CARBON FINANCE

Carbon Market Mechanisms , Accounting Aspects and Tax implications

UNDERSTANDING

ST.XAVIERS COLLEGE(Autonomous)
KUSHAL JHUNJHUNWALA
Project

B.COM(H) FINANCE, 3RD YEAR

ROOM NO: 11
Presentation on

ROLL NO: 202

CARBON FINANCE BY

Under the guidance of:

Professor Souvik Sarkar

OBJECTIVES
To gain an understanding of Kyoto Protocol and the interrelationship between Climate change and Finance Building a concept regarding the Carbon Market Mechanisms and understanding Investment opportunities Planning the future course of action Understanding the Accounting and Taxation Framework that needs to be in place with regard to Carbon Transactions

LIMITATIONS
Report based on Secondary data. Hence may contain discrepancies or errors. The project does not cover all aspects of the Carbon Markets and only a part of the whole mechanism has been highlighted due to time constraints and lack of resources. The tax interpretations made are only recommendatory as no guidance to that effect has been issued in India.

Climate Change
Earths climate is warming and human activities are primarily responsible (>90% certainty) 280 to 430ppm concentration between 1850 and 2000 (0.5-0.8oC increase) 550ppm likely by 2035 with 77-99% chance of 2oC increase 50% chance of 5oC increase

Kyoto Protocol
38 Developed Countries and Economies in Transition (Annex I countri es) took on reduction commitments in 1997
GHG Emissions ton/ year

The Demand: Kyoto Projects EU ETS Allowances AVG: 1990 - 5.2% 2008 2012

1990: Base Year

First Commitment Period: 2008-2012

Kyoto Protocol and CDM at a Glance

Kyoto Protocol Key points

Six emissions: CO2, CH4, N2O, PFCs, HFCs, SF6
Binding emission reduction targets for Annex I countries of 5.2% below 1990 over 2008-2012 Non-Annex I countries have no binding targets but must report on their actions Annex I countries can achieve targets through domestic policies and three market mechanisms Non-Annex I countries can participate through the Clean Development Mechanism to facilitate sustainable development Rules for implementation worked out at annual COP meetings
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Annex B countries (= Annex I under UNFCCC)

Australia Austria Belarus Belgium Bulgaria Canada Croatia Czech Rep Denmark EC Estonia Finland France Germany Greece Hungary Iceland Ireland Italy Japan Latvia Liechtenstein Lithuania Luxembourg Netherlands New Zealand Norway Poland Portugal Romania Russia Slovakia Slovenia Spain Sweden Switzerland Turkey Ukraine UK USA

* Countries with economies in transition to a market economy. * Countries which did not ratify Kyoto protocol.
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FLEXIBILITY MECHANISM Joint implementation

Clean development Mechanism

Emission trading

Project based

from

There are over 45 carbon markets but 3 principal regimes

Kyoto Mandatory Regime UNFCCC Non-Kyoto Mandatory Regimes New South Wales (Australia) Individual US States (East Coast, California, Oregon)
European Union Trading Scheme (EU-ETS)

Voluntary Regimes

Kyoto Protocol

Chicago Climate Exchange (CCX)

CDM
Non-Annex 1 Countries (Developing Countries)
Joint Implementation Annex 1 Countries

Linking Directive

Retail Market

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Kyoto Protocol and CDM at a Glance

What Annex I countries can do

Limitations of CO2 emissions in developed countries (Annex I)

4 options for companies

1/ Pay expensive fines.

2/ Carry out carbon reduction through processes improvement.

3/ Buy emissions 4/ Carry out carbon credits on the reduction through CO2 market (ETS). technology transfers in CDM or JI project.

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Assigned Amount Units (AAUs) Each Annex I Party that ratifies the Kyoto Protocol has a GHG emissions limitation commitment for 2008-2012, which is its "assigned amount." If a country's emissions are lower than that amount, it may sell the unused units. Certified Emission Reductions (CERs) - These are credits issued for emission reductions achieved by a project under the CDM. CERs can be used by an Annex I Party to help meet its emissions limitation commitment under the Kyoto Protocol. The credits issued for sink enhancements achieved by afforestation or reforestation projects under the CDM are either temporary CERs (tCERs), or long-term CERs (ICERs) that are subject to provisions to protect against possible reversals of the sink enhancements. Emission Reduction Units (ERUs) - These are credits issued for emission reductions or removals achieved by a project under the JI mechanism as defined in Article 6 of the Kyoto Protocol. ERUs can be used by an Annex I Party to help meet its emissions limitation commitment under the Kyoto Protocol. Each ERU equals 1 tonne of carbon dioxide equivalent (CO2 e).

Clean Development Mechanism

Annex I Country

Non-Annex I Country
Funding

Technology Projects to reduce GHG emissions

Emission reduction compared to an existing baseline Certified Emission Reduction (CER)

CDM Project Cycle

Overview: 9 steps
Project developer
1. Project Preparation i. Identification of project ii. Pre-screening of CDMApplicability iii. Development of Feasibility Study (under consideration of CDM Aspects)

DOE
2. Development of Project Idea Note (PIN)

DNA
3. Development of Project Design Document (PDD) i. Project Description ii. Select baseline approach iii. Assess additionality iv. Set baseline emission level v. Set Crediting Period vi. Calculate net emission reduction vii. Develop a monitoring plan viii.Assess environmental impacts ix. Invite stakeholders for comments

EB
4. Submission of the PDD and Host Country Approval to Validator

Host Country Approval

8. Project implementation and monitoring

Registration of the CDM project

Possible review by CDM EB

9. Yearly verification and certification

7. Submission of Validation Report and PDD of Project

6. Validation of Project

5. Make PDD publicly available for 30 days

Possible review by CDM EB

Registration of the CDM project

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Additionality benchmark analysis

Choose an appropriate financial indicator and compare it with a relevant benchmark value: e.g. required return on capital or internal company benchmark
Carbon revenue makes the project attractive relative to investment alternatives

Revenue / NPV / IRR

Investment threshold

Project without carbon

revenue is profitable but not sufficiently profitable compared with alternatives

Project without carbon element

Project with carbon element

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EMISSIONS TRADING

Carbon market at a glance, volumes and values, 200809

Sources: World Bank, and Bloomberg New Energy Finance and Ecosystem Marketplace for data on the voluntary market

2008 Volume (MtCO2e) Value (US$ million) Allowances Markets EU ETS 3,093 NSW 31 CCX 69 RGGI 62 AAUs 23 Subtotal 3,278 Spot & Secondary Kyoto offsets Subtotal 1,072 Project-based Transactions Primary CDM 404 JI 25 Voluntary market 57 Subtotal 486 Total 100,526 183 309 198 276 101,492 26,277 6,511 367 419 7,297

2009 Volume (MtCO2e) Value (US$ million) 6,326 34 41 805 155 7,362 1,055 211 26 46 283 118,474 117 50 2,179 2,003 122,822 17,543 2,678 354 338 3,370

Present Price of CCERs and VERs (Carbon Credits) Both the CERs and VERs are represented in terms of carbon dioxide equivalent (CO2e). The present price (As of 1 April, 2008): CERs : 12-13 t/CO2e VERs : US $ 7 to US $ 10/ ton Crediting Period for CERs and VERs Emission reductions can be claimed for maximum ten years, without revision of the project baseline, or for a period of seven years with two extensions of seven year each, provided the project baseline is revised at the time of each extension.

A simple example of 2 companies that represent a sector

PowerA Pty Ltd

PowerB Pty Ltd

Target: ER by 2000 tCO2e/yr each

2000tCO2e

C Market: CER (1tCO2e) = $4 Efficient ER cost = $2/tCO2e Reduce by 4000tCO2e/yr Total cost = $8000/yr No net cost for ER C revenue = $8,000/yr In absence of C market: Net cost of ER = 20 $12,000/yr

2000tCO2e

2000tCO2e

Locked in technology ER cost = $6/tCO2e Cost of ER internally = $12,000/yr Cheaper to buy CER from market Net cost for ER = $8,000/yr Cost of meeting target = $8,000/yr

The EU Emissions Trading Scheme dominates the market

Chicago Climate Exchange, $72 million Joint Implementation, $500 million
Secondary CDM, $26.3 billion Primary CDM, $6.5 billion

Other, $489 million

Global carbon market (2008): $126 billion

EU Emissions Trading Scheme, $92 billion

The EU ETS

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EU Emission Trading Scheme

-Compliance Mechanisms:
-Get allowances for free from the government (this may change in the future) -Purchase allowances from other installations -Internal abatement -Reducing emissions outside: Kyoto Credits

-2 Phases: 2005 - 2007 (pilot phase) 2008 - 2012 (Kyoto period) -EU has already indicated that a scheme after 2012 will be in place giving more confidence the market -The use of Kyoto Credits (CER/ERU) are restricted to a limit set by member states and European Commission. -On average companies can use up to 13% (~) of their allocated certificates in the form of CERs-ERUs for compliance purposes arbitrage potential

Market for Carbon Trading

Currently there are more than 6 Environmental Exchanges, trading in Carbon Credits

EUROPEAN CLIMATE EXCHANGE

POWER NEXT

MCX

India pocketed Rs 1,500 crores in the year 2005 just by selling carbon credits to developed- country clients. India has generated 30 million Carbon credits & 200 million are in pipeline

India is quite bullish on the carbon trade markets. It is estimated that one third of the total CDM projects registered with UNFCCC are from India and India claims 31% of the total world carbon credit trade. As per a CRISIL research report issued in May, 2010, carbon credits generated out from emission reduction projects undertaken in India, will triple over next three years and the numbers are expected to increase from 72 million in November 2009 to 246 million by December 2012.

Some of the Leading companies of India using & selling Carbon Credits

GUJARAT FLOUROCARBONS L

ACCOUNTING TREATMENT

Present Accounting treatment..

Treatment under IFRS IAS 20 (Government grants)(for allowances)
Treatment under US GAAPS currently no guidance note available Treatment under AS currently no accounting standard available

Accounting in India
CER credits are considered goods, as they have all the attributes thereof. CER Sale is Other Income, Not Turnover: Though CERs are goods, their sale is
undertaken, if not in exceptional circumstances, certainly on non-recurring basis. It has been seen that a CDM project cannot be a profit/cost centre in itself, and, therefore, it is neither possible nor desirable to attempt to work out separate profit or loss of any CDM project, with an accuracy expected from accountants. CER credits are goods, their sales proceeds have to be recognised in financial accounts as per para.11 of the Accounting Standard 9 (revenue recognition) Self-generated CERs held with registry cannot be included in Inventories as defined in Accounting Standard-2, as they are not held for sale in the ordinary course of business. On the other hand, such credits meet all the criteria of Intangible Asset as defined in Accounting Standard-26 i.e. (i) identifiability, (ii) control over a resource, and (iii) expectation of future economic benefits flowing to the enterprise.

Treatment as per AS 12-The logic forwarded appears to be misplaced, as in case of

financial transactions arising out of carbon credit, monetary consideration will not flow from any government or government agency. In total gambit, UNFCC CDM registry acts as a Demat banker recognising CER credits and keeping an account of it. There is no grant at all from any agency. Further, as soon as Carbon Credits are accounted as Government Grants, Accounting Standard-9 revenue recognition will cease to operate, leading to other accounting and taxation complications.

Tax Considerations
Is income from Carbon trade a capital gain or normal income???

TAX TREATMENT
DIRECT TAX Income from CERs INDIRECT TAX Goods VAT, etc Business Income Capital Gain Services Service tax

OR CER Transaction Tax

However, NO set Accounting or Tax Treatment has yet been decided

Other opportunities..
As an auditor. In audit of Carbon Trading As a Carbon Trading Consultant Carbon Trading Broker

CDM Based CFL Scheme- Bachat Lamp Yojana (BLY)

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Basic Objectives of BLY

Replace inefficient incandescent bulbs with CFLs for households only Reduce price of CFL to that of incandescent bulbproject developer (CFL Manufacturer/ DISCOM) provides initial investment Use CDM to recover balance cost Monitor energy consumption reduction in a project area as outlined in AMS-II.C of CDM-EB CERs generated after monitoring, validation and oversight of CDM Executive Board (CDM-EB) sold in international markets Revenue from sale of CERs used to service investments-Estimated revenue/ CFL of Rs. 25 per year- cost recovered in 2-3 years. Potential reduction in power consumption~6,000 10,000 MW .

Carbon Efficient Index

As cap and trade becomes more of a reality with a direct punitive financial impact on Companies. We can no longer afford to be complacent about the emission behaviour of our corporate entities. For many investors and investment managers, directing their investments toward companies with lower carbon emissions is a strategy they believe could strengthen their portfolios under any cap-and-trade scenario. To do that, though, they must be able to determine a companys carbon efficiency, and track carbon-efficient market indices with broader ones. To address this need, Standard & Poors has introduced its U.S. Carbon Efficient Index, which tracks the S&P 500 performance but with one-half the emissions of an S&P 500 portfolio. In the near future, Standard & Poors plans to launch an Emerging Markets Carbon Efficient Index to measure the performance of large and mid cap emerging market companies with relatively low carbon emissions, while seeking to closely track the return of the S&P/IFCI Large mid index. By leveraging the S&P/IFCI Large-mid Index, the leading emerging market index, S&P will provide the market with the first broad emerging market index that can be used to provide investment vehicles with a reduced carbon exposure and a performance similar to that of the original index. Carbon efficiency simply measures a companys emissions per U.S. dollar revenue it earns. Trucost, a global research company, has partnered with Standard & Poors Index Services to provide the carbon emissions data. Trucost uses a methodology that calculates the companys total GHG emissions. Broad market index tracking indices specifically track a broad market index, balancing tracking error and carbon reduction. The S&P U.S. Carbon Efficient Index fits precisely into this category, where the investor is provided an opportunity to get access to the broad market returns of an established index, in this case the S&P 500 for the U.S. market, with an ability to have a reduced carbon exposure.

MARKET MECHANISMS POST 2012 REGIME

Changes required in GHG emissions Trading introduce GHG emissions trading based on sectoral targets; introduce GHG emissions trading based on NAMAs; and introduce modalities and procedures for the recognition of units from voluntary GHG emissions trading systems in non-Annex I Parties for trading and compliance purposes under the Kyoto Protocol. Changes required in CDM include other LULUCF activities (afforestation and reforestation or A/R; reducing GHG emissions from deforestation and forest degradation; restoration of wetlands; sustainable forest management and other sustainable land management activities; soil carbon management in agriculture; and revegetation, forest management, cropland management and grazing land management); include carbon capture and storage (CCS); include nuclear activities; Under the new EU rules, industry sectors the ETS covers must start purchasing at least 20% of their emission permits at auction starting in 2013. That percentage will rise gradually to 70% in 2020, with a view to reaching 100% by 2027. The effect of ETS Phase III compliance on firms that have benefitted from the carbon markets is uncertain. Up to the start of Phase III in 2013, it is anticipated that carbon prices will continue to fluctuate, as they have in the past. Currently, CER prices are approximately 12-13 t/CO2e, about one-half of their 2008 level. The demand for CERs among EU compliance buyers will determine the price of carbon credits, as will the supply originating from CDM projects in developing countries. The Copenhagen negotiations and the proposed EU reforms are likely to affect both. It is believed that demand should in theory be strong in Phase III due to the overall allocation shortage relative to forecast emissions that is anticipated On June 26, the U.S. House of Representatives passed the Clean Energy and Security Act, the so-called Waxman-Markey bill, which aims to introduce a Federal cap-and-trade scheme similar to the EU ETS but on a much larger scale. Waxman-Markey pledges a 17% reduction in GHG emissions by 2020 and 83% by 2050, from 2005 levels. Carbon trading schemes are also under development in Korea, Japan, Mexico, and Canada.

Conclusion- what needs to be done yet!!!

All said, carbon revenues have not altered historical macro-economic development trends or overcome the sectoral and regional investment barriers faced by underlying projects. Carbon revenues have instead made relatively low-risk investments in proven technologies with marginal rates of return more attractive and profitable, enhancing their chances of being developed and remaining operational. A number of actions can help maximize the transformational impact of carbon finance and mobilize both climate and development finance. In tackling the most prominent constraints and supporting low-carbon development at scale, the following actions can ultimately make carbon finance better fit into public and private sector investment decision-making: (i) scale up: expand the demand side of the market by implementing more stringent emission reduction targets, and build a credible supply at scale by adopting a programmatic approach and moving toward large-scale sectoral and policy-based mechanisms; (ii) provide long-term predictability: enable lengthier contracts and provide long-term pricing signals; (iii) develop comprehensive insurance/guarantee products: underwrite political risks inherent in international negotiations and collective international actions, as well as the contractfrustration risk at country and sector levels. The combined efforts of multilateral development banks, international financial institutions and insurers/re-insurers might be required to create a sustainable business environment, enable the deployment of existing commercially unattractive low-carbon technologies and the development of new ones; (iv) use financial engineering to frontload future demand: accelerate the transition to lowcarbon investments (e.g., the issuance of bonds and monetization of future receivables); (v) wisely combine (blend) limited financial resources: maximize the impact of investments related to climate change (e.g., the Global Environment Facility, the to-be-implemented Copenhagen Green Climate Fund, the Climate Investment Funds, revenues from project-based emission offsets, etc.) and foster additional private sector investment.

Thank You