Carbon credits and Carbon Trading

What is Carbon Credit?

Carbon credits are generated by enterprises in the developing world that shift to cleaner technologies and thereby save on energy consumption, consequently reducing their greenhouse gas emissions. For each tonne of carbon dioxide (the major GHG) emission avoided, the entity can get a carbon emission certificate which they can sell either immediately or through a futures market, just like any other commodity.

The certificates are sold to entities in rich countries, like power utilities, who have emission reduction targets to achieve and find it cheaper to buy 'offsetting' certificates rather than do a clean-up in their own backyard. This trade is carried out under an UN-mandated international convention on climate change to help rich countries reduce their emissions.

The Kyoto Protocol and the Clean Development Mechanism (CDM)

Kyoto Protocol

The need for a reduction in carbon emissions was debated at the United Nations Conference on Environment & Development (The Earth Summit) in Rio de Janeiro in 1992, resulting in the adoption of United Nations Framework Convention on Climate Change (UNFCCC), an international treaty on environment. The Kyoto Protocol, 1998, was adopted by the parties to the UNFCCC with the objective of achieving quantified emission limitations through specific policies and measures to minimising the adverse effects of climate change. The protocol provides for various mechanisms like joint implementation, a clean development mechanism (CDM) and international emission trading to boost the cost effectiveness of climate change mitigation.

Kyoto Protocol is an agreement made under the United Nations Framework Convention on Climate Change (UNFCCC). The treaty was negotiated in Kyoto, Japan in December 1997, opened for signature on March 16, 1998, and closed on March 15, 1999. The agreement came into force on February 16, 2005, under which the industrialised countries will reduce their collective emissions of greenhouse gases by 5.2% compared to the year 1990 (but note that, compared to the emissions levels that would be expected by 2010 without the Protocol, this target represents a 29% cut). The aim is to lower overall emissions of six greenhouse gases - carbon dioxide, methane, nitrous oxide, sulfur hexafluoride, HFCs (Hydrofluro Carbon), and PFCs - calculated as an average over the five-year period of 2008-12. National targets range from 8% reductions for the European Union and some others to 7% for the US, 6% for Japan, 0% for Russia, and permitted increase of 8% for Australia and 10% for Iceland.CDM

The Clean Development Mechanism (CDM) is an arrangement under the Kyoto Protocol allowing industrialized countries with a greenhouse gas reduction commitment to invest in emission reducing projects in developing countries as an alternative to what is generally considered more costly emission reductions in their own countries. Under CDM, a developed

country can take up a greenhouse gas reduction project activity in a developing country where the cost of GHG reduction project activities is usuallymuch lower. The developed country would be given credits (Carbon Credits) for meeting its emission reduction targets, while the developing country would receive the capital and clean technology to implement the project.

Carbon credits are certificates issued to countries that reduce their emission of GHG(greenhouse gases) which causes global warming. Carbon credits are measured in units of certified emission reductions (CERs). Each CER is equivalent to one tonne of carbon dioxide reduction. Its rate stood at 22 Euros in April, fell to below 7 Euros, before stabilizing at 12-13 Euros.

The six greenhouse gases specified in the Kyoto Protocol are:

• Carbon dioxide (CO2)

• Methane (CH4)

• Nitrous oxide (N20)

• Hydrofluorocarbons (HFCs)

• Perfluorocarbons (PFCs)

• Sulphur hexafluoride (SF6)

Approximately 25 other gases, such as chloroform and carbon monoxide, qualify as climate-changing greenhouse gases, but only the above mentioned six are released in sufficient quantities to justify regulation under Kyoto. Water vapour is a very important greenhouse gas, but is not controllable by human intervention.

Carbon Trading

Carbon trading, or more generically emissions trading, is the term applied to the trading of certificates representing various ways in which carbon-related emissions reduction targets might be met. Participants in carbon trading buy and sell contractual commitments or certificates that represent specified amounts of carbon-related emissions that either:

1. Are allowed to be emitted;

2. Comprise reductions in emissions (new technology, energy efficiency, renewable energy); or

3. Comprise offsets against emissions, such as carbon sequestration (capture of carbon in biomass).

People buy and sell such products because it is the most cost-effective way to achieve an overall reduction in the level of emissions, assuming that transaction costs involved in market participation are kept at reasonable levels.

How is carbon trading undertaken?

The simplest type of carbon trade involves an entity preparing a contract that describes and specifies the kind of activity they are undertaking to either reduce or offset emissions. The contract may or may not be independently verified, although doing so will increase buyer

confidence and probably attract a higher price. This contractual commitment is then sold to another entity that wishes to make use of the specified amount of the reduction or offset.

Contractual commitments are usually traded "over the counter" (OTC), which means that the trade is usually a bilateral one between a willing buyer and a willing seller without the need for a market to exist. OTC trades are usually single trades where the terms are either partially or fully confidential. OTC markets are relatively simple and operate where there is limited "liquidity" (that is, not many trades are occurring) or where the product being traded is somewhat unique for each trade.

In contrast, a carbon trading market is more akin to a share market. Products traded on a market are generally more homogeneous; for example, all types of carbon sequestration that meet the rules defining the creation of a "carbon sequestration certificate" may be deemed to be identical in the market. This both increases the liquidity of the product and helps market participants understand and have more confidence in the product being traded. The existence of a set of enforced rules associated with the creation of both emission reduction and emission offset certificates also increases market confidence in the product.

Carbon finance

Carbon finance is the general term applied to resources provided to a project to purchase greenhouse gas (GHG) emission reductions (“carbon” for short). Commitments of carbon finance for the purchase of carbon have grown rapidly since the first carbon purchases began less than eight years ago. As of May 2004, the global market for GHG emission reductions through project-based transactions has been estimated at a cumulative 320 million tons of carbon dioxide equivalent since its inception in 1996. Asia now represents half of the supply of project-based emission reductions, with Latin America second with 27 percent. Volumes are expected to continue to grow as countries that have already ratified the Kyoto Protocol work to meet their commitments, and as national and regional markets for emission reductions are put into place, notably in Canada, Japan and the European Union (the European Union has already put in place its Emissions Trading Scheme as of January 2005).

World Report

Source: World Bank

Who is selling? (India is in 2nd position) Location of CDM projects

Carbon Credits: Indian scenario

India comes under the third category of signatories to UNFCCC. India signed and ratified the Protocol in August, 2002 and has emerged as a world leader in reduction of greenhouse gases by adopting Clean Development Mechanisms (CDMs) in the past few years.

Other than Industries and transportation, the major sources of GHG’s emission in India are as follows:• Paddy fields• Enteric fermentation from cattle and buffaloes• Municipal Solid Waste

Of the above three sources the emissions from the paddy fields can be reduced through special irrigation strategy and appropriate choice of cultivars; whereas enteric fermentation emission can also be reduced through proper feed management. In recent days the third source of emission i.e. Municipal Solid Waste Dumping Grounds are emerging as a potential CDM activity despite being provided least attention till date.

There is a great opportunity awaiting India in carbon trading which is estimated to go up to $100 billion by 2010. In the new regime, the country could emerge as one of the largest beneficiaries accounting for 25 per cent of the total world carbon trade, according to a report by World Bank. The countries like US, Germany, Japan and China are likely to be the biggest buyers of carbon credits which are beneficial for India to a great extent.

The Indian market is extremely receptive to Clean Development Mechanism (CDM). Having cornered more than half of the global total in tradable certified emission reduction (CERs), India’s dominance in carbon trading under the clean development mechanism (CDM) of the UN Convention on Climate Change (UNFCCC) is beginning to influence business dynamics in the country. India Inc pocketed Rs 1,500 crores in the year 2005 just by selling carbon credits to developed-country clients. Various projects would create up to 306 million tradable CERs. Analysts claim if more companies absorb clean technologies, total CERs with India could touch 500 million. Of the 391 projects sanctioned, the UNFCCC has registered 114 from India, the highest for any country. India’s average annual CERs stand at 12.6% or 11.5 million. Hence, MSW dumping grounds can be a huge prospect for CDM projects in India. These types of projects would not only be beneficial for the Government bodies and stakeholders but also for general public.

India, along with other developing nations, is at an advantage as it can implement approved CDM projects for the purposes of trading CERs. One third of the total CDM projects registered with UNFCCC are from India. India’s carbon credits’ trading is expected to reach $100 billion by 2010. In 2007, a total of 160 new projects were registered with UNFCCC. As a consequence, Indian industry managed to generate over 27 million carbon credits. Indian projects receive further impetus by way of investments and finance from developed nations who are potential buyers of CERs.

Carbon Credit Trading & Tax

The Multi Commodity Exchange of India Ltd entered into an alliance with the Chicago Climate Exchange in 2005 to introduce carbon credit trading in India. This association has integrated Indian markets with their global counterparts to cover risks associated with futures trading of

carbon credits and ensuring best prices. CDM projects, mostly in key sectors such as manufacturing, energy, agriculture, mining and mineral production, would thus result in providing a boost to the Indian economy. The major CDM projects are located in Rajasthan, Andhra Pradesh, Maharashtra Karnataka, Himachal Pradesh and Punjab.

Trading in CERs, although at a nascent stage, has resulted in huge foreign exchange earnings for Indian suppliers. Typically, an overseas buyer requiring carbon credits to meet emission reduction targets enters into an emission reduction purchase agreement with a company engaged in an emission reducing project in a developing nation.

However, on account of the ambiguity on the treatment of CERs from an indirect tax perspective, the following issues remain relevant for an Indian supplier of CERs: (i) whether CERs can be classified as goods or services for indirect tax purposes. Consequently, whether CERs would attract VAT (levied on sale of goods) or service tax (levied on rendition of services); (ii) whether the sale of CERs to overseas buyers would qualify as export of goods or services.

To determine whether VAT or service tax would be applicable, it is relevant to determine whether CERs are classifiable as goods or services. At present, indirect tax legislation does not provide guidelines for such treatment and jurisprudence on this issue is yet to evolve. In the event of CERs being taxed as goods, it is felt that they should be accorded the same treatment as electricity for VAT purposes, that is, either CERs be excluded from the purview of VAT or be specified in the schedule of exempted goods.

CERs, if made liable to indirect taxes, may adversely impact the carbon credit-trading boom in India. Indirect taxes embedded in an arrangement involving the sale or provision of services in respect of CERs would thus influence pricing and may make India a less attractive destination for carbon credit shopping. The government is expected to grant tax sops on carbon credit trading with a view to ensure its global commitment to the reduction of carbon emissions.

Lack of clarity on the treatment of CERs for indirect tax purposes exposes companies engaged in projects generating carbon credits to the threat of significant tax demands. The past year saw the Institute for Solid Waste Research & Ecological Balance urge the Centre to exempt carbon credit earnings from income tax, as well as service tax, and to issue separate orders to dispel all doubts on this issue. Various sectors had specifically sought clarification on the treatment of CERs in their Budget wish list. However, the Budget 2008 merely makes a passing reference to a trading platform for carbon emissions and does not shed any light on the aspect of taxation of CERs.

The Institute of Chartered Accountants of India (ICAI) is currently working on accounting norms for carbon credits. According to ICAI, companies who earn revenue by selling carbon credits will have to make their financial statements under the new norms from April 1. However, the new accounting norm on this issue is yet to be notified by ICAI. It, thus, has to be seen whether CERs are classified as a tradable commodity under the accounting norm.

Source of Information:

• www.worldbank.org • www.carbonfinance.org • www.ipcc.ch • www.timesofindia.indiatimes.com

• www.teri.org • NSWAI (National solid waste association of India)