Mumbai: Carbon trading has emerged as a new and exciting sphere of business activity in the last few years.
Carbon trading enables entities to meet their emission-reduction targets at market-determined prices. These targets may be self-imposed (as, for instance, in the case of British Petroleum) or a result of commitments under the Kyoto Protocol, which came into force on 16 February 2005.
The most advanced carbon trading regime is currently found in the European Union (EU). There are broadly two categories of carbon units, which are traded in the EU. There is the EUAs (European Union Allowances), which are units of allocations made by each EU country to various entities in its jurisdiction. EUAs represent the quantity of emissions which an entity can produce in a year, and any excess will be subject to an Excess Emissions Penalty. An entity which has been allocated, say, one million EUAs, may use them to meet its emission targets or sell them to another entity, hence creating a market for EUAs.
The other category of carbon units is the CERs (Certified Emission Reductions), which are issued under the Clean Development Mechanism (CDM) set up under the Marrakech Accords. An entity that implements a technology that reduces existing emissions by, say, a million tonnes of carbon dioxide, would be issued a million CERs. CERs are, therefore, units of account representing the quantity of emission reduction and are issued by the CDM Board.
The CDM facility has presented a host of opportunities to entities in India and similar developing countries, which are at a stage of economic and industrial development where they have the ability to introduce technology to reduce emissions. Since India, and consequently Indian entities, do not have mandatory targets to reduce emissions, they can get CERs issued against any emissions reduced pursuant to implementation of such technologies.
These CERs may then be sold in the carbon-trading market. The potential revenues from sale of such CERs will exceed the cost of the technology significantly.
Under the CDM rules, any project seeking to generate CERs is required to be registered with the CDM Board and undergo a process of certification by an independent agency. Once the registration is complete, periodic inspections and monitoring are required to verify the level of reduced emissions. Upon satisfactory compliance of all these procedures, the CDM Board issues the CERs into a CER account maintained by the entity, i.e. the project developer at the CDM Registry. Such CERs may then be transferred to the account of a buyer who may either be a trader in CERs or an entity intending to use the CERS for complying with its emission targets. The CDM rules also envisage crediting the CERs to the buyer’s account directly upon instructions from the project developer.
The principal objective of a CER purchase contract, like any other commercial contract, is to identify and allocate the various commercial, regulatory, fiscal and other risks that are associated with the transaction. The primary risk is that of the project itself. If the project fails to meet the registration and other requirements of the CDM rules, then no CERs would be generated from the project. The registration process will usually be the responsibility of the seller, being the project owner and developer. However, given the uncertainty surrounding the CDM process, a seller will seldom accept this as an absolute contractual obligation.
There is also some debate on the fiscal treatment of CERs. Being an intangible commodity , CERs would normally be subject to sales tax or VAT. Currently, most of these transactions involve a sale to foreign buyers and, therefore, it is possible to take the benefit of exemptions from VAT available for exports. However, whether CERs will become taxable at a future date remains an area of uncertainty.
The use of CERs generated by CDM-approved projects for complying with emission targets in certain countries may be subject to certain restrictions. The Linking Directive issued by the EU allows the use of CERs for compliance under the EU Greenhouse Gas Emission Trading Scheme (ETS) in the same manner as an EUA issued under the ETS. However, the directive permits individual member states to impose certain quantitative restrictions (limits on the maximum number of CERs that may be used by an installation for compliance) and qualitative restrictions (limiting the use of CERs generated from certain kinds of technologies, such as atomic or nuclear processes). While no major EU nation has yet introduced these restrictions, there is a perceived risk that these may come in subsequently. The CER purchase contract should be responsive to such a situation. Similarly, there could be a host of other eventualities such as a material adverse change or a failure of the CDM registry system, which need to be provided for in the contract.
While the CDM framework presents a unique opportunity to Indian companies operating in areas where there is scope of substantial emission reduction, it is important to identify and understand the commercial and legal risks associated with the CDM process and the sale of CERs.
Several Indian entities are implementing such technologies and have already entered into forward contracts with buyers for sale of the resulting CERs. The incentive for the seller is to commercialize in advance the potential CERs that will generated pursuant to the implementation of an emission-reducing project. The buyer is incentivized by the discount to market price at which CERs are usually sold in such forward contracts. And, of course, the mechanism provides an opportunity to developing nations to commercially incentivize reduction in pollution levels.
This column is contributed by AZB & Partners, Advocates & Solicitors
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