PIK’s cost optimization models for Jurisdictional Reward Funds (JRFs) focus on delivering the EU’s allowed 5% international flexibility (~236 MtCO₂ reductions in 2040 relative to 1990) at minimal cost while ensuring environmental integrity, accounting for economic rents, carbon leakage, and co-benefits.

The models treat the EU as a centralized buyer procuring high-integrity credits through multiple JRFs. They optimize the allocation of a fixed budget across different mitigation levers to maximize net emission reductions (or minimize cost per ton) under real-world constraints:

• Universal benchmarks and performance-based rewards (not project-level additionality).
• Informational rents (payments often exceed mitigation costs to maintain credible long-term incentives and avoid gaming/renegotiation).
• Carbon leakage adjustments (net global reductions after trade and production shifts).
• Co-benefits for the EU (e.g., lower global fossil fuel prices reducing import bills and improving energy security).

The models generate marginal cost curves and portfolio shares that shift with the target volume. Fossil fuel levers become more attractive at scale because of their leverage on global markets and lower effective costs after leakage and price effects.

A new study from the Potsdam Institute for Climate Impact Research (PIK) proposes a practical way for the EU to meet part of its ambitious 2040 climate target through international cooperation.

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Making international carbon markets work for Europe: Jurisdictional Reward Funds and the EU’s 2040 climate target

Full Policy Paper Summary (PIK Policy Paper, 16 June 2026)

Title: Making international carbon markets work for Europe: Jurisdictional Reward Funds and the EU’s 2040 climate target

Authors: Ottmar Edenhofer, Christopher Leisinger, Lennart Stern, Matthias Kalkuhl

DOI: 10.48485/pik.2026.17 (18 pages)

Direct PDF: Available on the PIK publications page.

Core Context

The revised EU Climate Law sets a 90% net GHG emissions reduction target by 2040 (vs. 1990). It allows up to 5 percentage points (roughly 236 MtCO₂ in 2040) to come from international carbon credits under Article 6 of the Paris Agreement. This is framed not as reduced ambition, but as a way to shift some mitigation abroad for cost containment while maintaining total global reductions.

Purpose of the 5% flexibility:

Lowers compliance costs as domestic decarbonization gets harder (hard-to-abate sectors).

Acts as an insurance/hedge against geopolitical uncertainty: If global ambition is weak, cheap international reductions help sustain EU policy support. If global ambition rises, international credits become scarcer/expensive, naturally shifting effort back home.

Problems with Traditional Mechanisms

The paper reviews why past systems (e.g., CDM, project-based offsets, Article 6) often fail:

• Additionality issues: Many credited reductions would have happened anyway.
• Over-crediting and weak verification.
• Strategic gaming: Countries may weaken policies or NDCs to create more “additional” credits later.
• Negotiated baselines create ratchet effects and perverse incentives.

Proposed Solution: Jurisdictional Reward Funds (JRFs)

JRFs pay national or sub-national governments for verified jurisdiction-wide performance improvements against universal, pre-announced benchmarks (not project-level or bilaterally negotiated).

Key design features (Box 1 in the paper):

• Fixed funding envelope + transparent rules upfront.
• Rewards based on measurable outcomes (e.g., satellite-tracked deforestation rates, fossil fuel phase-out metrics, effective carbon pricing).
• Competitive allocation: Better relative performance → higher share of the pot.
• Avoids additionality assessments by focusing on results at scale.
• Example in practice: Tropical Forest Forever Facility (TFFF) launched at COP30.

This creates credible incentives without the usual gaming problems.

Costs and Optimal Portfolio

An economically optimized mix could deliver the full 5% (~236 MtCO₂) at ~€5 billion per year in 2040 (€21/tCO₂).

Tropical forests alone would cost more (~€14 billion/year for the full 5% via an enhanced TFFF-style mechanism), so diversification into fossil fuel demand reduction is more efficient.

Integration with EU Policy

• Credits could integrate into the EU ETS (stronger price-dampening effect on ETS1: 40–45% lower allowance prices on average 2036–2050 in stylized scenarios).
• Smaller effects if integrated only into ETS2 or later.
• Provides fiscal predictability and political stability for the overall 90% target.

Broader Implications

JRFs support institutional capacity-building in partner countries and align with high-integrity Article 6 use. They represent a pragmatic, rules-based way to scale effective international climate finance while addressing additionality and incentive problems that plagued earlier approaches.

The paper positions this as a stabilizing tool for EU climate policy amid uncertainty, rather than a loophole. It includes references to related work on tax coalitions and reward funds for fossil fuels.

Lead author Ottmar Edenhofer (PIK Director and EU climate advisory board chair) argues this isn’t a loophole but a realistic “stabilizing mechanism” for ambitious EU policy.

Zusammenfassung

The revised EU Climate Law allows the use of international flexibility mechanisms for up to 5% of 1990 net emissions under the 2040 target. The provision is not a relaxation of ambition: it shifts part of the mitigation effort abroad to contain costs while keeping the overall emissions reductions unchanged. The challenge is ensuring that what is credited abroad is real.
Properly designed, international flexibility acts as an insurance mechanism against geopolitical uncertainty. If global climate ambition remains weak, access to lower-cost mitigation abroad helps contain compliance costs and sustain political support for ambitious EU targets. If international climate ambition strengthens, international opportunities for emission reductions become scarcer and mitigation efforts naturally shift back to Europe.
We propose Jurisdictional Reward Funds (JRFs) as a high-integrity framework for implementing the 5% provision. Unlike previous mechanisms, whose systematic failure to deliver real emissions reductions is well-documented, JRFs rely on universal baselines on jurisdiction-level rather than project-level additionality assessments or negotiated benchmarks. They thereby avoid the existing incentive problems undermining existing Article 6 mechanisms and ensure credited mitigation is environmentally credible.
A strategically optimized procurement portfolio for reducing fossil fuel use and conserving tropical forests could fully utilize the 5% provision at annual costs of roughly €5 billion in 2040 (€21/tCO2). Under stylized integration scenarios, international credits could reduce ETS1 allowance prices after 2030 by around 40-45% relative to baseline, with smaller but meaningful effects under ETS2 integration and substantially larger effects under earlier or more prolonged integration.

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ETS Price Modeling Details in the PIK Policy Paper (June 2026)

The paper does not present new, original ETS modeling but relies on stylized integration scenarios (informed by companion or related PIK work, with thanks to Tobias Bergmann and others). It focuses on the price-dampening effects of injecting international credits from JRFs into the EU’s Emissions Trading System.

Key Assumptions in the Scenarios

• Volume: Up to the full 5% flexibility (~236 MtCO₂ in 2040 relative to 1990 baseline).
• Phase-in: Gradual introduction starting at 1% in 2036, ramping up to 5% in 2040, then declining linearly to zero by 2050.
• Allocation: Stylized split between ETS1 (stationary installations: power, energy-intensive industry) and ETS2 (buildings, road transport) based on historical emission shares (1990 and recent years).
• Alternative scenarios: Earlier start dates or more prolonged use of credits, leading to larger cumulative volumes and stronger effects.

Main Results: ETS1 Price Impacts

• Integrating the credits into ETS1 (the main existing ETS) leads to 40–45% lower average allowance prices over the period 2036–2050 compared to a no-credits baseline. publications.

This is a significant dampening effect. It helps prevent sharp price spikes as domestic decarbonization becomes more expensive in hard-to-abate sectors, improving political feasibility and investment predictability without weakening the overall cap.

ETS2 and Other Variants

• Smaller but meaningful effects when credits are integrated primarily into ETS2.
• Substantially larger price reductions in scenarios with earlier introduction or longer use of international credits.

The paper notes that the exact price impact depends heavily on:

• Which compliance system (ETS1 vs. ETS2) absorbs the credits.
• The timing and cumulative volume allowed.

ETS2 and Other Variants

• Smaller but meaningful effects when credits are integrated primarily into ETS2.
• Substantially larger price reductions in scenarios with earlier introduction or longer use of international credits.

The paper notes that the exact price impact depends heavily on:

• Which compliance system (ETS1 vs. ETS2) absorbs the credits.
• The timing and cumulative volume allowed.

Why This Happens (Economic Logic)

• International credits increase the effective supply of allowances in the EU carbon market (while the cap remains fixed for the EU’s territorial target).
• This relaxes short-term scarcity → lowers equilibrium carbon prices.
• However, the design ensures the incentive for domestic decarbonization remains strong because:
  • Credits are limited and temporary.
  • Global ambition (if it rises) would make future international credits scarcer and more expensive, naturally shifting effort back to the EU.
  • Investors anticipate rising carbon prices outside Europe due to broader cooperation.

Additional Notes on Welfare and Fiscal Effects

• The headline €5 billion annual procurement cost in 2040 can be offset or even turned negative fiscally if credits are surrendered or sold into the ETS at prevailing (higher) allowance prices.
• Net welfare costs for the EU are lower than the gross fiscal outlay due to co-benefits: avoided climate damages + lower global fossil fuel prices (improved terms of trade and energy security).

The modeling is intentionally stylized to provide transparent benchmarks rather than highly detailed numerical runs. It builds on broader PIK expertise in EU ETS modeling (e.g., interactions with the Market Stability Reserve, banking behavior, and interactions between ETS1/ETS2).

Making international carbon markets work for Europe: Jurisdictional Reward Funds and the EU’s 2040 climate target