CO2 removal markets are needed to achieve the Paris climate targets

Recognizing the need for technical removal of CO2 from the atmosphere and trading of associated CO2 credits is an important task for the upcoming COP26 to address as part of fleshing out Article 6 of the Paris Climate Agreement. In 2019, no agreement was reached at the Madrid COP for the implementation of Article 6. However, it is critical to the efficient achievement of the Paris climate goals, as it aims to ensure that countries establish as extensive an international CO2 market as possible. This is, of course, not limited to CO2 removals.

CO2 markets basically allow emission reductions to be achieved where it is most cost-effective. In addition to emissions trading between companies in countries with defined reduction targets, the so-called CO2 offset market has become established as a result of the Kyoto Protocol, i.e. the reduction of emissions through projects in countries without reduction targets, supplemented or meanwhile replaced by the voluntary CO2 offset market. However, CO2 offset markets, which mainly generate CO2 certificates from additional avoidance of CO2, will not be able to meet the growing demand.

Demand for CO2 certificates increases, supply decreases

As more and more companies announce plans to achieve net-zero CO2 or net-negative CO2 emissions, global demand for CO2 certificates is projected to increase in order to achieve these goals faster and to offset hard-to-avoid CO2 emissions.  The Taskforce on Scaling Voluntary Carbon Markets, with support from McKinsey, estimates that demand for CO2 allowances in CO2 offset markets could increase by a factor of 15 by 2030 and by a factor of 100 by 2050.

But since, unlike under the Kyoto Protocol, virtually all countries commit to emission reductions, the question of offsets arises. If project-financed emission reductions are counted within national emissions, they can no longer count as emission reductions in another country. This means that rules must be created on how to credit avoided emissions without counting them twice. However, if global emissions (finally) fall, the opportunities for generating CO2 offsets through additional emission reductions will also fall. Accordingly, the supply of CO2 offsets from emission avoidance will decrease in the medium term.

Nevertheless, CO2 offsets from additional emissions avoidance will make an important contribution to the international energy transition on the way to net-zero emissions by promoting the use of low- or zero-CO2 technologies. At the same time, they provide incentives for emissions to be reduced or reversed by the loss of natural sinks through, for example, deforestation. For this to happen, however, clear rules for offsetting must be found. As long as the offsets are voluntary, the problem is not critical for the time being, because the CO2 certificates from offsets do not take effect in the country of the recipient. This means that a European company cannot count voluntary CO2 offsets in European emissions trading, and it is the company's responsibility to credibly communicate to its customers that CO2 has been avoided elsewhere through its projects and that it is worth paying more for the company's products or services for these efforts.

However, this restriction only applies for a limited time - because nationally accounted emissions must fall to zero as quickly as possible. For example, the proposals in the EU's Fitfor55 package call for the linear reduction factor to be raised and for the EU ETS to become net zero and then even net negative as early as the end of the next decade. A continuation of the European emissions trading system would then require the availability of eligible CO2 removal certificates that can no longer be credited outside the EU ETS in another country.

Technical approaches for CO2 removal with greater potential than nature-based solutions

Therefore, in addition to clear crediting of CO2 offsets through additional avoidance, there is an increasing need for CO2 certificates generated through atmospheric CO2 removal. In the case of such CO2 removal certificates, there has so far been a strong focus on nature-based solutions such as the reforestation of forests or the renaturation of peatlands. However, there are also creditability issues with these approaches, as these emissions or their change from a historical benchmark are recorded in the national greenhouse gas inventory. Furthermore, it is unclear whether these measures could or should achieve a sufficient supply of CO2 certificates. On the one hand, these ecosystems are under pressure from deforestation, water scarcity, and climate change, and on the other hand, these lands are often also in demand for agriculture and are needed for food production. In addition, the preservation or restoration of these ecosystems can have numerous positive effects on biodiversity, the quality of life of the regional population and the local climate, and thus also on adaptability to climate change. Accordingly, the management of these nature-based approaches often initially focuses on preserving threatened areas and thus avoiding emissions. The additional creation of CO2 removal certificates through nature-based solutions therefore requires a comprehensive approach that appropriately considers the numerous ecosystem services in its management.

In order to meet the demand for CO2 removal, technical solutions are needed in addition to nature-based ones, i.e., CO2 is removed from the atmosphere and then stored geologically or in building materials, or used as part of a circular CO2 economy. Methods such as the direct air capture process are already being operated on a small scale for example in Iceland. With these methods, decentralized development of different technologies and approaches lends itself. However, the prerequisite for this is that there are corresponding markets. There, the (still) few suppliers can come together with the demanders for CO2 removal and reduce the relatively high transaction costs of bilateral, project-based CO2 trading.  Through improved standardization and a uniform price signal, the decentralized market power can develop here that is needed to develop technical CO2 removal to the extent that would be necessary to still come close to the 1.5°C target.

CO2 Removal Market: A First Important Step to Comprehensive Global Emissions Trading

At the same time, CO2 removal markets offer the possibility of coming closer to the fundamental goal of comprehensive emissions trading. CO2 removal certificates, which are eligible in different national CO2 price systems, allow to link them. For example, linking the European emissions trading system with the Chinese one appears to be more demanding from a regulatory point of view than allowing a supply of uniform CO2 removal certificates, which can thus indirectly lead to price alignment on the markets. Under such a construct of indirect linkage, different market peculiarities such as the European market stability reserve can be preserved. Furthermore, with uniform CO2 removal allowances, it would be less difficult to prove their additionality nor to track their crediting in different countries.

For these different challenges, COP26 will not yet be able to deliver final solutions. On the contrary, it is more likely that the decisive impetus will come from regional initiatives, such as the EU certification system for CO2 removal announced for spring 2022. However, it is important at COP26 to recognize this need for an international CO2 removal market and to set the course for standardization and classification of CO2 certificates. This opens up an important perspective for countries such as China, whose export business will increasingly require CO2-neutral production.

Coverfoto: © Ivo Gretener - iStockphoto

The Kiel Focus series presents papers on current economic policy topics. Their authors are solely responsible for their content and their views or any policy recommendations they may make do not necessarily represent the views or recommendations of the Institute.