Tax: The carbon credit trade

We have all been offered the chance to do our bit in the fight against climate change by participating in carbon offset schemes sold by airlines and other organisations. But few of us are aware of what actually happens to the money we hand over, or the size of the market for carbon offset trading. Current estimates suggest that carbon offset trading in the UK alone is worth £50m.

The impetus behind the creation of local and international markets in carbon credits is the Kyoto Protocol, signed in 1997. It sets limits on the amount of carbon that can be produced by the 37 industrialised countries. The Kyoto Protocol also stipulates a framework for each signatory to manage its carbon emissions, including the ability to create and trade rights to produce the main 'greenhouse gases'. This has evolved into carbon neutralising schemes and the ability to trade in credits in order to offset excess carbon. In Europe this has led to the Emissions Trading Scheme (ETS) in which UK companies participate, as well as the UK Trading Emission Scheme - implemented by the Department for Environment, Food and Rural Affairs (DEFRA). On top of these programmes, there are voluntary offset schemes in the retail sector, which mirror the international market, but are not regulated by the Kyoto rules.

Industrial credits

The ETS and the UK schemes work by allocating the right to produce a certain amount of greenhouse gasses annually to companies in the most heavily polluting industries. The allocation process is free of charge, although this is under review. If companies want to produce more than this, they must purchase the capacity from elsewhere.

Units of emissions are centrally priced and can only be traded through regulated accounts; in the UK this is run through DEFRA. Non-polluters can, and do, participate in this market, either buying emissions certificates as a way of taking them out of the market - and so reducing the amount of carbon which can be generated overall - or as financial traders looking to make a gain as prices for carbon emissions rise or fall as in any other type of commodity business.

According to Point Carbon's 2007 report, the volume of carbon credits traded globally last year amounted to E40bn (£31bn), of which E28bn (£21bn) were traded through the European Union (EU) ETS scheme. Globally, and in Europe, the carbon credits market, which is concentrated in the EU, doubled between 2006 and 2007.

Contrary to what might initially be assumed, it is not only heavy industry-based companies that can trade emissions certificates in the UK. DEFRA's list of entities to which credits have been allocated includes hospitals, chemical and paper manufacturers, as well as agricultural and food producers.

Retail credits

The carbon credit retail market works slightly differently. There is no regulated price per unit of carbon offset. Customers simply pay an amount which the retailer claims offsets the used carbon. This is then invested in a carbon neutral project. The retail sellers of offset units generally transfer the money received to an intermediary, such as Carbon Footprint, which will allocate the funds to a project, usually in the developing world.

These projects might be recognised under Kyoto's Clean Development Mechanism, but need not be. Alternatively, funds could be used to buy industrial credit certificates, thus taking them out of circulation. The UK is in the process of developing a non-mandatory code of conduct for providers of carbon offsets in this market.

Tax treatment of credit trading

Despite the size and increasing significance of this market, the tax and accounting treatment of participators remains unclear. Aside from EU statements relating to the VAT implications of transfers of credits (they are treated as VAT-able supplies or services), there is no specific guidance in the UK about how these transactions should be treated for direct tax purposes.

The prevailing view in the accounting industry is that credits are intangible assets and fall to be accounted for under Financial Reporting Standard 10. This is borne out by the treatment recorded in the published accounts of UK companies to which credits have been allocated so far.

If this regime applies, all profits and losses relating to carbon credit trading rights will be taxable on a revenue basis in line with their recognition in the company's accounts. While that may seem to make the tax treatment of carbon credits fairly conclusive, it might not be the end of the matter.

It is interesting that other similar 'intangible rights' held by UK companies, such as fishing and milk quotas, have to date not been treated as intangible assets, but as capital gains tax assets. This is a more advantageous viewpoint. Relevant case law, and Her Majesty's Revenue and Customs' (HMRC's) own comments in relation to this type of asset, could easily be applied to carbon emissions certificates or units sold under an offset scheme. They are, essentially, a licence without which a polluter would not be able to carry on its basic activities. Any transfer would then be treated as a transfer of capital asset with nil base cost.

Capital treatment will not be relevant to those who are clearly trading in carbon credits, such as financial dealers, because the credits represent their stock in trade. It might also be possible to argue that those who sell carbon offset rights as an ancillary offering to their main trade, such as airlines and similar companies, should be treated as holding these as revenue trading items.

To some extent, costs and profits relating to such sales are performing a role similar to advertising or brand management. It seems unlikely that entities that have carbon credits allocated to them as polluters will be treated as traders in these certificates, unless they regularly sell them into the market - something which, if the allocation process is working properly, should not be the case.

Because a significant proportion of all carbon credit trading is often a forward or option to purchase carbon credits at a certain date in the future, it will be treated as a derivative for UK tax and accounting purposes, taxed in accordance with schedule 26 of the Finance Act 2002. This is essentially in line with the way in which profits are realised for accounting purposes (either on a mark-to-market or accruals basis).

There is no coherent tax regime governing carbon credit transactions in the UK, giving some latitude for companies to argue for a tax programme that provides the most advantageous treatment. In many cases, this will be a capital gains tax analysis.

No doubt HMRC will have its own views on how these transactions should be taxed. Until guidance is published or a specific case is considered by the courts, there will be plenty of room for argument and debate. At this stage companies should consider what their best position is and ensure that relevant documentation and evidence supports this view.

While carbon credits are a relatively recent innovation, political pressure over global warming issues is likely to ensure that they maintain their momentum. As a result, the imposition of a more substantial regulatory environment to monitor the environmental impact of industry is inevitable. This will foster increased profit motives among carbon credit owners and brokers, which will in turn result in closer scrutiny from HMRC on the treatment of profits generated. Expect some high-profile disputes as the market in these credits generates more profit for its participators than was ever intended.