Last month, Friedrich Merz was sworn in at the head of a new government in Germany, promising a new era of lower taxes, higher growth and tougher migration policy. In many respects, this is standard fare for a centre-right leader cleaning up after left-wing drift. But buried in the 144-page coalition agreement was a quietly revolutionary approach to dealing with climate change – the use of international carbon credits. And many of our peers are looking to do the same thing – Switzerland made headlines last year by funding electric buses in Thailand.
Yet here in the UK, the Labour Government is giving credits a firm ‘nein’ – prioritising ideology over pragmatism and likely making decarbonising more expensive than it needs to be. For politicians seeking a new strategy on climate that dispenses with some of the previous green dogma, carbon credits are a good place to start.
Basic economics says that if two parties face differing opportunity costs for the same good, trading can lead to better outcomes for both – the foundational logic behind free trade and all of the wealth it has brought the world. But in the world of carbon, while we embrace this logic domestically via emissions trading between firms, we shun it internationally – for the sake of our carbon budgets and international obligations, only reductions here at home ‘count’.
International carbon credits have had a rocky history over the last 20 years.
The Kyoto Protocol, the forerunner to the Paris Agreement (which governs climate change at an international level), included mechanisms for countries to trade emissions reductions – and the first global carbon market was born. After all, emissions reductions tend to be cheaper in developing countries than in developed ones, and the planet couldn’t care less – a tonne of CO2 is a tonne of CO2, regardless of who emits it.
But while the market got off to a strong start in the 2000s, 2012 saw a dramatic crash in the value of the credits, while integrity issues began to rear their head. The EU eventually decided it had had enough, and disavowed the credits for future use in the ETS – which has continued in the UK post-Brexit. More recently the voluntary markets (where for example do-gooding corporates purchase credits to show how green they are) have been in the news for all the wrong reasons, with similar allegations of over-counting (hotly disputed, it should be said).
And yet while bad apples have undoubtedly given carbon credits a dirty reputation, the concept itself is still sound – and the whole cart is not rotten. Indeed, the Paris Agreement endeavoured to learn from the mistakes of Kyoto and created a new international trading mechanism at the country-to-country level, known as Article 6. And though it’s taken nine grinding years of negotiations to put all the rules in place, COP29 in November saw a breakthrough agreement. Which means it’s deal-making time.
It’s a win-win – rich countries get to hit their targets at lower cost, while poorer countries get development finance through the door, and eventually reap the benefit of the emissions reductions. Returning to the basics of comparative advantage, trading lets all countries hit their emissions targets at substantially lower cost than if they did so on their own. Indeed, according to the COP29 presidency using Article 6 could save as much as $250 billion per year if all countries participated. While on an individual level, Singapore’s recent tender reportedly received bids ranging from $19 – $41 (£14 – £30) / tonne for delivery to 2030 – meanwhile, the European carbon price (which we’ll soon be pegged to) is trading at €76 (£65) / tonne. And thus countries both developed and developing are lining up to take advantage of these new markets, as the chart below from the IETA shows.
Article 6 bilateral agreements
Source: IETA, via The Nature Conservancy
As a self-professed climate leader, where is the UK in all this? Absent, unfortunately.
Despite the fact that the Climate Change Act 2008 explicitly allows for it, both the previous government and the new one are declining to use credits (though not completely ruling out their future use). This abstinence policy stems from the Climate Change Committee (CCC), who have consistently advised against it. Their recent CB7 report states ‘Planning to use credits to achieve UK targets carries risks, including the potential to undermine international leadership, reducing the clarity of domestic sectoral action, and failing to deliver carbon budgets if international credit supply proves unreliable’. (Though they are open to future use in limited circumstances).
And to be fair to them, past experience does at the very least warrant caution. But standards have undoubtedly been improving, thanks in part to our own Government. Rather ironically in a bid to position itself as a green finance hub, the Government is currently working on ‘establishing a global framework to build trust and confidence in carbon and nature credit trading’ – but only in the voluntary market, not for wider use.
And to be crystal clear, these credits absolutely must be ‘real’ if we are to use them – doing so cannot be an exercise in ‘greenwashing’. We should insist on the highest standards of integrity, monitoring and transparency – which we can, given the Government has to negotiate the relevant bilateral agreements before any projects can go ahead. Some sort of risk buffer (as the Swiss do) or non-delivery penalty (as in Singapore) would be prudent.
Furthermore we should only partner with countries with ambitious climate goals themselves (to avoid any bad incentives), and take care that we’re not buying the ‘lowest-hanging fruit’ which forces higher-cost reductions on the developing world. And presumably green groups here would be falling over themselves trying to poke holes in any UK-funded projects, providing (very welcome) scrutiny.
But beyond the understandable scepticism of whether such credits are ‘real’, in the wider green community there lies a far more deep-seated ideological opposition. Namely that using international credits is a moral hazard – a way for rich countries to slither out of their commitments, and delay the difficult work of decarbonisation at home.
Here I would make two points. The first is that the political winds seem to be shifting on climate action. From the US to the EU to Canada, voters are telling pollsters they want to go green, while voting for parties that want to do the opposite. Here in the UK, Kemi Badenoch recently abandoned the Net Zero by 2050 target altogether for being too expensive, while Labour’s commitment to the cause is a source of constant speculation and debate. And globally we are way off track to hit the Paris Agreement goal of limiting temperature rises to acceptable levels.
Now you may think the ‘greenlash’ is overblown, or that technology and economics will drive decarbonisation regardless of what politicians do. Alternatively, I suspect some CapX readers will be actively cheering this turn of events. But whatever your persuasion, a cheaper way to decarbonise is a powerful tool to convince politicians to stick to ambitious climate targets, rather than abandon them. Just look at Germany, where according to Politico, the inclusion of credits was critical to getting support from the new Government for the EU’s ambitious 2040 target.
The second point I would make is that the credits are time-limited – rich countries don’t ‘own’ those emissions reductions in perpetuity. The UN market for Article 6 credits sets explicit time limits, and while this doesn’t apply for bilateral deals, it’s unlikely any selling country would sign away these reductions forever. After all, seller countries will have their own targets to hit down the line. (The Swiss-Thai bus deal for example only grants credits until 2030).
So for a country like the UK, using credits is simply buying time (literally), not indefinitely postponing emissions reductions. And indeed, time can be quite valuable given the scale of economic change decarbonisation requires. For an industrial emitter, five or ten years might be the difference between getting the grid connection or hydrogen needed to decarbonise cost-effectively, rather than being forced to take a sub-optimal route, or worse yet offshore production. Or time to let cost curves come down for key technologies, so that mass uptake involves more consumer choice and fewer government subsidies and bans. Indeed, rather remarkably, while our CCC advises against it, the CCC’s equivalent in Australia makes exactly this point in a recent report (and unsurprisingly Australia is among the countries looking to make deals in the new Article 6 market).
Now, using credits is by no means a cure-all. For starters, it’s a bet that decarbonising in future will be cheaper or easier – if not, a company purchasing them could find themselves paying more overall – for the credits today, and the same decarbonisation tomorrow (time value of money aside). And in many cases, deployment itself will be a driver of cost reduction – just look at offshore wind. So deciding exactly which sectors to use credits in (whether public or private) and to what degree will be a thorny issue for the Government.
But none of the above justifies our current policy of total abstinence. Again the contrast with the Government’s position on the voluntary markets is stark – just this week the UK launched a Coalition with Singapore and Kenya committed to ‘rapidly boosting demand for carbon credits’. Kerry McCarthy, Minister for Climate is quoted as saying ‘the UK is championing the responsible use of carbon credits… giving businesses the clarity they need to invest in high-integrity credits that drive real impact for climate and nature, unlocking carbon markets as a trusted tool in accelerating towards net zero’. But again, this only applies for the voluntary markets – so essentially the Government is happy for a financial institution (which won’t have much direct emissions to begin with) to use these credits (alongside direct action themselves) – but not for heavy industry subject to our carbon tax.
Even if the Government decided it didn’t want to use them in any particular sector, at the very least they might come in handy as a ‘backstop’ to meeting our carbon budgets in case we fall short. Committing to such a policy in advance might also protect future Governments from the risk of Judicial Review that so bedevilled the last one on this issue.
The point is not to advocate for any particular use case – but rather to say we should at least start to have the conversation, as many of our peers are doing. In practice, our room for manoeuvre on this issue may have just been constrained by the new UK-EU partnership signed by Keir Starmer – though luckily the EU is reportedly looking at the use of credits as well.
The trickiest bit of all is of course the politics. Overseas aid is famously unpopular with voters. And while we get real tangible benefits from buying credits, it is undeniably funnelling money abroad that would otherwise be spent at home. But on other hand, deindustrialisation and the accompanying job losses are arguably even more unpopular – just look at Nigel Farage’s campaigning on the issue. And Article 6 credits could add another tool to our arsenal on this issue, alongside a well-designed Carbon Border and a strategy to lower industrial energy prices (Monday’s Industrial Strategy was a step in the right direction, but far more needs to be done).
More widely, as mentioned above, voters tend to like being green but not like it as much when it starts to hit their wallets – and using credits can help square that circle. Or to put it differently, from a political economy perspective, using credits would never be your first choice – but you could absolutely see a world in which it’s your least worst choice.
Which brings us back to Germany and the coalition agreement. A centre-right government entering power with a mandate from voters to clean up the mess made by the centre-left, not least on energy and environment. And thus Chancellor Merz has agreed to support ambitious climate targets – but put all options on the table for meeting them as cheaply as possible. Perhaps Germany points the way for our future.
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