Topic Gateway Series. Carbon trading. Carbon trading. Topic Gateway Series No. 53

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1 Topic Gateway Series No Prepared by Helenne Doody and Technical Information Service November 2008

2 About Topic Gateways Topic Gateways are intended as a refresher or introduction to topics of interest to CIMA members. They include a basic definition, a brief overview and a fuller explanation of practical application, and finally signpost some further resources for detailed understanding and research. Topic Gateways are available electronically to CIMA members only in the CPD Centre on the CIMA website, along with a number of electronic resources. About the Technical Information Service CIMA supports its members and students with its Technical Information Service (TIS) for their work and CPD needs. Our information specialists and accounting specialists work closely together to identify or create authoritative resources to help members resolve their work related information needs. Additionally, our accounting specialists can help CIMA members and students with the interpretation of guidance on financial reporting, financial management and performance management, as defined in the CIMA Official Terminology 2005 edition. CIMA members and students should sign into My CIMA to access these services and resources. The Chartered Institute of Management Accountants 26 Chapter Street London SW1P 4NP United Kingdom T. +44 (0) F. +44 (0) E. tis@cimaglobal.com 2

3 Definition and context is a market mechanism designed to put a price on carbon in order to reduce carbon dioxide emissions and help tackle climate change. Under a system of carbon trading, the right to exceed an agreed level of pollution has a price. Good organisations can benefit from reducing their emissions, while bad ones pay a financial penalty. Economists believe it is more efficient and effective than a tax or quota scheme, as it rewards or punishes particular patterns of behaviour. There are two main types of carbon trading emissions trading and trading in project-based credits. Project-based trading may also be known as offset trading. Schemes may be a hybrid of both emissions trading and offset trading. The Kyoto Protocol and the European Union Emissions Trading Scheme (EU ETS) are examples of hybrid carbon trading systems. These methods and schemes are discussed in greater detail in the following sections. Context is not covered in any detail under the current CIMA syllabus. However, carbon trading forms part of the wider sustainability issue and it is helpful for students to understand the concept and implications of carbon trading. 3

4 Overview Emissions trading Emissions trading is one way of creating a market for carbon and involves trading in carbon allowances. This is typically operated through a cap and trade system, where a target (cap) is established for emissions from a particular group and allowances are issued in line with that cap. Allowances can then be traded so that entities exceeding their allowance can purchase unused allowances from under-emitters and avoid penalties otherwise imposed on over-emitters. The cap is usually set in accordance with emissions from a baseline year. Targets are then set for a given period. For example, the baseline year for the Kyoto Protocol is emissions in 1990 and reduction targets are to be achieved between 2008 and Denmark was the first country to introduce greenhouse gas emissions trading in 2001 (for electricity generation), and the UK was the first to implement a national emissions trading system (in 2002). These were both operated on a voluntary basis. Created in conjunction with the Kyoto Protocol, the EU ETS has been operating since 2005 and is the largest companies-based emissions trading scheme. This scheme is mandatory for the companies captured within it. The Kyoto Protocol is the first scheme to introduce trading of greenhouse gases on a global basis. Around 170 countries and other governmental entities ratified the Kyoto Protocol, which is part of the United Nations Framework Convention on Climate Change (UNFCCC). Nearly 40 developed countries (excluding the US) have pledged to reduce their annual carbon emissions. In the US there is currently no federal cap and trade programme. However, it is likely that carbon reduction will move up the federal agenda once a new President is elected in November However, individual states have taken the lead. In 2007, at least 15 states had implemented or proposed greenhouse gas reduction programmes, with more likely to follow. The Chicago Climate Exchange has also been set up and has traded since It is a voluntary but legally-binding scheme for reducing and trading emissions. Members include many major global corporations, state and local governments, and environmental institutions. 4

5 All carbon trading schemes so far have involved governments giving allowances (or permits) away rather than auctioning them. However, the UK government is planning to introduce the Carbon Reduction Commitment (CRC), the first mandatory auction-based emissions trading scheme. It is expected to come into force in October 2009, with the first phase starting in 2010, and will apply to large, non-energy intensive organisations. The CRC excludes energy-intensive organisations as these are already covered by other schemes such as the EU ETS. It will be a cap and trade scheme, with participants being able to trade allowances at auction, depending on their energy usage. An auction-based scheme will help to establish a real market price for carbon and adds to the credibility and stability of the market. Offset trading Offset trading is the other main way of carbon trading. This refers to investment in carbon reduction projects to obtain credits in order to offset emissions. For example, under the Kyoto Protocol, there are three different mechanisms for carbon trading. In addition to the emissions trading scheme within the developed countries, the Kyoto Protocol introduced the Clean Development Mechanism (CDM) and Joint Implementation (JI). The CDM involves trading between a developed country and a developing one, in order to offset emissions in the developed country. JI is a similar project-based scheme but involves trading between two developed countries. Here one country receives emissions credits in return for financing an emissions reduction project in another. Countries can implement projects that demonstrate savings in carbon emissions, either by not emitting carbon or by absorbing carbon. Examples include forestry, biomass energy, hydropower and wood power plants. Projects in developing countries are supplied to the CDM market for developed countries to buy. The developing country will not only benefit from revenues from sale of carbon credits, but also from increased foreign investments and potential for technology transfer. To date, over 1,000 projects have been registered in almost 70 countries. China, India, Brazil and Africa are leading suppliers of CDM projects while the UK, Japan and Italy are leading buyers. 5

6 In practice Experience to date Trading in carbon offsets started in 2003 and the market has developed quickly. In 2004, an estimated 94 million tons of CO2e (carbon dioxide equivalent) were traded. By 2006, 1.6 billion tonnes of CO2e were traded and the global carbon markets were worth 22.5 billion. According to Point Carbon, the EU ETS accounted for 62 per cent of the volume and over 80 per cent of the value. Carbon markets continue to grow rapidly, more than doubling to 47 billion in 2007, with the EU ETS accounting for a similar proportion of the value ( 37 billion). Based on these figures, it is clear that emissions trading is fast becoming an industry in its own right. There are currently more than 10 carbon emission exchanges worldwide and London is the world s carbon trading capital. Barclays have been involved in carbon trading since 2005 and they were the first UK bank to set up a dedicated carbon trading desk. They are one of the most active players in the carbon market, having traded around 300 million tonnes of CO2e by Morgan Stanley launched the world s first carbon bank in 2007 and is another major player in the carbon market, along with the World Bank, the European Carbon Fund, and Japan Carbon Finance. By creating a price for carbon emissions, carbon trading gives organisations the incentive to go beyond compliance. It also encourages organisations to find ways to make reductions, including through investment in new technologies. There are a number of bodies that can assist organisations in this. For example, the Carbon Trust is an independent company that was set up by the UK government in It exists to work with organisations in reducing emissions and in developing commercial low carbon technologies that will assist the move to a low carbon economy. In many trading schemes, non-polluting organisations may also participate, purchasing and retiring allowances and credits to drive up the price. For example, environmental groups may buy allowances to lessen the number of permits on the market. Companies can also donate allowances to not-for-profit organisations and be eligible for a tax deduction. 6

7 Difficulties with carbon trading Despite the growing carbon market, there is still slow adoption of offset trading. This may be because establishing such a project can be a complex and expensive process. All CDM or JI projects must go through a rigorous validation process by the UNFCCC. Certification costs around US$10,000 and there are usually many other costs involved for the company. For Voluntary or Verified Emission Reduction Credits (VERs), this assessment is made by a third party organisation chosen by the project developer, not through an internationally agreed body at this stage. Late in 2008, the Department for Environment, Food and Rural Affairs (DEFRA) is to launch its Code of Best Practice for carbon offset providers. A draft of the Code is already available as part of the consultation process. Initially this Code will only cover Certified Emission Reduction Credits that are compliant with the Kyoto Protocol. However, VERs could be included in the future. According to DEFRA, business in the UK strongly supports emissions trading as a key tool for mitigating climate change. However, experience to date with the EU ETS has not all been positive. The EU ETS has demonstrated a major challenge to applying the cap and trade approach on an international basis, with individual governments over-allocating allowances to protect domestic industries. The distribution method of allowances has been criticised and price volatility has been a major problem. There is a need for clarity in the EU on the future of emissions trading and there have been calls to make the EU scheme auction-based. At the far end of the spectrum, there are those that argue carbon trading as a response to climate change is ineffective and unjust, giving entities permission to pollute. Some people are of the view that carbon trading allows governments and companies to avoid implementing serious and more immediate reductions in polluting activities, and that creating a market for carbon is not sufficient in itself. Permitted levels of emissions may need to be dramatically reduced if climate change is to be averted. It is also argued that carbon offsetting may become a substitute for reducing emissions at source. However, as stated by DEFRA, purchasing carbon credits should be considered as the next best solution for mitigating remaining emissions from essential activities after all practical steps have been taken to reduce them. 7

8 The Carbon Reduction Commitment (CRC) As mentioned earlier, the CRC is due to come into force in October 2009, with October 2009 to March 2010 forming the baseline period for emissions measurements. Participants in the scheme will be determined based on 2008 energy usage. Private and public sector organisations will be captured by the scheme if they pay a UK electricity bill and have annual half-hourly metered electricity consumption above 6,000 megawatt hours in Half-hourly meters are mandatory for sites using more than a set level of energy. In general, this will include organisations spending more than 500,000 a year on half-hourly metered electricity and it is estimated that around 5,000 organisations will initially be affected. It is worth noting that groups of companies will be treated as one organisation for CRC purposes, with the parent company taking responsibility for collating and reporting aggregate emissions. It is also not just those organisations directly covered by the trading scheme that will be affected. Larger organisations that are captured are likely to push efficiencies down the supply chain. It seems highly likely that the CRC will also be expanded in future years to bring in more organisations. Scheme participants will have to measure their half hourly electricity use and put in place processes to measure their entire non-transport energy consumption. These include all electricity, gas, oil, LPG, coal and other non-transport fuels. Finance managers should already be starting to hold conversations with colleagues to review energy efficiency measures across their organisation. They must ensure that they are in the best position to estimate the number of allowances they will need to buy and retire. It has been proposed that participants will initially have to pay 12 a tonne for their CO 2 emissions in Organisations taking early action are likely to benefit from an opportunity to generate additional revenue, reduce energy costs and use their higher league table ranking to provide positive marketing messages that will help win new customers and retain existing ones. 8

9 The role of the management accountant Despite the difficulties discussed in earlier in this section, carbon trading will continue to be a response to climate change. It is likely to become increasingly relevant to corporate life, particularly in the longer term. As the carbon trading market develops, management accountants are likely to have a major role to play. CIMA sponsored research published in 2006 found that emissions trading initiatives are likely to demand new organisational competencies to which management accountants will need to respond, while management accounting systems are already central to many environmental concerns. For example, processes such as capital investment appraisal, performance measurement and transfer pricing should all be incorporated into an organisation s environmental management system. There will also be a growing need to account for carbon trading and emissions allowances for financial reporting purposes. According to Hill et al: Management accountants will need to learn a new language associated with these initiatives if they are to be able to work alongside technical experts and to contribute to debates which are already affecting corporate agendas. The following points set out some of the areas in which carbon trading may impact on the role of the management accountant: Regulatory - accountants will need to work out how to process and account for transactions relating to the buying and selling of emissions allowances and credits. Emissions need to be monitored, assessed and managed during the year and reported on after the end of each year (see section below on Accounting for carbon trading). A recent study by JustAccountancyJobs.com found that 85% of 180 finance professionals believe that they will become involved in calculating carbon offsetting for their firms. Currently only 11% of accountants are involved in such activities. Profitability - carbon trading will result in business opportunities around revenue-generation (from selling surplus allowances and expertise on process development initiatives) and cost reduction (including areas such as insurance, energy, transport and trading scheme costs). 9

10 Strategy and decision making - decisions regarding the policies and frameworks for mitigation of climate change in the future will have a commercial effect on companies. For most of the companies involved in the review of the EU ETS, emissions trading was found to be a main issue in making long term decisions. Capital investment appraisal - this management accounting technique will be important in relation to investment in new processes and technologies aimed at reducing emissions. Organisations may also consider the relocation of facilities. Transfer pricing - one way companies can comply with emissions trading targets is to change behaviour by imposing internal charges for energy through transfer pricing. Research from Hill et al gives an example of a company that has changed its energy division from a cost centre to a profit centre, raising internal invoices to charge energy users on an arm s length basis. The transfer pricing scheme has been effective in driving behaviours to reduce energy in this company. Balanced scorecard - an additional segment can be added to the scorecard to cover environmental measures such as emissions output, extending the management accountant s scope of influence to include non-financial issues. Reputation - an organisation s activities around controlling emissions already interests institutional investors, and it is important that organisations can provide investors with the information they need. Reputation is of key importance in this area. The proposed CRC scheme is to include league tables. Representatives from major companies have commented that they are less concerned about any additional costs they may incur under the scheme than the potential adverse publicity of being shamed by league tables. Accounting for carbon trading Accounting for carbon emissions trading is a complex area for which there is currently no authoritative guidance. As a result, considerable diversity in practice has arisen. For example, a survey undertaken in 2007 by PricewaterhouseCoopers and the International Emissions Trading Association found that companies covered by the EU ETS had applied 15 distinctive approaches when accounting for EU allowances. 10

11 In December 2004, the International Financial Reporting Interpretations Council (IFRIC) issued IFRIC 3 Emissions Rights, which looked at how cap and trade emissions trading schemes should be accounted for. However, in June 2005 the International Accounting Standards Board (IASB) withdrew IFRIC 3 so that it could address the underlying accounting in a more comprehensive way. This project was deferred for some time, but the IASB are now commencing a joint project with the Financial Accounting Standards Board to develop such comprehensive guidance on accounting for emissions trading schemes. The guidance will cover: asset recognition measurement and impairment liability recognition and measurement timing of profit and loss recognition accounting for vintage year swaps presentation and disclosure. The guidance will also be applicable to all emissions trading schemes and not just those that operate on a cap and trade basis. The future A report by Lehman Brothers published in February 2007, The business of climate change, agreed that it is more than likely that some sort of global emissions trading system will be in place within five years. However, this will require the support of the US and also China, a large emitter of greenhouses gases that is currently under no obligation to reduce emissions. Progress was made at the UN conference in Bali in December 2007, with the US allowing the Bali Action Plan to pass. The Bali Action Plan paves the way for discussions over the next two years for government officials from 187 countries to agree on an international framework to combat climate change once the main provisions of the Kyoto Protocol expire in The aim is to agree a new climate protocol when the parties of the UNFCCC meet at the Climate Change Conference in Copenhagen in late This will be known as the Copenhagen Protocol (or Kyoto 2). Various meetings are being held in the interim, including the annual conference in Poland at the end of

12 In the UK, the number of organisations captured by emissions trading schemes will increase significantly with the introduction of the CRC in It is likely that carbon trading will also be extended to cover other sectors, such as transport, aviation and domestic energy use. For example, the EU is looking to bring aviation within the EU ETS by However, there are many questions that need to be considered first, such as which flights to include and which pollutants to cover. Currently the main focus is on reducing carbon emissions, although the Kyoto Protocol lists six harmful greenhouse gases. All six greenhouse gases are covered by some of the voluntary schemes, such as Chicago Climate Exchange. In time, it is likely that voluntary schemes will be brought into mandatory trading schemes such as the EU ETS. is also only one of a number of instruments available to governments. Other alternatives that have been debated include use of taxes and encouraging the development of appropriate technology. Further Information Articles Full text available from Business Source Corporate through My CIMA Goff, J.. CFO, January 2008, Volume 24, Issue 1, pp Koh, P. Carbon markets: hot times for emissions trading. Euromoney, September 2007, Volume 38, Issue 461, p. 68 Scott, M. Europe s carbon trading pioneers. Business Week Online, 29/04/2008, p. 14 Scott, M. Giant steps for carbon trading in Europe. Business Week Online, 24/01/2008, p. 17 Street, P. Trading in pollution: creating markets for carbon and waste. Environmental Law Review, 2007, Volume 9, Issue 4, pp BA denounces EU carbon trading plan. Travel Trade Gazette UK & Ireland. 30/05/2008, Issue 2819, p. 4 quandaries. New Zealand Management, June 2008, Volume 55, Issue 5, p. 6 MPs back personal carbon trading. Utility Week, 30/05/2008, Volume 26, Issue 24, p

13 Articles Abstract only available from Business Source Corporate through My CIMA Faris, S. The other side of carbon trading. Future International (Europe), 03/09/2007, Volume 156, Issue 4, pp Tollefson, J. Carbon-trading market has uncertain future. Nature, 03/04/2008, Volume 452, Issue 7187, pp Books Bayon, R., Hawn, A. and Hamilton, K. (eds.) (2007). Voluntary carbon markets: an international business guide to what they are and how they work. London: Earthscan Kanen, J.L.M. (2006). & privacy. London: Environmental Finance Publications Lohmann, L. (ed.) (2006). : a critical conversation on climate change, privatisation and power. Dag Hammarskjold Watchman, P.Q. (ed.) (2008). Climate change: a guide to carbon law and practice. London: Globe Law and Business Other publications Bréchet, T. and Peralta, S. (2007). The race for polluting permits. London: Centre for Economic Research. (Discussion paper (Centre for Economic Policy Research ((Great Britain)), No. 6209) Accounting for sustainability PART II: developments in the public and private sectors and environmental markets. The Accounting for Sustainability Group, December 2006 State and trends of the carbon market report 2008, The World Bank, May 2008 Draft code of best practice for carbon offset providers. Accreditation requirements and procedures. DEFRA, February 2008 Step by step: A guide to the carbon reduction commitment. KPMG LLP (UK), August 2008 Emissions trading and the management accountant lessons from the UK emissions trading scheme. Hill, McAulay and Wilkinson, 2006 The business of climate change. Lehman Brothers, February

14 Websites Carbon Disclosure Project The Carbon Disclosure Project is a not-for-profit organisation which acts as an intermediary between shareholders and corporations on all climate change issues. Available from: Carbon Solutions Group & GHG Markets Overview 2008 Carbon Solutions Group is an environmental asset management and engineering firm. Available from: Carbon Trust The Carbon Trust exists to accelerate the move to a low carbon economy by working with organisations to reduce carbon emissions and develop commercial low carbon technologies. Available from: COP15 Copenhagen 2009 Denmark s host country website for the United Nations climate change conference to be held in Available from: Carbon Reduction Commitment (CRC) CRC page of the DEFRA website. Available from: DEFRA Climate change and energy page of the DEFRA website. Available from: European Trading Scheme (EU ETS) EU ETS page of the Europa website. Available from: 14

15 International Emissions Trading Association (IETA) IETA is a non-profit organisation created in June 1999 to establish a functional international framework for trading in greenhouse gas emission reductions. Available from: Point Carbon Point Carbon provides independent news, analysis and consulting services for European and world power, gas and carbon markets. Available from : United Nations Framework Convention on Climate Change (UNFCCC) Available from: [Assessed 24 September 2008] Copyright CIMA 2008 First published in 2008 by: The Chartered Institute of Management Accountants 26 Chapter Street London SW1P 4NP United Kingdom No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the authors or the publishers. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means method or device, electronic (whether now or hereafter known or developed), mechanical, photocopying, recorded or otherwise, without the prior permission of the publishers. 15 Permission requests should be submitted to CIMA at tis@cimaglobal.com