdictions. As noted above, in so doing it provides for to be quoted; without the vehicle, 45 rates need to be ITUs to operate as a ‘vehicle currency’, analogous to the quoted. Hence using a vehicle currency can yield the role of the $US in FX transactions. The ITUs might be just advantage of fewer, larger and more liquid markets with a notional transaction currency, facilitating the transaction fewer currency balances, reduced informational needs and as in the scenario, or they might also serve an investment simpler operations. In theory, the same principles should purpose in their own right. There are many other possible hold for exchange rates in NCM. Such simplification mathematical configurations and variations on the idea of should allow the NCM transactions to flow more rapidly an index. These depend on what information is sought to and efficiently, reducing also the scope for error and be communicated, and to whom. Some of these other capacity for manipulation and fraud. variations, the feasibility and benefits of an index are [29] The nature, characteristics and other aspects posited discussed in Section 7. for an ‘International Transaction Unit’, such as how it could be comprised and what it would represent, are considered One possible application of MV in later in this paper. For the purpose of setting out here a assessment: to exchange rate transaction scenario involving an International Transaction [32] In each of the three scenarios outlined, domestic Unit, it is proposed that its value derives from an index. CV=1. The difference between (i) and (iii), versus (ii), However, it might equally be based on a standard or demonstrates that the form of the transaction, in relation to emissions budget (or the index might be), which refers when and how the traded carbon asset is ascribed a CV in back to a globally agreed emissions target (e.g., such as the buyer’s scheme, will impact on the risk and certainty of the UNFCCC objective of keeping average global the value derived from the trade. Scenario (iii) centralises temperature increase to less than 2° above pre-industrial the administrative aspect (conversion of A to B units), levels). These alternatives are explored in Section 7. which would enhance the certainty and efficiency of the process. However, in all three scenarios, the application of the exchange rate is translated into the number of units converted, which could have implications for the Index environmental integrity of the overall scheme, since it [30] In scenario (iii), there is an index (the ‘Index’). 20 Again, could potentially result in more units (which are rights to as in the previous two scenarios, units from the scheme in emit) being created in the scheme. While this risk might be Jurisdiction A (A units) are being sold by Seller A to Buyer addressed through design aspects,22 it raises a B, who has compliance obligations in Jurisdiction B, which fundamental question: should the scheme design be such trades B units. In this scenario, Seller A converts the A that the MV assessment process can translate into units being sold into International Transaction Units differentials between jurisdictions both in terms of (a) the (“ITUs”) at the applicable exchange rate; Buyer B then environmental integrity (manifested as the CV awarded to buys the number of B units into which those ITUs convert, traded carbon assets) and (b) the FV of the traded assets 20 21 For example, the Index could be based on a basket of, Whether these ITUs themselves would be tradable, or say, the average of MV assessment outcomes for all the simply notional units for the purposes of facilitating jurisdictions engaged in NCM, weighted according to their transactions, is another issue that is touched on briefly in respective GHG emissions. Note however, that indices all Section 7 of this paper 22 this issue considered in ‘Networked Carbon Markets – have their own method of calculation and the Index could be constructed in any one of many different ways Concept Development – Using Mitigation Value to Guide Design of Trading Rules’, by Jennifer Austin Glossary of Key Definitions 12 (i.e., the price)? Or should there be ‘only one moving part’, as converting high MV units into a bigger number of low so to speak? MV units (which still equate to emission rights). But, as noted, this situation would be avoided if each jurisdiction [33] An alternative approach to that outlined in the above could only ever buy its own units. It is anticipated that scenarios would be if the exchange rate were to be market participants might also be more receptive to such a reflected only in the price. However, this would mean that mechanism, as it would be simpler to understand and each jurisdiction could only ever buy its own units, so that interpret movements in the market. The drawback is that CV=1 would always apply. This is because if lower value jurisdictions could not trade with each other directly, but units were to be bought from another jurisdiction, and rather might only do so indirectly through a market maker. CV=1 applied to them automatically, the environmental This alternative is elaborated further in Section 7. integrity of the overall system would again be impaired. Overvaluing the CV of low MV units has the same effect Glossary of Key Definitions 13 [34] To summarise the transaction mechanisms floated above: Scenario Price No. of units on trade CV Administration occurring 1. Foreign unit Depends on market, but Depends on CV=1 as only Decentralized converted exchange rate relevant exchange rate domestic units credited 2. Foreign unit Depends on market, Depends on CV depends on Decentralized and imported exchange rate possibly exchange rate buyer’s scheme more complex less relevant due to CV administrator uncertainty 3. International Depends on market, but Depends on CV=1 as only Centralized Transaction Unit exchange rate relevant exchange rate domestic units transaction credited currency Via market maker, Depends on market, Will be whatever CV=1 as only Centralized no direct trade exchange rate very number buyer domestic units between relevant contracts to purchase credited counterparties assessments in an introspective sense, as a yardstick for Other applications for MV Assessment measuring the success of their own PPPs, as a tool for [35] Stepping back from the transaction level described in internal review and enhancement of policies. All the same, the preceding paragraphs, there are other possible for jurisdictions that do wish to engage in trading with applications for the MV assessments at an earlier stage in other jurisdictions, the NCM initiative is developing the process. For example, jurisdictions may use MV concepts to facilitate application of MV assessments to assessments to inform their decision making whether or inform exchange rates. not to engage in NCM transactions in the first place. Going a further step back, governments may see a benefit in MV Key roles and available tools 14 5. Key roles and available tools [36] Building on analysis of existing financial markets, this types of expertise and tools those institutions might section considers the types of institutions that might be leverage. However, before proceeding, it may be helpful to suitable to participate in the mitigation value assessment put them in an overall context by quickly reviewing all the process, providing practical examples, and considering the institutions and parties that might be involved: Institutions and parties Comment Individual jurisdictions opting into NCM Each maintains their own scheme registry Compliance entities from individual jurisdictions Engage in trading across jurisdictions Other market participants Brokers, dealers, market makers, etc: private sector entities Suitable entity/entities to perform MV assessments Considered in this Section 5 Regulatory supervisory body for MV assessments Considered in Section 6 of this paper Exchange rate determination and regulatory supervision Considered in a separate paper commissioned by NCM Settlement platform and clearing Considered in Section 7 of this paper Central registry Could be linked to settlement platform, see Section 7 ICAR Considered in a separate paper commissioned by NCM Overriding governance structure for NCM Considered briefly at the end of Section 6, but beyond scope of terms of reference for this paper Key roles and available tools 15 [37] Diagrammatically, the institutions, parties and their relationships might be considered as follows: [38] This section begins by examining what the mitigation jurisdictional ‘circumstances’”, so on this basis, value assessment process requires of a ‘suitable analysts need to be qualified in: institution’, including in terms of tools and expertise. Without disregarding the possibility of other options, two o assessing emission reduction programs, specific examples of types of institutions that, at least in o evaluating mitigation effectiveness, part, already may meet the requirements of the process are considered. o evaluating mitigation ambition, or pledges, What does the process require of a o evaluating jurisdictional circumstances and all that entails23, and ‘suitable institution’? [39] What are practical examples of the types of suitable apart from being able to review and evaluate large amounts of factual information, the analysis needs to institutions that would participate in the mitigation value be able to account for large data sets, complex assessment process? What tools and expertise would statistical analysis and mathematical modelling, they need to leverage? To answer these questions, the critical weighting of factors, detailed and extensive logical starting point is to consider what that process is, research, and the exercise of experienced, expert what it entails: judgment;  as a relative measure as between jurisdictions, it  ‘assessment’ requires suitably qualified analysts, would involve a process similar to rating processes, access to relevant information and the hardware for that is, design of a process to score the mitigation the analysts to evaluate that information; value of jurisdictions’ PPPs.  it is posited that ‘mitigation value’ means “a relative [40] These technical requirements presuppose: measure, as between jurisdictions, of the effectiveness of their emission reduction programs in  financial resources necessary to ensure in-house (or ‘mitigating’, which takes account of their respective access to) research materials; 23 See Section 3, sub-section E preceding Key roles and available tools 16  not only the ability to access and obtain databases  large global law firms (now that they can have multi- and datasets, but also: disciplinary teams), or o the ability to store the information,  consortia, made up from combinations of any of these types of organisations. o to assess, analyse and interpret the information, o the capacity to evaluate and form opinions based Credit Rating Process similar to MV on that information, and assessment process o the capacity to communicate the outcomes of [43] To the extent that this exercise is to look for suitable these deliberations in meaningful ways that are institutions to participate in the ‘mitigation value readily accessible to stakeholders; assessment process’, it is worth considering that the closest comparable business process would be that  mathematical analytics; carried out by credit rating agencies in rating public sector debt and public sector issuers of debt, including sovereign  skilled and experienced personnel, premises in which governments. to house those personnel in suitable locations (probably needing to be near a financial centre), [44] It is in the context of the bond market, and in relation appropriate organisational IT and communications to debt and borrowings generally, that the concept of infrastructure; ratings is most often used. When borrowing, sovereigns, all levels of government, corporate borrowers, even  these personnel requirements presuppose not only individuals, are rated on their creditworthiness, that is, financial resources, but the appropriate support their willingness and capacity to meet their commitments: systems such as an effective management structure, to pay interest and repay their capital borrowing. operational and administrative systems, training and Continuing the analogy for NCM, the jurisdiction issuing governance systems. the carbon asset would be evaluated as a whole, in terms of the MV of the PPPs in place to mitigate emissions from [41] Bearing these requirements in mind, a minimum size within its boundaries. The carbon trading scheme would of organisation would appear to be necessary, needing to be evaluated as a part of this MV assessment process. be capitalised to a minimum extent. In view of the need to The MV of the jurisdiction could be considered relative to avoid conflicts of interest or perceptions of bias, it is that of other jurisdictions (or against a composite weighted unlikely that national or sub-national public sector bodies average thereof), to give an ordinal ranking similar to that would be suitable. It is possible that a multilateral agency of sovereign or other governmental issuer credit ratings. might be considered suitable, however, this might also be viewed as ‘putting all the eggs in one basket’, limiting the Points to be drawn from consideration of scope for a diversity of views and methodological approaches, and also increasing the potential for credit ratings and credit rating agencies bureaucratic hurdles. So, focusing on private sector [45] A number of important points can be drawn from the entities, a certain type of organisation would more readily experience of credit ratings and credit ratings agencies: have the personnel profile and internal infrastructure to undertake the process elements described above. These  just as is the case with credit rating agencies, suitable considerations point initially towards: (a) credit rating institutions for performing the MV assessment agencies; and (b) organisations that have been accredited process should be independent, private sector and, as Designated Operational Entities (DOEs), under the preferably, for-profit organisations. The aim would be Kyoto Protocol. to avoid any potential risk of national, or sub-national jurisdictional bias, or even the perception of such [42] This is not to exclude other organisations that might bias, on the part of the entities carrying out the equally undertake such operations, such as: assessments. For-profit organisations are preferred, as most not-for-profit organisations derive some form  large international (ex-accountancy) consultancies of governmental benefit – even if only in the form of (PwC, KPMG, EY, etc); non-taxable status, and this could leave open  investment banks; suggestions of partiality, no matter how unfounded;  large global accounting firms or other large global  suitable institutions should be subject to regulatory multi-disciplinary consultancies (e.g., non-DOE supervision: environmental consultancies); o this is now the case with credit rating agencies  organisations like Climate Action Tracker (a under, for example: consortium of consultancies and NGOs); or even Key roles and available tools 17  the EU Regulation on Credit Rating small levy on transactions arising from NCM Agencies – Regulation (EC) 1060/2009, and trading (as in the example of Share of Proceeds  in the US, the 2010 Dodd-Frank Wall Street (SOP-Admin) in CDM) to create a pool from which Reform and Consumer Protection Act; MV assessment agencies would be remunerated. This and other possible approaches need to be o under the EU Regulation, for instance, credit explored; rating agencies must fulfil certain obligations, such as:  the type of organisation and the number will ultimately be up to the relevant supervisory body; however, it is  avoiding conflicts of interest; suggested that:  ensuring the quality of their ratings and rating methodologies; and o organisations should be required to satisfy minimum criteria in order to be considered  ensuring transparency; suitable to become an MV assessment agency, o under the EU regulation, credit ratings agencies including for example: will be subject to a high level of supervision, including investigatory powers, centralised under  technical and financial capacity; European Securities & Markets Authority  access to resources; (ESMA);  governance; o what might be appropriate in this respect is  knowledge-base; considered more in Section 6;  management systems and personnel;  there should be encouragement for a multiplicity of  training; and organisations to become MV assessment agencies:  any other matters pertinent to the the greater the number of suitable organisations there requirements mentioned at [39] and [40] is, independently performing MV assessments, in above; theory, the greater the reliability of the MV assessment o the methodologies for carrying out the MV process should be. In light of some of the criticism assessment process should either be: levelled at the credit ratings sector in the wake of the global financial crisis24, it would preferable to avoid a (i) specified by the supervisory body; or small number of large organisations dominating the market, for example, it has been reported that just three (ii) accredited by the supervisory body and organisations, Moodys, S&P and Fitch, have about transparent, for example, by being made 95% of the global credit ratings market25; publicly available: the opacity of ratings methodologies was another criticism levelled  remuneration of MV assessment agencies should be at the credit ratings sector in the wake of the structured so as to avoid potential conflicts of interest global financial crisis;26 or the perception of such and, if possible, so as to foster desired policy outcomes: o while suitable institutions for conducting MV assessments should be afforded regulatory recognition, this should not be allowed to become a hurdle for potential new entrants; o the ‘issuer pays’ model, (versus subscriber pays) which is the usual method of remuneration in o in considering the types of organisations that credit ratings at the very least gives rise to a might be suitable institutions for conducting MV perception of possible conflicts of interest risk; assessments, it is important to remember that, from the perspective of both their core business o one possible alternative approach to remuneration and their regulatory obligations, credit rating for MV assessment agencies might be to have a agencies are solely focused on rating their subjects’ creditworthiness, that is, the willingness 24 25 World Bank Group, Financial and Private Sector European Commission, Memo/ 13/571, 18 June 2013, Development Vice Presidency, ‘Credit Rating Agencies, New Rules on Credit Rating Agencies (CRAs) enter into No Easy Regulatory Solutions’, Crisis Response, Public force http://europa.eu/rapid/press-release_MEMO-13- Policy for the Private Sector, Note Number 8, October 571_en.htm, accessed 15 April 2015; note that this was in 2009, part due to the quasi-regulatory status they were afforded http://siteresources.worldbank.org/EXTFINANCIALSECTOR/Reso as “nationally recognised statistical rating organisations” urces/282884-1303327122200/Note8.pdf, accessed 15 April per 1975 US SEC Regulations 2015 26 Note 25 supra Key roles and available tools 18 and capacity to meet commitments: to pay written consent of the provider of the information, interest and repay capital. Hence, while there are except as required by national law. useful principals to be drawn from the experience of credit rating agencies, per se, they may not be [49] It can be seen that the DOE roles and functions are suitable institutions to conduct MV assessments. quite closely prescribed. The CDM Executive Board is quite prescriptive in its approach to supervising performance by the DOEs of their roles and functions. For DOE roles and functions comparable to MV example, the annual activity report must include assessment process information on activities relating to the consideration of project activities as follows: [46] The other types of organisations that have experience conducting similar types of assessments to those  List of project activities; envisaged in the MV assessment process are Designated Operational Entities (DOEs), accredited under the Kyoto  Status of project activities; Protocol. DOEs will have already had a taste of the type of  Regional distribution of project activities; assessments described, albeit in the context of CDM projects, and Programmes of Activities (POAs).  Sectoral distribution of project activities; [47] DOEs are accredited by the CDM Executive Board  List of project activities declined, if any, including the and designated by the COP/MOP27 to undertake usually reasons for doing so; either validation, or verification and certification, of CDM  List of the project activities undertaken in countries projects and POAs. They are independent auditors that having less than 10 registered project activities; assess whether a potential project meets all the eligibility requirements of the CDM (validation) and whether the  Number of project activities under validation or verification per qualified auditor; project has achieved greenhouse gas emission reductions (verification and certification). In one sense, the  Average timeframes for the validation and verification experience of DOEs is more pertinent, since it involves of project activities (from the signing of contract to risk-based evaluations of processes designed to mitigate submission of the request to the CDM EB), divided by GHG emissions. However, in another sense it is more region; limited, since it might be characterised as a rule-based  Average fees for the validation and verification of audit process of mitigation activities, based to some CDM project activities, divided by region. degree more on box ticking and to a lesser extent on the exercise of professional judgment. [50] DOE functions are to independently audit the project methodologies, including baselines and to assess whether [48] The roles and functions of DOEs include: the project has achieved the intended mitigation. In this sense their roles are very much aligned with the types of  Validating proposed CDM project activities; activities that suitable institutions participating in the  Verifying and certifying reductions in anthropogenic mitigation value assessment process would be expected emissions by sources of greenhouse gases; to carry out, that is, in relation to the subject matter. However, as noted above, the actual activity performed  Complying with applicable laws of the Parties hosting being more a rule-based audit process of mitigation CDM project activities when carrying out functions; activities, would probably be less aligned than the  Demonstrating an absence of real or potential conflict activities carried out by, say, credit ratings analysts. of interest with the participants in the CDM project activities for which validation or verification and [51] The analysts employed by DOEs would clearly satisfy certification functions being carried out; at least the first two requirements outlined above at [39], that firstly, they need to be qualified in assessing emission  Maintaining a publicly available list of all CDM project reduction programs; and secondly, they need to be activities validated, verified and certified; qualified in evaluating mitigation effectiveness. On the  Submitting an annual activity report to the Executive other hand, analysts from credit ratings agencies would be Board; more likely to satisfy the third requirement that they need to be qualified in evaluating jurisdictional circumstances  Making information obtained from CDM project and all that entails. participants publicly available, as required by the Executive Board. Information marked as proprietary or confidential shall not be disclosed without the 27 Conference of Parties to the Convention serving as the meeting of Parties to the Protocol Key roles and available tools 19 Points to be drawn from a consideration of September 2014, as reported to the COP/MOP in December 2014.28 This suggests there is a large potential DOEs pool of suitably qualified professionals available from this [52] Guidance and regulatory supervision of the MV source. Whether this potential might be borne out, assessment process is considered in more detail in depends to a degree on the processes carried out by Section 6, however, to summarise the preceding points, it these entities and the quality of the training provided to is noted in relation to DOEs under the Kyoto Protocol that: their analysts.  the subject matter of their activities is directly relevant Suitable institutions to participate in the as it relates to risk-based evaluations of processes designed to mitigate GHG emissions; mitigation value assessment process [54] A conclusion that might be drawn from the foregoing  consequently, DOE analysts need to be qualified in is that the type of institution most suitable for participating assessing emission reduction programs and in in the mitigation value assessment process may be one evaluating mitigation effectiveness; that combines the skills, knowledge, experience and resources of a credit rating agency with that of an  however, the process they carry out might be organisation that has been accredited as a DOE. characterised more as a rule-based audit process of mitigation activities; and [55] It is suggested that suitable institutions should be independent, private sector organisations. They would  the CDM Executive Board exercises a tight rein on need to be well resourced technically and financially, and the scope of their activities. should be subject to regulatory oversight. Encouragement [53] In spite of the current lower level of demand for should be provided for a reasonable number of certified emission reductions produced by CDM registered organisations to participate in the MV assessment process project activities and programmes of activities, there were and consideration should be given, in particular, to how still fifty-one entities accredited and provisionally they are remunerated to avoid the potential conflict of designated to carry out various ranges of sectoral scopes interest, inherent in ‘issuer pays’ arrangements. by the Executive Board in the period October 2013 to 28 Annual report of the Executive Board of the clean Protocol. Lima, Peru. December 2014. development mechanism to the Conference of the Parties http://unfccc.int/resource/docs/2014/cmp10/eng/05.pdf , serving as the meeting of the Parties to the Kyoto accessed 17 August 2015 Guidance and regulatory supervision of mitigation value assessments 20 6. Guidance and regulatory supervision of mitigation value assessments [56] MV and the MV assessment process are integral to Regulation of CRAs the NCM initiative. Given the need to avoid, and to be perceived to avoid, conflicts of interest in undertaking the [59] Returning to regulatory supervision of the MV MV assessment process, it is unlikely that state entities or assessment process in particular, reference has been even intergovernmental organisations could be involved in made to US and EU rules at [45] above in the context of performing this role. This paper has proceeded on the credit ratings. These rules of themselves would not directly basis that the MV assessment process will be carried out apply to MV assessment, since they deal specifically with by independent, private sector, for-profit organisations, to credit rating agencies (‘CRAs’). Hence, irrespective of the extent feasible, without connections to the government whether carbon assets in NCM are characterised as of (a) their domicile, or (b) their location of residence for financial instruments and the NCM as a financial market, it tax purposes, or (c) their main operational location. will still be necessary to provide specifically for regulatory supervision of the MV assessment process and the [57] On the other hand, it is likely that an institutions considered suitable to undertake that process. intergovernmental organisation, or organisations, will have an important role to play in providing regulatory [60] To illustrate an approach that might be taken for supervision of both the entities that carry out the MV regulatory supervision of institutions undertaking MV assessments and of the process itself. In view of the assessments, it is useful to consider the CRA regulations importance of the MV assessment process and the more closely. For example, the EU Regulation on Credit proposition that it be conducted by the private sector, Rating Agencies – Regulation (EC) 1060/200931 includes regulatory supervision of the MV assessment agencies provisions that: and the MV assessment process is a critical part of the  to perform ratings for regulatory purposes, a CRA model. But what level of regulatory supervision will be must be registered and in order to be registered, must required and why? fulfil certain obligations (i) on the conduct of their business, (ii) intended to ensure the integrity and Financial regulation independence of the rating process and (iii) to [58] In considering these questions, it is noted as a enhance the quality of the ratings issued; broader point, that carbon assets are already regulated as financial instruments in some jurisdictions. This may not  the European Securities and Markets Authority be the case in all jurisdictions that potentially may (ESMA) is responsible for registering and directly participate in NCM. Furthermore, where they do apply, the supervising CRAs; financial regulations may apply to some carbon assets, but  CRAs must avoid conflicts of interest (e.g., to ensure not to others. For example, in the EU, Directive an employed analyst does not rate an entity in which 2014/65/EU29, defines ‘financial instrument’ to include they have a financial interest); must ensure the quality emission allowances, consisting of any units recognised of the ratings (e.g., carry out on-going monitoring of for compliance with requirements of Directive 2003/87/EC credit ratings); must ensure the quality of the (Emissions Trading Scheme)30. This means that EUAs methodologies (e.g., methodologies must be rigorous and some, but not all, CERs are financial instruments. and systematic); and must have a high level of Other carbon assets that may come under NCM, do not transparency (e.g., by publishing an annual fall within that definition. In time, these financial transparency report); regulations may need to be modified to take account of carbon assets under NCM more uniformly. However, the  ESMA is endowed with comprehensive investigatory basic point is that there already exist bodies of rules that powers, including the power to demand documents or will need to be taken into account in developing NCM and, data; to summon persons to hearings; to conduct on- once the NCM is functioning, observed by participants. site inspections; to impose administrative sanctions, fines and penalties; 29 30 Directive on Markets in Financial Instruments and Directive on Markets in Financial Instruments and amending Directives 2002/92/EC and 2011/61/EC (‘MiFID amending Directives 2002/92/EC and 2011/61/EC (‘MiFID II’) II’), Annex I, Section C, paragraph (xi) 31 As amended by Regulation 462/2013 and Directive 2013/14/EC Guidance and regulatory supervision of mitigation value assessments 21  places requirements on CRAs as to when ratings of to satisfy CDM Executive Board requirements. DOEs are sovereign debt are undertaken, how many unsolicited fully responsible to the CDM Executive Board for the such ratings can be made per year, the timing of quality of their work, and therefore cannot include publication of outcomes, and for six-monthly (as disclaimers, but the same is not true for client opposed to annual) reviews; relationships. Client contracts routinely disclaim liability other than in situations of gross negligence and even then,  make CRAs accountable for their ratings, which are often limit commercial liability. This is understandable, no longer considered ‘mere opinions’; given that DOEs do not want to carry the risk of liability to the client stemming from a third party intervention, namely  require publication of all ratings on a European Rating that of the CDM Executive Board. The inevitable Platform (established by ESMA) to improve consequence is that clients suffer the consequences, such comparability and visibility of all ratings; as delays, due to DOEs not meeting the CDM Executive  address conflicts of interest by imposing restrictions Board’s prescriptive requirements, a situation exacerbated on shareholdings covering CRAs and rated entities by the market for DOE services being a seller’s market. and requiring rotations of CRAs at least every four [64] The roles and functions of the CDM Executive Board, years where the ‘issuer pays’ model applies; include:  encourage issuers to use smaller CRAs with less  making recommendations to the COP/MOP on further market share to encourage broadening of the market. modalities and procedures for the CDM; [61] The CRAs still devise and apply their own ratings  approving new methodologies relating to, inter alia, methodologies. However, process timing requirements baselines, monitoring plans and project boundaries; mean issuers have more time to respond before they are made public, so at least there is time for factual errors to  being responsible for the accreditation of operational be rectified and publication is less distortive of markets. If entities, in accordance with accreditation standards, CRAs intend to change materially existing or use new and making recommendations to the COP/MOP for methodologies, models or key rating assumptions that the designation of operational entities. This may impact rating outcomes, they must first publish the responsibility includes: intended changes and invite comment for a fixed period, together with detailed explanation of the reasons and o decisions on re-accreditation, suspension and implications. withdrawal of accreditation; DOEs and the CDM Executive Board o operationalization of accreditation procedures and standards; [62] The other specific example considered in relation to suitable institutions for undertaking the MV assessment o review the accreditation standards; process was that of DOEs accredited under the Kyoto Protocol. These entities are accredited (‘provisionally  making publicly available relevant information, designated’) by the CDM Executive Board upon a submitted to it for this purpose, on proposed CDM project activities in need of funding and on investors recommendation by the CDM Accreditation Panel, which seeking opportunities, in order to assist in arranging is advised by a specially constituted CDM Accreditation funding of CDM project activities, as necessary; Team.32 They are then designated by the COP/MOP and are required to submit annual activity reports to the CDM  making any technical reports commissioned available Executive Board. Annual reports must satisfy CDM to the public and provide a period for public Executive Board guidance to ensure consistency and comments on draft methodologies and guidance completeness of reporting with respect to the key CDM before documents are finalized and any activities of a DOE. recommendations are submitted to the COP/MOP for [63] DOEs are accountable to the COP/MOP through the their consideration; CDM Executive Board and are required to comply with the  developing, maintaining and making publicly available decisions and instructions of the Board, which have been a repository of approved rules, procedures, many and frequent. Problems have arisen due to the fact methodologies and standards; that DOEs are under contractual arrangements with client project developers, while at the same time being obliged 32 Membership is open to both external experts and accreditation roster of experts’, version 01.0, document secretariat staff: see ‘Procedure: Selection and CDM-EB79-A02-PROC, UNFCCC performance evaluation of experts on the CDM Guidance and regulatory supervision of mitigation value assessments 22  developing and maintaining the CDM registry; to the level of regulatory supervision appropriate might be along the following lines:  developing and maintaining a publicly available database of CDM project activities containing  institutions considered suitable to undertake MV information on registered project design documents, assessments should be registered and maintain their comments received, verification reports, its decisions registration with the supervisory body at all material as well as information on all CERs issued; and times;  addressing issues relating to observance of  to be eligible for registration, institutions would need modalities and procedures for the CDM by project to satisfy criteria, such as those outlined at [39] and participants and/or operational entities, and report on [40] above; them to the COP/MOP.  registered suitable institutions would also need to [65] In spite of this seemingly broad mandate, in a number submit their proposed methodologies for undertaking of respects the COP/MOP, not the CDM Executive Board, MV assessments, which would need to be accredited is the final decision maker. Additionally, the level of by the supervisory body; transparency with regard to the performance of DOEs and actual issues arising from registration and issuance has  it would be important for the supervisory body to been found to be generally low. A 2010 report exercise close oversight of the methodologies for MV commissioned by WWF,33 found that meeting reports and assessments: referring again to the illustration of case-specific recommendations information was kept CRAs, one of the main points of criticism of credit confidential in the case of accreditation, and registration ratings agencies’ roles in the 2008 financial crisis, and issuance. was that they created complex but unreliable models to calculate probability of default for mortgages as Regulatory conclusions well as securitised mortgage-backed products;34 [66] While the illustrations outlined above evidence  the supervisory body might publish guidelines on the significant levels of regulatory supervision of the factors and criteria on which it would accredit respective activities, they offer different approaches to methodologies, then it would be up to the registered how regulatory supervision might be applied to the MV institutions to submit their proposed methodologies, assessment process. In both cases, the entities need to criteria, factors to be taken into account in making MV satisfy the requirements to become registered or assessments, to the supervisory body for accredited/designated. However, the CRAs devise and accreditation. In determining these guidelines, the apply their own ratings methodologies, whereas DOEs supervisory body might obtain useful guidance from must conform to the methodologies, modalities and expert bodies such as the International Standards procedures laid down for the CDM by the Executive Organisation (ISO); Board. In the case of CRAs, there is a shift towards greater accountability for their decision-making. In the  MV assessment methodologies would be publicly case of DOEs, the CDM Executive Board performs its role available, either on the supervisory body’s website in relation to the DOEs, but largely leaves the DOE and its and/or the relevant institution’s website; project developer client to sort out liability and risk issues  if a registered institution intended to change materially as between themselves. In a similar vein, regulation of existing or use new methodologies, models or key CRAs is moving towards greater transparency, whereas assumptions that may impact MV assessment the evidence suggests regulation of DOEs has been outcomes, they would be required first to publish the treated as confidential, hence less transparent. intended changes and invite comment for a fixed [67] Bearing these points in mind, and taking account of period, together with detailed explanation of the the fact that the process of MV assessment is closer to reasons and implications; that performed by the CRAs in making credit ratings, but  registered institutions would be required to publish a noting also that the process of credit rating has been schedule of the MV assessments (solicited and around for over one-hundred years and so is developed, unsolicited) proposed to be undertaken over specified refined and, within boundaries, a settled process, whereas forthcoming (e.g. next six-months, annual) periods; MV assessment is an entirely new concept, an approach 33 Öko-Institut e.V., Berlin June 2010. ’2010 rating of 34 for example, in 2007 as US housing prices began to fall, Designated Operational Entities (DOEs) accredited under Moody’s downgraded 83% of the US$869 billion in the Clean Development Mechanism (CDM)’, report for mortgaged-backed securities it had rated AAA in 2006 WWF. Guidance and regulatory supervision of mitigation value assessments 23  all MV assessment outcomes would be published, supervisory body should be accountable? This question along with reasons, key assumptions, etc, in would arise also for any other regulatory bodies formed accordance with the accredited methodology applied; under NCM, such as the one that might be needed to and supervise exchange rate determination, setting and adjustments. Bearing in mind the ultimate objective of  registered institutions would be accountable for the mitigation, and the purpose of the NCM initiative, one MV assessment outcomes they publish; and answer would be appear to be that oversight should be exercised by the UNFCCC COP, possibly by making the  the supervisory body might be vested with supervisory body a Constituted Body under a new investigatory and regulatory powers and functions protocol. But bearing in mind also that the NCM, in similar to those vested in ESMA, under the EU essence, will be a new global financial market, other Regulation on Credit Rating Agencies (as amended). possibilities need to be considered. While there may be no [68] There are many models for how the supervisory body single body responsible for overseeing the entire global might be constituted. For example, the CDM Executive financial system, there are treaty-based bodies whose Board is established by the Kyoto Protocol and various functions encompass global roles: for example, the Bank decisions of the UNFCCC COP have determined its role of International Settlements (BIS), the International and functions. Its rules of procedure have been adopted Monetary Fund (IMF), International Organisation of by the COP and cover matters such as its composition; Securities Commissions (IOSCO), while in Europe, there nominations and appointments; terms of service of is the European Central Bank (ECB) and now ESMA. The members; qualifications and conduct; officers; meetings, World Trade Organisation (WTO) might also provide a voting rules and so on. On the other hand, it is noted that useful comparative example for such a supervisory body. the supervisory body would be performing a role similar in If the NCM initiative develops and carbon markets many respects to that performed by ESMA in relation to continue as instruments of policy for mitigating CRAs, so ESMA might provide another pertinent model, anthropogenic GHG emissions, it may be appropriate to as a financial market regulator. consider the need for a treaty-based organisation to ensure both environmental and financial market regulatory [69] Whichever way the supervisory body is constituted, coordination and governance going forward. This is an the question arises of to what higher authority the area for further research. Relationship between mitigation value and compliance value, settlement platform; and ITUs and the Index 24 7. Relationship between mitigation value and compliance value, settlement platform; and ITUs and the Index [70] This section, firstly, revisits in more detail the o If the exchange rate is not binding, for instance, relationship between mitigation value and compliance because participating jurisdictions have not value and, in so doing, considers the role and function of agreed to be bound by it, then the scheme the settlement platform; and secondly, examines the administrator/regulator in the buyer’s jurisdiction concept of ITUs in more detail, and the feasibility and may or may not take account of the relative MVs potential benefits of an index, as introduced in Section 4 at the time it is surrendered for compliance above. purposes under that scheme; Relationship between mitigation value and o If, on the other hand the jurisdictions have given the exchange rate binding, or official status, then compliance value the scheme administrator/regulator in the buyer’s [71] Carbon assets trading in the ETS of the jurisdiction in jurisdiction may be bound to award a CV that which they were created, will most usually have CV=1. By reflects the exchange rate and hence relative giving the domestic units a CV of 1, the scheme MVs. However, this may be affected by any time administrator/regulator is implicitly saying, MV=CV=1.35 delay between the transaction date and the date when the asset is surrendered for compliance; [72] When units of a carbon asset from one jurisdiction are traded into another, comparison of the MVs of the two  If the transaction mechanism provides for conversion jurisdictions participating will translate into an exchange of the traded asset into units under the buyer’s rate. There are a number of options for how the exchange jurisdiction at the time of the trade, then the units rate might relate to the CV the scheme received will all be CV=1 (since they are now buyer’s administrator/regulator in the buyer’s jurisdiction might jurisdiction units) so the decision is taken out of the give to it: hands scheme administrator/regulator in the buyer’s jurisdiction. The relative MVs of the two jurisdictions,  If the asset is transferred into the buyer’s registry through the exchange rate, will determine the number account in the buyer’s jurisdiction: of those units received – hence determining the total CV of the carbon assets traded on the transaction date. [73] The following table summarises these possibilities: Transaction mechanism Exchange rate Outcome Asset transferred to buyer’s account Not official for scheme CV determined by buyer’s scheme administrator administrators Asset transferred to buyer’s account Official as between scheme MV informs exchange rate, buyer’s scheme administrators administrator takes into account in setting CV – but note, also may be affected by time delay between transaction and surrender Asset converted into buyer’s units at Exchange rate applied in MV informs exchange rate, which determines transaction transaction to determine number number. CV=1, but number of units credited = of buyer’s units credited total CV [74] It can be seen that a critical link between the MV and assessment process outcomes for the participating the CV is the exchange rate, which is derived from the MV jurisdictions. How the MVs translate into the exchange per Marcu, ‘NCM and the Post-2020 Global Climate 35 Change Regime’: see Annexure “A” Relationship between mitigation value and compliance value, settlement platform; and ITUs and the Index 25 rate, by whom the process is carried out and the [78] The settlement platform would probably also provide supervisory regulation exercised over that process, and central counterparty clearing, since settlement and the nature of the exchange rate, itself, once it has been clearing are frequently handled together. For clearing, derived, for instance, how dynamic it is, are all there would need to be clearinghouse member firms that fundamental issues, considered by another paper would act for counterparties to transactions. Under this commissioned under the NCM initiative.36 structure, just as with the exchange traded segment of the FX market, there would be daily marking to market and [75] However, in the third example above, the exchange settlement, and margin calls, thus frequent payments to rate determines the number of units the traded carbon and from brokers and clearers, reducing counterparty assets are converted into and credited to the buyer. This default risk as well as the risk of fraud. may affect the total number of units in the overall scheme, by either increasing or decreasing that number, depending [79] For such an arrangement to be viable, however, it on the prevailing direction of trade. An increase in units would need to be supported by an adequate volume of would correspond to more rights to emit, which would trading. If all transactions needed to take place via a single impact the environmental integrity of the scheme. Another centralised settlement platform, this would be more way to look at this is to ask whether the application of an likely.40 It is probable also that, with such an arrangement, ‘exchange rate’ to carbon assets based on MV, should the risk of double counting (as well as fraud) could be apply to the environmental integrity of the asset (its CV), more easily controlled. or its price (its FV), or both.37 [80] The settlement platform would need to be linked to [76] While this risk to the environmental integrity of the the scheme registries of the participating jurisdictions. As scheme might be addressed through design features such, it would make sense for the settlement platform to applied to the exchange rate,38 it could also be removed if either incorporate or be linked also to a central registry CV=1 and the number of units credited are fixed. The tracking the movement of carbon assets between exchange rate would then only affect the price. Such a jurisdictions across the NCM.41 This would provide a transactional mechanism would be possible if all trading means to ensure double counting was avoided.42 A central was through a single counterparty market maker. This registry could also facilitate an audit mechanism for alternative possibility is explored further in the context of crosschecking the individual scheme registry holdings. the role and functions of the intermediary/settlement platform following. [81] Apart from a settlement platform, central clearing counterparty and registry, the other types of institutional Nature and role of the intermediary – the entity that may be involved in the transaction is the asset reserve (ICAR). The settlement platform/central clearing settlement platform and registry functions could be fulfilled without needing [77] Whatever the transaction structure, there will need to also to include the ICAR function. It is beyond the scope of be a way to effect the physical and financial settlement of this paper to look at the purpose and role of the ICAR.43 transactions. This will be the case irrespective of whether However, it is understood the ICAR role is to support the transactions are OTC or exchanged traded. Hence, for administrators of the schemes participating in NCM to the purpose of the transaction scenario set out in Section maintain domestic prices in the target ranges envisaged 4 involving the Index (scenario (iii) in Annexure “D”), it was by the policies of their respective jurisdictions. If so, this assumed that there would be an intermediary – the would seem to be more policy related and fundamentally settlement platform (referred to in that example as the different to the transactional management nature of the “International Settlement Platform”) where the conversion settlement platform/central clearing/registry functions. of units into and out of Index Units would take place.39 36 ‘Networked Carbon Markets – Concept Development – automatically checks, records, and authorizes all Using Mitigation Value to Guide Design of Trading Rules’, transactions that take place between accounts in the by Jennifer Austin Union registry. This verification ensures that any transfer 37 see also earlier discussion at [32]-[33] of allowances from one account to another is consistent 38 see Austin, note 36 supra with EUETS rules. The Union registry centralised the 39 Note: the nature and role of the intermediary/settlement national registries of the 31 participating states in 2009. 42 platform are not strictly part of the terms of reference for Although, if the transaction mechanism was index-based this paper. with IUs, conversion into and out of IUs should ensure that 40 this is envisaged under the NCM proposals – the this is the case. International Settlement Platform 43 See, for example, ‘Design Options for an International 41 the International Transaction Log (ITL) under the Kyoto Carbon Asset Reserve’ prepared by Juerg Fuessler and Protocol and the European Union Transaction Log (EUTL) Martin Herren, INFRAS Consulting Group, July 2015, under the EUETS provide models for centralised checking Networked Carbon Markets, A Knowledge Series, World of transactions and holdings. For example, the EUTL Bank Group Relationship between mitigation value and compliance value, settlement platform; and ITUs and the Index 26 Sole market maker function currency’, in the form of International Transaction Units (ITUs). As noted, the introduction of the ITU, would be [82] However, as an alternative way to remove the risk to analogous to the use of the US$ as a “vehicle” currency in the environmental integrity of the scheme, where traded FX transactions. However, the fact that the US$ is the units convert to a greater number of domestic units, hence most widely transacted currency reflects not only its use more emissions, it is worth considering the possibility that as a vehicle currency in FX transactions, but also its the intermediary/settlement platform, or ICAR, or the two roles44 as: in conjunction, might also act as sole market maker, quoting both bids and offers and standing ready to make a  investment currency in many capital markets; two-sided market for compliance entities in any participating jurisdictions who wish to trade carbon units,  reserve currency held by many central banks; for whatever reason, externally to their domestic situation.  transaction currency in many international commodity The idea would be that both the offer/bid prices and the markets; buy/sell spread would reflect the exchange rate in the case of any jurisdiction.  invoice currency in many contracts; and  intervention currency used by monetary authorities. [83] If the market structure were such that a single market maker was counterparty to all transactions, where an It is unlikely the ITU would perform similar roles (except entity sought to buy units from a seller outside their possibly as an asset for investment in its own right). In jurisdiction, or wished to sell excess units to a buyer fact, it is conceivable that ITUs might only exist in pending outside their jurisdiction, application of the exchange rate accounts on the International Settlement Platform, for the would affect only the price. Hence the exchange rate purpose of facilitating NCM transactions. Entities wishing would not determine the number of carbon asset units to sell carbon assets would convert those assets into ITUs transacted. The scheme administrator or each (at the applicable exchange rate) and entities wishing to participating jurisdiction would still be free to set CV=1, buy carbon assets would need to hold ITUs in their since it would only ever deal with its own domestic units. pending account for conversion into the desired carbon asset denomination (at the applicable exchange rate). [84] Whatever entity were to perform such a role as the sole market maker, whether the intermediary/settlement [88] Irrespective of whether the ITU were to be notional or platform, or ICAR, the two acting in conjunction, or some a tangible asset for investment, its purpose, how its value other entity, it would need to be capitalized with units from is derived, how and by whom it is created and issued and the participating jurisdictions. This may recommend ICAR pursuant to what authority, are characteristics that need to for the role, since ICAR may probably need to be active in be considered and defined. Much further work will be the markets that make up the NCM anyway. required to elaborate and define this instrument. [85] A drawback of this proposal is that jurisdictions would [89] For example, the ITU might be defined as a not actually be trading with each other, but just with the transaction unit for the purposes of facilitating trading market maker, so it would be a more limited form of between networked carbon markets, its value being a networking. However, if there is a limited trading function of the Index: this might be a composite average of environment when NCM begins, the introduction of a the MV assessment values of all jurisdictions that have single market maker might be useful for generating opted into NCM trading, weighted according to their liquidity. Such an arrangement may prove helpful in respective emissions budgets, which might be derived fostering initial trading and promote familiarity with from the global level of emissions necessary for keeping concepts such as MV, MV assessment and the exchange average global temperature increase to less than 2° above rates based on it. pre-industrial levels. Governments might agree by treaty that ITUs be created and issued by an overriding [86] Irrespective of the transaction mechanism which is supervisory body established to ensure proper applied in NCM, there will be scope for MV assessments governance in globally networked carbon markets. and the exchange rate to be based around a ‘transaction currency’ and an index. Consideration is now given to the [90] Continuing this example, the environmental value of feasibility and potential benefits of doing so. an ITU might be set at one metric tonne CO2-equivalent gas, calculated using GWP as defined by decision of 2 of International Transaction Unit the third meeting of the COP/MOP (Decision 2/CP.3) or as [87] Mention has been made above at [28] and [29] of the subsequently revised in accordance with Article 5 of the benefit to be derived by introducing a transaction ‘vehicle KP.45 Other considerations that would need to be 44 Query the extent to which these other roles for the US$ Cf. definition of a CER – Decision 17/CP.7 (Marrakesh 45 underpin its role as a vehicle currency in FX trading? Accords) Relationship between mitigation value and compliance value, settlement platform; and ITUs and the Index 27 addressed include definition of its delivery mechanism, [95] While it would be possible to have the Index as a how further definition or limitation might be made, how composite in these terms, the question is what purpose legal restrictions on the use of an ITU might be made and would it serve? An index of the MV assessment outcomes communicated, what facility an ITU would have as an of all sovereign (national) jurisdictions (irrespective of investment vehicle and how a price could be placed on it. whether they engage in NCM), whichever way it is weighted, might serve to provide an indicator tracking the Feasibility of an Index progress of countries generally towards the UNFCCC [91] As noted earlier, an index is a statistical composite objective. Comparing an individual jurisdiction’s that measures changes in the economy or a financial performance against such an index would provide a market, often expressed as changes from a base year or a valuable independent marker on how well or poorly that preceding month. Each index has its own method of jurisdiction’s PPPs were addressing emissions, relative to calculation. Components may be weighted according to the weighted average. This would be of benefit to certain characteristics, as in for example, a shares index governments, as well as interested third parties. But its weighted for market capitalisation. application to NCM is not clear, as the comparison would not be like-with-like if some of the jurisdictions included in [92] The first question, then, might be what will the Index the composite were not trading.46 be a composite of? If it is an MV Index, then it could be formed by a basket of MV assessment outcomes for all [96] Another possibility is for the Index to be a composite jurisdictions involved in NCM, as in the transaction of a limited number of NCM jurisdictions’ MV scenario in Annexure “D”. Another possibility is a assessments, based on pre-determined criteria for composite formed by a basket of MV assessment inclusion in the basket. A model for such an index is the outcomes for all sovereign (national) jurisdictions composition and valuation of the IMF’s Special Drawing (irrespective of whether they engage in NCM). There are Rights (SDR) basket. In the case of SDRs, the basket many other possible variations on this theme. In any case, comprises the four currencies issued by member states however, the MV assessment outcomes for individual that had the largest exports of goods and services over jurisdictions would be compared against the composite. the preceding five year period, and have been determined Which of these methodologies would be more appropriate by the IMF to be ‘freely usable’, that is, widely used to for the purposes of NCM and why that would be the case, make payments in international transactions and widely are questions to be considered. traded on exchange markets. What the pre-determined criteria for inclusion in a limited NCM basket might be, to [93] Components of the composite may be weighted, and ensure validity of application of such an Index, requires there is any number of possible different weightings that careful consideration. The criteria for inclusion could, for might be applied to a basket of MV assessment outcomes example, be derived so as to ensure the basket provided a including, for example: more stable yardstick, rather than one for which the basket composition changed regularly. Stability would foster  weighting according to annual emissions; greater confidence in the Index. However, it would also be important that the basket covered a substantial part of the  weighting by some measure of economic size, such overall market in carbon assets, for the Index to be as GDP; relevant for traders47.  weighting according to population size. [97] A further possibility would be for the Index to be [94] If the Index is a composite of MV assessment based on a basket of the MV assessment outcomes of all outcomes for all jurisdictions involved in NCM only, then jurisdictions engaged in NCM. Such an Index could serve the weighting might take account of factors such as the % as a proxy for how effective the NCM market is performing of the jurisdiction’s economy covered by the trading to bring about mitigation. Ultimately, the questions to be scheme, or the % of the jurisdiction’s overall emissions answered are what information is the Index covered by the trading scheme. On the other hand, from communicating, and who wants it? Commercial the perspective of traders, the most important weighting of exchanges offer index products to their clients after the Index might be according to FV. Again, which of these conducting thorough market research to ascertain what methodologies would be more appropriate for the would be of most value to them. This would be a good purposes of NCM and why that would be the case, are approach to follow. questions that need further detailed consideration. 46 Query whether this would be a technical problem with determined to be freely usable and will be included as a the Index? fifth currency, along with the U.S. dollar, euro, Japanese 47 In November 2015, the IMF Executive Board decided yen, and pound sterling, in the SDR basket. that, effective October 1, 2016, the Chinese renminbi is Relationship between mitigation value and compliance value, settlement platform; and ITUs and the Index 28 Benefits of an Index ITUs, or to have converted units from one of the NCM participating trading schemes, or project credits, into ITUs. [98] Direct comparison between jurisdictions may be As envisaged, the ITUs would exist in pending accounts exactly what is better avoided, pointing to a clear benefit on the settlement platform and of themselves would not be served by having the Index: no direct jurisdictional able to be surrendered against the compliance obligations comparisons. As can be seen in transaction scenario (iii) of any participating scheme, but might also be capable of in Annexure “D”, interposing the Index avoids direct being traded on other exchanges. Thus the ITUs might comparison of MV assessment between jurisdictions. All serve two purposes: firstly, as initially outlined in Section 4 jurisdictions’ assessments are considered only against the above, as the ‘transaction currency’ – a simple pass Index, the weighted average of all such assessments. through to facilitate transactions; and secondly, as an Similarly there would not be an exchange rate directly investment vehicle. between the carbon assets of two jurisdictions, as all carbon asset units are only ever exchanged for transaction [102] The degree of liquidity in the NCM will depend on the vehicle units (in the case of transaction scenario (iii), ITUs, number of buyers and sellers there are willing to trade where exchange rates measure jurisdictions’ carbon across jurisdictions. This in turn, will be a function of the assets against ITUs). potential arbitrage opportunities from one participating jurisdiction to another. The ability of investors to hold ITUs [99] Another clear purpose served by the Index is that, by would increase their ability to find those opportunities, not introducing the ITUs, there is a transaction mechanism to least because it would facilitate price disclosure across the provide for physical settlement not by the movement of entire market at a glance. However, it also raises the carbon asset units from one jurisdiction to another, but by question of whether, in maintaining holdings of ITUs, the movement of the value – the mitigation value – that they investors wouldn’t at the same time be draining supply, embody. Hence each jurisdiction will only ever need to hence liquidity, from the market. deal with its own carbon asset units.48 [103] This is a relevant consideration in a market based on [100] The other benefit of this mechanism is that investors a number of ETSs, since by definition, in an ETS there is a and market makers might need only to hold ITUs in a limited, finite number of carbon assets available, with that pending account on the international settlement platform, number, in theory, reducing over time. NCM addresses rather than maintaining accounts in denominations of all this by facilitating compliance entities from one ETS participating jurisdictions in which they might wish to trade. accessing carbon assets from another ETS. But as all This would significantly reduce transaction costs and participating schemes are based on the same premise, administration, making participation in the market a more namely that a limited, finite number of carbon assets is attractive option.49 available, and is reducing over time, this benefit is, to a degree, nugatory.50 Other benefits? [101] Can the use of the Index bring other benefits, such [104] The limited supply issue would, of course, be as greater liquidity, to the NCM? As a statistical countered by project credits being available. However, not composite, there is no capacity to invest in the Index itself. all participating jurisdictions may accept project credits An investor or market maker that wished to trade under the terms of their scheme: introduction of project speculatively might hold ITUs, just as they might hold units credits to NCM cannot be assumed as automatic. An of the carbon assets under any of the individual schemes, index-based transaction mechanism might help overcome or hold project generated credits if these are tradable this difficulty, as the risk-assessed project credits would be under NCM. As proposed in scenario (iii) in Annexure “D”, converted to ITUs, which in turn would be converted at the the ITUs would only come into existence as a result of a applicable exchange rate to the carbon asset jurisdiction’s carbon asset units, or project credits (if denomination of a buyer’s jurisdiction, eliminating the risk included), being converted into ITUs. In order to hold ITUs, of non-acceptance of the project credits by the scheme the investor would need either to have purchased them as 48 50 Note that in the case of the sole market maker proposal, This issue of satisfactory balancing of supply and this would be implicit, so the Index would not add anything demand to ensure that the NCM, as well as its constituent in this respect trading schemes, continues to provide a price signal in 49 although with the sole market maker proposal, if the keeping with the overall UNFCCC policy objective is carbon assets were converted into and held as ITUs, their principally addressed by the NCM proposal for an electronic certificates would need to have identifiers to International Carbon Asset Reserve (ICAR). While this is show from which jurisdiction they originated; since they the subject of research by other parties for the World would just be converted back to the carbon assets of that Bank, it is noted that ICAR may have a significant role same jurisdiction, query what benefit would be gained through the Index by acquisition and disposal of ITUs from holding them as ITUs Relationship between mitigation value and compliance value, settlement platform; and ITUs and the Index 29 administrator.51 Participating jurisdictions would need to be [106] It is noted also that an investment fund based on an in agreement over the methodology for inclusion of risk- MV index will be holding carbon assets, but investors will assessed project credits, in the first place. be trading shares in the fund.52 The mechanism for how such a structure may generate liquidity in the NCM is yet [105] An index can form the basis for an investment fund, to be explored, as are other possible structures and as in the case of some exchange-traded funds (ETFs). indices. Other products such as forward contracts based However, whether investment funds based on the Index on the Index, or spreads between future prices of the would add to liquidity in the NCM would depend on how Index and the carbon assets of various jurisdictions, could actively those funds were traded, rather than the fact that also generate liquidity and depth in the market. It is likely there is an index on which they are based. ETFs that commercial exchanges such as the LSE, EEX and themselves have a widely varying range of liquidity. The ICE would develop derivative products along these lines. popularity and hence degree of trading in a fund would be more a function of how it is set up, its overall structure, rather than just the fact that it is based on an index. 8. Recommendations for Next Step [107] As a general observation, the overall body of work given to the sequencing of these activities, especially in for developing the NCM initiative might be considered to relation to the identification and timing of engagement with comprise seven modules/strands: relevant stakeholders.  development and refinement of the concept of [109] There are a number of areas identified in this paper ‘mitigation value’ and developing the process for that invite specific, follow up work. For the purpose of mitigation value assessment; making recommendations as to next steps, these might be grouped into the following five categories:  derivation of the ‘exchange rate’ between carbon assets, based on mitigation values; (i) general development of mitigation value concept and process for assessment;  development of the transaction mechanism for NCM trading; (ii) forming the ‘view’ on level of ambition;  development of the role and functions for the (iii) translating mitigation values into exchange rates; settlement platform; (iv) the supervisory body for suitable institutions making  elaboration of a market design; mitigation values assessments; and  development of the International Carbon Asset (v) International Transaction Units and the Index. Reserve (ICAR); and General development of the Mitigation  identifying and fostering development of the market – Value concept participants, size, demand, modelling. [110] Firstly, a basic outline for the MV assessment [108] It is understood that work under the NCM initiative process in a jurisdiction is: has been progressing in relation to each of the strands listed above. Work to develop some of these modules will (a) assess the individual PPPs; involve identifying and engaging important stakeholders at (b) assess the jurisdiction’s PPPs collectively; an early stage. It is noted also that some of these modules need to be developed sequentially, while others do not. (c) evaluate overriding factors such as strength of For example, the last item listed above, the market, can be supervising institution, political will of 
 government, worked on independently of the other items, however, it etc; 
 will provide a critical plank for engagement of stakeholders in relation to some of the other strands. As such, it is (d) set the above in the context of the jurisdiction’s recommended that, as an initial step, consideration be circumstances – level of emissions, 
 structure of 51 52 NB: the inclusion of project credits will have a bearing on Exact mechanism to be checked how the index is devised: needs further consideration as introduces potentially invalid comparisons Recommendations for next step 30 economy, financial profile, demography, institutions, required to account for 
 differences; how account could politics; 
 be taken of factors such as sub-national jurisdictions not having a level of 
 ambition, or there not being a global Assuming something along these lines is settled on for the expectation of ambition placed on them (whereas there framework for an MV assessment process, follow up work would be for national jurisdictions) and whether this would be required on how such assessment process might difference would invalidate comparisons between the two; be structured. Engagement with CRAs would assist this and in making MV assessments of sub-national work. jurisdictions, how issues such as the application of the [111] Secondly, there is the overlay of the ‘level of principles of subsidiarity and supplementarity could, if ambition’ and whether, in the jurisdiction’s circumstances, necessary, be taken into account. 
 that is sufficient in a global context (‘level of expectation’). Further work would be necessary to consider how this Forming the ‘view’ on level of ambition might be linked, or relate to, the assessment made by [114] It is posited that a jurisdiction’s ‘level of ambition’ undertaking the assessment process. might be compared against a ‘view’, forme d by an independent, unbiased, expert group, as to what the level [112] Thirdly: of ambition for that jurisdiction should be (taking account For jurisdictions that have an ETS, (as one of the of its circumstances) in the context of achieving the jurisdiction’s PPPs), there should be the same ultimate objective of the UNFCCC. This gives rise to approach to the jurisdiction’s MV assessment, as if it another area of follow up work in researching and forming didn’t have an ETS: in other words, all jurisdictions’ proposals as to how such a group might be constituted MV assessments should be carried out the same way, and the boundaries set within which they form their ‘view’. whether or not they have an ETS as one of their PPPs (that is, all PPPs looked at equally), OR
 For all jurisdictions that have an ETS, there should be the same approach to the jurisdiction’s MV assessment, but that this might differ from the MV assessment for jurisdictions that don’t have an ETS, in that (as noted at Section 3, B above): 
 ‘If one of the PPPs, that a jurisdiction has in place, is a carbon trading mechanism generating carbon Translating mitigation values into exchange assets for trading within the scheme but which, by participating in NCM, might also be traded into rates schemes in other jurisdictions, then not only will that [115] How the MVs translate into the exchange rate, by particular PPP be evaluated, but it will be evaluated in whom the process is carried out and the supervisory the context of the jurisdiction overall...’ 
 regulation exercised over that process, and the nature of the exchange rate, itself, once it has been derived, for In other words, when there is an ETS, the MV instance, how dynamic it is, are all fundamental issues. assessment process focuses on that PPP in the Work is being undertaken on the definition of exchange context of all the others (as opposed to just looking at rates, and how they might relate to MV and CV. Follow up them all equally). work may be required to expand upon this current work. More thorough consideration needs to be given to which of these two propositions is the more valid from a The supervisory body for suitable ratings/statistical perspective and why that is the case. institutions making mitigation values Engagement with CRAs would facilitate this work. 
 assessments [113] The MV assessment process would apply to national [116] The nature of the role for the supervisory body, how and sub-national jurisdictions that have an ETS, with the it might be constituted, to what higher authority the intention that trading could take place between national supervisory body should be accountable and many other and sub-national jurisdictions, if desired. Follow up work is questions concerning this element of the NCM governance required to examine and resolve questions such as framework will require further follow up work. how
 the assessment process could provide for the need to be able to compare MV of national jurisdictions with the International Transaction Units and the 
 MV of sub-national jurisdictions, the criteria that might be Index Recommendations for next step 31 [117] The possibility of introducing the Index and the roles it might perform invites a great deal of further investigation. For example, questions such as what will the Index be based on – a budget approach or a composite approach and, if the latter, a composite of? What weighting factors might be taken into account in devising a composite index for NCM? Whether in composing it, the weighted average might only be composed of similar entities e.g. MVs of trading jurisdictions, or could risk assessed project credits be included – must the comparison be like-with-like? If the Index were to be based on an emissions budget approach, who would determine jurisdictions’ budgets and by what methodology? On the other hand, if the Index were to be a basket of just a limited number of NCM jurisdictions, based on pre-determined criteria (like SDRs), what would those pre-determined criteria be aimed at achieving? Whether investors holding ITUs would act as a drain on supply so as to cause problems with liquidity, rather than fostering greater liquidity? Whether the inclusion of risk- assessed project-based credits could address liquidity concerns? And whether and how basing the transaction mechanism on an index would increase market liquidity? Engagement with NCM partners, such as the EEX, London Stock Exchange and other exchanges, should help to address these and related questions. Glossary of acronyms 32 9. Glossary of acronyms BAU Business as usual CCC Central counterparty clearing CDM Clean Development Mechanism CERs Certified Emission Reductions CO2 Carbon dioxide CO2-eq Carbon dioxide equivalent gas COP Conference of Parties to the UNFCCC COP/MOP Conference of Parties serving as the Meeting of Parties to the Kyoto Protocol CRA Credit Rating Agency CV Compliance value DOE Designated Operational Entity EC European Commission EEX European Energy Exchange ESMA European Securities and Markets Authority ETS Emission Trading Scheme EU European Union EUETS European Union Emissions Trading Scheme FTSE Financial Times Stock Exchange FV Financial value FX Foreign exchange GHG Greenhouse gas GWP Global warming potential ICAR International Carbon Asset Reserve ICE Intercontinental Exchange IISD International Institute for Sustainable Development ITU International Transaction Unit IMF International Monetary Fund Glossary of acronyms 33 INDC Intended Nationally Determined Contributions IPCC Intergovernmental Panel on Climate Change ISO International Standards Organisation LSE London Stock Exchange MV Mitigation value NCM Networked Carbon Markets NGO Non-governmental organisation POA Programme of Activities PPP Programs, policies and pledges QELRC Quantified emission limitation and reduction commitment S&P Standard & Poor’s SDR Special Drawing Rights SO2 Sulphur dioxide SOP Share of proceeds UNFCCC United Nations Framework Convention on Climate Change US United States USEPA US Environmental Protection Agency WBCSD World Business Council for Sustainable Development WRI World Resources Institute WTO World Trade Organisation WWF World Wide Fund for Nature Annexure “A” 34 ANNEXURE “A” This Annexure sets out an extract of relevant sections of The MV, as a relative value, can be interpreted in more the discussion paper titled “NCM and the Post-2020 than one way. One perspective is that it shows how much Global Climate Change Regime” by Andrei Marcu. the effort to reduce a unit (e.g. a ton of CO2e) in a jurisdiction is worth – relative to another jurisdiction. 3. Basic Concepts Alternatively, it could be expressed as how the effort to A number of concepts and definitions need to be contribute to addressing climate change is rated in a examined, and well understood, as they will appear jurisdiction, relative to a defined standard. frequently in this paper and used to answer the questions The MV of unit can also be described as the value identified in Section 2. It is especially important to stakeholders/society attaches to the effort to reduce a unit understand what NCM is, and especially what it is not. in terms of what it thinks that the jurisdiction should do to The concepts that will be reviewed include: address climate change. In this perspective, the MV can be a function of a number of factors, which may include:  Markets: Natural vs. Regulatory;  The level of the effort that is promised and undertaken  Markets: Voluntary vs. Compliance;  Characteristics of the economy – what is the  Markets: Domestic vs. International; abatement cost curve  Markets: Under international agreement vs. outside  Characteristics of the program or activity undertaken international agreement; to reduced GHG – that is the quality of the program and the certainty of delivery of the reduction.  Markets: Linked vs. Networked  Resources available to dedicate to mitigation efforts.  Value of Units: Financial, Mitigation, Compliance  Capacity to undertake mitigation efforts  Networked Carbon Markets Another perspective can be a probabilistic one (or risk 3.1 Value of units based), and refers to the probability that a unit of reduction in a jurisdiction (credit issued, or allowance to emit a ton of In GHG markets units can have a number of values: CO2e) represents a ton of CO2e. The MV value is Financial Value (FV), Mitigation Value (MV) and therefore a 1 ton x MV= amount of CO2e reduction that a Compliance Value (CV). The concept of Mitigation Value unit represents. In this perspective the elements of risk is fundamental to the discussions on NMC, as is the that define the MV are discussed below. relationship between the Mitigation Value and Compliance Value. Program level - Carbon Integrity risk Mitigation value: The Mitigation Value refers to the This risk relates to the extent to which a specific low- relative value of a unit versus a defined Standard Unit of carbon program or activity (e.g., regulatory instrument, reduction. What the concept of Mitigation Value is can be price instrument and quantity instrument) will achieve its described in a number of ways, but it is also important to intended outcome. The challenge is to establish an define what it does not refer to. approach that can accommodate the wide range of new and heterogeneous low-carbon programs that are now MV is a relative value that is helpful in defining the emerging. Currently, systems like the Clean Development fungibility of units in heterogeneous carbon markets where Mechanism provide only a binary ‘yes or no’ outcome on it is difficult to compare the value of different units. the validity and verification of emissions reductions. MV does not refer to the atmospheric impact of a unit of a However, this limits the ability to differentiate among tom of CO2e reduced. It is used as a relative value to help projects that have met minimum requirements, or to define the value of units coming from different carbon evaluate to what degree projects perform, vis-à-vis the pricing systems. One expression that has been sometimes threshold. As a result, there a wide range of low-carbon in relation to MV is that “a ton is not a ton”. This has been programs and activities whose overall benefits/risks are interpreted as implying that a ton of GHG reduced in one not captured by this approach. This is evident in certain place does not have the same environmental effect in sectors, geographies and areas of activity with the highest terms of combating climate change. That is not the case, sustainable development potential, or those, which and indeed, can never be the case contribute most to transformational change. Annexure “A” 35 Jurisdiction level - Policy/regulatory risk 1 ton of reduction, while the other one, rightfully or wrongfully, were seen as less probable as representing 1 Policy/regulatory risk relates to the extent to which a ton of reduction. This was reflective of the desire of those jurisdiction’s collective low-carbon policies will achieve the purchasing an AAU that it represent a 1 ton actual effort to intended outcomes. It involves technical considerations, reduce, not an incidental reduction. such as the extent to which the set of policies designed to achieve the mitigation target within the existing policy The MV of CERs provides another example. Gold context are likely to achieve the intended outcome. It also Standard CERs and “regular CERs”, in spite of having involves political considerations, such as the extent to gone through the same CDM regulatory cycle, receive a which the government has the political will, track-record, higher MV from stakeholders. The added Gold Standard and institutional strength to maintain or adjust policies to filter re-assures those willing to purchase CERs or achieve appropriate mitigation targets. reductions that it has a high probability to actually represent a ton CO2e reduced. Global level - Relative climate mitigation Compliance value: this is the value that the regulator contribution decides to assign to a unit used for compliance purposes Assessing a jurisdiction’s relative climate mitigation in a jurisdiction. A unit could have multiple CVs: contribution relates to the extent to which its climate mitigation targets are perceived as a sufficient contribution  Domestic, in the jurisdiction where it was issued to the global effort to limit global warming. The objective of  International this approach is to incentivize jurisdictions to increase their level of effort.  Domestic, in the jurisdiction where it is imported, and used for compliance. A Mitigation Value can be determined and assigned by a regulator, or by any stakeholder. Those that wish to assign As opposed to the Mitigation Value of a unit, where any a MV to a unit of GHG reduction can use many algorithms stakeholder can assign a MV, in a compliance regime it is and factors. only the regulator that can decide the compliance value in a given jurisdiction. Alternatively, the regulator may It is important to note that both concepts outlined above decide, voluntarily, that it delegates that decision to represent a valid point of view in terms of relativity another body. concepts, and are in some ways, a mirror image of each other. The former sees relativity in the effort that is put into For illustration purposes, CERs resulting from HFC reducing a ton of CO2 in different jurisdictions. The later projects have different CVs. Whereby a CER is worth a see relativity in what can be achieved with a unit of effort, tone for UNFCCC compliance, it is valued at 0 (zero) for or in a more classic way, what is the probability that a unit compliance under the EU ETS. It is therefore possible that reduction in a jurisdiction represents 1 ton of CO2e. the issuing regulator and the regulator that controls the compliance process, if not the same, may assign different What these two concepts also share is a degree of values to the same unit. subjectivity in assigning value, whether it is to the relative effort, or the probability of delivery. The body of knowledge Relationship between MV and CV and experience developed in assigning probability of outcome is much better understood and consequently this An important element in creating fungibility across paper will take the definition of Mitigation Value as being heterogeneous markets is the relationship between MV the probability of a unit of reduction from a jurisdiction and CV. That relationship is not well understood, and yet it represent 1 ton of CO2e. can be used to explain many of the symptoms emerging in GHG markets, and which need to be addressed. For illustration purposes we will provide an example. When the KP was agreed, AAUs were assigned by the As discussed above, the regulator, or any stakeholder can regulator (the COP) at a MV=1 (that is representing the set a MV. It is an important value as it provides the probability of representing a reduction, in terms of credibility of the GHG market, which is purely regulatory in probabilities defined above). However, the as nature, and therefore needs a license to operate. circumstances changed, and “hot air” emerged as an The tendency of the regulator is to set (assume) a issue, the MV of an AAU from the former Eastern Block CV=MV=1. As long as this equation holds true, the GHG was seen as less than 1, and less than the MV of a market will maintain credibility, and will be allowed to Japanese or NZ AAU. function. This is a relative and judgmental value, but there was a Once the set CV is different from the generally accepted clear differentiation that emerged. AAUs from one MV, then the market losses credibility, and is under jurisdiction were seen as representing a high probability of Annexure “A” 36 pressure to introduce measures to address the situation. illustration purposes, currently a CDM project is deemed to A few examples can illustrate this type of situation. be additional (and meet the rest of the regulatory cycle). In the case that project is deemed additional a CER is When KP was signed, the COP, as a regulator, saw AAUs issued. If not there is no issuance. as having as MV=CV=1. Stakeholders initially accepted this MV. However, as soon as significant amounts of “hot The reality is that as a counterfactual argument, a project air” starting to emerge in Russia, Ukraine, etc. perception can never be said with 100% certainty to be additional or of AAU having a MV less than 1 became prevalent. not. As such, an alternative approach would be to assign it However, the CV of the AAUs was maintained at 1 for KP a risk-adjusted value (between 0% and 100%). This compliance, which led to a loss of credibility of AAUs (the would be an approach more in line with the realities of the ones available on the market were from former Eastern how credits are created and the MV of a unit of reduction. Block countries) as a trading for compliance unit, while maintaining its accounting function. Financial value. This is the value that the market place assigns to a compliance unit, and will be dependent on a This situation eventually led to pressure to “do something” number of issues, including demand/supply balance, about surplus AAUs. That pressure materialized in Doha, market liquidity of the product, etc. However, the FV is when provisions were introduced to eliminate the surplus likely to be dependent on the MV as well as the perceived AAU in the SCP of the KP. relationship between the Mitigation Value and the Compliance Value. The FV is a function of the MV in two The EU ETS finds itself in a situation that is not dissimilar. ways. Firstly, if the CV=MV then the market will pay There is currently a huge surplus of EUAs primarily due to accordingly, 1 or less than 1. Alternatively, if there is a the economic recession (could be seen as EU ETS “hot discrepancy between the determined MV, and assigned air”). This has led the MV of the EUA to be seen as less CV, this leads to the expectation of a regulatory than it assigned CV, resulting in efforts to address the intervention, with implications for its FV. situation in an ad-hoc manner through back loading, and through the MSR, on a more permanent and predictable While market actors set the FV in the marketplace, it is by basis. no means a rare occurrence to have legislation of regulation or legislation interfere in setting a FV. One aspect that needs to be highlighted is the fact that the MV and CV of units, can be binary or risk adjusted. For Annexure “B” 37 ANNEXURE “B” This Annexure sets out the findings of the earlier o there should be encouragement for multiplicity of discussion paper titled “Designing a Model for Networked MV raters; Carbon Markets”, which draw on the examination of three o ‘issuer pays’ problems should be avoided – comparable financial markets, namely the bond/debt payment for MV ratings should be structured to market; the foreign exchange market; and physical foster desired policy outcomes, rather than commodities markets. offering excessive arbitrage opportunities; Section 4: NCM model, as a focus for  the NCM model should be flexible enough to allow for policy adjustment, in other words, to allow for the further discussion management of the supply of carbon assets in the market to ensure policy goals, just as is the case with [55] To summarise points/issues elicited from the monetary policy. In this respect, the proposed foregoing, for the purpose of proposing elements of a International Carbon Asset Reserve is relevant, but model: how should it intervene in the market? Under what conditions?  Trading should be on an exchange, as opposed to OTC, through a central clearing counterparty model;  In terms of the trading mechanism, is it to be an exchange mechanism (i.e., based on an exchange of  Rating: carbon assets between the schemes) or a price mechanism? o MV rating will be of the jurisdiction overall; o under an exchange mechanism, since carbon o however, at the beginning, there will also need to assets move in both directions, the asset be an evaluation made of the carbon asset and holdings of each scheme should be the same trading scheme53 to assess whether electronic immediately after the transaction as before. trading architecture can be applied to it – that is, Query the effect on the MV ratings of the whether the carbon assets under different jurisdictions engaged in such exchange? Also schemes can be described or expressed in query what the effect is when the MV ratings of terms of trading attributes in such an architecture. those jurisdictions fluctuate up or down As this involves costs, a preliminary question is subsequently: does that affect the rate at which whether it can be demonstrated empirically that those assets may be traded in the future? price dislocations exist in the market as it stands, that warrant development of the architecture. In o under the price mechanism, the movement of other words, is there a demand for NCM that will carbon assets is in one direction only. Hence, justify the cost of this work? immediately after the transaction, the asset holding of one scheme will be less, and the o MV rating is expressed as an opinion – what level holding of the other scheme more, than before of confidence will need to be attached to the the transaction. Will this be material to the MV opinion to make it acceptable to the market? rating of those jurisdictions? o MV rating is relative – as between schemes this o there is also the possibility of the exchange is acceptable, but query need also to be against mechanism being via a ‘vehicle’ carbon asset – an empirical standard – and , if so, what is that would this be useful? standard?  MV rating should be based on a broad range of o MV rating should be capable of applying at any factors, being broader than the concept of jurisdictional level, that is, national, provincial, “creditworthiness”, more akin to FX rate setting, and local; it should be possible to have an MV rating equally dynamic. As market confidence/sentiment of a jurisdiction irrespective of whether it engages derives from the MV rating, this process should be in NCM trading able to withstand rigorous scrutiny;  MV raters:  Pegging of MV ratings – would this be possible? o should be subject to regulatory supervision; Desirable? What purpose would it serve? o rating methodologies should be accredited by the  Market participants should include not only entities supervisory body and transparent; under the trading schemes, but also market makers 53 Some of the issues that might arise in this context surrendered under one scheme or another (annual?); include banking and borrowing; grandfathering; the length whether carbon assets based on allowances should be of time a carbon asset can be held before it must be fully fungible with carbon assets based on project credits. Annexure “B” 38 and other investors (the application of KYC, anti-fraud (iii) it will be relative to the MV ratings of other and AML protocols being implicit); jurisdictions;  Trading contract wording should be standardised (e.g. (iv) the MV rating, or exchange rate, may be relative as ISDA); between jurisdictions and their respective carbon assets, however, ultimately there needs to be an  If it transpires that the carbon assets under different empirical standard against which they would be schemes cannot be described or expressed in terms measured to impart sufficient confidence to the of trading attributes in an electronic trading market and regulators. The ‘value’ in carbon assets architecture, such as FpML or FIX, it may be possible comes from the degree of confidence there is that the to define standardised grades of asset which can. reductions are being made, that the scheme is enforced so that the cap on a participant’s permitted Proposal for a model: emissions is not exceeded, that emissions permitted under the scheme will gradually be reduced and that [56] Elements of the proposed model might include: the scheme will continue to be operated, managed  the MV rating and an empirical reference standard; and policed appropriately throughout its anticipated lifetime;  the MV raters; (v) for illustration, two suggestions as a way to determine  Regulatory supervision; an empirical reference standard (the “Standard”) against which MV ratings, and hence the value of  carbon asset characterization; carbon assets, might be judged are:  the Trading mechanism; firstly:  infrastructure; and o based on international consensus to limit temperature increase to 2o C, which in turn  institutions. translates into a specified level of global emissions per year (annual global emission cap); 1. The MV rating and an empirical o the annual global emission cap is allocated on a reference standard: per capita basis to give annual nation state emission caps (the per capita approach accords [57] The MV rating lies at the heart of the NCM idea. The with various UN principles on equality and MV rating is a rating of the jurisdiction within which the objections can be offset by dropping the historical carbon trading scheme is located. The jurisdiction issuing emissions argument from the debate); the carbon asset is evaluated as a whole, in terms of the mitigation value of the P&Ms – including the trading o the ‘value’ is self-evident: scientists say that the scheme which generates the carbon assets – it has in 2o C cap is the level necessary to avoid serious place to mitigate emissions from within its boundaries. climate disruption; Factors taken into account might include the profile of its economy, levels of production, levels of emissions, level of OR alternatively, ambition in setting targets to mitigate those emissions and so on. A broad range of factors.  annual nation state emission caps are based on a country’s INDC (this might risk being considered as [58] The task of devising frameworks and methodologies being too imprecise/susceptible to manipulation, and for assessing MV is beyond the scope of this paper. For so as having less ‘value’, by the financial markets, on the purpose of this paper, it is assumed simply that there the basis of the proposition that the ‘value’ of the will be an MV rating. In terms of proposing a model for asset is what ultimately drives market sentiment – NCM, however, some further thoughts about the nature of confidence that what is being purchased has a value MV ratings are as follows: that will be honoured); [Author note: these early ‘thoughts’ should be (vi) if the Standard were to be based on either of the two distinguished from the discussion of the carbon alternative approaches outlined above, then clearly, assets having ‘Compliance Value’ and ‘Financial each nation state could have an MV rating. If the Value’ cf AM’s paper] jurisdiction that housed the trading scheme were sub- national – provincial or local – then the MV rating (i) the MV rating is of the jurisdiction as a whole; by this methodology would need to be able to provide a it is meant, the jurisdiction in which the trading rating at that sub-national level as a subset of the scheme operates – hence, if the scheme operates at national MV rating. This would be analogous to the a provincial level, then the MV rating is of the way in which credit ratings can be made at sovereign, provincial jurisdiction; provincial, or municipal levels of government. The MV rating of the sub-national jurisdiction would contribute (ii) the MV rating will translate into the rate of exchange, to/be considered in reaching the MV rating of the or the price, or the ratio, at which a carbon asset national jurisdiction overall [or probably vice versa]; generated by the trading scheme in that jurisdiction, will be exchanged or purchased; (vii) being the result of a large suite of variables, it is envisaged that the MV rating will be dynamic in Annexure “B” 39 nature, more akin to the daily rate settings of relation to the Share of Proceeds levies for administrative currencies for FX, in its fluctuations, than to the expenses and adaptation. possibly longer timeframe settings of credit ratings; [64] [For example, in the case of NCM, any number of MV (viii) an MV rating could be ascribed to a jurisdiction, at raters could quote a particular rate (e.g. for Korean ETS-v- any time, even without the jurisdiction opting into EUETS). The pool of funds generated by transactions NCM. While the MV rating translates to an exchange Korean ETS/EUETS would then be shared between them, rate, or ratio, of a carbon asset and be dynamic and except for outliers e.g. those MV raters whose quoted subject to [daily/regular] fluctuations, in practice it will rates differ by more than a specified percentage from the only be specifically relevant [in terms of its [mean/mode/median?] of quotes. This could encourage compliance value] at the time the carbon asset is rate setting towards a norm, avoiding more extreme surrendered or cancelled for compliance purposes, [or assessments skewing the MV rating, and generate greater possibly also when it expires due to effluxion of time confidence in the rate applied. In cases where an MV in accordance with the rules of the scheme by which it rating is made for a jurisdiction, but it is not engaging in was created]. NCM trading, there could be an alternative mechanism, for example, a fixed amount payment, from the pool.] [needs 2. The MV raters more consideration] [59] There are a number of types of organizations that 3. Regulatory Supervision might serve as possible models for the MV raters: Designated Operational Entities (DOEs) under the Kyoto [65] Oversight of the MV raters might be exercised by the Protocol; credit rating agencies; global consulting firms UNFCCC/COP through [a constituted body under a new [such as PwC or KPMG??]; environmental economics protocol, possibly structured along similar lines to the consultancies [??]. CDM Executive Board]. As noted above, they would be recognized as MV raters if they satisfy minimum criteria, [60] The nature of the activity suggests that a cross for example, in terms of technical and financial capacity; in between a DOE and a credit rating agency might produce terms of access to resources, knowledge base, systems an entity with the right mix of skills, resources and and personnel, training, etc. The supervisory body might expertise. also specify methodologies, criteria, etc, to be applied, factors to be considered in carrying out the ratings. [61] The MV raters should be independent, private sector Alternatively, the MV raters might submit what they organizations, subject to regulatory supervision. The proposed as their methodologies, criteria to be applied, actual entities deemed suitable to provide MV ratings will factors to be taken into account, to the supervisory body be a matter for the supervisory body. This will be an for certification, the supervisory body having published important function, in view of the importance of the role guidelines on what criteria it would apply in making that performed by these entities, although it will be important decision. not to elevate them to the special quasi-regulatory status which has been afforded credit rating agencies, leading to [66] The methodologies should be transparent, for some of the problems identified in the fall out from the example, by being made publicly available (at least to global financial crisis. One way to address this issue would some degree which also takes in account commercial be to encourage a significant number of organizations to confidentiality issues to the extent relevant). As noted seek recognition as an MV rater. Greater numbers would earlier, the EU Regulation on Credit Rating Agencies operate against a small number having dominance in the might serve as a model. market as well as offering other benefits, such as better, more diverse scrutiny and evaluation of jurisdictions’ 4. Carbon asset characterization mitigation efforts, the trading schemes and carbon assets. [67] How should carbon assets be characterised for the [62] How many entities are deemed suitable, in the end, purposes of NCM? In one sense, they are more like a will be up to the supervisory body (see paragraphs [65] currency: the value derives from the integrity of the and [66] following). The entities seeking to be recognized scheme that stands behind them. In another sense, they as MV raters should satisfy minimum criteria, for example, are more like debt securities or physical commodities: in terms of technical and financial capacity; in terms of ultimately, the contract they represent needs to be access to resources, governance, knowledge base, honoured – there needs to be a mitigation of carbon systems and personnel, training, etc. The methodologies emissions, tonnes of CO2-eq not emitted or sequestered applied by the MV raters should be accredited by the from the atmosphere – they need to be surrendered or supervisory body and should be transparent – for cancelled against the compliance obligation of a regulated instance, by being publicly available (at least to some entity. degree which also takes in account commercial confidentiality issues to the extent relevant). [68] Carbon assets cannot be characterized as falling neatly into one or another financial market model. They [63] How the MV raters are remunerated for providing the have characteristics of all three considered. More MV ratings should be structured to foster the desired important, perhaps, is whether the electronic trading policy outcomes, rather than offering excessive arbitrage architecture can be applied to them: whether the carbon opportunities for parties. One possibility might be for assets under different schemes can be described or payment setting to be based on a small levy on the expressed in terms of trading attributes in such an transactions arising from NCM trading. This idea of a architecture. This will determine the extent to which they transaction levy has already been applied in the CDM in are fungible. Annexure “B” 40 5. Trading mechanism exchanges spread globally but linked electronically, will probably depend on the size of the NCM market. The [69] How will trading take place? Is the trading mechanism exchange (or exchanges) will perform settlement and an exchange mechanism (i.e., based on an exchange of clearing and should be linked electronically to registries in carbon assets between the schemes) or a price the jurisdictions that have opted into the NCM, either mechanism? directly or through a central registry such as, or modeled on, the ITL. [70] Under an exchange mechanism, since carbon assets [75] The exchanges and the brokers would all be move in both directions, the asset holdings of each regulated under applicable financial regulatory provisions. scheme should be the same immediately after the Whether all trading contracts for carbon assets would be transaction as before. However, what might be the effect regulated as financial instruments, or whether financial on the MV ratings of the jurisdictions engaged in such regulation would only apply to derivatives contracts, would exchange? Also query what the effect is when the MV need to be resolved, in the context of developments in ratings of those jurisdictions fluctuate up or down financial regulation. subsequently: does that affect the rate at which those 6. Infrastructure assets may be traded in the future? [NB: this does not yet address the CV that might be attached by each [76] Will the carbon assets across all the heterogeneous jurisdiction to the exchanged assets, or what trading schemes be fungible and, if so, to what extent? To answer this question, the different schemes need to be implications there may be for the MV rating of each evaluated to see whether an electronic trading architecture jurisdiction by such determinations] can be applied to them: whether the carbon assets under those different schemes can be described or expressed in [71] Under a price mechanism, the movement of carbon terms of trading attributes in such an architecture. assets is in one direction only. Hence, immediately after Standardised contract wording will be required for the transaction, the asset holding of one scheme will be transactions involving those assets which do fit within the less and the holding of the other scheme more, than trading architecture. The other infrastructure required before the transaction. [Also query whether this change in comprises the electronic links between exchanges (if more asset holdings will be material to the MV rating of the than one) and between the exchange(s) and registries, or the ITL-type central registry (if it is decided to establish jurisdiction] one). [There would be a need to develop cross-border [72] There is also the possibility of the exchange [trading] rules and a crossing-platform.] mechanism being via a ‘vehicle’ carbon asset. Further consideration needs to be given as to whether this might 7. Institutions be useful or desirable in the NCM context. However, what [77] As noted above, a supervisory body to recognise MV does seem clear is that the ‘vehicle’ carbon asset would raters and accredit their MV rating methodologies should need to be from a jurisdiction with a large over-supply for be set up and the proposal is that this be done by the there to be sufficient carbon assets available at any time UNFCCC/COP [as a constituted body under a new to perform this role. They would also need to have a protocol, possibly structured along similar lines to the reliably stable MV rating. [At this stage, it’s hard to see CDM Executive Board]. what benefit there would be for any jurisdiction to have its carbon assets used in this capacity, however this issue [78] Whether an International Settlement Platform needs might still be researched further.] to be established as a central clearing and settlement institution is an open question. A determination would [73] In the absence of a primary transaction, such as an need to be made whether it may be simpler and more international trading transaction in the case of FX, efficient to engage with existing exchanges – the majority necessitating an exchange mechanism for carbon assets, of which do not have international reach – or create a new a price mechanism seems simpler and more efficient. As dedicated platform to clear trades via existing clearing the carbon assets will move only in one direction, there will bodies. be half the administrative adjustments in registries that would be required by the exchange mechanism. This may [79] Whatever approach is taken to the exchange(s), they not be a significant issue in an electronic age, will need to be linked to the registries operated by the nevertheless, less administration would mean less costs. different trading schemes. In this context, it may be decided to establish a further institution in the form of a [74] Trading should be through an exchange, with a central registry, modeled along the lines of the ITL [or just central clearing counterparty to reduce counterparty use the ITL]. This institution would then have links to each default risk. There should be standardized wording for of the registries in the different schemes. trading contracts used globally, with schedules attached according to which carbon asset was being traded into [80] The importance of NCM to global efforts to mitigate which other trading scheme. Parties wishing to trade the effects of climate change may be considered such as should do so through brokers registered with the to warrant the establishment of dedicated institutions as exchange (and it is implicit that appropriate KYC, anti- an exchange and as a central registry. If this were the fraud and AML protocols would be applied). Whether there case, then it would be more efficient for these functions to is a single exchange, in the form of the proposed be carried out by the same institution. International Settlement Platform, or a number of Annexure “B” 41 [81] The NCM proposals include the establishment of the might intervene in the market are matters for further International Carbon Asset Reserve which, as considered consideration beyond the scope of this paper. above, would perform a role analogous to that which ANNEXURE “C” central banks have in applying monetary policy. How the ICAR would be established and how, when and why it Annexure “C” 42 ANNEXURE “C” A glossary of key definitions is proposed as follows: *NB: initials signify source Concept/expression Definition Explanatory Notes /term administrator or JDM*: the legal entity that operates, manages JDM: will most usually be an arm of regulator and has the legal power to enforce compliance government in the jurisdiction where the with an ETS or cap-and-trade scheme scheme operates allowances JDM: means a carbon asset that is: JDM: Usually measured in base units of a o usually issued (either free or by tonne carbon dioxide equivalent auction) by a compliance scheme greenhouse gas (CO2-eq GHG), whereby administrator to scheme participants Global Warming Potentials of other GHGs (‘compliance entities’) – entities are used to give the equivalent number of emitting GHGs who have obligations tonnes of CO2, and GWP CO2 = 1 under the scheme to mitigate their emissions; o compliance entities will be required to surrender allowances equivalent to their GHG emissions for the compliance periods determined under the scheme (e.g. annually); baseline JDM: the emissions scenario that exists in the JDM: the starting point for measurement of absence of the PPP the MV of a PPP business-as-usual JDM: the level of emissions that will occur if no JDM: also can be the baseline against (BAU) scenario mitigation action is taken which to measure mitigation performance cap-and-trade JDM: an emissions mitigation scheme in which JDM: caps are reduced over time to send a regulated entities’ emissions are capped; they price signal to the regulated entities as to must surrender carbon assets against actual when abatement is cheaper than paying emissions; can trade units of carbon assets: for more carbon assets selling if emissions below cap, buying if their emissions exceed cap carbon asset JDM: An instrument generated as part of a BS: carbon assets include: scheme, project or program the purpose of  ETS allowances which is mitigation of carbon emissions. In some jurisdictions, the legal system may  INDC units classify a carbon asset as a ‘chose in action’,  Credits/offsets meaning that it confers a right enforceable at law. May be classified also as a ‘financial JDM: carbon assets will be issued as part instrument’, depending on application financial of a scheme that allows for trading in those regulations in the particular jurisdiction. assets, so that entities with compliance Usually measured in base units of a tonne obligations can buy assets to make up any carbon dioxide equivalent greenhouse gas shortfall for compliance purposes, or sell (CO2-eq GHG), whereby Global Warming any assets that are surplus to Potentials of other GHGs are used to give the requirements, to derive a financial gain equivalent number of tonnes of CO2, and GWP from having emissions below their limit CO2 = 1 Annexure “C” 43 Can take the form of an ‘allowance’ or a ‘credit/offset’:  Allowances: o are usually issued (either free or by auction) by a compliance scheme administrator to scheme participants (‘compliance entities’) – entities emitting GHGs who have obligations under the scheme to mitigate their emissions; o compliance entities will be required to surrender allowances equivalent to their GHG emissions for the compliance periods determined under the scheme (e.g. annually);  credits/offsets: o are generated by projects which avoid or reduce emissions that would otherwise occur, or which sequester GHGs from the atmosphere, in both cases, compared to a baseline; o need to be real, measurable and verifiable, as well as additional to BAU; o can be surrendered on a voluntary basis, by entities that do not have compliance obligations; depending on the rules of the relevant compliance scheme, may also be able to be surrendered in respect of compliance obligations; carbon asset JDM: the rate, or ratio, at which a carbon asset JDM: the exchange rate may not exist as a exchange rate generated under a scheme in one jurisdiction separately defined metric, but rather simply concept yet to be might be traded into a scheme in another be the price agreed by parties to a tested for feasibility jurisdiction transaction, as informed by the MVs of the respective jurisdictions carbon integrity risk AM: the risk that a PPP will achieve its IISD: CI risks are: characterization; concept yet to be intended outcome; governance and management; GHG tested for feasibility IISD: the risk that emission reductions or assessment boundary; GHG estimation; removals reported for a PPP actually occurred GHG monitoring; reporting and are attributable to the interventions implemented as part of it; IISD: the risk that reductions or removals resulting from a PPP are not (i) real, measurable and verifiable and additional to what would have occurred in their absence; or not (ii) real, permanent, additional, verified, avoid double counting and achieve net decrease and/or avoidance of GHGs to preserve environmental integrity; central counterparty Federal Reserve, Chicago: a process by which UNK: clearing denotes all activities from clearing financial transactions are cleared by a single the time a commitment is made for a (i.e., "central") counterparty who interposes transaction until it is settled. Clearing of payments is necessary to turn the promise itself between contract parties to become of payment into actual movement of money buyer to every seller and seller to every buyer from one bank to another. In trading, Annexure “C” 44 clearing is necessary because the speed of trades is much faster than the time for completing the underlying transaction. It involves the management of post-trading, pre-settlement credit exposures to ensure that trades are settled in accordance with market rules (even if a buyer or seller should become insolvent prior to settlement). Processes included in clearing are reporting, monitoring, risk margining, netting of trades to single positions, tax management and failure risk management. clearinghouse UNK: a financial institution that provides clearing and settlement services for financial transactions compliance value JDM: the value ascribed by the JDM: if the carbon asset has been issued (CV) administrator/regulator of an ETS, to a unit of a by the administrator under that scheme, it concept yet to be carbon asset, at the time it is surrendered for would usually be given a value CV=1; if the tested for feasibility compliance purposes under that ETS carbon asset has been issued under the scheme of another jurisdiction, the administrator might be guided by the MV of that other jurisdiction in ascribing a CV to that scheme’s carbon asset at the time of surrender credit JDM: means a carbon asset which is: JDM: Usually, but not necessarily, o generated by projects which avoid or measured in base units of a tonne carbon reduce emissions that would dioxide equivalent greenhouse gas (CO2- otherwise occur, or which sequester eq GHG), whereby Global Warming GHGs from the atmosphere, in both Potentials of other GHGs are used to give cases, compared to a baseline; the equivalent number of tonnes of CO2, o need to be real, measurable and and GWP CO2 = 1 verifiable, as well as additional to BAU; o can be surrendered on a voluntary basis, by entities that do not have compliance obligations; depending on the rules of the relevant compliance scheme, may also be able to be surrendered in respect of compliance obligations; emissions trading JDM: an emissions mitigation scheme, that scheme (ETS) usually operates as a cap-and-trade scheme exchange JDM: a central location bringing together JDM: can be either physical location or brokers and dealers/traders in commodities or electronic location financial instruments financial value (FV) JDM: the price a buyer is willing to pay for a JDM: will depend on a number of market unit of a carbon asset factors, including demand and supply, market liquidity, and depth of the market; will also be influenced by the carbon asset exchange rate between the relevant jurisdictions Intended Nationally UNFCCC: national statement to be made by Determined UNFCCC Parties setting out their mitigation Contributions (INDC) goal which eventually can be transformed into Annexure “C” 45 a legally binding commitment, must be transparent, quantifiable, comparable, verifiable and ambitious, reflecting the principles of Art.s 4.1 and 4.2 re national circumstances, etc INDC unit JDM: carbon asset generated by an ETS introduced as part of the PPPs established by a country’s INDC Index UNK: statistical composite that measures UNK: each index has its own method of (NB feasibility of changes in the economy or a financial market, calculation; components may be weighted using an Index often expressed as changes from a base year according to certain characteristics, e.g., considered in Section or a preceding month. stock index weighted for market cap 6) International JDM: The unit of a ‘transaction currency’ JDM: a large number of issues need to be Transaction Unit introduced for the purpose of facilitating trading considered before a more definitive between schemes in diverse, heterogeneous definition can be settled: see Section 7. jurisdictions. jurisdiction JDM: means the relevant level of government, JDM: although some sub-national ETS are which may be national or sub-national; to be a applied at provincial level, while others are jurisdiction there needs to be clear legislative at city or local level, these distinctions are and administrative control exercised over a unhelpful as not all countries apply geographic area with clearly defined and province/city/ municipal distinctions in the accepted boundaries same way level of ambition JDM: the intended target level of mitigation, JDM: each individual PPP may also have sought to be achieved by all the PPPs its own intended target level of mitigation, implemented, as stated by a jurisdiction; for so query whether the ‘level of ambition’ UNFCCC Parties is a component of their concept should/could also be applied to INDC, which eventually can be transformed each PPP? into a legally binding commitment mitigation UNFCCC: means stabilising GHG UNFCCC: can be achieved in two ways: (i) concentrations in the atmosphere at a level limiting or reducing anthropogenic GHG that would prevent dangerous anthropogenic emissions by sources to the atmosphere, interference with the climate system, which is or (ii) preserving or enhancing sinks or the ultimate objective of the UNFCCC reservoirs of GHGs mitigation value (MV) JDM: a relative measure, as between JDM: level of performance in carrying out concept yet to be jurisdictions, of the effectiveness of their mitigation actions might also be compared tested for feasibility emission reduction programs in ‘mitigating’, against jurisdiction’s ‘level of ambition’ and which takes account of their respective level of ambition assessed in terms of its jurisdictional ‘circumstances’ adequacy mitigation value JDM: the numeric outcome of the mitigation JDM: methodology yet to be derived outcome value assessment process, which may concept yet to be evaluate a jurisdiction relative to other tested for feasibility jurisdictions, but may also provide an assessment of mitigation actions against the jurisdiction’s ‘level of ambition’, and assess the level of ambition in terms of its adequacy in global terms mitigation value JDM: an entity accredited or otherwise JDM: entities so accredited will satisfy a assessment agency sanctioned, by the appropriate authority, to suite of criteria, as will the methodologies carry out and publish assessments of applied by them; Annexure “C” 46 concept yet to be jurisdictions’ performances in carrying out tested for feasibility mitigation Networked Carbon JDM: WBG initiative, inter alia, to facilitate Markets (NCM) fungibility of carbon assets between initiative heterogeneous efforts to mitigate GHG emissions offset JDM: same as a credit programs, policies JDM: means the policies, programs and and pledges (PPP) pledges put in place by a jurisdiction to mitigate its GHG emissions settlement JDM: delivery of the transacted financial JDM: settlement comprises the ‘physical instrument (carbon asset) against payment, settlement’ (delivery) and the ‘financial usually simultaneously, and otherwise in settlement’ (the payment against delivery) accordance with the counterparties’ contractual agreement settlement platform JDM: similar to a clearinghouse, a financial JDM: these days the functions of institution that performs the role of central exchange, settlement platform and central clearing counterparty so as to minimise clearing counterparty might be bundled up transactional risk of counterparty failure into a single financial institution [TBC] unit of measurement JDM: the base unit in which a carbon asset is JDM: most often, a tonne carbon dioxide measured, or in which emissions are equivalent greenhouse gas (CO2-eq GHG), measured whereby Global Warming Potentials of other GHGs are used to give the equivalent number of tonnes of CO2, and GWP CO2 = 1 Annexure “D” 47 ANNEXURE “D” This Annexure sets out three example NCM transaction scenarios:  the Foreign Unit converted model  the Foreign Unit imported model  the International Transaction Unit model Example NCM transaction scenario: Foreign Unit conversion model Jurisdiction A Jurisdiction B MV = A MV = B Trades A units Trades B units Compliance entity A wishes to sell 12000 A units to Compliance entity B wishes to buy 12000 A units from Compliance entity B Compliance entity A On xx/yy/zz date: e.g., MV A/B translates into an exchange rate of 0.67 (that is, 1.5 A units = 1 B unit) 12,000 A units debited Compliance entity A’s account in 8,000 B units credited Compliance entity B’s account in B A registry registry Transaction: Compliance value:  The respective MVs of the two jurisdictions translate  Jurisdiction A regulator/scheme administrator into an exchange rate between them (how this is determines the CV of A units worked out will be critical, but assume for purpose of this example it can be)  Jurisdiction B regulator/scheme administrator determines the CV of B units  The counterparties agree how many of the seller’s carbon units they wish to transact  CV doesn’t come into the transaction equation, because the units surrendered against compliance in  The applicable exchange rate, on the date of the any jurisdiction will always only ever be the domestic transaction, determines the number of carbon units units of that jurisdiction that are credited to the buyer’s account in the buyer’s registry in the carbon units of the buyer’s jurisdiction: Financial value: the regulator/scheme administrator in Jurisdiction B The price reached by Seller A and Buyer B will be cancels the 12000 A units received in the registry substantially influenced by the exchange rate on the account and issues in their place 8000 B units date of the transaction, as in effect, this will determine  The transacted number of seller’s carbon units are the compliance value debited from the seller’s account in the seller’s  As the exchange rate derives from the respective registry: regulator/scheme administrator in Jurisdiction MVs, the price should be a reflection of the relative A doesn’t need to do anything after the 12000 A units MVs of the two jurisdictions. have been transferred out of the A registry account Annexure “D” 48 Example NCM transaction scenario: Foreign Unit imported model Jurisdiction A Jurisdiction B MV = A MV = B Trades A units Trades B units Compliance entity A wishes to sell 12000 A units to Compliance entity B wishes to buy 12000 A units Compliance entity B from Compliance entity A On xx/yy/zz date: e.g., MV A/B translates into an exchange rate of 0.67 (that is, 1.5 A units = 1 B unit) 12,000 A units debited Compliance entity A’s account 12,000 A units credited Compliance entity B’s in A registry account in B registry  Jurisdiction A regulator/scheme administrator Transaction: determines the CV of A units  The respective MVs of the two jurisdictions translate into an exchange rate between them (how this is  Jurisdiction B regulator/scheme administrator worked out will be critical, but assume for purpose of determines the CV of B units this example it can be)  CV becomes relevant on the date [aa/bb/cc] that  The counterparties agree how many of the seller’s Compliance entity (buyer) B wishes to surrender them carbon units they wish to transact to the Jurisdiction B regulator/scheme administrator against compliance obligations under Jurisdiction B  The applicable exchange rate, on the date of the ETS. On that date, Jurisdiction B regulator/scheme transaction, is immaterial to the transaction as the administrator determines what CV to give to the number of carbon units that are credited to the Jurisdiction A units. If the exchange rate has changed buyer’s account in the buyer’s registry are the same between the dates, xx/yy/zz and aa/bb/cc, then the as the number debited from the seller’s account in the CV Buyer B gets for the 12,000 A units on aa/bb/cc seller’s registry: the regulator/scheme administrator in may be different from that which would have applied Jurisdiction B by agreement with Jurisdiction A, on xx/yy/zz. Buyer B carries that risk. accepts A units and credits the 12000 A units received in the registry account to Compliance entity Financial value: (buyer) B  The price reached by Seller A and Buyer B will be  The transacted number of seller’s carbon units are influenced by the exchange rate on the date of the debited from the seller’s account in the seller’s transaction, but only to the extent that: (a) the registry: regulator/scheme administrator in Jurisdiction exchange rate is relevant to the CV on that date, A doesn’t need to do anything after the 12000 A units which may be a function of the NCM arrangements, have been transferred out of the A registry account e.g., might be exchange rate on date of transfer converts directly to CV, or alternatively, might be left up to Jurisdiction B regulator/ scheme administrator; and (b) the surrender date for compliance in Jurisdictional B is proximate to the transaction date. Compliance value: Annexure “D” 49 Example NCM transaction scenario: International Transaction Unit ‘transaction currency’ model Index (‘II’) based on e.g., all MVs of Jurisdiction A trading jurisdictions; Index has notional Jurisdiction B International Transaction Units (ITU) MV = A MV = B Trades A units Trades B units Compliance entity B wishes to buy Compliance entity A wishes to sell 12000 A units from Compliance 12000 A units to Compliance entity B entity A On xx/yy/zz date: e.g., MV A/II translates into an exchange rate of 0.67 (that is, 1.5 A units = 1 ITU) 12,000 A units debited Compliance 8,000 ITUs held in Seller A’s pending entity A’s account in registry A account on International Settlement Platform 8,000 ITUs transferred from Seller A’s pending account to Buyer B’s pending account e.g., MV II/B translates into an exchange rate 1.2 (that is, 0.8 ITUs = 1 B unit) 10,000 B units credited Compliance entity B’s account in registry B  Jurisdiction B regulator/scheme administrator Transaction: determines the CV of B units;  The respective MVs of the two jurisdictions translate into an exchange rate between each of them  CV doesn’t come into the transaction equation, respectively and the Index (how this is worked out will because the units surrendered against compliance in be critical, but assume for purpose of this example it any jurisdiction will always only ever be the domestic can be) units of that jurisdiction.  The counterparties agree how many of the Seller A’s Financial value: carbon units they wish to transact;  The price reached by Seller A and Buyer B should be  The applicable exchange rate A/II, on the date of the substantially influenced by the two exchange rates transaction, determines the number of ITUs that are applicable on the date of the transaction, as in effect, credited to the Seller A’s pending account on the this will determine the number of B units received by International Settlement Platform; B;  On financial settlement, the ITUs in Seller A’s pending  As the exchange rates derive from the respective account are transferred to Buyer B’s pending account; MVs in relation to the Index, the price should be a reflection of the relative MVs of the two jurisdictions to  The applicable exchange rate II/B, on the date of the Index and ultimately, to each other; transaction (or on whichever date Buyer B decides to move them from its International Settlement Platform  However, nothing above prevents the Buyer B from pending account to its account in registry B), speculating on an improvement of the exchange rate determines the number of B units that are credited to II/B, by continuing to hold the ITUs in its pending the Buyer B’s account in registry B. account and only transferring them to its account in registry B as B units, when that more favourable rate Compliance value: applies or when it absolutely needs to, e.g., for compliance reasons. This would not impact in any  Jurisdiction A regulator/scheme administrator way on the other elements, such as the CV, since it determines the CV of A units; would just be the number of B units received in the B Annexure “D” 50 registry that might vary. The ITUs held in this way in the pending account would only be able to be converted into B units.