Carbon Trading – A Brief…

"Carbon Trading" is still in its nascent phase, but the kind of growth this market is experiencing is tremendous and that is what makes it so exciting to talk about. Carbon Trading! It comprises two words ‘Carbon’ and ‘Trading’. So, how do we do trading of carbon? In order to understand these, firstly we have to understand Carbon and finally Trading of the same.
As we all know that we are having a big problem in front of us i.e. Global Warming and the main reason for it is Green House Gases (GHGs)and we have to do something for it. Therefore to mitigate the global warming,International Treaties such as the Kyoto Protocol set quotas on amount of Green House Gases (GHGs) countries can produce. Countries, in turn, set quotas on the emissions of businesses. NGOs or non-profit organizations for long have been screaming for everybody's attention towards this huge problem, but no one seems to care enough, not until there is a financial incentive attached to it. That's what the governments of various countries have been trying to come up with, a trading mechanism where companies gain a monetary benefit out of polluting the air less.

Only burning fossil fuel (coal, gas, oil and peat) is not the source of GHG, major industries such as, Cement, Steel, Textiles and Fertilizer manufacturers are also emitting huge amount of GHGs. Common green house gases include CO2, Nitrous Oxide (NO2) Chlorofluorocarbons (CFCs), and methane (CH4). Global warming impacts of each of these gases differ significantly. CO2, the most common GHF, is assigned an index value = 1. Index values for CH4 = 21; NO2 = 310; HFCs = 150; PFCs = 6500.

The concept of carbon credits came into existence as a result of increasing awareness of the need for pollution control. It was formalized in the Kyoto Protocol, an international agreement between 169 countries. Carbon credits are certificates awarded to countries that are successful in reducing emissions of greenhouse gases.

 Carbon credits are a tradable permit scheme. They provide a way to reduce greenhouse gas emissions by giving them a monetary value. For trading purposes, one credit is considered equivalent to one tonne of CO2 emissions. Credits can be exchanged between businesses or bought and sold in international markets at the prevailing market price. These Credits
can also be used to finance carbon reduction schemes between trading  partners and around the world. There are currently two exchanges for carbon credits: the Chicago Climate Exchangeand the European Climate Exchange.

How does Carbon Credits work in real life? And how buying carbon credits attempts to reduce emissions?
Carbon credits create a market for reducing greenhouse emissions by giving a monetary value to the cost of polluting the air. This means that carbon becomes a cost of business and is seen like other inputs such as raw materials or labor.

 Assume that British Petroleum is running a plant in the United Kingdom. Say, that it is emitting more gases than the accepted norms of the United Nations Framework Convention on Climate Change (UNFCCC). It can tie up with its own subsidiary in, say, India under the Clean Development Mechanism (CDM). It can buy the ‘carbon credit’ by making Indian plant more eco-savvy with the help of technology transfer. It can tie up with any other company like Indian Oil, or anybody else, in the open market.

 By way of another example, assume a factory produces 80,000 tonnes of greenhouse emissions in a year. The government then enacts a law that limits the maximum emissions a business can have. So the factory is given a quota of say 60,000 tonnes. The factory either reduces its emissions to 60,000 tonnes or is required to purchase carbon credits to offset the excess.

A business would buy the carbon credits on an open market from organisations that have been approved as being able to sell legitimate carbon credits. One seller might be a company that will plant so many trees for every carbon credit you buy from them. So, for this factory it might pollute a tonne, but is essentially now paying another group to go out and plant trees, which will, say, draw a tonne of carbon dioxide from the atmosphere.

As emission levels are predicted to keep rising over time, it is envisioned that the number of companies wanting to buy more credits will increase, which will push the market price up and encourage more groups to undertake environmentally friendly activities that create for them carbon credits to sell. Another model is that companies that use below their quota can sell their excess as ‘carbon credits.’ The possibilities are endless; hence making it an open market.

The Kyoto Protocol provides for three mechanisms that enable developed countries with quantified emission limitation and reduction commitments to acquire greenhouse gas reduction credits. These mechanisms are Joint Implementation (JI), Clean Development Mechanism (CDM) and International Emission Trading (IET).

Under JI, a developed country with relatively high costs of domestic greenhouse reduction would set up a project in another developed country that has a relatively low cost.

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

Under IET, countries can trade in the international carbon credit market.

The European Union Emission Trading Scheme (EU ETS) is the largest multi-national, greenhouse gas emissions trading scheme in the world and was created in conjunction with the Kyoto Protocol. It commenced operation in January 2005 with all 27-member states of the European Union participating in it. It contains the world’s only mandatory carbon trading program. The program caps the amount of carbon dioxide that can be emitted from large installations, such as power plants and carbon intensive factories and covers almost half of the EU’s Carbon Dioxide emissions.

 Critics of carbon trading, such as Carbon Trade Watch argue that “it places disproportionate emphasis on individual lifestyles and carbon footprints,  distracting attention from the wider, systemic changes and collective political action that needs to be taken to tackle climate change”.

Critics also argue that emissions trading does little to solve pollution problems overall, as groups that do not pollute sell their conservation to the highest bidder. Overall reductions would need to come from a sufficient and challenging reduction of allowances available in the system. They doubt whether these trading schemes can work as there may be too many credits given by the government, such as in the first phase of the European Union’s scheme. Once a large surplus was discovered the price for credits bottomed out and effectively collapsed, with no noticeable reduction of emissions.

 Perhaps the most successful emission trading system to date is the SO2 trading system under the framework of theAcid Rain Program of the 1990 Clean Air Act in the United States. Under the program, which are essentially cap-andtrade emissions trading system, SO2 emissions are expected to be reduced by 50% from 1980 to 2010.

Isn’t it bit dubious to allow polluters in Europe to buy carbon credit and get away with it?

It is incorrect to say that because under UNFCCC the polluters cannot buy 100 per cent of the carbon credits they are required to reduce. Say, out of 100 per cent they have to induce 75 per cent locally by various means in their own country.

They can buy only 25 per cent of carbon credits from developing countries.

 Carbon Credits – Indian Scenario
India comes under the third category of signatories to United Nations Framework Convention on Climate Change (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. According to Report on National Action Plan for operationalising Clean Development Mechanism (CDM) by Planning Commission, Govt. of India, the total CO2-equivalent emissions in 1990 were 10,01,352 Gg (Giga grams), which was approximately 3% of global emissions. If India can capture a 10% share of the global CDM market, annual certified emission reduction (CERs) revenues to the country could range from US$ 10 million to 300 million (assuming that CDM is used to meet 10- 50% of the global demand for GHG emission reduction of roughly 1 billion tonnes CO2, and prices range from US$ 3.5-5.5 per tonne of CO2). As the deadline for meeting the Kyoto Protocol targets draws nearer, prices can be axpected to  rise, as countries/companies save carbon credits to meet strict targets in the future. India is well ahead in establishing a full-fledged system in operationalising CDM, through the Designated National Authority (DNA).

There is a great opportunity awaiting India in carbon trading which is estimated to go up to $100 billion by end of this year. 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, says a recent World Bank report. 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.

Carbon Trading: Accounting and Reporting Issues
Carbon markets have the effect of putting a price on what was until very recently free and this change is likely to have financial consequences for firms in the longer term. As regards accounting issues, the problems that is associated with the valuation of pollution allowances and their identification as assets (and the liabilities that arise if companies pollute beyond allowed levels). A closer inspection of the risks and uncertainties that arise from Global Climate Change (GCC) initiates a discussion of non-financial accounting and reporting about carbon. Non-financial reporting is necessary to allow conditions for democratic accountability in an uncertain setting. In particular, this is a process of translating ecological concerns into economic phenomena, which will then impact upon accounting practice.

 The way in which governments respond to GCC will affect all parts of society, including organisations which accountants have traditionally prepared accounts for. In fact, accounting is already involved in GCC in different ways, something that deserves the attention of researchers, given the intensity of social changes that GCC is likely to imply. Second, that the public policy domain is a fast moving one with legal and fiscal regimes developing that will require actions that will affect both those who buy goods and services as well as those who supply them. One element in the policy environment is the creation of markets where emission rights are traded and these create particular challenges for accountants. The different ways in which accounting and reporting is involved in GCC are explored using three layers of analysis: the financial accounting of carbon emission allowances, accounting and reporting for the risk associated with GCC and accounting and reporting for the uncertainty associated with GCC.

ØFinancial Accounting of Carbon Emission Allowance Units 
In the first instance, carbon trading creates short-term financial implications for companies (and potentially long-term implications as these schemes develop). Short-term implications arise from the cost of allocated or purchased allowances. For example, in the EU ETS companies receive free allowances annually to emit one tonne of carbon dioxide equivalents during a specified period (these are called European Union Allowances, hereafter EUAs). Theseallowances are allocated on a calendar year basis. In addition to EUAs issued by cap and trade schemes (such as the EU ETS), emission CERs are also available from the CDM and JI mechanisms provided for by the Kyoto protocol. At the end of each year, organisations must match their actual emissions with a sufficient amount of EUAs and CERs and then surrender these to the national registry (this matching has to be complete by 30 April of the year following the end of the calendar year). Organisations can trade their excess allowances and must acquire extra allowances if their emissions are higher than their allowances, including EUAs in the secondary market and CERs issued by entities carrying out CDM and JI projects. Carbon emission trading schemes raise the question of whether and how to recognise EUAs as assets and the obligation to deliver allowances as liabilities (with timing issues arising from the EU ETS process and year end dates for companies). Two aspects have centered the debate on the accounting for EUAs. First, considering that the majority of EUAs, in the initial allocation, are free for the companies affected and that only a small amount of the total emission rights contained within the EUETS are purchased, the valuation of granted allowances is debatable and, given the volume of EUAs for some companies, has a potential significant impact in their accounts. Second, the recognition of assets and liabilities with different valuation bases could produce a volatility of results in some companies. These two aspects, together, lead to lobbying for the recognition and reporting of the net position with respect to emission allowances. According to this view, only purchased allowances would have an impact on the balance sheet. In the absence of regulation on this matter, IETA found that 60% of a sample of companies affected by EU ETS followed this net approach, recognising granted allowances at nil value, with the whole of the obligation recognised at the carrying value for the allowances already granted/purchased and the balance valued at market price.

 Ø Accounting and Reporting for the Risk Associated with GCC
 The importance of GCC suggests that accounting and reporting should move beyond the conventional accounting toolbox to reflect risks associated with GCC to assist decision makers to understand the possible effects of GCC on corporate performance and prospects. In other words, in addition to financial information, non-financial information will be needed to provide relevant information about the risks associated with GCC. Indeed, in order to reflect a 'true and fair view' of corporate  performance and the context of their operations, non-financial reporting will be needed to provide information about the impact of GCC and adaptation to GCC (via changing regulations or via changing corporate activities) on organisations.

In a carbon constrained future, competitive risks arise from the likelihood that carbon-intensive products and services become obsolete compared with low emission products and technologies. A company's carbon risk profile is mainly determined by:
(a) the company's asset mix,
(b) the dependency on and intensity of carbon-based input factors and energy production,
(c) the possibility for substitution and technological alternatives,
(d) the technological trajectory and industry specific innovation patterns,
(e) the company's position in the value chain, and
(f) the location of its operational activities and sales.

Ø Accounting and Reporting for the Uncertainty Associated with GCC
The methods of standard economics, focusing on marginal analysis and abstract from dynamics and uncertainty, are not suited for the problems raised by GCC. As explained above, GCC is unique in several respects:
(a) it affects the whole planet regardless of where GHGs are emitted;
(b) the effects of GHGs are persistent (CO2, for example, lasts in the atmosphere for 100 years) and develop over time; and
(c) the chain of causality between emissions, GCC and the effects on humankind is characterised by uncertainty.

A precautionary approach has been defined by UNESCO thus:
When human activities may lead to morally unacceptable harm [e.g. serious and effectively irreversible, or inequitable to present or future generations] that is scientifically plausible but uncertain [i.e. should apply to very low probabilities], actions shall be taken to avoid or diminish that harm.

Two consequences of such a precautionary/integrated assessment approach are important for accountants and accounting/reporting approaches. First, any account of the uncertainty associated with GCC should adopt a participatory approach by way of, for example, engaging stakeholders and mapping their different preferences according to their different 'risk windows'. One inspiration for such accounts of uncertainty could be Lehman's communitarian approach towards environmental accounting, which would 'be constructed as a vehicle that facilitates communication within the community and the development of possibilities for change, thereby creating democratic conditions'. Second, technical facts and social issues are incommensurable and this leads to call for attention to the potential problems involved in the standardisation of carbon accounting and carbon reporting without a sound understanding of the social and scientificcauses and consequences involved in GCC. The accounting literature has often argued that some forms of environmental accounting in the contexts of environmental auditing and carbon markets could result in environmental issues being transformed into an economic and risk-based language and could result in the capture, limitation and distortion of the social and political issues involved in the environmentalist discourse.

In conclusion, the above outlined a number of areas where research on accounting and reporting for GCC is required. In the first instance, accounting for EAUs requires a relatively straightforward development and application of traditional accounting principles to ensure that accounts show a true and fair view of the financial implications of pollution allowances. In addition, there is likely to be a need for organisations to communicate with their stakeholders about the risks that arise from GCC and also to reflect the uncertainties of how GCC will unfold. This moves the debate into the area of non-financial reporting which, while not as well developed as financial accounting and reporting, has already started to exercise the accounting profession. This also suggests the need for more research on the ways in which accounting is implicated in the unveiling of, and the negotiation of the interplay between, GCC risks and GCC uncertainties.