Why is the Adaptation Benefit Mechanism a non-market mechanism?

Article 6 of the Paris Agreement makes provision for the development of both market and non-market mechanisms. While there is no formal definition of a market and a non-market mechanism, one may suppose that market and non-market mechanisms could share a common basis of how to methodologically determine baselines and estimate climate outcomes. The verification process could also be similar. The key difference could be that non-market mechanisms do not result in universal and internationally tradable units that could be re-sold and be subject to market price fluctuations and speculation. It may be assumed that non-market-based mechanisms is an umbrella for a variety of climate policies, measures and actions that could not be described as market mechanisms.

So, what are the features which define a market mechanism? Markets are characterized by a demand for a good met by a supply of a good, with a price determined by a supply and demand function. There is a high degree of comparability or fungibility between the units that are for sale and the goods can be transferred between the buyer and seller. With these characteristics, we can consider that a market may be a simple bartering exercise in a village market where goats are exchanged for grain or the most sophisticated foreign exchange market operating in real time across multiple time zones.

If we take away some of these characteristics then, the author proposes, that a market becomes more of a non-market.

For the ABM, the “good” which we need to consider is the Adaptation Benefit Unit of “ABU” – this is what is delivered to the entity which provides the funds (the “funding source”) for the adaptation project. Under the ABM as proposed:

1)  There are no supply and demand curves for ABUs. There cannot be a supply curve because the units are not fungible or even remotely comparable – a cooking-stove project might deliver ten thousand ABUs at a price of USD10 per year for three years (total cost USD 300,000) whilst a mangrove management project to protect a community of 100 houses may need to sell 100 ABUs at a price of USD50 each per year for 10 years (total cost USD 500,000). So, it is not possible to add up the national or global supply of ABUs. Likewise, there is no accumulated demand curve – whilst there may be an obligation to support adaptation, there is no definition of adaptation against which to assess compliance and no way of saying how many ABUs donors and the CSR sector want to buy. And hence there is no supply and demand function to set the price, as seen in market mechanism, but instead project costs are used to set the price for a given ABU;

2)  As stated, there is no fungibility between units. An ABU from one project cannot be substituted for an ABU from another project and since there is no compliance regime, there is no need to do so; and

3)  If ABUs are issued into a registry from which they cannot be exported, they are not subject to international transfer and funding sources cannot take delivery of the ABUs. All the funding source receives is the cancellation codes. These cancellation codes could be sold but there is no scope for the seller to profit from on-selling the cancellation codes. A buyer may pay a small fee for the sake of convenience but the price of ABUs will always be close to the cost of production as detailed in the project documentation.

So, on this basis the mechanism for financing the generation of ABUs is very different than for market mechanisms and may therefore be considered to be a non-market mechanism.

An interesting element of the ABM is the role played by the project developer. The project developer may be a commercial private sector company, a non-profit NGO, any other kind of Civil Society Organization, an MDB or a Governmental agency. They all would be entitled to recover (a portion of) the project costs from the generation of the ABUs to compensate them for the risks they have undertaken in the process. These project costs are made transparent in the project document so that the buyer can assess whether they are reasonable. There is an element of a market in this respect because one project developer might offer to implement an Adaptation Benefit Mechanism project of the same quality at a lower price, but this would be a normal competition among project developers and service-providers that exists for all tendering procedures. Such contracting is an aspect that does not play a role in qualifying an international mechanism as a market- or non-market based. Such kind of competition is considered to be a good thing as it encourages quality, reliability and value for money.

An exciting component of the ABM is how the project developer would use the projected cash flow from the delivery of the ABUs.

In the simplest case of a project which has no underlying revenue stream – for example, a project which aims to educate farmers in climate smart agriculture techniques, the project developer may operate “hand-to-mouth” and pay the extension workers directly from the revenues from the delivery of the ABUs. A more sophisticated project developer may be able to borrow money from a commercial or a development bank to pay his staff before any ABU cancellation codes are delivered.

In a project where there is an underlying revenue model, for example an ethanol cook-stove project, the project developer may use the ABU offtake agreement to borrow money to buy an inventory of ethanol cook stoves and convince a sugar factory to make ethanol from their waste molasses to meet the expected demand; or the project developer may add some of their own equity and even bring their own technology to the project. Once the initial barriers have been overcome, there is a profitable long term business for the project developer.

Therefore, while ABM has the potential to leverage finance to otherwise economically unattractive climate activities and create employment for project developers and implementing staff, the underlying financial instrument – the ABU – remains the product of a non-market mechanism.