SPECIAL REPORT

(
tax notes ®
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Tax Issues Relating to Trading Cop
.
ht. 2
In Carbon Emissions Rights Mat
.
w. P
By Matthew P. Haskins .
Has
.
s.3
All
8 r
Matthew P. Haskins is a director with the rese
2
Washing-ton National Tax Services office of II
Pricewaterhouse-Coopers LLP and a member of
.
Tab
the firm’s steering committee on climate change
and sustainability. Con
G
As part of global efforts to reduce emissions of
greenhouse gasses, several governments either I. re
e
have already adopted or are considering adopting a n
system of tradable permits for carbon dioxide O h
emissions, and many observers anticipate ri o
Congress will give serious consideration to adopting gi u
a similar system in the United States. ‘‘Green n s
trading’’ in carbon dioxide emissions rights or other s e
environmental attributes poses significant technical o G
f a
tax issues both for U.S. taxpayers who participate in ‘ s
existing programs and for policymakers C R
contemplating the design of a U.S.-based trading a e
system. This report describes the devel-oping p d
spectrum of green tradables and outlines some of - u
the most significant tax issues that should be a ct
addressed both to facilitate existing trading systems n io
and to ensure that tax concerns do not impede the d n
environmental policy objectives of proposed trading - E
systems. T ff
r o
The author would like to thank Lauren Janosy of a rt
PricewaterhouseCoopers LLP for her significant d s
con-tributions to this report and Chip Harter, Peter e’ .
Merrill, and Constance Skidmore, each of . .
Pricewaterhouse-Coopers LLP, for their support . .
and helpful comments. Any errors or omissions, . .
however, remain the sole responsibility of the . .
. .
author.
 382 61. Carbon Trading Programs . . . . . . . . . . . . e
. 383
1. European Union Allowances
is
Exchanges . . . .. .. . . .
. . . . . . 383 su
es
2. Credits From Developing
Countries . . . . 384 pr
es
3. Verified Emissions
Reductions . . . . . . . . 384 en
te
4. Regional Greenhouse Gas
d
Initiative . . . . 384
by
38 VI.
cli
IV. The Emerging Spectrum of ‘Green 5 m
T ra d a b le s ’. . . . . . . . . . . . . . . . . .. .. .. .VII.
at
38 e
V. Secondary Markets for Carbon Credits . . . ch
an
ge
.
A
s
pa
rt
of
V III.
th
. . .
e
eff
or
n
t
re
to
ce
re
nt
du
ye
ce
ar
e
s,
mi
th
ss
er
io
e
ns
h
of
as
gr
b
ee
e
nh
e
ou
n
se
in
ga
cr
ss
e
es
as
(G
e
h
d
G)
gl
,
o
se
b
ve
al
ral
at
go
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ve
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rn
tio
m
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en
to
ts
th
either have already adopted or are considering 2
adopting a system of tradable permits for carbon 00
dioxide emissions, frequently known as ‘‘cap-and- 9.
trade’’ or ‘‘carbon trading.’’ Because President-elect A
llr
Obama and most key members of the Democratic ig
Con-gressional leadership team now publicly support hts
cap-and-trade legislation, many observers anticipate re
Congress will give serious consideration to such se
legisla-tion in 2009. r
v
e
While the science and environmental policy behind d
carbon trading have been hotly debated, few policymak- .T
ers have focused on the technical tax issues presented ax
by existing environmental trading systems or the need to A
n
consider tax issues when designing carbon trading or al
y
other green trading systems for potential future imple- st
1 s
mentation. The discussion below seeks to highlight a d
o
number of tax issues that must be resolved to ensure e
that s
n
o
tc
la
i
m
c
o
p
y
1
ri
As an alternative to cap-and-trade programs, many econo- g
h
mists have recommended implementing a direct tax on carbon ti
emissions or fuels that contain carbon, arguing that a tax can n
a
achieve comparable environmental outcomes while providing n
greater stability in the ‘‘carbon price’’ than a trading system y
p
does. Several European countries and two Canadian provinces u a
have implemented carbon taxes. See Carbon Tax Act of 2008, bl ic rt
y
Statutes of British Columbia, Chapter 40 (May 29, 2008); d c
Sidhartha Banerjee, ‘‘Quebec Starts Green Tax,’’ The Toronto o m o
n
Star (Oct. 2, 2007); EPA National Center for Environmental ai t
Econom-ics, ‘‘Economic Incentives for Pollution Control,’’ n e
o n
available at http://yosemite.epa.gov/ee/epa/eed.nsf/Webpages/ rt t.
hi
EconomicIncentivesPollutionControl.html (summarizing car-bon r
taxes imposed in Finland, Denmark, the Netherlands, Norway, d
p
Poland, and Sweden).

TAX NOTES, January 19, 2009

381
COMMENTARY / SPECIAL REPORT multilateral agreement to impose binding obligations on certain
ratifying countries to limit (and, in most instances, actually reduce) (
tax issues do not impede or distort the environmental policies their GhG emissions. The Kyoto Protocol covers emissions of six C
GhGs — CO2, methane, nitrous oxide, hyrdofluoro-carbons,
underlying either existing or proposed cap-and-trade systems.2
perfluorocarbons, and sulfur hexafluoride — and establishes )
I. Origins of ‘Cap-and-Trade’ reduction commitments for each.
Carbon credits are only one portion of an emerging spectrum The Kyoto Protocol distinguishes between ‘‘Annex I’’ parties T
of ‘‘green tradables,’’ and, indeed, they are not even the first (typically, developed nations) and other parties (typically,
such instrument. By putting a market price on pollutiondeveloping nations). Under the Kyoto Proto-col, Annex I a
emissions or other environmental harm, ‘‘green trading’’signatories have agreed to binding reduction targets for GhGs
schemes aim to force market participants to factor into privatethat generally are intended to reduce emissions so that by 2012 x
decision-making costs that previ-ously were passed off to their annual emissions are no more than 95 percent of those
society as economic externali-ties. emissions in 1990. In contrast, other parties do not face binding A
Under the Clean Air Act Amendments of 1991, the GhG reduction targets but may be incentivized to participate in
Environmental Protection Agency (EPA) developed a program ofthe UN’s ‘‘Clean Development Mechanism’’ (as described in n
tradable permits for sulfur dioxide (SOx) and nitrogen oxide more detail below).
al
(NOx) intended to control acid rain pol-lution. Effective in 1995, The Kyoto Protocol effectively fixes the amounts of GhGs to
the Acid Rain Program created a number of air basins in whichbe emitted by each Annex I party between 2008 and 2012. y
overall emissions of SOx and NOx were subject to a regulatory Although the Kyoto Protocol covers six GhGs, measurement
cap. The EPA issues allowances to utilities within each air basinand trading is based on metric tons of CO 2-equivalent st
to emit a certain number of tons of SOx or NOx. Those emissions. The Kyoto Protocol contem-plates that these national
allowances may be traded, with the intention of minimizing theallocations of ‘‘assigned allow-ance units’’ will be suballocated s
private sector cost of achieving emissions reduction targets. by each ratifying Annex I country to private businesses
Example: Utility A and Utility B both operate in the Losoperating within its borders in certain economic sectors, 2
Angeles air basin. Utility A can reduce its SOx emissions at a including agricul-ture, utilities, manufacturing, energy, and
cost of $80 per ton. Utility B also can reduce its SOx emissions, transportation. A private business that has been allocated or 0
but at a cost of $120 per ton. Under traditional ‘‘command and otherwise obtained emissions units (for example, through
control’’ regulation, if Utility A and Utility B each were required to trading) must surrender units to the relevant national 0
reduce emissions by a ton, the aggregate cost of compliancegovernment agency for cancellation in amounts equal to its
would be $200. Under the Acid Rain trading program, it isemissions. A private emitter’s failure to meet required emissions 9
possible for Utility A to reduce its emissions by two tons and selllevels is expected to result in a fine for the amount of pollution
its excess allowance to Utility B. In this case, the aggregate cost emitted in excess of the emissions credits the party surrenders. .
of compliance would be reduced by 20 percent to $160. Additional units can be created through three mecha-nisms.
The cap-and-trade mechanism in the Acid Rain Pro-gram isRemoval units are created by actions of Annex I governments, A
widely regarded as successful in reducing the costs of pollutionsuch as reforestation projects, and cannot be traded in private
control. In fact, the Government Ac-countability Office hasmarkets. Emission reduction units (ERUs) are created through llr
estimated that cost of pollution control under the Acid Rain‘‘Joint Implementation’’ (JI) projects that either reduce or absorb
Program was cut in half by using a trading mechanism rather GhG emissions in Annex I countries. Certified emission ig
than command and control regulation.3 reduction units
h

II. Greenhouse Gas Reduction Efforts ts

In 1992, 166 nations signed the United Nations Frame-work 4
Convention on Climate Change (UNFCCC) with the stated objective United Nations Framework Convention on Climate Change, Article 2 r
(New York, May 9, 1992).
of stabilizing greenhouse gas concen-trations in the atmosphere at 5
For a complete list of signatories to the Kyoto Protocol, including both e
a level that would prevent ‘‘dangerous anthropogenic interference’’
Annex I and non-Annex I countries, see http://
with the climate unfccc.int/kyoto_protocol/status_of_ratification/items/2613. php.
s

e
2
For an overview of those issues from an academic commen-tator, see r
Jonathan R. Nash, ‘‘Taxes and the Success of Non-Tax Market-Bassed
Environmental Regulatory Regimes,’’ University of Chicago John M. Olin
Law & Economics Working Paper No. 412 (2d Series) (July 2008). v
3
See, e.g., General Accounting Office, ‘‘Overview and Issues on
e
Emissions Allowance Trading Programs,’’ GAO/T-RCED-97-183 (July 1997).
This agency has been renamed the Government Accountability Office.
d

.
system.4 The UNFCCC was the first international treaty to focus
on the harmful environmental effects of GhGs, including carbon T
dioxide (CO2). Binding limits on GhG emissions were adopted in
the Kyoto Protocol to the UNFCCC. As of October 16, 2008, 182 a
countries have ratified or otherwise adopted the Kyoto Protocol.
Of the initial signatories, only the United States and Kazakhstan x
have not yet ratified the protocol.5
The Kyoto Protocol entered into force on February 16, 2005, and A
its first binding commitment period for GhG reductions started on
January 1, 2008, and ends on December 31, 2012. It is the first n
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382 TAX NOTES, January 19, 2009

 initiatives and ‘‘certified’’ by a non-governmental standard
setter; not usable to meet (
VERs regulatory requirements.
(CERs) are issued only in connection with a Clean Development C
Mechanism (CDM) project under which an Annex I party Credits issued by consortium of U.S. Northeast-ern and
finances activities of non-Annex I parties. CDM projects typically mid-Atlantic states under a mandatory
carbon cap-and-trade program for utilities. )
are financed by private parties in countries such as China, India, RGGI
and Vietnam; the CERs generated in those projects can be used T
to meet a portion of a company’s compliance obligations in anLike their counterparts under the Kyoto Protocol, EUAs can be
Annex I country. JI projects are similar but typically take place in viewed as a permit, right, or allowance to emit, free of penalty, a
Eastern European countries. one ton of CO2 or its equivalent.
The Kyoto Protocol specifically allows a signatory country to During Phase I, approximately 12,000 utilities and large x
transfer or acquire emissions credits from another signatoryindustrial GhG emitters were granted by each EU member state
country.6 Thus, Annex I parties can meet their emissionsan initial allocation of specific rights to emit EUAs based on prior A
reductions requirements by obtain-ing additional emissionsemissions and governmental pollution reduction goals. In Phase
rights through (1) emissions trading by countries or privateII of the EU-ETS, which began in 2008, GhG emitters in some n
sector emitters that deter-mine it is more cost-effective toindustries were required to bid for EUAs9 at auction, and the
purchase additional rights to emit GhGs rather than to reduceoverall cap on EUAs has been reduced. In other significant al
emissions by modifying behavior, (2) financing CDM projects, or respects, however, the EU-ETS trading mechanism is expected
(3) financing JI projects. to remain unchanged until the currently slated expiration of the y
Kyoto Protocol in 2012.
The Marrakesh Accords, adopted in 2001, established three The EU-ETS is backstopped with a penalty tax on the extent
registries that are required to log trading in emis-sionsthe measured emissions of a regulated emitter exceed its EUAs. st
allowances.7 The registries operate at the following levels: (1)In Phase I, the penalty tax for each ton of CO or its equivalent s
2
each Annex I party is required to establish a registry at the emitted without a corresponding surrender of an EUA was €40;
national level that tracks units held by the Annex I party as wellin Phase II, the penalty tax is €100 per ton of excess emissions. 2
as those held by private parties; (2) a registry that is maintained The EU-ETS contemplates that a regulated business may
by the United Nations regarding the issuance and distribution ofavoid penalties either by engaging in the reduction of emissions 0
CERs in con-nection with CDM projects; and (3) the to an amount not exceeding its allotment of EUAs, or by
International Transactions Log, which is to be maintained by thepurchasing (directly or indirectly) additional allowances from 0
UNFCCC once finalized, and will trace the issuance, other regulated businesses that have excess allowances or
cancellation, or registration of Kyoto emissions allow-ances infinancial intermediaries (brokers and investors). Thus, if a 9
any registry, as well as the acquisition or transfer of those unitsregulated business is able to abate its own pollution and has
between registries. excess EUAs as a result, it may sell any surplus EUAs to .
another person. The EU-ETS contemplates and permits such
III. Carbon Trading Programs trading. A
In response to the Kyoto Protocol, a market for carbon emissions When the market price for EUAs is higher than the cost of
rights (carbon credits) has developed under a number of programs pollution reduction, a regulated business may be expected to llr
sponsored by national governments and arising out of voluntaryincur the cost of abating its emissions, and recouping the same
ig
efforts to reduce GhG emissions. Increasingly, U.S.-basedwith a profit, by selling its resulting surplus of EUAs. Conversely,
corporations and in-vestment funds are trading both in the where the cost of abating emissions for a particular business
h
European markets and in parallel U.S. markets in five major types ofexceeds the market price of EUAs, that business may be
expected to forgo abatement, and instead simply incur the cost
carbon credits (see table in next column).
of purchas-ing additional EUAs as necessary to negate the ts
A. European Union Allowances imposi-tion of a fine. To avoid the imposition of a fine, a
r
The European Union decided to meet its obligations under
the Kyoto Protocol collectively, and, in fact, ‘‘early adopted’’ e
emissions trading with the implementation of its Emissions
9
Trading Scheme (EU-ETS) between 2005 and 2007.8 The EU- See generally http://ec.europa.eu/environment/climat/ s
ETS is an EU-wide cap-and-trade program that requires each emission/2nd_phase_ep.htm. In implementing Phase II, the EU Commission
member state to adopt a national allocation plan for distributinghas exercised its authority to reduce national caps proposed by member
states. e
its allocation of European Union allowances (EUAs) among all
busi-nesses in some industries operating within its borders. r

6 e
Kyoto Protocol, Article 6(1).
7
The full text of the Marrakesh Accords may be found on the UNFCCC’s
Web site available at http://unfccc.int/cop7/ documents/accords_draft.pdf. d
8
See http://ec.europa.eu/environment/climat/emission/
emission_plans.htm. .
COMMENTARY / SPECIAL REPORT
T

Existing Types of Carbon Credits a

Issued or auctioned by EU governments to EU-EUAs
x
resident GhG emitters.
Created by implementation of GhG reduction initiatives A
in developing countries and certified
CERs by the UN. n
Similar to CERs but created under a different ERUs
Kyoto Protocol program. al
Created through the implementation of GhG re-duction
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TAX NOTES, January 19, 2009 383

COMMENTARY / SPECIAL REPORT states, as 59 bidders participated in the auction.13 RGGI reports that
approximately 80 percent of the bidders at the September auction (
regulated business must surrender EUAs representing thewere ‘‘compliance entities,’’ that is, utilities and other facilities C
amount of its measured emissions for the relevant period. Thesubject to RGGI compliance requirements and that demand for
imposition of fines and the possibility that some emitters may beallowances exceeded the auctioned supply by a ratio of four-to- )
14
able to abate their level of emis-sions at a lower marginal cost one.
than the per-ton level of fines has led to active trading in EUAs. Numerous other programs are under development at the state, T
regional, and international levels. Of particular interest to U.S.-
B. Credits From Developing Countries based companies, California’s Global Warming Solutions Act of a
Although developing countries have no binding GhG emission2006 (also known as ‘‘Assem-bly Bill 32’’ or ‘‘AB 32’’) permits
reduction targets under the Kyoto Protocol, they may participateCalifornia’s Air Re-sources Board (CARB) to adopt a mandatory, x
in the CDM under which govern-ments and companies instatewide cap-and-trade system for CO .15 In October, 2008, CARB
2
developed countries help fi-nance GhG emissions reductionissued a report outlining its scoping plan for implement-ing AB 32, A
projects that can be certified as achieving measured levels of including adoption of a cap-and-trade system that would begin in
emissions re-ductions (CERs). Another of the Protocol’s flexible
2012.16 That system would be inte-grated with the broader Western n
mechanisms involves JI programs, typically in Eastern Europe, 17
that can be issued certificates for successful implementationsClimate Initiative that also is scheduled to launch in 2012. al
(known as ERUs). Similarly, the Midwestern Greenhouse Gas Reduction Accord calls
Importantly, CERs and ERUs may be used to meet afor the establishment of a regional cap-and-trade 18
program in several y
specified percentage of an EU emitter’s need for carbon credits Midwestern states and Canadian provinces.
and also may be used in other non-EU jurisdic-tions. (Although At the national level, New Zealand is in the process of st
this percentage varies, it typically falls between 10 percent andimplementing a mandatory cap-and-trade system for CO2, and
15 percent in most EU member states.) This creates an Australia plans to adopt a similar system beginning in 2010.19 s
opportunity for EU GhG emitters to import credits associated
with developing country projects and provides financial 2
incentives for both GhG emitters and third-party project
developers to manage and fund CDM projects. 12 0
The 10 participating states are Connecticut, Delaware, Maine,
Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode
C. Verified Emissions Reductions Island, and Vermont. 0
Projects that are not certified by either the EU or the UN may 13See Timothy B. Wheeler, ‘‘Emissions Auction Runs Smoothly,’’ The
meet the certification criteria set by some nongovernmentalBaltimore Sun (Sept. 30, 2008), accessible at 9
organizations as verified emissions reductions (VERs). http://www.baltimoresun.com/news/local/bay_environment /bal-
However, VERs cannot be used to meet compliance obligationsmd.auction30sep30,0,2887416.story.
14
.
outlined in the Kyoto Pro-tocol or the EU-ETS. See http://www.rggi.org/docs/Auction_1_PostSettlement
_Report_from_Market_Monitor.pdf. A
There is no official registry system for VERs to track 15California Global Warming Solutions Act of 2006, Calif. Health & Safety
ownership, but there are new initiatives to establish such aCode Division 25.5. llr
system. Also, a wide variety of organizations either have, or are 16CARB, ‘‘Climate Change Proposed Scoping Plan’’ (Oct.
currently developing, standards for the issuance of VERs. For 2008) at 30, available at http://www.arb.ca.gov/cc/
ig
example, ‘‘voluntary carbon units’’ (VCUs) certified under thescopingplan/document/scopingplandocument.htm.
International Emissions Trad-ing Association’s Voluntary Carbon 17The Western Climate Initiative encompasses seven U.S. states —
Standard10 have emerged as a market standard for trading inArizona, California, Montana, New Mexico, Oregon, Utah, and Washington h
VERs. Another emerging standard is the WWF’s Gold Stand-— and four Canadian provinces — British Columbia, Manitoba, Ontario, and
ts
ard.11 If a project fulfils the requirements of a particular standard Quebec.
18
See http:// www.westernclimateinitiative.org.
setter, a certificate may be granted. Illinois, Iowa, Kansas, Manitoba, Michigan, Minnesota, and Wisconsin
are participating in this effort. Three additional states r
For current participants in the VER market, the pri-mary— Indiana, Ohio, and South Dakota — are ‘‘observers’’ in the process.
economic motivations appear to be either an intan-gible benefitSee http://www.midwesternaccord.org/index.html. e
to their corporate images as taking action to address 19See Barry Critchley, ‘‘Australia’s Cap-and-Trade Plan,’’
environmental issues (that is, achieving carbon neutrality) or anFinancial Post (Nov. 6, 2008); available at http://www. s
anticipation that current participants in (Footnote continued on next page.)
e

r
10
The International Emissions Trading Association is a non-profit
organization composed of 175 member companies that seeks to establish v
an international framework for trading in GhG emissions reductions. See
http://www.ieta.org/ieta/ www/pages/index.php?IdSitePage=1152. e
11
The Gold Standard Foundation is an outgrowth of efforts by the WWF
(formerly known as the World Wildlife Federation) to facilitate voluntary GhG d
emissions reductions. See http:// www.cdmgoldstandard.org/index.php.
.

the voluntary markets may be rewarded with allocations of T

carbon credits in an eventual U.S. cap-and-trade system
a
(‘‘precompliance’’ investors).
D. Regional Greenhouse Gas Initiative x
On September 25, 2008, the first U.S. auction of carbon
A
emissions rights was conducted by the Regional Green-house Gas
Initiative (RGGI). Under RGGI, utilities in 10 Northeastern and mid-
n
Atlantic states will be required to submit allowances sufficient to
cover their CO2 emissions beginning in 2009.12 The September al
RGGI auction raised a total of $38.5 million for the participating
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384 TAX NOTES, January 19, 2009

 the Malaysian state of Sabah to estab-lish a ‘‘biobank.’’
New Forests manages ‘‘eco funds’’ designed to earn (
IV. The Emerging Spectrum of ‘Green Tradables’ competitive returns through un-locking the value of the
C
ecosystem services provided by forests.24 Under the
Carbon credits are only one portion of an emerging spectrum biobank plan, public and private capital will be put to )
of ‘‘green tradables.’’ The genie is out of the bottle on applying use to preserve a Malaysian forest habitat for
market mechanisms to environmental policy issues, and this orangutans and rhinos. New Forests will be T
may be one of the most fertile grounds for the development of compensated through its ability to sell biodiversity
new financial instru-ments and products over the next decade, credits to other users of forest assets, such as palm oil a
as illustrated by the following catalog of existing green tradables, producers.25
each of which are currently tradable or monetizable: x
0• Renewable Energy Certificates (RECs). More than V. Secondary Markets for Carbon Credits
A
half the states now have ‘‘renewable portfolio stan- Many industrial companies and investment funds have begun
dards,’’ requiring that a designated portion of thetrading in EUAs. In 2008, market research firm Point Carbon n
state’s total electricity generation come from renew-estimated that trading volume under the EU-ETS would reach
able sources.20 In some states, electric utilities can$68 billion in 2008 and that the overall
26
global carbon market
al
buy tradable RECs from developers of renewablewould grow by 56 percent in 2008. A recent World Bank study
energy projects to comply with the renewable port-found27that carbon trading volume doubled between 2006 and y
folio standards. A recent report from the Depart-ment2007. CERs, ERUs, and even VERs also trade in secondary
of Energy stated that an estimated 10.5 billionmarkets. (Because VERs are not standardized or useful for st
kilowatt-hours of renewable energy was sold throughcom-pliance, the value of VERs is usually significantly lower
RECs in 2007.21 than the value of CERs or EUAs.)
s
Carbon trading now occurs through a number of exchanges
0• Energy Efficiency Certificates (EECs). Connecticut,
and bilateral contracts in both the United States and Europe, 2
Pennsylvania, and Nevada now require energy effi-
detailed below.
ciency efforts as part of their renewable portfolio
standard and permit a secondary market in EECsA. European Exchanges 0
generated by those projects.22 Pennsylvania allows The largest carbon trading exchanges in Europe are the London- 0
utilities to buy EECs for projects done outside the statebased European Climate Exchange (ECX), the Leipzig-based
but in the Pennsylvania-New Jersey-MarylandEuropean Energy Exchange and Oslo-based NordPool.28 The ECX 9
transmission area; Connecticut allows utilities to useoffers futures contracts in
EECs only for in-state projects. Some market observ- .
ers expect that a national market for EECs eventu-ally
will develop. A
23
0• Water. Although water rights are not widely traded at For a brief description of the arguments in favor of tradable water
rights, see Michael Greenstone, ‘‘Tradable Water Rights,’’ Democracy: A llr
present, many environmental observers believe
Journal of Ideas (Spring 2008), reprinted at http://
www.brookings.edu/articles/2008/spring_water_rights_ greenstone.aspx. ig
24
See generally http://www.newforests.com.au.
25
See ‘‘New Forests in Sabah Conservation Deal,’’ The Aus-tralian (Nov. h
climatechange.govt.nz. For a useful summary of existing and proposed 28, 2007), accessible at http://www.
emissions trading schemes worldwide, see http:// theaustralian.news.com.au/story/0,25197,22836267-20142,00 ts
www.climatechange.govt.nz/emissions-trading-scheme/ international- .html.
examples.html. Although beyond the scope of this article, a valuable 26
Keith Johnson, ‘‘Market Making: Carbon Keeps Growing,’’ r
discussion of the Australian tax issues arising from the implementation of a Wall Street Journal Environmental Capital Blog, Feb. 26, 2008:
cap-and-trade system is contained in chapter 11 of the Australian http://blogs.wsj.com/environmentalcapital/2008/02/26/ market-making- e
government’s recent ‘‘Green Paper’’ on its carbon pollution reduction plan. carbon-keeps-growing/trackback/.
27
That publication can be accessed at http://www.climatechange.gov.au. World Bank, ‘‘State and Trends of the Carbon Market — 2008,’’ May s
20
A useful summary of state renewable portfolio standards may be found2008, accessible at http://carbonfinance.org/docs/ State___Trends —
formatted_06_May_10pm.pdf. See also Fiona Harvey, ‘‘World Carbon
at the ‘‘Database of State Incentives for Renew-ables & Efficiency,’’ which is e
Trading Value Doubles,’’ Financial Times (May 8, 2008) at p. 27.
maintained by the North Carolina Solar Center at North Carolina State
28
University. See http:// See http://www.europeanclimateexchange.com and
www.dsireusa.org/documents/SummaryMaps/RPS_Map.ppt. http://www.nordpool.com. The ECX (ECX)/International Cli-mate Exchange r
21
Lori Bird, Claire Kreycik, and Barry Friedman, ‘‘Green Power Marketing(ICE) is a member of the Climate Exchange group of companies. ECX
manages the product development and marketing for ECX Carbon Financial v
in the United States: A Status Report,’’ Na-tional Renewable EnergyInstruments listed and
Laboratory, U.S. Department of En-ergy (Oct. 2008), at 19. One market (Footnote continued on next page.)
participant has estimated the value of such trading as exceeding $250 e
million in 2007. See Andrew Ertel, president and CEO of Evolution Markets
LLC, ‘‘Global Overview of Emissions & Renewable Trading,’’ Power-Point d
presentation for the 2008 Wall Street Green Trading Summit (Apr. 2, 2008).
.
22
For more information about EECs, see Sterling Planet’s description of
its proprietary ‘‘White Tags’’ program available at T
http://www.sterlingplanet.com/upload/File/Sterling_Planet_
White_Tags_Fact_Sheet.pdf. a
COMMENTARY / SPECIAL REPORT
x
an active market in water rights will develop in the coming
years, particularly in the West.23 A
0• Biodiversity and Forestry. Demonstrating the po-
n
tential reach and scope of green trading concepts, an
Australian-based investment management com-pany,
al
New Forests Pty., recently entered into a venture with
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TAX NOTES, January 19, 2009 385

COMMENTARY / SPECIAL REPORT
(
EcoRegistry has approximately 30 corporate members. It is not
both EUAs and CERs. NordPool offers both spot and forward a CFTC-regulated exchange. C
contracts in EUAs and forward contracts in CERs.
D. Bilateral Contracts
)
B. U.S. Exchanges In addition to exchange trades, transactions in all types of
U.S.-based carbon trading occurs on three exchangescarbon credits, including total return swaps over carbon credits, T
regulated by the Commodities Futures Trading Commis-sionmay occur via bilateral transactions that take place off an
(CFTC): exchange or other market mechanism. Several companies now a
0• Chicago Climate Exchange (CCX). The CCXfacilitate over-the-counter trans-actions in EUAs.34
was launched in 2003 and describes itself as x
‘‘North America’s only active voluntary, legally VI. EU Precedents
binding integrated trading system to reduce Despite the EU’s head start in implementing carbon trading, A
emissions of all six major greenhousethere is relatively little harmonized guidance within Europe
gases.’’29 The CCX now has over 300regarding the appropriate income tax treatment of carbon n
members, including industrial companies thatcredits. For example, while the United Kingdom has provided
have pledged to make carbon emissionsguidance allowing carbon trading to occur under the U.K.’s al
reduc-tions and ‘‘liquidity providers’’ such as‘‘investment manager exemption’’ (a concept similar to the U.S.
35 y
proprietary traders. Trading on the CCXtrading safe harbor of section 864(b)(2)), other income tax
includes the ‘‘carbon financial instrument’’issues are resolved by analogies to principles of established tax st
(CFI), which is a VER that meets certainlaw or by reference to accounting treatments, which 36 are,
common market standards. The CCX isthemselves evolving and subject to significant uncer-tainty. In s
regulated as an exempt contract market by theother EU jurisdictions, guidance37has been similarly piecemeal or
CFTC; it is subject to less restrictive regulationreliant on accounting treatment. 2
than a retail-oriented designated contract In contrast, the European Commission has moved relatively
market but available for trading only toquickly to ensure consistency of VAT treatment to facilitate 0
cross-border trading within the EU. Under this guidance,
predetermined mem-bers, rather than to thetransactions in EUAs are treated as the provision of a service
broader public. 0
within the meaning of the EU VAT Directive.38 As a result, non-
0• Chicago Climate Futures Exchange (CCFE).EU businesses engaged in carbon trading with EU businesses
The CCFE is a wholly owned subsidiary of thegenerally should not incur VAT, while EU-based recipients of 9
CCX that offers standardized futures andEUAs self-assess VAT and then recover it on their VAT returns.
options contracts over emissions allowances .
and other environmental products, including
VII. U.S. Tax Analogies for Green Trading A
CFIs.30 The CCFE is regulated as a
designated contract market by the CFTC. The taxation of carbon credits and other green trad-ables
presents a number of novel issues. Existing pre-cedents provide llr
0• The Green Exchange. The Green
Exchange is a joint venture of NYMEX,some useful analogies but may be hard to generalize across the ig
Evolution Markets, and a num-ber of otherspectrum. As is the case with many efforts to characterize new
financial institutions. It opened for trading onfinancial instruments using the existing tax cubbyholes, the h
March 17, 2008, as a members-onlytechnical result that seems most persuasive may depend on the
exchange but currently is being certified as astarting analogy. ts
retail-oriented designated contract market
31
under CFTC rules. The Green Exchange r
hosts trading in EUAs and CERs. However,
it plans to add trading in VERs in the 34For an example of one such company, see Natsource LLC’s Web site e
future.32 at http://www.natsource.com.
35
3. Other Trading Platforms See Her Majesty’s Revenue & Customs Statement of Prac-tice s
SP1/01. An explanation for this change to the applicable U.K. regulations
The Environmental Resources Trust operates thecan be found in the 2007 U.K. Budget. See
EcoRegistry trading platform in the United States, which ishttp://www.hmrc.gov.uk/budget2007/bn47.htm. e
36
intended to encourage transactions in VERs and to develop See Iain Calton, Helen Devenney, and Sarah Nolleth, ‘‘Ac-counting
and Taxation,’’ Climate Change: A Guide to Carbon Law and Practice (2008) r
market liquidity in these instruments.33 The at 143-156.
37
For a good summary of tax treatment across EU jurisdic-tions, see the v
PricewaterhouseCoopers report, ‘‘Taxation of emissions trading within the
EU: From (non)existing regulation to daily practice and opportunities,’’ e
admitted to trading on the ICE Futures electronic platform, which is a available at http://www.
European energy exchange for futures and options. The Chicagopwc.com/extweb/pwcpublications.nsf/docid/F2F77C97055F9 d
Climate Exchange (discussed below) is also a member of the Climate80E85256F3F006808AE/$File/Emission%20Tax_200406.pdf.
Exchange group of companies, and enables its members to buy and sell 38
See http://ec.europa.eu/environment/climat/pdf/vat_ guidelines.pdf .
credits for emission reductions. See(summarizing TAXUD/1625/04).
http://www.chicagoclimateexchange.com.
29
T
See http://www.chicagoclimateexchange.com/about/
pdf/CCX_Overview_Brochure.pdf. See generally http://www.
chicagoclimateexchange.com. a
30
See http://www.ccfe.com/about_ccfe/products/cfi/CCFE
_CFI_Overview.pdf. x
31
See http://www.greenfutures.com.
32
It is likely that the Green Exchange’s standards for VERs will closely A
resemble those for VCUs (VERs certified under the Voluntary Carbon
Standard, supra note 9). VCUs currently trade only via principal-to-principal n
contracts.
33
See http://www.ert.net and http://www.ecoregistry.org/. al
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386 TAX NOTES, January 19, 2009

 were ‘‘intangible property held for use in a trade or business’’ rather
than property held to generate passive income. The ruling also (
A. SOx and NOx Permits notes, however, that the IRS is currently studying whether it may be
appropriate to treat emissions allowances as commodities, leaving C
As noted above, under the EPA’s Acid Rain Program, both open the possibility that they may be so characterized either under
utilities and financial investors trade SOx and NOx permits. The subpart F or other provisions of the code. )
IRS has accommodated this program through administrative
Similarly, it may be appropriate to treat purchases of VERs or T
guidance. In Rev. Proc. 92-91,39 the IRS concluded that the
voluntary purchases of RECs as creating a marketing intangible
costs of acquiring allowances must be capitalized. Those costs
relating to the purchaser’s environ-mental branding and image. a
constitute the utility’s basis in its allowances. A utility will
generally recover its basis in an emission allowance in one ofC. Treatment as a Commodity
two ways. If the allowance is applied against emissions in a Because many types of carbon credits trade on com-modities x
particular year, the utility in most cases will deduct the basis inmarkets, it may be possible to characterize their tax treatment
that year. If the allowance is sold or exchanged, the utility will by reference to existing authorities. In Rev. Rul. 73-158,44 the A
realize capital gain or loss to the extent of the difference Service held that even bilateral trans-actions in property that
between the amount realized in the transaction and the utility’s could be traded on an organized commodities exchange (in that n
basis in the allowance. Under Rev. Proc. 92-91, allowances arecase, sugar) could qualify for the ‘‘trading safe harbor’’ of section
not subject to depreciation, because ‘‘an emission allowance864(b)(2). The U.S. trading safe harbor excludes trading and al
has no ascertainable useful life over which it could beinvesting in stocks, securities, or regulated commodities for
depreciated.’’ However, Rev. Proc. 92-91 interpreted a priorone’s own account from the definition of a ‘‘trade or business y
version of reg. section 1.167(a)-3 and also predates thewithin the United States.’’ More specifically, section 864(b)(2)(B)
enactment of section 197. Amend-ments to reg. section(ii) provides a safe harbor for trading in commodities for the st
1.167(a)-3 in 2003 created a safe harbor for certain intangibletaxpayer’s own account, whether by the taxpayer or his
assets that permits 15-year amortization in manyemployees or through a resident broker, commission agent, s
circumstances.40 custodian, or other agent, and whether or not any such 2
Also, Rev. Rul. 92-1641 holds that a utility’s receipt of allocatedemployee or agent has discre-tionary authority to make
allowances will not be treated as gross income within the meaningdecisions in effecting the transactions. This commodities trading 0
of section 61. As a result, those allowances receive a zero basissafe harbor is premised, however, on the relevant commodities
and income is recognized when they are sold. This ruling, however,being the type of commodities that are ‘‘of a kind customarily 0
contains no legal analysis supporting the reasons for this treatment. dealt in on an organized commodity exchange’’ and only if the
While the Acid Rain Program guidance may provide a startingcommodities transactions are ‘‘of a kind custom-arily 9
point for evaluating the treatment of other green tradables, it is consummated at such place.’’45
unclear whether that guidance may be generalized beyond the Although the application of the trading safe harbor to carbon .
program and industry for which it was issued. In particular, it istrading is unclear, there are compelling argu-ments that carbon
difficult to apply this guidance to VERs, which typically need notemissions rights should be treated as ‘‘commodities’’ for A
be surren-dered to any governmental or nongovernmentalpurposes of the U.S. trading safe harbor and other provisions of
organi-zation and, indeed, may be resold in the secondarythe code. Chief among these is that a CFTC-regulated market llr
market. Moreover, the absence of analysis in Rev. Rul. 92-16has arisen for carbon credits in the United States and that
suggests its issuance may be best viewed as a policytreating carbon credits like other commodities or securities ig
accommodation to another federal agency, that is, the EPA.42 Itwould facilitate depth and liquidity in the carbon markets.
is unclear whether the same policy consid-erations apply to non- h
U.S. green trading programs.
ts
through grandfathering privileges, lottery, or some other method does
not result in the realization of gross income, despite the general r
39 principles of section 61 and Commissioner v. Glenshaw Glass Co., 348
1992-2 C.B. 503.
U.S. 426 (1955). e
40
Compare reg. section 1.197-2(c)(13) (generally excluding from 43
LTR 200825009 (Mar. 7, 2008), Doc 2008-13707, 2008 TNT 121-32.
treatment as a section 197 intangible ‘‘any license, permit, or other right 44 s
granted by a governmental unit’’ if the right has either a fixed duration of less 1973-1 C.B. 337.
45
than 15 years or a fixed amount of value); reg. section 1.197-14(c)(2) and (3) See section 864(b)(2)(B)(iii).
(providing cost recov-ery rules for items described in reg. section 1.197-2(c) e
(13)).
41 r
1992-1 C.B. 15.
42
The IRS has made similar accommodations to other gov-ernmental
agencies. For example, in Rev. Proc. 2002-49, 2002-2 C.B. 172, Doc 2002- v
15494, 2002 TNT 126-7, modified and super-seded by Rev. Proc. 2005-62,
2005-2 C.B. 507, Doc 2005-17797, 2005 TNT 165-4, the IRS ruled that e
utilities undergoing deregu-lation need not treat as gross income the receipt
of a statutory property right to recover ‘‘stranded costs’’ of capital expendi- d
tures through rate surcharges even though that right could be immediately
securitized. Similarly, GCM 39606 (Feb. 8, 1987) concludes that an airline’s .
initial acquisition of an airport landing slot from the Federal Aviation
Administration, whether T
(Footnote continued in next column.)
COMMENTARY / SPECIAL REPORT a

B. Treatment as an Intangible x
On June 20, 2008, the IRS released its first private letter ruling
A
on carbon trading issues. In LTR 200825009,43 the IRS considered
a situation in which a taxpayer’s EU affiliate was granted allowances n
under the EU-ETS and sold off its surplus allowances. The IRS
ruled that the taxpayer need not treat the income from those sales al
as current subpart F inclusions on the grounds that the allowances
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TAX NOTES, January 19, 2009 387

COMMENTARY / SPECIAL REPORT existing cap-and-trade programs sug-gests a variety of tax
policy issues that must be consid-ered both to adapt the code to e
Commodities treatment also would open the possibility ofdeal with the emerging markets in green tradables and to r
allowing traders in these emerging markets to make a mark-to- facilitate the potential implementation of additional federal
market election under section 475(f), so that their carbon books policies in this area. Also, as policymakers move toward globally v
could be treated similarly to their positions in other market-linked cap-and-trade systems, it may be advisable for the OECD
traded assets. or other multilateral bodies to provide guidance on devel-oping
e
The commodities analogy, however, may be more difficult tothe tax rules applicable to such trading systems so that
square with the language of reg. section 1.954-2(f)(2)(i), which differences in national tax treatment do not hinder efficient d
defines a commodity as consisting of ‘‘tangible personalcarbon trading.
property.’’ .

D. Treatment as an Expense T
In some cases, it may be appropriate to analogize the costs of 47For example, in LTR 200813009 (Mar. 28, 2008), Doc 2008-6844,
acquiring carbon credits (particularly VERs) to other section 1622008 TNT 62-35, the IRS ruled that when a resort hotel’s intangibles such as a
expenses. For example, in Rev. Rul. 2000-4,46 the IRS addressedits trade names, brand names, and goodwill were ‘‘inextricably linked’’ with
the tax treatment of costs incurred by companies to obtain, the real estate so that those intangibles could be treated as ‘‘real estate x
maintain, and renew certification under ISO 9000, a series ofassets’’ and the license fees from those intangibles would qualify as ‘‘rents
international standards for quality management systems. While ISOfrom real property’’ for purposes of section 856(c). However, no similar A
guidance has been issued regarding carbon credits.
9000 certification is often a contractual requirement for doing
business with many organizations, it is never-theless voluntary (that n
is, not required by any govern-mental authority). The IRS concluded
al
that the costs related to ISO 9000 certification, except to the extent
they create an asset with a useful life substantially beyond the y
current tax year (for example, a quality manual), can be deducted in (
the year incurred, reasoning that ‘‘the ben-efits derived from ISO st
9000 certification are akin to the current benefits derived from C
advertising, training, and similar expenditures incurred in . . . s
improving the over-all quality or attractiveness of the taxpayer’s )
business operations.’’ Similar arguments can be made regarding the d
purchase of VERs. Depending on the nature of the underlying VER T
project or issuer, it also may be possible to analogize the purchase o
a
of a VER to a charitable contribution that is deductible under section
170. e
x
E. Treatment for Special Entities s
The current-law treatment of carbon credits in the hands of A
certain special entities under the code also is unclear. For example, n
n
if an environmentally oriented tax-exempt organization undertakes a
project within its exempt purpose that also generates carbon credits, o
al
it is unclear whether the sale of those credits may give rise to
tc
y
la
st
46
2000-1 C.B. 331, Doc 2000-1084, 2000 TNT 5-3. i
s
m
2
unrelated business taxable income. Similarly, although the IRS
has shown some flexibility in defining the term ‘‘real property’’ for c
0
real estate investment trust testing purposes, it is unclear
whether carbon credits qualify as ‘‘real property’’ for purposes of o
0
applying the 75 percent asset test applicable to REITs under
p
section 856(c)(3).47 9
y
VIII. Conclusion .
Even in the absence of U.S. federal climate change ri
A
legislation, many U.S.-based companies and investors have
crossed the green frontier into trading in both compliance- g
llr
oriented and voluntary carbon markets. These activities raise a
host of federal income tax issues that are difficult for clients and h
ig
their advisers to resolve at strong levels of comfort under
existing authorities. While the issuance of PLR 200825009 ti
h
represents a useful start by the IRS in coming to grips with
carbon trading, more guidance will be required to facilitate both n
ts
U.S.-based carbon trading and the participation of U.S.-based
firms in existing cap-and-trade systems. a
r
Looking ahead, because President-elect Obama and many n
leaders in Congress have publicly supported cap-and-trade e
legislation, many observers anticipate Con-gress will give y
serious consideration to such legislation soon. A review of s
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388 TAX NOTES, January 19, 2009