Networked Carbon Markets The Regulatory Framework to Support Carbon Market Linkage— A Concept Paper April 2016 Networked Carbon Markets The Regulatory Framework to Support Carbon Market Linkage— A Concept Paper April 2016 Peter Zaman and Adam Hedley Acknowledgements This report was prepared jointly by the World Bank and Reed Smith. The World Bank team included Chandra Shekhar Sinha, Bianca Sylvester and Rachel Mok. The report also benefited from the guidance and valuable contributions by World Bank colleagues, Celine Ramstein and Pierre Guigon. The Reed Smith team included Peter Zaman and Adam Hedley. Peter Zaman is a partner in Reed Smith’s Singapore office and Adam Hedley is a senior associate in Reed Smith’s London office. 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.” Contents 1 Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 3 The Impact of the Paris Agreement on Linking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 4 Governance, Legal and Regulatory Frameworks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 5 The Regulatory Framework for Carbon Markets Linked under the NCM . . . . . . . . . . . . . . . 9 6 Analysis of Existing Regulatory Frameworks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 7 Networking, Linkages and the NCM Transaction Scenarios . . . . . . . . . . . . . . . . . . . . . . 17 8 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 Figures 1 Hierarchy of Frameworks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2 Direct Bilateral Linking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 3 Indirect Bilateral Linking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 4 Networking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 5 Carbon Club Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 6 Multilateral Trading Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 7 Possible Transaction Structures: Example of Country A Importing Units from Country B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 1. Executive Summary 1.1.  This paper considers the regulatory framework the bilateral model may be relatively few, whereas the that is required to be put in place in order to support the multilateral model requires a more formal and tailored establishment of carbon market linkages, in particular, approach, often requiring a number of different regulatory in light of the bottom-up approach contemplated by the bodies to be established. Whilst at a high level the Paris Agreement. Section 2 describes the key purpose of structure of the regulatory framework in a generically the paper and details the assumptions and other factors linked market can be predicted based on existing models, that are made in this paper concerning ‘networking’—a the particular structure applied in the context of a linked form of linking contemplated by the World Bank Group’s carbon market would have to be tailored to the objectives Networked Carbon Markets (NCM) initiative. The key of its legal framework and the specific issues that must be assumption in the paper is that the parties seeking to link resolved to enable an effective linkage. two or more carbon markets will, before considering the 1.5.  In section 6 we analyse a number of existing regulatory elements required for linking, have concluded trading arrangements to assess whether they offer a that there must be political, administrative and/or suitable foundation for future linked carbon markets. This economic rationale for linking. would potentially enable existing regulatory frameworks 1.2.  Section 3 considers the impact of the Paris to be used as a means of jump-starting the linkage Agreement, in particular Article 6, on carbon market process. Ultimately for reasons on which we elaborate linkage. With respect to Article 6, we assume that the in the section, we conclude that most of them are not scope and application of the transactions covered by this particularly suited to such purposes. paper, in the context of networking, will be those which 1.6.  Section 7 includes a more detailed discussion of qualify as internationally transferred mitigation outcomes the World Bank Group’s proposal for networking and the under the cooperative measures in Article 6(1–3). concept of mitigation value (MV) which is a fundamental 1.3.  Section 4 introduces the concepts of governance, element of networking. We consider the variety of legal and regulatory frameworks and seeks to draw modalities for linking, including the networking model a distinction between these three concepts, whilst and the NCM transaction scenarios discussed in the NCM recognising there is a degree of overlap. Whilst the Concept Paper (and summarised in Appendix 1). We go required governance and legal frameworks are beyond the on to explore the regulatory framework considerations scope of this paper, both are a necessary precursor to a that are specific to these transactions and the MV concept. regulatory framework and so are considered briefly by way We conclude that using MV as a basis for linking creates a of context to our main discussion. unique regulatory framework feature for linked countries that does not appear in the context of the traditional or 1.4.  In section 5 we discuss the regulatory framework classical linking model. This relates to the acceptance that we consider to be necessary for carbon market linking by one country of its MV assessment by a third party when considered in the context of traditional linkage assessor. Although we highlight some of the new models (i.e., those that require greater homogeneity challenges this will throw up, we conclude that further in order to establish linkages). We conclude that the development about how MV could be operationalised will difference between the regulatory frameworks for bilateral be required before guidance on the regulatory framework and multilateral linkages is mostly one of scale and for networking can be further advanced. complexity. The additional regulatory bodies required by 1 2. Introduction 2.1.  Abstract 2.2.2.  Beyond MV, in order for two or more countries or subnational level regions to link, there are a number of other factors or drivers that must be satisfied. Most 2.1.1.  The key purpose of this paper is to consider fundamentally, there must be political, administrative the regulatory framework that is required to be put in and/or economic rationale for linking. The economic place to support the establishment of carbon market rationale for linking includes (but is not limited to) linkages, in particular, in light of the bottom-up approach increasing cost efficiencies, greater heterogeneity of contemplated by the Paris Agreement. abatement costs, reducing competitive distortions 2.1.2.  The successful conclusion of the Paris Agreement and concerns surrounding leakage, increasing market in December 2015 means that such consideration liquidity, limiting the scope of market dominance of of linking under the World Bank’s Networked Carbon certain participants, etc. The administrative rationale Markets (“NCM”) initiative cannot be in the abstract and for linking includes sharing best practices, lower cost of therefore, it is justified to consider the impact of Article 6 management, etc. The political rationale is often more of the Paris Agreement in the context of this paper. Doing tenuous; for example, the signalling of common efforts to so also helps frame any discussion regarding linking of combat climate change (Burtraw et al. (2013)). There are carbon markets. This statement reflects an assumption numerous papers which have discussed such rationales on our part that any country wishing to link with another and the factors associated to that at length1 and we do would wish for its efforts through linking to either count not propose to repeat that discourse here. Needless to towards its obligations under its nationally determined say, we must also assume that those factors would have contributions (“NDC”) under the Paris Agreement or, at been satisfied for the purposes of those countries or the very least, not detract from its efforts under its NDC. subnational level entities to link. It is only once they reach The authors recognise that countries who engage in that point that considerations of the governance, legal and linkage efforts at a subnational level may not necessarily regulatory framework necessary to support such a linked wish to ensure its efforts count towards its NDC (as that arrangement begin to apply. is a national prerogative), but would wish to avoid the 2.2.3.  In no particular order, we therefore assume that risk of it having any prejudicial impact at a national level. the following factors, which are considered fundamental Therefore, the scope of this paper also briefly considers to any linkage arrangement (Tuerk et al. (2009)), have the impact of Article 6 of the Paris Agreement on market either been harmonised or the heterogeneities have been linking. sufficiently accounted for in an MV that is applied: i. the relative stringency of targets; 2.2.  Assumptions ii. eligibility of offsets credits; 2.2.1.  As the transactional models highlighted in Appendix 1 of this paper illustrate, the concept of iii. intensity targets; and mitigation value (“MV”) is a fundamental element of the iv. cost containment measures. linking approach proposed by the NCM Initiative. However, how MV will be operationalised is, at the time of writing 2.2.4.  In addition, we also assume that those factors this paper, still very much under development. As such, it that are not necessarily barriers to linkage but which is necessary to assume that the nature of MV will be such nonetheless must be addressed as part of the linkage that it justifies and supports linking between two or more arrangement (Tuerk et al. (2009)), have been satisfied: carbon schemes or that the countries wishing to link will i. monitoring, reporting and verification (“MRV”) rules be suitably comfortable with the process of evaluating, for units; publishing and applying MV. In the three transaction scenarios contemplated in Appendix 1, this assumption ii. banking compliance periods; applies most to the domestic unit (the “International iii. compliance periods; Transaction Unit” or “ITU”) model. 1 See for example Tuerk et al. (2009), Burtraw et al. (2013), and Kachi et al. (2015). 2 Introduction  3 iv. registries; the context of more traditional approaches to linking (i.e., direct or indirect linking). Networking seeks to add a v. rules governing new entrants and closures; and less traditional approach towards linking to respond to a vi. allocation methods. new carbon market landscape that is decentralised and is characterised by heterogeneities in their design and 2.2.5.  It is, however, fair to say that much of the work ambition. We discuss this further in section 7 of this paper. referred to above and our assumptions have been in 3. The Impact of the Paris Agreement on Linking 3.1.  Article 6 of the Paris Agreement contemplates three 3.4.  It is important that the World Bank Group’s proposal broad mechanisms: (I) cooperative approaches on a for networking align with Cooperative Measures in the voluntary basis (Article 6(1)–(3)); (II) a mechanism to requirement that Parties shall “apply robust accounting contribute to the mitigation of greenhouse gases and to ensure, inter alia, the avoidance of double counting, support sustainable development (Article 6(4)–(7)); and consistent with guidance adopted by the Conference (III) a framework for nonmarket approaches (Article 6(8) of the Parties” (Article 6(2)). This means that, should a and (9). For obvious reasons, the nonmarket approach is Party wish to ‘network’ as a means to link two or more not relevant for networking (discussed in further detail at carbon markets and wish for the international transfer section 7 below). This leaves us to consider Article 6(1)– of any ITMOs under that linkage to count towards the (3) (“Cooperative Measures”) and Article 6(4)–(7) (the satisfaction of its obligations under its NDC, the networked “Sustainable Development Mechanism”). markets would need to be consistent with any guidance or standards that the Conference of the Parties serving 3.2.  Cooperative Measures is a decentralised mechanism as the meeting of the Parties to the Paris Agreement that allows voluntary bilateral and multilateral linkages of (“CMA”) develops pursuant to this article. We note that markets, for example, into a “carbon club.” These linked the CMA’s guidance is not likely to be overly prescriptive markets may be able to trade internationally transferred and may be ‘principles based’, thereby allowing a lot mitigation outcomes (“ITMOs”) in a manner supported of flexibility for interpretation at the national level of by robust accounting to avoid double counting. It is clear the Parties concerned. The less prescriptive the CMA’s that ITMOs are wider than the Kyoto Protocol concept of guidance, the more governments and market participants assigned amount units. We assume the generic nature of may need guidance from other sources. This is because, an ITMO is aimed at capturing multiple types of emission without sufficient guidance and oversight about rights that may be the basis of the linkages established accounting procedures, the less confidence governments by two or more participating countries. Japan’s current and market participants will have about assets that are approach of signing bilateral offset agreements with being traded. Without this confidence, there may be little certain countries may fit within this cooperative approach trade of carbon assets. Ultimately, of course, the test framework. Albeit stating the obvious, Cooperative will be whether the accounting approach adopted in the Measures, like ‘networking’, has no relevance to domestic linked markets is consistent with the guidance on such mitigation actions or their outcomes until such time accounting that is adopted by the CMA in its first session. as a decision is made for the ITMOs (that the action or outcome in question represents to be transferred 3.5.  In contrast to the Cooperative Measures, the internationally). Sustainability Development Mechanism is a centralised mechanism with broad similarities to both the Kyoto 3.3.  It is worth noting that there is nothing in the short Protocol’s Clean Development Mechanism (“CDM”) and description of an ITMO that would preclude the use Joint Implementation (“JI”). This mechanism allows for of Cooperative Measures to apply to units/outcomes emission reductions achieved to be used by a Party to emanating from mechanisms or markets that are both demonstrate achievement of its NDC. As such, with its within the authority of the COP (e.g., REDD+), as well as additional mandate to support sustainable development, outside the authority of the COP (e.g., EUAs under the this mechanism will be broader in scope than the CDM EU ETS via its link with Switzerland2). Furthermore, there and JI. It also does not differentiate between developed is no qualitative requirement (e.g., additionality) in this or developing countries as host Parties for the activity in mechanism which, conceptually, does not create a limitation question. Like the CDM and JI, the new mechanism will on the type of ITMO available for international transfer. 2 We note that, in contrast to the approach of merely agreeing to cooperate in implementing the respective parties’ NDCs envisaged by Article 6(1), should countries decide to aggregate their respective NDCs and meet those NDCs jointly (as may be the case for the EU member states), then such joint compliance is catered for by Article 4(16–18). Arguably, therefore, the EU ETS model of aggregating compliance under the Kyoto Protocol would fall within Article 4 while its measure of linking to Switzerland would, under the Paris Agreement, fall under Article 6(1). 4 The Impact of the Paris Agreement on Linking  5 also allow for participation in the activity by private entities mechanism that is operated by the CMA (and supervised authorised by the relevant Parties. by a body to be established by it); (b) it appears to be limited to offsets and would preclude cap-and-trade 3.6.  On the face of it, the new mechanism seems to markets; and (c) does not, on its face, suggest an offset provide an opportunity to launch a centralised offset mechanism that would differentiate between various Party mechanism that benefits from all of the knowledge, know- offsets on the basis of their MV. how and experience of CDM/JI. However, it also appears that this mechanism is not envisaged as a cap-and-trade 3.8.  As such, for the purposes of this paper, we will mechanism and has the characteristics of an offset assume that the scope and application of the transactions mechanism. to be covered by this paper in the context of networking will be limited to those, whose international transfers 3.7.  Given the centralised nature of the Sustainability via their linked markets will qualify as ITMOs under Development Mechanism, it seems to preclude the Article 6(1)–(3) of the Paris Agreement. application of networking because: (a) it is a ‘top-down’ 4. Governance, Legal and Regulatory Frameworks 4.1.  Distinguishing One from the Other international law (where the rights of private persons would normally otherwise be pursued). 4.1.1.  In order to provide some shape to our discussion, 4.1.4.  Finally, a regulatory framework is defined as the it is worth reminding ourselves that governance, legal existence of the necessary infrastructure to support the and regulatory frameworks are each distinguishable from control, direction or implementation of a proposed or one another and although there may be some crossover adopted course of action, rule, principle or law. Therefore, or overlap in the way they are created and applied, in the context of this paper, the regulatory framework differences nonetheless do exist. Although there may refers to a group or set of bodies, agencies, actors and be terms to define each of these concepts universally, supervisors whose role is to oversee, implement and to avoid any confusion, we nonetheless set out the ensure the effectiveness of the linked markets in two or definitions we propose to use for the purposes of this more countries. Again, given the decentralized nature paper. of the Cooperative Measures mechanism (described in section 3), it is not expected that the CMA will provide this 4.1.2.  Governance “can be defined as the rule of the infrastructure and that the regulatory framework relating rulers, typically within a given set of rules. One might to the establishment and enforcement of linked carbon conclude that governance is the process—by which markets may be developed outside of the CMA. authority is conferred on rulers, by which they make the rules, and by which those rules are enforced and 4.1.5.  It is important to recognise those differences in the modified.”3 As such, used in the context of networking context of this paper, in particular because discussion of and this paper, a governance framework would refer the required governance and legal framework is beyond to the process by which a set of rules relating to the the scope of this paper. That said, the following points are linkages between countries are established, how they are worth making. enforced and how any changes to those rules are brought about. Given the decentralized nature of the Cooperative Measures mechanism and the role of the CMA to provide Figure 1: Hierarchy of Frameworks guidance, it is not expected that the CMA will prescribe these rules and/or be the authority to enforce them. Therefore, the governance arrangements that prescribe the establishment and/or enforcement of linked carbon markets may be developed outside of the CMA. 4.1.3.  A legal framework is a broad system of rules that Regulatory governs and regulates decision making and is reflected in agreements, laws, etc. In the context of this paper, therefore, the legal framework would be the end product of the governance framework and it is the legal framework that specifies the boundaries within which the relationship Legal of the linked countries are managed and regulated. By extension, if the legal framework is deficient in any respect (e.g., if there is no legal framework for private citizens of one country to seek remedies in the courts of another country in the context of a dispute in relation to ITMOs) Governance then how that deficiency is addressed may fall within the realms of public international law rather than private 3 From the World Bank website: http://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/MENAEXT/EXTMNAREGTOPGOVERNANCE/ 0,,contentMDK:20513159~pagePK:34004173~piPK:34003707~theSitePK:497024,00.html 6 Governance, Legal and Regulatory Frameworks  7 4.2.  Governance Framework political implications and intent of the parties. The EU’s link with Switzerland is established through an agreement 4.2.1.  For linked markets, the multiplicity of issues that between the EU and Switzerland but until it is signed by will need to be resolved (and which we have already the relevant authorities and ratified by the two parties, assumed would have been agreed upon before the that agreement is not binding on the parties. In effect, this issue of the regulatory framework can be addressed) agreement is an international treaty within the meaning of must nonetheless be addressed. The forum in which the 1969 Vienna Convention on the Law of Treaties. those issues are to be addressed and the process by which they are discussed goes to the heart of the 4.3.2.  In contrast, linkages established at the subnational governance framework. For example, in bilateral directly level by two or more countries will have to fit within linked markets, that process may kick off through bilateral limits imposed on those subnational agencies under the memoranda of understanding (“MOUs”) or cooperation respective constitutional national laws of their respective agreements between the parties. Examples of such nations dealing with international relations. For example, arrangements include the recent US-China Climate in order for a linkage between Quebec and California Change Working Group under which they have launched (discussed further below) to arise, the question of US action initiatives on vehicles, smart grids, carbon capture, national authority and sovereignty and whether the utilization and storage, energy efficiency, greenhouse linkage interferes with the autonomy/policy choices of the gas data management, forests and industrial boilers. national government, needed to be considered. Therefore, From the seeds of such forums grow the more formal the shape of such linkages at the subnational level will arrangements that lead to institutionalised governance be a question of the extent and scope of the subnational structure. Ensuring such a forum exists to coordinate entity’s jurisdiction. This can be a limiting factor in the efforts is a key example of where a suitable governance ability for states or subnational entities to negotiate with structure can be important. It is also necessary to ensure each other in the context of market linkages. Where the there is a forum in which to address issues that cannot efforts of two linked subnationals also need to ensure be resolved on a mutual basis. For example, if one party that, going forward, their efforts did not detract from were to unilaterally wish to withdraw from a linked market the efforts at the national level counting towards their and did so in contravention of the pre-agreed process NDC under the Paris Agreement, this becomes a greater under the legal framework that otherwise established that limiting factor for subnationals that are securing to link and linkage, to which platform does the aggrieved country will need to be taken into account in developing the legal elevate that grievance (e.g., providing for resolution under framework. the International Court of Justice or, in the context of 4.3.3.  Whatever legal framework that is applied in the a multilateral organisation, by developing an in-house context of two or more linked markets, whether that be dispute resolution forum for its members)? through ‘networking’ or more classic forms of linking, that framework will lay the foundation for the regulatory 4.3.  Legal Framework framework to be established between two or more linked parties. It is not necessary for all of the details to 4.3.1.  A distinction is also to be drawn between the legal be prescribed in the legal framework but it is important frameworks required to support linkages at the national for authority to be delegated to the appropriate body or level from the subnational level. This is because, typically, group of bodies in order for those details to be further international legal relations between two or more states developed. The absence in the legal framework of suitable are the subject of public international law and therefore, organisations to delegate the responsibility of detailing agreements made between two or more contracting policy development may lead to the creation of new states often take the form of international treaties. organisations or bodies outside the scope of the legal Although not always called a treaty, many terms are used framework in order to service the two linked markets. to describe internationally binding relations between two As such, the legal framework needs the foresight to or more countries. These terms include international anticipate potential issues that may have to be resolved conventions, international agreements, covenants, final between two or more countries or subnational entities. acts, charters, MOUs, protocols, pacts, accords, and An illustration of such an issue faced by California during constitutions for international organisations. Usually, these its considerations for linkage with Quebec included different names have no legal significance in international the following: “California might find a market design law as the degree of formality chosen will typically depend flaw that can only be corrected if Quebec implements upon the gravity of the problems dealt with and upon the the same market rule change. However, it would be 8  Governance, Legal and Regulatory Frameworks difficult, if not impossible, for CARB to compel Quebec 4.3.4.  The legal framework may also wish to address the to implement this market rule.”4 Arguably, the inability exclusivity of the membership of the plurilateral or, to a for one subnational to enforce a breach of a linking lesser extent, the multilateral organisation. For example, agreement against another country’s subnational would will it be open for any country to join or would it be be a significant design flaw for the linked markets. Other limited to its founding countries? Would it allow a country examples include the lack of harmonisation of EU VAT or international organisation to be an observer as a means laws regarding EU allowances as part of the EU ETS to promote itself or its activities? establishment process in 2004. These laws were only harmonised recently following the VAT fraud scandal in the EU ETS in 2009/10. 4 Issue Analysis: Linkage with Quebec in California’s Greenhouse Gas Emissions Cap-and-Trade Market by Bailey et al. (2012). 5. The Regulatory Framework for Carbon Markets Linked under the NCM 5.1.  Regulatory Framework Issues in General those changes impact the harmonisation of the two markets. This also applies to changes to their respective offset protocols; 5.1.1.  The regulatory framework for a bilaterally linked market (whether direct or indirect), or a multilaterally • The ability of each to void compliance instruments linked market, will have to address the same issues. (i.e., allowances) that it has issued but not issued by Where they differ is likely to be in terms of their size and the other; complexity. • Notification to each other of any violations of rules 5.1.2.  In this discussion of two or more linked carbon by registered participants of each of their respective markets, it must be recognised that in each of the programmes; countries that are likely to be linked, there will probably • The creation of joint auction and common registry already be in place a group or set of bodies, agencies, platforms; actors and supervisors whose role it is to oversee, implement and ensure the effectiveness of the carbon • To coordinate on technical and administrative support markets in their respective countries or subnational for registered participants of the respective programs; jurisdictions. It is important to note, therefore, that in • To share information between themselves (to the the context of linkages of two or more such markets, extent permitted by their respective data privacy laws) the question is often not what the regulatory framework to facilitate enforcement and avoid cases of fraud, for a specific country is but rather what is the specific abuse and market manipulation, etc.; and regulatory framework required to deal with linkage issues? Underpinning this question is the assumption that • A mechanism to enable a party to withdraw on frameworks for linkages on bilateral and multilateral levels 12 months’ notice. Notably, there is no mention of need to create sufficient homogeneity of the markets how to compensate any registered participant for being linked, which in turn dictates the level of technical any adverse financial consequences that may befall and political complexity. that party from its holding of carbon units of the withdrawing party or because of any other investment 5.1.3.  In some instances, especially in the directly exposure it may have arising from an assumption that linked model, the institutions that are responsible for the the linkage was enduring. regulation of the national or subnational market will also be the institutions given the role in the context of the 5.1.5.  This list is not comprehensive but is illustrative linked markets. Perhaps, as in the case of the California- of the issues that the legal framework would need to Quebec linkage, all that is done to address the issues address to enable two directly linked markets to establish arising from linkage is to add or create a new joint body. the regulatory framework to support it. As illustrated In this context, under the linkage agreement between through this example, a single coordinating committee California and Quebec, a Consultation Committee was deemed sufficient with much of the other necessary comprising one executive officer of each of the California rule development, oversight and enforcement issues Air Resources Board (“CARB”) and the Quebec Ministry delegated to the bodies already existing under their own of Sustainable Development, Environment, Wildlife and respective programmes or within the Western Climate Parks (“MoSDE”) was established. Notably, there is no Initiative (“WCI”) arrangements. independent third party dispute resolution solution that 5.1.6.  However, this is slightly simplistic when the two parties here are willing to submit to in situations ‘networking’ is factored into the equation because the where the differences cannot ultimately be resolved. question of who determines the respective MV of the 5.1.4.  Looking at the example of California-Quebec, it is two linked countries or subnationals has not yet been worth noting that the other institutional arrangements that addressed. It is understood that the process would be were required to be altered or added including: independent and neutral, and that it would be designed to provide assurance of the environmental integrity of • A consultative approach to address changes made the asset, in accordance with rules and procedures that to each of their respective programmes where are recognized by regulations, the regulatory body and 9 10  The Regulatory Framework for Carbon Markets Linked under the NCM the participating jurisdictions. This step is not required for mechanisms as required to implement the objectives of more traditional forms of linking. The key question for two the club. markets that are ‘networked’, will relate to the regulatory 5.2.4.  A number of Sub-Administrative Bodies: framework that is used to apply the MV, as determined by may be required to deal with specific aspects of the a third party, for the respective schemes. We discuss this plurilateral or multilateral arrangement. The rules of further in section 7 of this paper. procedure of these bodies are often very thinly specified in the legal framework pursuant to which they were 5.2.  The Regulatory Framework established and therefore, they are empowered to for Linked Markets determine their own rules of procedure as they see fit. For example, a body may be set up specifically to 5.2.1.  As previously mentioned, the difference in the deal with dispute resolution and enforcement issues regulatory framework for bilateral and multilateral linkages relating to breaches by a country of its obligations under are mostly one of scale and complexity. As illustrated the rules of the instrument. Other examples of Sub- by the California-Quebec example above, the additional Administrative Bodies may relate to those dealing with regulatory bodies or institutions required in a bilateral the fiscal or budgetary concerns of the instrument and model may be relatively few. However, this is not the the contributions of participating country members. case with plurilateral (i.e., regional or carbon clubs) After all, the operation of the various activities of the or multilateral linked models. The complexity of those instrument, the resources necessary for organising the models, where the parties are signing up to a common various meetings as well as costs of the permanent staff set of rules, requires a more formal and structured of the instrument’s bodies and its secretariat will be a approach to enable the formulation, development, significant factor in the decision to establish the body in elaboration, ratification, implementation and enforcement the first place. Under-resourced organisations are likely of those rules between the participating countries. This to be ineffectual in the implementation and performance formalisation of approach often leads to the following of their objectives. This is particularly likely to be an types of bodies being established, each with a specific issue where the club countries or multilateral instrument role to play to ensure the effective running of the carbon members require capacity-building support for the club or multilateral instrument: implementation of their obligations under the rules of the 5.2.2.  A Decision Making Body: to make political instrument. decisions, carry out the functions of the body and 5.2.5.  A number of technical committees and take necessary actions. This is typically the apex level working groups: are required to achieve the often of the body made up of the most senior government mundane but nonetheless important nitty-gritty aspects representatives of the participating members of the of the instrument. The tasks of these committees or carbon club countries or of the multilateral instrument. working groups may involve receiving notifications This body will typically meet once a year or with such of new regulatory measures being proposed by its other frequency as may be agreed or required. member countries, compiling databases of information 5.2.3.  An Administrative Body: to oversee the day-to- (e.g., emissions data, monitoring reports, accounting day running of the carbon club or multilateral instrument information), conduct technical verification of documents, on behalf of the participating country representatives etc. The importance of these technical committees in the Decision Making Body. The Administrative Body and working groups is sometimes understated. These will report to the Decision Making Body and is often platforms often provide the best source of ideas and supported by additional subsidiary committees or information (to include discussion, elaboration, justification groups. The Administrative Body will also be made up and contestation). Communication and cooperation of representatives of all the participating countries. This between the participating countries in turn often have body will meet more regularly than the Decision Making the effect of reducing the risk of conflicts arising between Body, sometimes as frequently as every six weeks. Often the parties concerned. These committees or working this body will be empowered under the legal framework groups can also facilitate the development of shared to determine its own rules of procedure as well as to norms between the participating countries, for example establish any subsidiary bodies that it sees fit to support by providing a forum for airing views on the interpretation its activities. This body will often approve the rules of of specific or ambiguous provisions with the rules of procedures of any committees or subsidiary bodies that it procedure of the instrument or the legal framework under establishes. It may also formulate policy, review progress, which the instrument was established. identify new areas of cooperation and establish new The Regulatory Framework for Carbon Markets Linked under the NCM  11 5.2.6.  Often the technical committee or working group Level Body SAARC Example will be tasked with ensuring specific elements of the instrument. For example, in the case of traditional forms 1 Decision SAARC Heads of State Summit of linking, a working group may be tasked with ensuring Making Body the harmonisation of monitoring, reporting and verification 2 Administrative Council of Ministers arrangements across the participating countries. The task Body of harmonising is not as relevant for networking so a working group may be set up to develop the principles, 3 Sub- Standing Committee/ Administrative Programming Committee rules and procedures for accepting an MV determined by Bodies a third party as well as how the suitable third party may be accredited as an MV assessor. Other examples include 4 Technical Technical Committees— the running of specific tools of the instrument, such as an Committees/ (i) Agricultural, (ii) Transport and international transaction log to link up the carbon registries Working Communications, (iii) Forestry, of the linked participating countries or, in the context of Groups Environment and Meteorology, the International Transaction Unit model to operate the (iv) Social Development, platform for issuing ITUs. (v) Science and Technology, (vi) Human Resource and 5.2.7.  A Secretariat: The head of the secretariat may (vii) Energy. be appointed by the Decision Making Body. That person 5 Secretariat SAARC Secretariat is likely to be empowered with the responsibility of appointing the staff to the secretariat, as well as setting their responsibilities, duties and terms of service, each 5.2.9.  Whilst any regulatory structure applied in the of which may be under regulations adopted by the context of linked carbon markets would have to be Decision Making Body. The Secretariat should be impartial tailored to the objectives of its legal framework and the towards any member country and should be exclusively specific issues that are needed to be resolved to create international (as opposed to national) in character. Its role sufficient homogeneity and ensure the ability of those is to coordinate and monitor the decisions of the Decision two or more participating markets to link, the bodies Making Body and the activities of the organisations. It suggested above could, in principle, be applied to regulate may also act as the point of communication with other most generically linked markets. international organisations or carbon clubs and its location will act as the headquarters for the carbon club or 5.2.10.  This of course raises the question of whether any multilateral instrument. current or existing plurilateral or multilateral arrangements could be used to link carbon markets using their existing 5.2.8.  In the table shown, we use the bodies under legal or regulatory framework. We explore this in the the South Asian Association of Regional Cooperation following section. (“SAARC”) (a plurilateral organisation) to illustrate how the bodies listed above have been established under that regulatory framework: 6. Analysis of Existing Regulatory Frameworks 6.1.  Introduction • A consultation committee to monitor the coordination of the respective cap-and-trade programmes and report annually, comprised of one executive officer 6.1.1.  In this section, we review a number of existing from each of the CARB and the MoSDE. regulatory frameworks that provide for trade on a bilateral, regional/plurilateral and multilateral basis and the • A common registry for emissions allowances and challenges these existing frameworks might present for offsets, and a common auction platform to enable linked carbon market architecture. The historic challenge, joint auctions to be held. particularly in the context of the bilateral linkages referred • An obligation on the parties to work cooperatively to to below, has been to create a regulatory framework that prevent fraud, abuse and market manipulation, and achieves the required degree of homogeneity between to ensure the reliability of joint auctions and their the linked markets. The level of complexity in these respective cap-and-trade programmes.7 regulatory frameworks is therefore largely driven by this assumed goal of homogeneity. 6.2.4.  In both of the cited examples of bilateral linkage, the arrangement could be more accurately described as an accession by one party to the established carbon 6.2.  Bilateral Linkage market of the other. In the EU-Swiss linkage, many 6.2.1.  The EU-Swiss ETS linkage and California-Quebec elements of the Swiss ETS were designed from the linkage are two examples of recently established bilateral outset to match provisions in the EU ETS (e.g., allocation carbon market linkages, on a national and subnational benchmarks) to facilitate subsequent linkage. The level, respectively. California-Quebec linkage was marginally less one sided. Nevertheless, it is still the case that Quebec redesigned 6.2.2.  The EU-Swiss bilateral linkage represents the first elements of its cap-and-trade system so that it had such linkage by the EU. The technical negotiations were equivalency with California’s system in all key aspects. It is concluded in January 2016 and an agreement has been telling that, as a precondition to California implementing initialled, although not yet ratified as noted in paragraph the linkage, the Californian governor had to make four 4.3.1 above.5 This will provide for mutual recognition of key findings: (1) that Quebec’s programme was similar emission allowances between the two schemes. The or identical to California’s in all material respects; (2) that precise details of the agreement are not covered in this linkage would not change California’s ability to enforce paper as the agreement is not yet publicly available its programme against entities located inside or outside and little is otherwise known about its contents. The California; (3) that Quebec’s laws and regulations agreement will in essence be a form of international treaty provided for equivalent enforcement of its cap-and-trade once ratified. programme; and (4) that linking was unlikely to place any 6.2.3.  The California-Quebec linkage was formalised significant liability on California.8 in an agreement effective from 1 January 20146 which 6.2.5.  The above illustrates that existing carbon market was agreed under the auspices of the WCI: a regional linkages on a bilateral level have required a high degree collaboration to establish a combined carbon market of harmonisation in relation to their respective emissions intended to produce overall emissions reductions of caps, price controls and other features of their systems, 15% by 2020. The agreement provides for a governance inevitably resulting in some loss of sovereignty and control framework for collaboration on emissions reductions over national carbon market policy. This loss of sovereignty and trading, which, as noted in paragraph 5.1.3 above, and carbon market control is a common feature in direct includes: 5 As reported by Carbon Pulse in January 2016: http://carbon-pulse.com/14646/ 6 The agreement was between the California Air Resources Board and the Government du Quebec concerning the harmonisation and integration of cap-and-trade programs for reducing greenhouse gas emissions. 7 Articles 8 to 12 of the California-Quebec Agreement. 8 As noted in Carbon Market Watch paper, “Towards a Global Carbon Market, Risks of Linking the EU ETS to Other Carbon Markets” (2015). 12 Analysis of Existing Regulatory Frameworks  13 linkages,9 although the extent of the loss of sovereignty linkage, the negotiations took nearly 5 years to conclude varies according to a variety of factors, as evidenced an agreement. It therefore seems unlikely that the direct above. The loss of sovereignty issue is a major challenge linkage model would work in the context of linking the EU to the adoption of direct linkages, particularly in the case ETS with more divergent, emerging carbon markets, given of plurilateral or multilateral linkages. the regulatory, political and structural incompatibilities. As to the ability of the EU ETS to link under the MV 6.2.6.  Therefore, in order for direct linkages of the type model where direct linkage is not possible, it is unclear if established by the EU-Swiss and California-Quebec this could happen as there is nothing in the directive to linkages to be viable, the following key aspects need to be suggest that the strict compatibility requirements would addressed by the framework: not apply to such an agreement. This potential obstacle • How strictly the environmental integrity of a system under the EU ETS may require further consideration. is maintained, though MRV standards, i.e., so that 6.2.9.  Even if the required alignment can be achieved there is sufficient alignment on the value of carbon for the purposes of initial bilateral linkage, maintaining allowances, meaning there is no mitigation value a harmonised, linked carbon market throughout the consideration. regulatory lifecycle of the respective systems may present • Whether the registry and accounting systems are a challenge. For example, Switzerland is targeting a 50% aligned on issues such as carryover of allowances into reduction in its emissions (compared to 1990 levels) future compliance periods. by 2030, of which at least 30% must be achieved by Switzerland itself and the remaining 20% achieved • The level of ambition in the participant’s domestic through the purchase of international offsets.12 Conversely, cap-and-trade system, i.e., at what level the regulatory the use of offsets is excluded from the EU’s 2030 target emissions cap and reductions targets are set. This of achieving a 40% reduction. This policy divergence directly impacts on the price of carbon allowances. towards 2030 potentially represents a loss of control on • Whether a system has an absolute target or a relative the part of the EU, given the potential for international target. The Chinese system—relatively—is unlikely to offsets to enter the combined market via the back door. be compatible with the EU ETS for this reason. 6.2.10.  The California-Quebec agreement addresses 6.2.7.  It follows that there needs to be close alignment, the potential for regulatory divergence by providing not only a regulatory level, but also on a legal and for regulatory harmonisation measures, including governance level in order to achieve the necessary a commitment to consult each other regularly and harmonisation in the direct linkage model. The requisite constructively to ensure ongoing harmonisation of the degree of alignment was self-evidently present in the regulatory regimes for reporting of carbon emissions and case of the EU-Swiss linkage and the California-Quebec cap-and-trade systems.13 This is one way to mitigate the linkage, but the fact that examples of bilateral linkages risk of the parties having to de-link at some later stage are few in number (at least at present) suggests that the due to regulatory incompatibility. need to achieve this degree of multifaceted alignment 6.2.11.  The need for close regulatory alignment in the is a potential limiting feature of the direct linkage model, direct linkage model could potentially be overcome particularly in terms of the ability to expand a bilateral through adoption of the Carbon Club Model or Multilateral linkage into an indirect bilateral linkage model (through Trading Model. However, it would not necessarily multiple bilateral linkages, see Figure 3 on page 18) or the address origination concerns regarding, for example, the Multilateral Trading Model. environmental integrity of units produced by another 6.2.8.  The EU ETS Directive10 contains strict requirements participant or their MRV standards. To address such with regards to linking with other ETS schemes; it provides concerns would require a higher degree of regulatory that such linkages may only be established if the other oversight by an appropriately qualified, independent scheme is compatible and mandatory, and has absolute decision making body, which the bilateral model presently emissions caps.11 Even in the case of the EU-Swiss does not provide for. The effort and cost of achieving this integrity assurance would suggest that networking would 9 As noted by Ranson and Stavins in “Linkage of Greenhouse Gas Emissions Trading Systems: Learning from Experience” (2014). 10 Directive 2003/87/EC establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC. 11 Article 25(1a). 12 https://icapcarbonaction.com/en/about-emissions-trading/linking 13 Articles 3 and 4 of the California-Quebec Agreement. 14  Analysis of Existing Regulatory Frameworks be most cost effective on a plurilateral or multilateral 6.3.3.  The above bodies could potentially provide basis, as common regulatory bodies could be utilised and regulatory oversight of a linked carbon market within the costs of supporting the regulatory infrastructure spread their existing powers. However, the SMC is likely to lack across more participants. the requisite expertise in carbon market regulation, as compared to a body such as the CDM Executive Board; 6.2.12.  Geographic proximity also appears to be a the narrow focus of SAFTA on trade in products is likely significant feature in the majority of existing bilateral to mean that it is likely to be ill equipped to provide a linkages. Whilst geographic proximity is not a necessary sufficiently rigorous regulatory platform for trade in more feature of bilateral linkage, the need for a high degree of complex instruments such as carbon allowances. regulatory and political alignment militates in favour of linking with geographically close partners. It follows from 6.3.4.  A further limiting feature of agreements like SAFTA the discussion above that geographic proximity may be is geographic exclusivity. Participation in SATFA is limited less of an issue with regards to linkage in the NCM model, to SAARC states, which would limit the potential of its but only if the requisite supervisory framework is in place. combined carbon market. 6.3.5.  The Trans-Pacific Partnership (“TPP”) Agreement 6.3.  Regional/Plurilateral Linkage is an example of a more recently established plurilateral trade agreement; again not one that seeks to establish 6.3.1.  As noted above, the potential to develop a regional a carbon market linkage. The agreement was signed by or plurilateral carbon club using the direct linkage model the 12 participating Pacific Rim countries in February is inhibited by the requirement to have a high degree 2016, although it has yet to be ratified. Whilst principally of regulatory, legal and governance alignment, and the an agreement to establish a free trade area, the TPP loss of sovereignty that necessarily entails. Neither of the (unlike SAFTA) also covers a wider range of issues over its agreements cited in this section seek to interfere with the 30 chapters, including intellectual property, labour and the national sovereignty of its members on these issues, so environment. their potential to support a direct linkage would appear to be low. However, linkage using the Carbon Club Model is 6.3.6.  The TPP does not expressly cover carbon markets not so inhibited, and so is considered. and trading, nor does it impose a cap-and-trade scheme. However, Article 20(4) provides that the TPP members 6.3.2.  The Agreement on South Asian Free Trade Area should enter into dialogue on trade and environmental (“SAFTA”) is a regional trade agreement that was issues of mutual interest, particularly with respect established in 2004 by the members of SAARC. There is to the implementation of multilateral environmental potential appeal in utilising a trade platform such as SAFTA agreements (“MEAs”). The Paris Agreement is likely to to create a regional carbon club, in that it could provide meet the definition of an MEA, so the implementation an established regulatory framework and governance of Cooperative Measures and ITMOs (as discussed structure on which to build a specialised carbon trading previously in paragraphs 3.2–3.4) is theoretically within platform. The institutional arrangements under SAFTA, the scope of the TPP. As such, there appears to be consist of: potential to utilise the framework established by the TPP • SAFTA Ministerial Council (“SMC”): the highest to establish a linked carbon market. decision making body of SAFTA, responsible for 6.3.7.  A number of provisions in the environmental implementing the agreement. chapter are relevant to the question of whether the • Committee of Experts (“COE”): provides expert agreement could potentially provide a platform for carbon support to the SMC in the implementation of the market linkage. Article 20(3) recognises the sovereign agreement, and acts as the Dispute Settlement Body right of each party to establish its own levels of domestic under the agreement. environmental protection and its own environmental priorities. The retention of national sovereignty means that • SAARC Secretariat: provides secretarial support to the TPP would not support a directly linked carbon club in the SMC and COE in the discharge of their functions which the parties cede control over domestic emissions under the agreement.14 reduction targets and carbon market control in favour of an EU ETS type system. However, it does potentially leave room for the MV model, in which participants would 14 Article 10 of SAFTA. Analysis of Existing Regulatory Frameworks  15 not necessarily need to relinquish sovereignty over their gives wide discretion to the TPP Commission to domestic carbon emissions policies. establish subsidiary bodies and develop arrangements for implementing the agreement. Therefore, it would 6.3.8.  Article 20(12) promotes the use of cooperation theoretically be within the powers of the TPP Commission frameworks as a mechanism to implement the to establish a subsidiary body dealing solely with the environmental provisions of the TPP, which may be establishment of a networked carbon club, which would carried out on a bilateral or plurilateral basis. Whilst the be accountable to the TPP Commission. establishment of a carbon market is perhaps outside the ambitions of the TPP, it is interesting that the language 6.3.12.  The above tends to suggest that the TPP could mirrors that of Article 6(1) of the Paris Agreement, offer a regulatory platform for carbon market linkage on a which promotes voluntary cooperation to implement plurilateral scale. Whether it would be a cost-efficient and the parties’ nationally determined contributions. Further, operationally effective means to do so is questionable, Article 20(15) makes reference to cooperation on and would require further detailed consideration. emissions monitoring and market mechanisms. 6.3.9.  An obvious limitation of utilising a framework such 6.4.  Multilateral Linkage as the TPP as a platform for carbon market linkage is that it covers such an expansive range of topics, of which 6.4.1.  The World Trade Organisation (“WTO”) is an carbon markets if ‘bolted on’ would be only one small example of a global, multilateral trade framework. Various part. This means that countries wanting to join the carbon commentators have already considered whether the club established thereunder, who are not presently TPP global carbon market and carbon units are caught by participants, would potentially have to accede to the full the WTO agreements—whether as a product, financial agreement (there is no ability to unilaterally opt out of any instrument or financial service—and the potential issues provisions) and would have to be accepted for full TPP this creates. For the purposes of this paper, it is assumed membership by the existing participants. that carbon units fall within the auspices of the WTO agreements and the analysis of its potential to support 6.3.10.  The TPP provides that accession is open to any multilateral carbon market linkage is premised on that country as may be agreed (unanimously) by the existing assumption. TPP members, provided that country is willing to comply with the obligations in the Agreement.15 Accordingly, 6.4.2.  The WTO operates under comprehensive unlike other free trade agreements such as SAFTA, there institutional arrangements, which consist of the following are no geographic limitations on membership, only a bodies: requirement that prospective members are willing to • General Council: the highest level decision making align with the TPP on all issues set out in the agreement. body, which also acts as the Dispute Settlement Body In this sense, it is not a regional agreement, with the and the Trade Policy Review Body. connotations that has about exclusivity of membership; even amongst the existing TPP members (i.e., the • Councils for Trade in Goods, Services and Trade- Pacific Rim region), there is huge diversity in regulation, Related Aspects of Intellectual Property Rights: who economic policy and governance, which demonstrates have responsibility for the WTO Agreements, namely that alignment on such factors is not essential for the General Agreement on Tariffs and Trade (GATT) membership. and the General Agreement on Trade in Services (GATS); and 6.3.11.  The TPP may be a cumbersome instrument to utilise for a discrete issue such as carbon trading, albeit • Various committees and working groups: who deal that it is still too early to make any judgments on this. The with specific aspects of the WTO Agreements, and TPP provides for the establishment of a TPP Commission, report to either the Councils for Trade and Services or whose functions will include monitoring and reviewing directly to the General Council.17 the implementation of the agreement.16 It is unlikely that 6.4.3.  The WTO certainly appears, on the face of it, to the TPP Commission would have the requisite expertise have sufficient prowess to provide the requisite regulatory or time to effectively supervise the establishment and oversight of a multilateral carbon market linkage. However, functioning of a carbon club. However, the agreement as noted in relation to the TPP, it may be cumbersome 15 Article 30(4) of the TPP. 16 Article 27 of the TPP. 17 https://www.wto.org/english/thewto_e/whatis_e/tif_e/org2_e.htm 16  Analysis of Existing Regulatory Frameworks for a body such as the General Council to exercise a agreements. For example, the general prohibition on specialist regulatory function as a supervisory body of discrimination18 by obliging WTO members to afford most a global carbon market given its broad remit. Although favoured nation treatment to all other members, could the General Council could be supported in this function mean that discriminatory treatment of carbon units based by the councils, committees and working parties below on country of origin or type of unit (i.e., allowance or it, this may only serve to create an overly complicated offset) violates WTO rules. Accordingly, prior commitments governance structure. made by participants of the multilateral carbon club, for example through existing bilateral arrangements, may be 6.4.4.  One might argue that the United Nations classed as discriminatory.19 Equally, national measures Framework Convention on Climate Change (“UNFCCC”) imposing quantitative restrictions on the import of foreign has an equally complicated governance structure. carbon units could fall foul of the WTO rules against However, its climate change function is more focused and quantitative restrictions. relevant than that of the WTO. Further, it is more likely that a body constituted under the UNFCCC, such as the CDM 6.4.6.  The applicability of these principles to carbon Executive Board, has the requisite specialist knowledge units—and the potential obstacles this may present for to act as an effective supervisor of a multilateral carbon carbon market linkage under WTO—is by no means certain market linkage. Therefore, there would need to be a and would require further examination. Nonetheless, compelling reason to elect the WTO framework over the the potential complexity of bolting on carbon trading to UNFCCC as the primary platform for multilateral linkage. the WTO framework militates in favour of adopting an alternative multilateral framework that does not start from 6.4.5.  That conclusion is reinforced when one considers such a position, such as UNFCCC. the other regulatory obstacles presented by the WTO Article I of GATT. 18 As posited by J. Munro in “Trade in Carbon Units as a Financial Service under International Trade Law: Recent Developments, Future 19 Challenges” (2014). 7. Networking, Linkages and the NCM Transaction Scenarios 7.1.  Networking Modality for Scope for 7.1.1.  This section considers ‘networking’ based on a Linking Differences Description number of concept discussion papers, but predominantly Full Direct Requires greater Compliance unit in one on the basis of the paper titled, ‘Networked Carbon homogeneity jurisdiction is accepted Markets—Key Elements of the Mitigation Value without restriction in the Assessment Process’ (Macinante, October 2015) (the “linked” jurisdiction(s). “NCM Concept Paper”). The transactions described in Limited Requires some Compliance unit Appendix 1 are directly from the NCM Concept Paper. Direct homogeneity in one jurisdiction is accepted with 7.1.2.  In light of the bottom-up approach of the Paris qualitative/quantitative Agreement, it is clear that national efforts will lead to restrictions in the “linked” many heterogeneous approaches to managing carbon jurisdiction(s). pricing. As a result, the traditional approaches of direct and Indirect Requires less Markets are not linked indirect linking that often require greater homogeneity20 homogeneity directly, but have access before linkages can be successfully established, must be to a common third supplemented by other ways of considering linkages. carbon market. 7.1.3.  ‘Networking’ (also referred to as ‘NCM systems’) Networking Least Fungibility of carbon aims to enable the comparison of different carbon pricing homogenous assets across schemes systems and trade across different carbon assets with and accomodates facilitated by risk- efficiency, transparency and integrity (Macinante, October greater based assessment and 2015). The NCM initiative sees linking of diverse and heterogeneity discounting. heterogeneous carbon markets as desirable. Networking is about facilitating trade of carbon assets by recognising 7.2.2.  The World Bank Group anticipates that a future differences and placing a value on those differences international carbon market, whether through linking through MV which allows systems to participate in the traditional sense or networking, would develop without necessarily aligning whilst still preserving the gradually and in a phased manner—starting with linked environmental integrity of trade. At the core of the markets within countries, then bilaterally, on a regional/ networking concept is the need for a reliable analytical multilateral basis and long term, helping markets link on a framework to better understand the differences between global basis. systems, in order to compare the relative “mitigation value” of carbon units and facilitate their trade.21 7.2.3.  Bilateral and multilateral linkages effectively create a common market for carbon units if there are no quantitative limits in or other restrictions in place. Carbon 7.2.  Modalities for Linking units originating in one or more markets are eligible for use in the others, and vice-versa.22 An example of such a 7.2.1.  As such, the variety of ways of linking may be Full Direct bilateral linkage is that between California and illustrated as follows: Quebec discussed above. 20 Therefore, leading to greater delay in achieving the desired linkages. 21 PMR and ICAP, “Emissions Trading in Practice: A Handbook on Design and Implementation” (2016, International Carbon Action Partnership & the World Bank). 22 Ibid. 17 18  Networking, Linkages and the NCM Transaction Scenarios Figure 2: Direct Bilateral Linking of establishing homogeneity before linking is time consuming and challenging (as illustrated by the Bilateral Link experiences described in the preceding sections of Country A Country B this paper) then finding alternative or softer linkage pathways, ‘networking’, is worth considering. Of course, networking requires the MV concept to be fully explored and accepted by participating jurisdictions which, while Figure 3: Indirect Bilateral Linking it may have political challenges, may be more practical and achievable, in the nearer term, than achieving agreement on a single homogeneous carbon market. At Country B the heart of ‘networking’ is the idea that there should be an independent assessment framework to determine the climate change mitigation value of the different climate Country A Country C mitigation efforts to enable the carbon units from each scheme to be made fungible in another scheme or more broadly, in the international market. Country D 7.3.  Scale of Linking 7.3.1.  Expanding on the points illustrated above, the Countries B, C and D are each only indirectly linked via linking of carbon markets can also be considered through Country A. the prism of its scale, for example, bilaterally (smaller scale) or multilaterally (larger scale). Within the multilateral Figure 4: Networking context, there are at least two models that could be adopted that are differentiated in their scope by the number of participants and, therefore, scale. Units 7.3.2.  The smaller multilateral model (see Figure 5 System A System B below) is where a number of countries within regional or geographic proximity or other political affiliations sign up to a set of common rules that they agree to apply in Source: NCM. Note: Rather than linking schemes that are the same (e.g., linking two squares), networking seeks to link schemes that are different (e.g., linking squares and circles). Figure 5: Carbon Club Model 7.2.4.  Unilateral linkages are also an example of direct linkages albeit one where emissions flow in one direction Country A Country C only, i.e., one system accepts units from one or more other systems, but not vice-versa.23 7.2.5.  Indirect linkage occurs when two unlinked systems each link a common third system.24 Increasing in scale Regional/Club when numerous countries are linked, the participant countries (see for example the countries illustrated in Figure 3 as Country B, C, D, etc.) are indirectly linked via their common bilateral link with Country A. 7.2.6.  If a global carbon price is the desired outcome, Country B Country D but with a recognition that the classical approaches 23 Ibid. 24 Ibid. Networking, Linkages and the NCM Transaction Scenarios   19 Figure 6: Multilateral Trading Model Country F Country G Country H Country I Country J Multilateral Agreement Country A Country B Country C Country D Country E the context of their trading relationship with each other 7.4.  Transacting Carbon Assets in a Future (the “Carbon Club Model”). This sort of club is often International Market—the NCM Transactions characterised as a ‘carrot and stick’ approach, where (and their relevance in a regulatory framework) benefits are offered to attract countries to sign up to play by the rules and, therefore, exclude those who do not. 7.4.1.  In order to provide a setting in which to assess the regulatory frameworks described in sections 5 and 6, 7.3.3.  The larger multilateral model (see Figure 6 above) this subsection considers the NCM transaction scenarios is where a lot of countries, with little or no geographic described in Appendix 1 (as extracted from the NCM connectivity to each other, sign up to a common set Concept Paper). of rules that they agree to apply in the context of their relationship, sometimes in the context of trading with 7.4.2.  Before seeking to address the regulatory framework each other but not exclusively so (the “Multilateral for networking through MV, it is first worth summarising Trading Model”). Examples of this model already exist the sample transactions highlighted in the NCM Concept such as the World Trade Organisation, the International Paper. Maritime Organisation and the International Civil Aviation 7.4.3.  The NCM Concept Paper describes three possible Organization. options for networking transactional structures in a 7.3.4.  In the context of the multilateral linking approach networked carbon market. For ease of reference, we described above, parallels may be drawn to the have paraphrased Annex D of the NCM Concept Paper two notions of clubs described in the sister paper in Appendix 1 of this paper. However, those transactions commissioned by the World Bank (Brewer, et al. make certain assumptions which necessitate a 2016). That paper describes two notions of clubs; the consideration of their impact on this paper. first “emphasizes the role of benefits as incentives for 7.4.4.  We note that the NCM Concept Paper assumes that participation and compliance . . . the [benefits] must be carbon units will be transferred via an intermediary (e.g., a shareable among complying participants and excludable settlement platform). Broadly speaking, these transactions, to non-participants and non-complying participants.” In in the context of the linked markets, will involve (i) contrast, the second notion “has been stimulated and the import of a foreign unit from another country (the developed more inductively in an effort to supplement “foreign unit”); (ii) the conversion of a foreign unit into existing international institutional arrangements . . . a local unit; and/or (iii) the issuance of a new unit by a the key issue in this approach, then, is the size . . . third party entity following the surrender of the local unit in particular the number of governments involved in to the third party and where the number of new issued negotiations and therefore the prospective size of the units will be based on the applicable MV of that ITU. institution or other arrangements.” These two notions broadly reflect the two approaches to multilateral linkages described above. 20  Networking, Linkages and the NCM Transaction Scenarios 7.4.5.  For the purposes of this paper and for ease of 7.5.  Regulatory Framework Issues Specific cross-reference against the NCM Concept Paper, we have to MV adopted similar terms to describe the three transactional approaches set out in the NCM Concept Paper. These are, 7.5.1.  In each of the three transactional approaches respectively: described in the NCM Concept Paper, one country or subnational entity’s unit is converted based on its MV. i. the Foreign Unit Transaction model; We note that the responsibility of determining the MV ii. the Foreign Unit Imported model; and of a participating country or subnational is assumed to not be determined by that or another country or sub- iii. the International Transaction Unit model (referred to national as they would obviously risk certain biases. We as the ‘Index Unit transaction currency model’ in the agree with this assumption as it is difficult to foresee any NCM Concept Paper). country or subnational willing to have another country or 7.4.6.  Please note that although this is not provided for subnational pass judgment on its relative MV where such in the NCM Concept Paper, in our assumptions above at assessment would result in any other outcome than sections 2 and 3, any of the units used in the transactions MV  1. at (i) and (ii) above would appear to be treated as an 7.5.2.  As such, if some third party (without us passing ITMO under the Paris Agreement but it is less clear comment on the identity or suitability of that third party) whether an ITU under the transactions falling within private sector entity, multilateral entity or international (iii) would qualify as an ITMO, given that the transfer may organisation were to be the assessor of the linked country not be directly to another Party to the Paris Agreement or subnational’s MV (the “MV Assessor”), the legal but to a third party intermediary settlement platform (see framework would also have to ensure that there was p. 34 of the NCM Concept Paper). In order to qualify as an acceptance between the two linked parties of the an ITMO, it will be necessary to link the unit transferred determinations made by the MV Assessor and establish to the third party intermediary and the subsequent a regulatory process to resolve issues arising from such ITU to a unit that is capable of being transferred to the determinations vis-a-vis the impact it would have on any acquiring party. Where that transfer is achieved in a third conversion or mutual recognition of each other’s units party intermediary platform, the mechanism leading to or under the Foreign Unit Transaction model or the Foreign achieving that transfer will arguably need to be recognised Unit Imported model. As mentioned in section 5, one within the accounting guidelines to be developed by the option would be for participating jurisdictions/parties CMA or else the acquisition by a party of the ITU for the to establish a technical working group to agree on the purposes of its NDC will be frustrated. principles, rules and procedures for accepting an MV Figure 7: Possible Transaction Structures: Example of Country A Importing Units from Country B 1. Foreign Unit Transaction Model 2. Foreign Unit Imported Model 3. Index Unit Model International International Domestic Domestic Domestic Transaction Transaction Unit/s Unit/s Unit/s Unit Unit Imports are converted into a certain Imports are converted into a certain Imports are converted into a certain quantity of Country A units, based quantity of generic ‘International quantity of generic ‘International on the MV of Country B’s units. Transaction Units’, based on the MV Transaction Units’ based on the of Country B’s units. MV of Country B’s units, relative to an index. Networking, Linkages and the NCM Transaction Scenarios   21 determined by the MV Assessor as well as how the third that applies MV. To illustrate this point we set out party may be accredited as the MV Assessor. some random examples of points that may need to be addressed depending on the linking modality and linking 7.5.3.  The regulatory framework would also have to scale applied, in each case using MV: consider the relationship between the compliance value and MV. We have assumed that the unit price would be set • In the Foreign Unit Imported model, it would need by market principles. Issues may arise, for example, where to be agreed whether the conversion rate of a unit one of the linked parties seeks to add a qualitative criterion from Jurisdiction A to Jurisdiction B (based on the to the acceptance of the other party’s unit that is in excess relationship of MV to compliance value) is static of any criteria used by the MV Assessor in setting the MV or dynamic. If the MV is based on a forecasted or for the source country’s unit. This becomes an even more anticipated basis, then when the forecast is revised acute issue in the context of the International Transaction (e.g., at an end of compliance phase), what impact Unit model because, in that, the ITU is not issued by does that have to the carbon units that were previously either of the parties to the linked markets. The regulatory converted based on the earlier MV rate? There may framework would have to reflect a solution to complaints be a range of options for how this is achieved but the raised by the other linked party regarding the inclusion of regulatory framework must address this. any additional qualitative criteria (unless that was agreed • In the Foreign Unit Transaction model, if the type of in advance as part of the legal framework negotiations). unit converted from Jurisdiction A is an offset unit, but However, if the MV Assessor’s mandate is, by necessity (in both Jurisdiction A and Jurisdiction B apply cap-and- order to gain international acceptance (e.g., in a multilateral trade mechanisms, how will the MV or Jurisdiction A model)), limited in some of the factors it assesses as part impact offsets that arise outside Jurisdiction A’s cap- of its process, it is possible to contemplate some countries and-trade mechanism? Will Jurisdiction A have both wishing to add its own qualitative criteria on top of the an MV for its offset programme and its cap-and-trade MV. For example, Country B could say that it accepts that programme? What happens if Jurisdiction A expands Country A’s units are worth 5 ITUs via its MV but it could the scope of its sectoral coverage, bringing the offset then say that if the ITU is sourced from an offset source that was from a source originally outside the scope that represents a methodology that Country B does not of that ETS, into it? The regulatory framework linking support, it will not accept those 5 ITUs. Whether such Jurisdiction A to Jurisdiction B will need to address granular linkage between the ITU and Country A’s units are the consequences of such events (e.g., it may need going to be possible or necessary will only be determined to have procedures to limit acceptance of units at the once the MV calculation and ITU issuance process is risk of double counting). further developed. • In the International Transactional model, if a carbon 7.5.4.  In the context of the concepts being considered club chose to establish a common single settlement as part of the NCM systems, other framework such as platform for ITUs but retained their own national an ‘international carbon asset reserve’ (ICAR) or an carbon registries for their own national units, how ‘international settlement platform’, will create additional would a compliance obligation (e.g., a surrender layers of regulatory consideration. In the case of an ICAR, of unit requirement) using ITUs as well as national the intention is to offer jurisdictions an alternative to units be practically managed without private sector establishing their own domestic carbon asset reserve, participation in the international settlement platform? thereby lessening the resource requirement and additional The regulatory framework for using an international regulatory considerations at the domestic level. The settlement platform would need to address the degree and complexity of these regulatory framework issues associated with private (as opposed to considerations will turn on whether the MV is used state level) participation in an inter-governmental for the purposes of bilateral, multilateral or plurilateral process, thereby potentially importing aspects of linkages. For example, it is possible to envisage a single private international law in an otherwise pure public international settlement platform as well as a series of international law regulatory framework. settlement platforms each representing a carbon club that uses MV as their basis for linking. A regulatory framework 7.5.6.  There are of course many other considerations to address the above mentioned tools, will be on top of arising from the MV assessment process, each party’s the regulatory framework aspects already identified in acceptance of the MV Assessor’s determination and the sections 5 and 6 of this paper. issuance of credits based on the MV for which solutions will have to be provided via the regulatory framework. However, 7.5.5.  In addition to those identified in paragraph 7.5.3 it is not possible to articulate further regulatory aspects until above, it is possible to envisage a multiplicity of matters the MV concept and process has matured further. that will require resolution under a regulatory framework 8. Conclusions 8.1.  8.1.1.  The challenge of establishing a regulatory 8.1.4.  We hope that it is clear from the paragraphs framework for carbon market linkages in the abstract above, that it is difficult to suggest a regulatory framework is that it can only be done at a very high level. In the for linked carbon markets without knowing the drivers traditional model of linking whereby greater homogeneity for their linkage. We have provided a few examples to is established, the specific considerations for a regulatory enable ‘food for thought’. However, a lot more analysis framework for linked carbon markets are likely to be will ultimately be required in respect of the governance influenced by the differences between the two markets and legal framework for the specific markets to be that must be resolved prior to or as a condition of linking linked before additional granularity can be provided on (in the bilateral linking model), or by the market design the applicable regulatory structure. Using the MV as a under the common set of rules to be established for the basis for linkage creates the most significant regulatory purposes of setting up the Carbon Club or multilateral framework feature between linked countries—that of instrument. The hierarchy of frameworks also means acceptance of an MV assessed by the MV assessor. This that the regulatory framework only follows from the legal is because this step is not required for more traditional framework, which itself follows from the governance forms of linking as there is usually an assumption, at framework. the end of the negotiations that create the homogeneity required for traditional linking, that a tonne of CO2 is the 8.1.2.  It is because of that challenge that this paper same for each scheme. If this assumption were to not does not seek to address questions of supervision and apply then, there would also be a need for acceptance enforcement of linked markets. After all, as illustrated between the two linked parties of the determinations in the California-Quebec example, the question of how made by the independent assessment process and private citizens, participating in the scheme of one sub- establish a regulatory process to resolve any issues that national are subjected to the enforcement jurisdiction arise from it. With this, all the questions that typically arise of another subnational, was not addressed in its legal in relation to a third party assessment (e.g., withdrawal framework and therefore, there is no regulatory oversight from the assessment, revision of the MV levels post facto, other than presumably for each market or scheme to impact on investors, market certainty, fraud/corruption regulate its own actors and to invite one regulator to assist by the assessor, etc.) become material elements for the another on a cross border basis. Many other examples of regulatory framework to consider. regulatory supervision may arise because of the specific features or characteristics of the two markets to be linked. 8.1.5.  In terms of our analysis of existing plurilateral and multilateral frameworks as suitable foundations for 8.1.3.  At a high level, the institutional regulatory future linked carbon markets, we perceive most of them framework discussed in this paper will be familiar to many to not be particularly suitable for such purposes. One of readers. This sort of institutional framework is common in the often raised criticisms of a platform that is primarily many plurilateral or multilateral bodies and is not original designed to promote trade is that those priorities will or unique to the carbon markets. That said, one carbon often conflict with environmental objectives. This can lead market feature that does not arise in those models, and to a lack of effective integration and implementation of therefore is unique to carbon markets—is the registry environmental policies as part of an organisation’s work and auction platform. However, whether (i) a common on trade. As such, few existing trade organisations include registry or auction platform is created for the linked an environmental focus or chapter. Even if they do, they markets, or (ii) the existing registries of the two markets are given lower ranking priority to perceived greater goals. are merely linked via a transactional log is a feature of However, the TPP, as an example of a more modern trade the remaining differences of the two markets post linkage agreement, seems to strike a better balance in recognising or of the overall market design for the linked markets. the importance of environmental policies as part of its Certainly in the context of the Foreign Unit Transactional broader remit. Therefore, the TPP may provide a better model and the Foreign Unit Imported model, a common foundation for its members on which to build a linked registry or settlement platform in unlikely. However, in carbon market than many of the other trade agreements the International Transaction Unit model, an independent where the environment or climate change is not its raison registry, on top of the respective registries for each of the d’être. linked parties would be contemplated. 22 Appendix 1 8.2.  NCM Transaction Scenarios Compliance Value 8.2.1.  This part sets out three example NCM transaction • Jurisdiction A regulator/scheme administrator scenarios: determines the CV of A units. • the Foreign Unit Converted model; • Jurisdiction B regulator/scheme administrator determines the CV of B units. • the Foreign Unit Imported model; and • CV does not come into the transaction equation, • the International Transaction Unit model. because the units surrendered against compliance in any jurisdiction will always only ever be the domestic Example NCM Transaction Scenario: Foreign Unit units of that jurisdiction. Converted Model Financial Value Jurisdiction A Jurisdiction B • The price reached by Seller A and Buyer B will be substantially influenced by the exchange rate on MV = A MV = B the date of the transaction, as in effect, this will Trades A units Trades B units determine the compliance value. Compliance entity A wishes Compliance entity B wishes • As the exchange rate derives from the respective to sell 12,000 A units to to buy 12,000 A units from MVs, the price should be a reflection of the relative Compliance entity B Compliance entity A MVs of the two jurisdictions. On xx/yy/zz date: e.g., MV A/B translates into an exchange rate of 1.5 (that is, 1.5 A units = 1 B unit) Example NCM Transaction Scenario: Foreign Unit Imported Model 12,000 A units debited 8,000 B units credited Compliance entity A’s Compliance entity B’s account in A registry account in B registry Jurisdiction A Jurisdiction B MV = A MV = B Transaction Trades A units Trades B units • The respective MVs of the two jurisdictions translate Compliance entity A wishes Compliance entity B wishes to sell 12,000 A units to to buy 12,000 A units from into an exchange rate between them (how this Compliance entity B Compliance entity A is worked out will be critical, but assume for the purpose of this example it can be). On xx/yy/zz date: e.g., MV A/B translates into an exchange rate of 1.5 • The counterparties agree how many of the seller’s (that is, 1.5 A units = 1 B unit) carbon units they wish to transact. 12,000 A units debited 12,000 A units credited • The applicable exchange rate, on the date of the Compliance entity A’s Compliance entity B’s transaction, determines the number of carbon units account in A registry account in B registry that are credited to the buyer’s account in the buyer’s registry in the carbon units of the buyer’s jurisdiction: Transaction the regulator/scheme administrator in Jurisdiction B cancels the 12,000 A units received in the registry • The respective MVs of the two jurisdictions translate account and issues in their place 8,000 B units. into an exchange rate between them (how this is worked out will be critical, but assume for the • The transacted number of seller’s carbon units purpose of this example it can be). are debited from the seller’s account in the seller’s registry: regulator/scheme administrator in • The counterparties agree how many of the seller’s Jurisdiction A does not need to do anything after the carbon units they wish to transact. 12,000 A units have been transferred out of the A registry account. 23 24  Appendix 1 • The applicable exchange rate, on the date of the them to the Jurisdiction B regulator/scheme transaction, is immaterial to the transaction as administrator against compliance obligations under the number of carbon units that are credited to Jurisdiction B ETS. On that date, Jurisdiction B the buyer’s account in the buyer’s registry are the regulator/scheme administrator determines what CV same as the number debited from the seller’s to give to the Jurisdiction A units. If the exchange rate account in the seller’s registry: the regulator/ has changed between the dates, xx/yy/zz and aa/bb/ scheme administrator in Jurisdiction B by agreement cc, then what the CV Buyer B gets for the 12,000 A with Jurisdiction A, accepts A units and credits the units on aa/bb/cc may be different from that which 12000 A units received in the registry account to would have applied on xx/yy/zz. Buyer B carries Compliance entity (buyer) B. that risk. • The transacted number of seller’s carbon units Financial Value are debited from the seller’s account in the • The price reached by Seller A and Buyer B will be seller’s registry: regulator/scheme administrator in influenced by the exchange rate on the date of Jurisdiction A doesn’t need to do anything after the the transaction, but only to the extent that: (a) the 12,000 A units have been transferred out of the A exchange rate is relevant to the CV on that date, registry account. which may be a function of the NCM arrangements, Compliance Value e.g., might be exchange rate on date of transfer converts directly to CV, or alternatively, might be left • Jurisdiction A regulator/scheme administrator up to Jurisdiction B regulator/scheme administrator; determines the CV of A units. and (b) the surrender date for compliance in • Jurisdiction B regulator/scheme administrator Jurisdictional B is proximate to the transaction date. determines the CV of B units. • CV becomes relevant on the date [aa/bb/cc] that Compliance entity (buyer) B wishes to surrender Example NCM Transaction Scenario: International Transaction Unit Model Index (‘II’) based on, e.g., all MVs of trading jurisdictions; Index has Jurisdiction A notional ITUs Jurisdiction B MV = A MV = B Trades A units Trades B units Compliance entity A wishes to sell Compliance entity B wishes to buy 12,000 A units to Compliance entity B 12,000 A units from Compliance 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 of 0.8 (that is, 0.8 ITUs = 1 B unit) 10,000 B units credited Compliance entity B’s account in registry B Appendix 1  25 Transaction • CV does not come into the transaction equation, because the units surrendered against compliance in • The respective MVs of the two jurisdictions translate any jurisdiction will always only ever be the domestic into an exchange rate between each of them units of that jurisdiction. respectively and the Index (how this is worked out will be critical, but assume for purpose of this Financial Value example it can be). • The price reached by Seller A and Buyer B should be • The counterparties agree how many of the Seller A’s substantially influenced by the two exchange rates carbon units they wish to transact. applicable on the date of the transaction, as in effect, this will determine the number of B units received • The applicable exchange rate A/II, on the date of by B. the transaction, determines the number of ITUs that are credited to the Seller A’s pending account on the • As the exchange rates derive from the respective International Settlement Platform. MVs in relation to the Index, the price should be a reflection of the relative MVs of the two jurisdictions • On financial settlement, the ITUs in Seller A’s pending to the Index and ultimately, to each other. account are transferred to Buyer B’s pending account. • However, nothing above prevents the Buyer B from • The applicable exchange rate II/B, on the date of speculating on an improvement of the exchange transaction (or on whichever date Buyer B decides rate II/B, by continuing to hold the ITUs in its pending to move them from its International Settlement account and only transferring them to its account Platform pending account to its account in registry B), in registry B as B units, when that more favourable determines the number of B units that are credited to rate applies or when it absolutely needs to, e.g., for the Buyer B’s account in registry B. compliance reasons. This would not impact in any Compliance Value way on the other elements, such as the CV, since it would just be the number of B units received in the • Jurisdiction A regulator/scheme administrator B registry that might vary. The ITUs held in this way determines the CV of A units. in the pending account would only be able to be • Jurisdiction B regulator/scheme administrator converted into B units. determines the CV of B units. References A. Petsonk and N. Keohane (August 2015) Creating a J. Macinante (2015) Network Carbon Markets Key Club of Carbon Markets: Implications of the Trade Elements Mitigation Value Assessment Process. System. J. Meltzer (2014) The Trans-Pacific Partnership A. Tuerk, W. Sterk, E. Haites, M. Mehling, C. Flachsland, Agreement, the environment and climate change. H. Kimura, R. Betz, and F. Jotzo (May 2009) Linking J. Munro (2014) Trade in Carbon Units as a Financial Emission Trading Schemes—synthesis report. Service under International Trade Law: Recent C. 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Paper. 27 http://www.worldbank.org/en/topic/climatechange/brief/globally-networked-carbon-markets Contact: Bianca Ingrid Sylvester Tel: 202.473.4549 email: bsylvester@worldbank.org