INFORMATION PAPER Defining Results-Based Climate Finance, Voluntary Carbon Markets and Compliance Carbon Markets © 2022 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of the World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of the World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Design and copyediting by Clarity Global Strategic Communications TABLE OF CONTENTS Acknowledgments 2 Glossary 3 Introduction 4 Results-Based Climate Finance 5 Voluntary Carbon Markets 7 Compliance Carbon Markets 8 Linkages between Voluntary and Compliance Carbon Markets 9 I N F O R M AT I O N PA P E R S 11 ACKNOWLEDGMENTS This paper has been jointly developed by the Carbon Markets and Innovation (SCCMI) and the Climate Funds Management (SCCFM) teams of the World Bank. This information paper seeks to distinguish across different types of payments provided against emission reductions by defining results-based climate finance, voluntary carbon markets, and compliance carbon markets. The paper is intended to facilitate further discussion on these topics. 2 DEFINING RBCF VCM COMPLIANCE MARKE TS GLOSSARY Activity-based climate finance (ABCF): Activity-based becomes an ITMO. An ERC can be converted to an ITMO climate finance refers to climate finance that is made available through the sovereign act of authorization. prior to project implementation and is often used for meeting upfront investment costs. To date, ABCF has accounted for Mitigation Outcome (MO): Under the Paris Agreement, 95 percent of international public climate finance. a ton of CO2 reduction or removal is called a “mitigation outcome” (MO) when the reduction is quantified based on an Crediting Standards: A crediting standard outlines a set agreed methodology and independently verified. An MO is an of detailed requirements that must be met for a mitigation ERC that can be produced from any mechanism procedure, activity to generate carbon credits using that standard. These or protocol that is recognized or approved to be eligible standards are typically maintained by independent bodies under Article 6.2 of the Paris Agreement by Parties to the and are established using expert inputs. Examples include cooperative approach. the UNFCCC’s Clean Development Mechanism, the Gold Standard, Verra’s Verified Carbon Standard (VCS), and the MRV: Monitoring, Reporting, and Verification refers to the World Bank’s Forest Carbon Partnership Facility (FCPF). process of measuring the amount of greenhouse gas (GHG) emissions avoided, reduced, or removed by a specific Compliance carbon markets (CCM): Article 6 of the Paris mitigation activity over a period of time, and independently Agreement sets out the framework for the regulated or verifying the results to ensure robustness and accuracy. compliance carbon market where Internationally Transferred Mitigation Outcomes (ITMOs) are traded internationally. Nationally Determined Contribution (NDC): Under the Buyers include governments purchasing ITMOs to meet their Paris Agreement, all countries make some commitment to Nationally Determined Contributions (NDCs), as well as private reduce emissions. These commitments are voluntary and sector entities. are articulated through Nationally Determined Contributions (NDCs) submitted to the United Nations Framework Convention Corresponding Adjustment (CA): An accounting mechanism on Climate Change (UNFCCC). established under Article 6 of the Paris Agreement intended to ensure that mitigation outcomes (MOs) are not “double Registry: A platform that maintains information related to the counted”, that is, trading of MOs should not result in more than creation, transfer, use, and cancellation of ERCs to enable one country using the same MO to demonstrate achievement tracking. The level of sophistication of a registry system can of their NDCs. vary, with some serving as data repositories while others may include trading functions. Emission reduction credits (ERCs): An emission reduction credit (ERC) represents a standard unit to measure an emission Results-Based Climate Finance (RBCF): Results-based reduction equivalent to one metric ton of carbon dioxide climate finance (RBCF) is provided upon verifying achievement (tCO2e). A generic term for ERCs is a “carbon credit”. When of agreed climate results but does not involve the transfer of issued by a particular standard, an ERC becomes a named assets from the recipient project. Results could be specified unit, for example, an ERC issued under the Verified Carbon in the form of any milestone (typically verified GHG emissions Standard is called a “Verified Carbon Unit” and an ERC issued reduced or removed) that marks progress toward greater by Gold Standard is called a “Gold Standard carbon credit”. climate mitigation. Internationally Transferred Mitigation Outcomes (ITMOs): Voluntary Carbon Markets (VCM): The Voluntary Carbon The Paris Agreement sets out principles for cooperation Market (VCM) operates in parallel to compliance carbon between countries that involves the international transfer of markets. Buyers are corporates with net zero or other voluntary mitigation outcomes. When authorized by the selling country corporate commitments or pledges (i.e., emission reductions and transferred internationally to another country, an MO are not required under any regulatory mechanism). I N F O R M AT I O N PA P E R S 33 INTRODUCTION U nder the Kyoto Protocol, compliance carbon markets (CCM) were primarily in the form of the Clean Development Mechanism (CDM) and Joint Implementation (JI). In 2015, the Paris Agreement introduced a new bottom-up approach to address climate change. Under the Paris Agreement, Parties set non-binding climate targets through their nationally determined contributions (NDCs). Article 6 of the Paris Agreement recognizes cooperation among countries for achieving their NDCs and raising climate ambition. This provides the basis for international CCM, where countries can trade emission reduction (“carbon”) credits with each other. Article 9 of the Paris Agreement stipulates that developed countries shall provide resources to developing countries for climate mitigation and adaptation. Developed countries would also take the lead in mobilizing climate finance from a variety of sources that represents a progression beyond previous efforts. The objective of this information paper is to outline three avenues for monetizing climate results – results-based climate finance (RBCF), voluntary carbon markets (VCM), and CCM. The paper is intended to describe activities by non-state or private sector actors in these mechanisms, and how their participation can facilitate the achievement of climate benefits in a cost-effective manner. It is important to note that all three options for monetization discussed in this note require a robust monitoring, reporting, and verification (MRV) framework to demonstrate the achievement of emission reductions against which payments can be made. Furthermore, countries require a consistent policy approach or framework at the national level to ensure transparent and streamlined access to markets for entities operating within their respective jurisdictions and outline their preferred approach for participation in markets. 4 DEFINING RBCF VCM COMPLIANCE MARKE TS RESULTS-BASED CLIMATE FINANCE A vast majority of international public climate finance (about 95 providers of RBCF may claim a climate finance contribution percent) is provided as activity-based climate finance (ABCF). that enables the seller country to reduce emissions, while ABCF refers to climate finance that is made available early in the ownership of the ERCs themselves would remain with the project cycle, typically in the form of loans, grants, equity, the seller country and may be used toward demonstrating or guarantees. RBCF, by contrast, is only provided upon achievement of its NDC. verifying achievement of agreed climate results. Therefore, The provision of RBCF requires clear definition of the program RBCF provides an additional revenue stream for climate or project that will generate emission reductions. The payment change-related projects and can play an important role in amount against the achievement of emission reductions is incentivizing climate action, enhancing project viability, and agreed between the project developer (or recipient)3 and the catalyzing private sector investment. RBCF provider. During project preparation, the approach for Results could be specified in the form of any milestone estimating emission reductions ex-ante and arrangements for (typically, a verified GHG emission reduction) that marks monitoring and verifying them ex-post should be set out in a progress toward greater climate mitigation. In this note, we project design document. Any additional attributions that the consider RBCF payments made against the achievement of RBCF provider recognizes and means of verifying them should verified emission reductions by an identified mitigation project. also be identified and agreed. The document may then be Since RBCF is a form of climate finance, it does not involve validated by an independent third party, if requested. Validation the transfer of assets from the recipient project. In other ensures that the selected methodology4 for the estimation of words, while a project would be required to demonstrate the emission reductions has been correctly applied.5 achievement of real and additional ERCs to receive RBCF payments, ownership of the ERCs would remain with the host Once the project is commissioned and commences operation, country and would not be transferred to the RBCF provider. 1 the actual or ex-post emission reductions would be verified by They can be used towards demonstrating the achievement an independent third party. Upon submission of the verification of the host country’s NDC. 2 report confirming achievement of the desired outcomes, the RBCF payment may be released to the project. Verification Sovereign providers of RBCF to developing countries may may be carried out periodically during project operation at report RBCF as a contribution of financial resources under specified intervals, or when a sufficient volume of emission Article 9 of the Paris Agreement. RBCF may also be provided reductions has been generated.6 by private or non-state actors. In such cases, private sector 1 However, the RBCF provider may require that the project owner not sell the ERCs paid for through RBCF to a third party. 2 Host country refers to the jurisdiction in which the mitigation activity generating ERCs is located. 3 The project developer may be a state-owned entity, a private sector entity, a government ministry or department, or a sub-national government, that is responsible for implementing the project. 4 Providers of RBCF may specify requirements for methodologies – for example, they may deem certain existing methodologies eligible, or they may develop their own methodologies. Hybrid approaches are also possible, i.e., existing methodologies are used where available, and new methodologies are developed where existing methodologies are unavailable or inapplicable. 5 Validation may be followed by registration of the project by a standard. While registration is essential for carbon markets (whether voluntary or compliance), it is not necessary for RBCF. 6 The World Bank is also exploring opportunities for incorporating digital MRV, which could enable the generation of ERCs on a near real-time basis. This could create possibilities for innovative approaches for the provision of payments against ERCs. I N F O R M AT I O N PA P E R S 55 At present, RBCF is primarily made available through trust Figure 1 below describes the types of ERCs used for RBCF, funds managed by multilateral organizations. For example, VCM, and CCM. RBCF can operate in the broadest space, since the launch of its first carbon fund in 1999, the Prototype that is, it can provide payments against verified emission Carbon Fund, the World Bank has made about US$2 billion in reductions, ERCs issued by a carbon standard, or authorized emission reduction payments across 65 countries. Since their ERCs, depending on how “climate results” are defined and inception, the World Bank has managed about US$4.5 billion agreed between the provider of RBCF and the recipient. VCM (of which nearly US$1 billion was from the private sector) in typically trade issued ERCs. In addition, they can also trade the form of carbon funds that make payments against ERCs.7 authorized ERCs, depending on buyer preferences. CCM has the most narrowly defined criteria for eligible credits, focusing exclusively on the trade of authorized ERCs. FIGURE 1. Results-Based Climate Finance, Voluntary Carbon Markets, and Compliance Carbon Markets Project Preparation Project Verification Issuance Authorization Project commences Commissioning Monitoring and Process after For compliance preparation and design Project begins verification of verification by the or for defined according to the operation and leads to outcomes/units carbon standard (e.g. claim/use for the agreed standard and is emission reductions CERSs, VCUs etc.) voluntary market “Validated”/“Registered” Result-based finance space Provider of results-based finance pays for verified outcome or emission reduction credits (ERCs) following agreed methodology and MRV (which can be based on a carbon standard) Voluntary Carbon Market space Credits issued by the carbon market standard or bought/sold by the private sector. Host country engagement is not mandatory, but possible Compliance Carbon Market space (Article 6, CORSIA etc.) Credits authorized and issued by the sovereign party or by a carbon market standard recognized by the sovereign is bought/sold by compliance entities or the private sector. Credits are accompanied by Letter of Authorization committing to corresponding adjustment under Article 6. Voluntary market participants can also transact in authorized credits “labeled” for corresponding adjustment depending on the use and/or claim. Notes: • Letter of Authorization: Government authorizes the ERCs and commits to CA. • Uses and Claims/Label: “Contribution” or “support” claims by corporate or voluntary market participants. • From left to right, the figure reflects an increasing degree of oversight or regulation associated with generating an ERC. Source: World Bank 7 Historically, the World Bank’s carbon funds have engaged in a combination of payments for emission reduction results as well as purchases of ERCs that would be eligible in CCM. 6 DEFINING RBCF VCM COMPLIANCE MARKE TS VOLUNTARY CARBON MARKETS Voluntary carbon markets are driven by demand from non- Crediting standards may choose to label units to indicate state actors, such as corporations, institutions, and individuals the eligible uses or claims or highlight other key attributes.10 that wish to offset their GHG emissions or contribute to the Labeling can help distinguish among different use cases11 by reduction of GHGs within their jurisdictions. Unlike CCM, transparently listing the characteristics of units. These labels activity in VCM is not currently regulated by a state or and use cases are still evolving and are expected to become supervisory body. Therefore, demand is driven by voluntary 8 more well defined over time.12 buyers, who may have varied objectives. It may be noted that there are examples of interactions between In addition to the process followed for verifying emission voluntary and compliance carbon markets. For example, the reductions for RBCF, VCM also require certification by a voluntary offset project protocols developed by Climate Action crediting standard. Based on its processes and requirements, 9 Reserve (CAR) were subsequently adapted by the California the crediting standard body would register the project and list Compliance Offset Program. While the linkages between it in its data management system after validation, and issue global VCM and CCM under the Paris Agreement are still credits upon completion of verification. Issuance refers to a evolving, and the need for their convergence is still debated, specified quantity of serialized units of ERCs being issued to some elements will remain common between the two. project participants’ accounts in accordance with the rules Since 2019, VCM have seen rapid growth. In 2020, the total and requirements of the standard. These steps are intended value of the market tracked was $473 million, the highest to ensure that the process used for quantifying and generating annual value since 2012, bringing the cumulative market value ERCs for VCM is consistent and robust. Issued ERCs or to $6.7 billion. The volume of traded carbon credits in VCM hit carbon credits may be traded by private sector entities and record volumes of 188.2 MtCO2e in 2020, representing an 80 used to claim contribution toward the generation of emission percent increase over 2019. Market transactions in 2021 are reductions from an identified project. likely to be the highest annual value ever tracked, exceeding $1 billion in November 2021.13 8 It may be noted that multi-stakeholder groups such as the Integrity Council for Voluntary Carbon Markets (IC-VCM) and the Voluntary Carbon Markets Integrity Initiative (VCMI) are working to define supply side and demand side integrity, respectively, for voluntary carbon markets. 9 A “crediting standard” outlines a set of detailed requirements that must be met for a mitigation activity to generate ERCs against that standard. These standards are maintained by independent bodies that typically also provide GHG registry services for issuing credits. For example, Verra’s Verified Carbon Standard and the Gold Standard Foundation’s Gold Standard are among the largest standards by volume of voluntary carbon market credits issued. 10 “Attributes” may include the type of activity through which the project generates emission reductions (for example, renewable energy and forestry), the jurisdiction of origin, the sustainable development benefits associated with the project, and the approval or authorization received by a project, among others. 11 A “use case” refers to the purpose for which an ERC is used. For example, one “use case” could be to demonstrate achievement of net-zero goals by a corporation. Table 1 summarizes different use cases. 12 The World Bank, together with the International Emissions Trading Association (IETA) has convened an Informal Working Group of Independent Carbon Standards, which includes representation from American Carbon Registry, Climate Action Reserve, Gold Standard, Global Carbon Council, and Verra. The Working Group is working toward consistent terminology, processes and linkages across compliance and voluntary carbon markets, and to provide greater clarity on labels and associated claims and use cases. 13 Ecosystem Marketplace. Voluntary Carbon Markets Top $1 Billion in 2021 with Newly Reported Trades, a Special Ecosystem Marketplace COP26 Bulletin. November 10, 2021, https://www.ecosystemmarketplace.com/articles/voluntary-carbon-markets-top-1-billion-in-2021-with- newly-reported-trades-special-ecosystem-marketplace-cop26-bulletin/ I N F O R M AT I O N PA P E R S 77 FIGURE 2. International Carbon Markets VOLUNTARY CARBON MARKETS (VCM) COMPLIANCE CARBON MARKETS • Corporates use VCM to “pledge and comply”, that is, demonstrate • Used to achieve compliance with NDC achievement of their Voluntary Commitments. For example, or another compliance requirement net-zero goals. (CORSIA, Emissions Trading System like Korea) • Market for Emission Reduction Credits (ERCs) with and without seller country authorization (corresponding adjustment), • Only ERCs with authorization can be traded depending on buyer preferences. Only ERCs with authorization ERCs WITHOUT ERCs WITH for Corresponding Adjustment Authorization Authorization (called Internationally Transferred Mitigation Outcomes “Claimed” “Counted” or ITMOs under the Paris Agreement) can be traded Source: World Bank COMPLIANCE CARBON MARKETS Compliance carbon markets refer to regulated systems includes two types of market mechanisms: Article 6.2 and where national, regional, or provincial authorities mandate Article 6.4. Article 6.4 or the “Sustainable Development emissions sources to comply with GHG emission reduction Mechanism” is expected to be the successor to the CDM, requirements. Several national and regional compliance establishing a regulated carbon market under the supervision schemes are established as cap-and-trade systems or of the Conference of the Parties.14 Article 6.2, by contrast, crediting mechanisms. The full list of such schemes is available provides flexibility for bilateral and plurilateral cooperation on the World Bank’s Carbon Pricing Dashboard. across countries for the trading of authorized ERCs.15 With the agreement on the rules for operationalizing Article 6 at This note focuses on international CCM under the Paris COP26, there is growing interest in carbon markets, and Agreement. Article 6 of the Paris Agreement recognizes some countries have already initiated requests for proposal voluntary cooperation, including carbon markets. Article 6 to procure authorized ERCs.16 14 The Conference of the Parties serving as the meeting of the Parties to the Paris Agreement (CMA) agreed at COP26 that a Supervisory Body would be established for Article 6.4. Nomination of members and alternate members for the Supervisory Body have been invited, and at least two meetings are to be held in 2022. Significant technical work is expected to be carried out by the Supervisory Body through these upcoming meetings, including the development of provisions for the approval of methodologies, monitoring, verification, issuance, renewal, and other processes. 15 In the language of the Paris Agreement, an ERC authorized for international transfer under Article 6.2 by the seller country government is called an Internationally Transferred Mitigation Outcome (ITMO). Authorization implies commitment by the seller country to undertake a CA to avoid double counting. 16 The first Requests for Proposal (RFP) for ITMOs were launched in 2019 by the KliK Foundation, Switzerland. Other countries that have issued RFPs for ITMOs include the Ministry of Environment – Japan and the Swedish Energy Agency. 8 DEFINING RBCF VCM COMPLIANCE MARKE TS Trades of authorized ERCs can only occur between Parties through the submission of Biennial Transparency Reports to the Paris Agreement, or between entities authorized to the UNFCCC by the countries. by such Parties.17 Furthermore, the transfer of authorized ERCs from one Party to another must be accompanied by By carrying out CA, a seller country ensures that the appropriate accounting, through “corresponding adjustment” authorized ERC is not counted toward the achievement of its (CA). CA refers to an accounting adjustment made by the own climate targets. This would mean that the seller country buying and selling countries to their NDC accounting to has to undertake additional mitigation action to demonstrate reflect the transfer of the authorized ERC. It is intended the achievement of its own NDC. Such additional mitigation to ensure that an authorized ERC is not double counted, action would be associated with an opportunity cost, which meaning that both countries cannot use the same authorized is expected to be reflected in the price of an authorized ERC to demonstrate achievement of their respective NDCs. ERC. While there are no CA units currently traded in the Commitment to carry out CA is expected to be provided by market, it is expected that authorized credits will be priced the seller country through a Letter of Authorization issued significantly higher than ERCs that are not accompanied by prior to transfer of an ERC. Evidence of CA is provided such authorization. LINKAGES BETWEEN VOLUNTARY AND COMPLIANCE CARBON MARKETS The process for generating ERCs under voluntary and climate ambition is increased, are likely to play a major role. compliance carbon markets is expected to be similar. Some crediting standard bodies, such as Gold Standard However, participation in CCM under the Paris Agreement, Foundation, have indicated that all the credits on its registry if the acquiring country intends to use the authorized ERCs would require CA by 2025. The COP26 text does not make for meeting its NDC target, involves the additional mandatory any mention of CA for VCM, and the decision of whether step of obtaining a Letter of Authorization that commits to VCM credits should be subject to CA is left to host countries. carrying out CA from the government of the seller country. CAs are likely to be based on aggregate annual volumes of Participation in these markets and the associated rules for relevant transactions for a country rather than being carried private sector actors primarily depend on the purpose of their out for each individual market transaction. The question of participation, the claim made against the ERCs, and use of applying adjustments to VCM transactions is, therefore, not the acquired ERCs. Requirements such as approval and/or an issue limited to individual activity participants securing authorization from the selling countries, measures to ensure Letters of Authorization; rather, it depends on whether host avoidance of double counting, linkages with NDCs to prevent countries intend to incorporate these transactions in their overselling, and measures to ensure NDC targets are met and national accounting and reporting under Article 6.18 17 For example, Switzerland’s KliK Foundation is authorized to procure ERCs under Article 6.2 to meet legal obligations set out under Swiss CO2 Law. 18 Some signatories to the San Jose Principles Coalition have committed to apply corresponding adjustments to support voluntary corporate climate commitments in mitigation outcomes used by corporate actors for voluntary climate goals through international voluntary carbon markets. These include Colombia, Costa Rica, Fiji, Finland, Marshall Islands, Peru, and Switzerland. I N F O R M AT I O N PA P E R S 9 9 It is also important to note that CA is an accounting In some cases, the private sector may purchase credits mechanism, and not a measure of quality or integrity of the internationally for the achievement of compliance requirements ERC. The claims associated with a carbon credit would need under a domestic or regional emissions trading scheme. For to be linked to the underlying characteristics of an ERC. example, South Korea’s Emissions Trading Scheme (K – ETS) permits a part of the compliance requirement of covered Transactions in authorized ERCs are not limited to CCM. entities to be met using international offsets. In these cases, The private sector can also transact in authorized ERCs. the need for CA will depend on the rules of the national or In order to be able to make claims related to contributing regional scheme, and whether the country intends to use the toward increasing the ambition of a seller country, CA credits generated under such a mechanism to demonstrate would be essential. The private sector can also contribute achievement of its NDC. to the achievement of its own country’s NDC by securing authorization to participate in CCM and submitting its While the labels and claims associated with different types purchases of authorized ERCs to its country government of ERCs are still evolving, the table below summarizes the for use toward demonstrating achievement of its NDC. broad use cases and claims that may be associated with RBCF, VCM, and CCM. TABLE 1. Summary of Use Cases and Claims Registration Letter of Verification and Authorization by an Claim for Private Implication for Mechanism Issuance by committing Independent Sector Seller Country a Crediting to CA by Third Party Standard seller country Contribution to ERC remains in climate finance; Results-Based the seller country Yes No* No contribution to Climate Finance and can be used meeting existing toward NDC climate goal ERC remains in Contribution to VCM without the seller country Yes Yes No the generation of authorization and can be used emission reductions toward NDC VCM with ERCs ERC transferred Contribution to labeled for out of seller country Yes Yes Yes increasing ambition corresponding and cannot be of the seller country adjustment used for NDC Compliance ERC transferred Carbon Market Contribution to buyer out of seller country (and surrendered Yes Yes Yes country’s NDC and cannot be to own country used for NDC government) * May be required by some providers of RBCF, but not considered an essential feature of RBCF. For example, the World Bank’s forest Carbon Partnership Facility (FCPF) requires issuance of credits. Note: The table illustrates minimum requirements and does not preclude other possibilities. For example, registration for RBCF is not needed, but it is allowed. 10 DEFINING RBCF VCM COMPLIANCE MARKE TS