(image: UNFCCC)

Wed 3 Apr 2019 – The ICAO Council has now adopted long-awaited eligibility standards that set guidelines for what types of units airlines can use to offset their emissions growth under CORSIA. There are currently about two billion carbon offsets in circulation produced by the UN’s Clean Development Mechanism (CDM). A large proportion of that volume has already been used for compliance purposes by governments and also companies, for example under the EU ETS. If the remaining units – and those to be generated by CDM projects in the future ­– are allowed under the scheme, their volume would far surpass demand for offsets by air carriers. On the flipside, restricting the amount of CDM units eligible under CORSIA to only those with high environmental integrity would severely limit offset supply. This analysis by Refinitiv highlights a few possible offset unit supply scenarios, each reflecting potential restrictions to CDM unit eligibility on the basis of the adopted offset criteria.

ICAO’s CORSIA carbon offsetting scheme caps international aviation emissions at their 2020 level and air carriers can use it to offset emissions they do not manage reduce through technical and operational measures. Specifically, air carriers will use CORSIA to offset emissions that surpass the established baseline of average emissions in 2019 and 2020. Offsetting consists of paying for emissions mitigation elsewhere in the world, an attractive option for aviation operators as it allows them to cut emissions at a lower price.

The scheme begins in 2021 on a voluntary basis, with carriers having to offset emissions from countries participating from that year. Participation is mandatory as of 2027, meaning the offsetting requirement applies to emissions from most major routes in the world as of that year. Although this timeline has been set since 2016, ICAO did not weigh in on what type of offsets might be allowed until more recently. In late 2018 and early this year, the ICAO Council elaborated CORSIA’s details by outlining eligibility requirements for offset project standards and offset types. Known as Emissions Unit Criteria (EUC), these guidelines form the basis for offset eligibility. A new ICAO sub-entity operationalised at the March Council meeting – the Technical Advisory Body (TAB) – will now apply the EUC to project standards and offset types interested in supplying units to aircraft operators under CORSIA.

The CDM is one of those standards. The programme was set up as part of the Kyoto Protocol, under which countries and companies could purchase reductions from CDM projects (called CERs) to offset their emissions to reach targets under the treaty. The first CERs were issued in 2005. Since then and up till now, the CDM has produced a huge amount of carbon units (nearly 2 billion tonnes), which companies and countries in Europe and elsewhere purchased for compliance in emission trading systems. While the CDM spawned emission reduction activities in developing countries and investment in mitigation, many of the CDM projects lack environmental integrity and are not vulnerable to the risk of discontinuing GHG abatement. The mechanism has been disfavoured in retrospect, which has drastically decreased demand for CERs, whose prices have in turn tumbled from €6/tonne back in 2012 to 20 Euro cents ($0.22). The lack of demand accumulated a large surplus of CERs.

CDM project developers consider CORSIA a potential new source of demand for their credits. But given the controversy over the environmental integrity of CERs, ICAO is likely to be cautious about their eligibility under CORSIA. Observers have lobbied for an outright ban on the eligibility of CERS from at least the most dubious CDM project types or those from projects that have been ongoing for many years. Allowing the entire existing CER surplus into the scheme would result in very low prices, and thus little incentive for airlines to achieve real emissions reductions.

According to a recent assessment by Carbon Market Watch, the CDM fails to meet three of the 11 eligibility criteria set by the EUC (the full list of EUC criteria can be found here):

• a safeguard system (ability to identify negative environmental and social impacts while implementing the project);
• sustainable development criteria (which should be publicly disclosed for each project); and
• avoidance of double counting, issuance and claiming (should be adjusted to the corresponding rule adopted under the Paris Accord).

Consequently, the body in charge of the CDM may have to adjust the mechanism’s methodologies to correspond with all the EUC requirements. It is worth noting that none of the offset programmes reviewed by Carbon Market Watch met the criteria, meaning the lack of particular required characteristics is not just CDM-related but rather a general problem by that group’s assessment. Some of the criteria are impossible to meet at this stage, such as the requirement avoiding double counting, given that corresponding regulations under the Paris accord have not yet been finalised.

In this context, we provide our view on the potential CER use restrictions and correlating supply for CORSIA. We also look at these different supply scenarios with our baseline demand estimation, to highlight the role of the CDM in the overall CORSIA market balance.

Who is in, who is out?

We accessed the existing CDM project portfolio (source: UNFCCC, Refinitiv CDM databases), starting from projects at validation stage and up to those that were issued CERs (prior to registration, CDM projects have to pass a validation stage). We disregarded projects that got stuck at validation and did not move to further stages, as these projects are likely dead – even if they are operating, they likely lack so-called ‘vulnerability’ since they managed to survive without CER revenue.  

Furthermore, we disregarded projects that stopped issuing CERs after the first Kyoto Protocol’s commitment period. A large number of project owners simply stopped requesting CER issuance given the extremely low CER prices. If these projects are still operating without issuance and sale of CERs, they are not dependent on CER-related income and thus not vulnerable to the risk of discontinuing GHG abatement. We consider ICAO may disregard such projects with a low vulnerability component.   

Our CDM project database indicates that overall CDM project performance is close to 80% – out of planned annual volume, close to 80% is usually issued. We assume it takes up to two years from generation to issuance of a credit, based on the UNFCCC projects’ issuances statistics.

The table below explains our high, medium and low supply scenario based on other criteria: accepted vintage year and project type. The discussion about restricting CER eligibility by vintage (i.e. by when the unit was issued, with earlier vintages being too old to be considered eligible) has centred around the cut-off dates 2013, 2016 and 2020. The latter would be the most strict, with only CERs issued after 2020 being eligible. As for restrictions by project type, stakeholders have generally considered large projects like hydropower or industrial gas reduction activities most objectionable – they have produced the largest number of dubious CERs, which we eliminate from potential circulation under CORSIA.

CERs supply scenarios:

In our high volume scenario, we assume all the credits generated from 2013 on are eligible, without any project type restrictions. We choose 2013 as the first year after the Kyoto period ended. Some ICAO member states prefer to allow offset units from as far back as possible – the Kyoto commitment period or right after the Kyoto era. We attribute a low probability to this scenario, since it would mean CORSIA becomes oversupplied with a variety of carbon units lacking environmental integrity. That would put the scheme’s efficiency under question.  

In our medium volume scenario, we limit eligible project types by eliminating the most contentious ones (HFC, large hydropower and adipic acid projects). Since these account for the lion’s share of issued CERs, this reduces supply significantly. Furthermore, we limit vintage year to 2016 and later.

Our low volume scenario restricts potential supply even more by setting the vintage eligibility cut-off at 2020 (this cut-off year was proposed by some ICAO parties). We consider that both medium and low scenarios are equally likely. The time limit may be the hardest point to agree on in the negotiations. If the cut-off date is set shortly before the start of CORSIA (2021) it would eliminate most existing units. The inflow of new projects was low over the past years, as was the number of crediting period renewals. Most projects entered the CDM pipeline back in Kyoto times, and as just a few of them renewed their crediting periods, the share of projects still generating carbon units after 2020 is rather low.

In our lowest volume scenario, we eliminate CER supply from projects in countries that have not declared they will participate in CORSIA from the pilot phase (China, India and Brazil). This scenario is rather speculative, since ICAO may still allow offset units from projects in these countries (or some of them) as a means to support socially disadvantaged groups or implement mitigation measures in cities with high air pollution, such as for example India. We attribute a low probability to this scenario.  

The graph below shows projections of volume in four different supply scenarios. From 2021, our demand curve takes into account only those countries that have so far committed to take part in CORSIA from that year. From 2027 onwards, we assume that all countries (in particular large emitters) corresponding to CORSIA’s requirements will participate. How does this compare to likely supply?

Baseline demand/supply scenarios:

As can be seen from the graph above, the high volume scenario will provide twice the amount needed to meet demand all the way up to 2035, the default expiry date of CORSIA. The medium scenario almost coincides with the estimated demand (2 billion units). And finally, both low scenarios are far from meeting the demand. Cutting eligible vintage years to 2020 would result in only about 500 Mt CERs by 2035, which is one-fourth of the same supply scenario, allowing vintages from 2016. Excluding the largest CER providers from the list leaves us with only 243 Mt of CER supply by the end of 2035. Given how much vintage restrictions can influence CER supply, it is not surprising that ICAO stakeholders have flagged them as a key controversial offset eligibility consideration.

Increased demand incentivises supply

The CORSIA market balance cannot be assessed with certitude until after the detailed eligibility criteria have been set. It is hoped that by the end of 2019 we may know more about what kind of projects and programmes will be able to supply credits to CORSIA. As more clarity arises, the more active the market may get.

We assume airline operators that fly routes between countries joining CORSIA in 2021 will show interest in pre-compliance offset purchases to hedge against future offset price increases. Such increased demand in turn usually incentivises increased supply. With current low CER prices, many project owners have temporarily suspended their projects’ development or CERs issuance, since income from CER sales was hardly enough to cover the project and transaction cost. With real demand materialising in future, both these so-called ‘dormant’ and new projects may enter the CDM cycle and issue credits, so increasing supply.

All this may not result in a dramatic increase in CER trading during CORSIA’s pilot phase (2021-2023), as the first compliance deadline is not until April 2025. However, market activity can be expected to increase in the run-up to CORSIA’s mandatory phase in 2027. Any news that countries (especially the largest ones: China, India and Brazil) currently not slated to participate in CORSIA’s voluntary phase but deciding to do so earlier than 2027 will spur market activity considerably. 

It is still unknown if the Paris Agreement (PA) would accept CERs or remodeled CDM projects. At the moment, only a handful of countries have said they are willing to use foreign carbon units to comply with their post-2020 emission reduction objectives. With more clarity on the PA and its eligible units, more countries may be willing to rely on offsets, including CERs. If that happens, the governments of these countries may become a source of demand for offsets as well, presenting competition for air carriers over eligible international offset units. The scale of such competition will matter most if both ICAO and the UN parties apply the strictest rules defining eligible offsets.

The author of this article, Maria Kolos, is a carbon market analyst with Refinitiv, formerly the Financial & Risk Business of Thomson Reuters.

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