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SPECIAL REPORTtax notes

Tax Issues Relating to TradingIn Carbon Emissions Rights

By Matthew P. Haskins

Matthew P. Haskins is a director with tWashing-ton National Tax Services office Pricewaterhouse-Coopers LLP and a member the firms steering committee on climate changand sustainability.

As part of global efforts to reduce emissions

greenhouse gasses, several governments eithhave already adopted or are considering adoptingsystem of tradable permits for carbon dioxiemissions, and many observers anticipaCongress will give serious consideration to adoptia similar system in the United States. Gretrading in carbon dioxide emissions rights or othenvironmental attributes poses significant technictax issues both for U.S. taxpayers who participateexisting programs and for policymakecontemplating the design of a U.S.-based tradinsystem. This report describes the devel-opispectrum of green tradables and outlines some the most significant tax issues that should addressed both to facilitate existing trading system

and to ensure that tax concerns do not impede thenvironmental policy objectives of proposed tradinsystems.

The author would like to thank Lauren Janosy PricewaterhouseCoopers LLP for her significacon-tributions to this report and Chip Harter, PetMerrill, and Constance Skidmore, each Pricewaterhouse-Coopers LLP, for their suppoand helpful comments. Any errors or omissionhowever, remain the sole responsibility of tauthor.


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38261. Carbon Trading Programs . . . . . . . . . .. 383

1. European Union Allowances .. . . . . . 383

2. Credits From DevelopCountries . . . . 384

3. Verified EmissReductions . . . . . . . . 38

4. Regional Greenhouse GInitiative . . . . 384

IV. The Emerging Spectrum of Green385

Tradab les . . . . . . . . . . . . . . . . . . .

V. Secondary Markets for Carbon Credits.

Exchanges . . .


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either have already adopted or are consideadopting a system of tradable permits for cardioxide emissions, frequently known as cap-atrade or carbon trading. Because President-eObama and most key members of the DemocraCon-gressional leadership team now publicly suppcap-and-trade legislation, many observers anticip

Congress will give serious consideration to slegisla-tion in 2009.

While the science and environmental policy behcarbon trading have been hotly debated, few policymers have focused on the technical tax issues presenby existing environmental trading systems or the neeconsider tax issues when designing carbon tradingother green trading systems for potential future im

mentation.1 The discussion below seeks to highlighnumber of tax issues that must be resolved to ensthat

1As an alternative to cap-and-trade programs, many econmists have recommended implementing a direct tax on carboemissions or fuels that contain carbon, arguing that a tax canachieve comparable environmental outcomes while providinggreater stability in the carbon price than a trading systemdoes. Several European countries and two Canadian provinchave implemented carbon taxes. See Carbon Tax Act of 200Statutes of British Columbia, Chapter 40 (May 29, 2008);Sidhartha Banerjee, Quebec Starts Green Tax, The TorontStar(Oct. 2, 2007); EPA National Center for EnvironmentalEconom-ics, Economic Incentives for Pollution Control,available athttp://yosemite.epa.gov/ee/epa/eed.nsf/WebpageEconomicIncentivesPollutionControl.html (summarizing car-b

taxes imposed in Finland, Denmark, the Netherlands, NorwaPoland, and Sweden).

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COMMENTARY / SPECIAL REPORT

tax issues do not impede or distort the environmental policies

underlying either existing or proposed cap-and-trade systems.2

I. Origins of Cap-and-TradeCarbon credits are only one portion of an emerging spectrum

of green tradables, and, indeed, they are not even the first

such instrument. By putting a market price on pollutionemissions or other environmental harm, green tradingschemes aim to force market participants to factor into privatedecision-making costs that previ-ously were passed off tosociety as economic externali-ties.

Under the Clean Air Act Amendments of 1991, theEnvironmental Protection Agency (EPA) developed a program oftradable permits for sulfur dioxide (SOx) and nitrogen oxide(NOx) intended to control acid rain pol-lution. Effective in 1995,the Acid Rain Program created a number of air basins in whichoverall emissions of SOx and NOx were subject to a regulatorycap. The EPA issues allowances to utilities within each air basinto emit a certain number of tons of SOx or NOx. Thoseallowances may be traded, with the intention of minimizing theprivate sector cost of achieving emissions reduction targets.

Example: Utility A and Utility B both operate in the LosAngeles air basin. Utility A can reduce its SOx emissions at acost of $80 per ton. Utility B also can reduce its SOx emissions,but at a cost of $120 per ton. Under traditional command andcontrol regulation, if Utility A and Utility B each were required toreduce emissions by a ton, the aggregate cost of compliancewould be $200. Under the Acid Rain trading program, it ispossible for Utility A to reduce its emissions by two tons and sellits excess allowance to Utility B. In this case, the aggregate costof compliance would be reduced by 20 percent to $160.

The cap-and-trade mechanism in the Acid Rain Pro-gram iswidely regarded as successful in reducing the costs of pollutioncontrol. In fact, the Government Ac-countability Office hasestimated that cost of pollution control under the Acid RainProgram was cut in half by using a trading mechanism rather

than command and control regulation.3

II. Greenhouse Gas Reduction EffortsIn 1992, 166 nations signed the United Nations Frame-work

Convention on Climate Change (UNFCCC) with the stated objectiveof stabilizing greenhouse gas concen-trations in the atmosphere ata level that would prevent dangerous anthropogenic interferencewith the climate

2For an overview of those issues from an academic commen-tator, seeJonathan R. Nash, Taxes and the Success of Non-Tax Market-BassedEnvironmental Regulatory Regimes, University of Chicago John M. OlinLaw & Economics Working Paper No. 412 (2d Series) (July 2008).

3See, e.g., General Accounting Office, Overview and Issues onEmissions Allowance Trading Programs, GAO/T-RCED-97-183 (July 1997).This agency has been renamed the Government Accountability Office.

system.4 The UNFCCC was the first international treaty to focuson the harmful environmental effects of GhGs, including carbondioxide (CO

2). Binding limits on GhG emissions were adopted in

the Kyoto Protocol to the UNFCCC. As of October 16, 2008, 182countries have ratified or otherwise adopted the Kyoto Protocol.Of the initial signatories, only the United States and Kazakhstanhave not yet ratified the protocol.5

The Kyoto Protocol entered into force on February 16, 2005, andits first binding commitment period for GhG reductions started onJanuary 1, 2008, and ends on December 31, 2012. It is the first

multilateral agreement to impose binding obligations on cratifying countries to limit (and, in most instances, actually retheir GhG emissions. The Kyoto Protocol covers emissions

GhGs CO2, methane, nitrous oxide, hyrdofluoro-ca

perfluorocarbons, and sulfur hexafluoride and estabreduction commitments for each.

The Kyoto Protocol distinguishes between Annex I p(typically, developed nations) and other parties (typdeveloping nations). Under the Kyoto Proto-col, Ansignatories have agreed to binding reduction targets for that generally are intended to reduce emissions so that bytheir annual emissions are no more than 95 percent of emissions in 1990. In contrast, other parties do not face bGhG reduction targets but may be incentivized to participthe UNs Clean Development Mechanism (as describmore detail below).

The Kyoto Protocol effectively fixes the amounts of Ghbe emitted by each Annex I party between 2008 and Although the Kyoto Protocol covers six GhGs, measureand trading is based on metric tons of CO

2-equi

emissions. The Kyoto Protocol contem-plates that these naallocations of assigned allow-ance units will be suballoby each ratifying Annex I country to private busin

operating within its borders in certain economic seincluding agricul-ture, utilities, manufacturing, energytransportation. A private business that has been allocatotherwise obtained emissions units (for example, thtrading) must surrender units to the relevant nagovernment agency for cancellation in amounts equal emissions. A private emitters failure to meet required emislevels is expected to result in a fine for the amount of polemitted in excess of the emissions credits the party surrend

Additional units can be created through three mecha-nRemoval units are created by actions of Annex I governmsuch as reforestation projects, and cannot be traded in pmarkets. Emission reduction units (ERUs) are created thJoint Implementation (JI) projects that either reduce or aGhG emissions in Annex I countries. Certified emreduction units

4United Nations Framework Convention on ClimateChange, Articl(New York, May 9, 1992).

5For a complete list of signatories to the Kyoto Protocol,including Annex I and non-Annex I countries, see http://unfccc.int/kyoto_protocol/status_of_ratification/items/2613. php.


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(CERs) are issued only in connection with a Clean DevelopmentMechanism (CDM) project under which an Annex I partyfinances activities of non-Annex I parties. CDM projects typicallyare financed by private parties in countries such as China, India,and Vietnam; the CERs generated in those projects can be usedto meet a portion of a companys compliance obligations in anAnnex I country. JI projects are similar but typically take place inEastern European countries.

The Kyoto Protocol specifically allows a signatory country totransfer or acquire emissions credits from another signatorycountry.6 Thus, Annex I parties can meet their emissionsreductions requirements by obtain-ing additional emissionsrights through (1) emissions trading by countries or privatesector emitters that deter-mine it is more cost-effective topurchase additional rights to emit GhGs rather than to reduceemissions by modifying behavior, (2) financing CDM projects, or(3) financing JI projects.

The Marrakesh Accords, adopted in 2001, established threeregistries that are required to log trading in emis-sionsallowances.7 The registries operate at the following levels: (1)each Annex I party is required to establish a registry at thenational level that tracks units held by the Annex I party as wellas those held by private parties; (2) a registry that is maintainedby the United Nations regarding the issuance and distribution of

CERs in con-nection with CDM projects; and (3) theInternational Transactions Log, which is to be maintained by theUNFCCC once finalized, and will trace the issuance,cancellation, or registration of Kyoto emissions allow-ances inany registry, as well as the acquisition or transfer of those unitsbetween registries.

III. Carbon Trading Programs

In response to the Kyoto Protocol, a market for carbon emissionsrights (carbon credits) has developed under a number of programssponsored by national governments and arising out of voluntaryefforts to reduce GhG emissions. Increasingly, U.S.-basedcorporations and in-vestment funds are trading both in theEuropean markets and in parallel U.S. markets in five major types of

carbon credits (see table in next column).A. European Union Allowances

The European Union decided to meet its obligations underthe Kyoto Protocol collectively, and, in fact, early adoptedemissions trading with the implementation of its EmissionsTrading Scheme (EU-ETS) between 2005 and 2007.8 The EU-ETS is an EU-wide cap-and-trade program that requires eachmember state to adopt a national allocation plan for distributingits allocation of European Union allowances (EUAs) among allbusi-nesses in some industries operating within its borders.

6Kyoto Protocol, Article 6(1).7

The full text of the Marrakesh Accords may be found on the UNFCCCsWeb site available athttp://unfccc.int/cop7/ documents/accords_draft.pdf.8Seehttp://ec.europa.eu/environment/climat/emission/

emission_plans.htm.COMMENTARY / SPECIAL REPORT

Existing Types of Carbon Credits

Issued or auctioned by EU governments to EU-EUAsresident GhG emitters.

Created by implementation of GhG reduction initiativesin developing countries and certified

CERs by the UN.

Similar to CERs but created under a different ERUsKyoto Protocol program.

Created through the implementation of GhG re-duction

initiatives and certified by a non-governmental standsetter; notusable to meet

VERs regulatory requirements.

Credits issued by consortium of U.S. Northeast-ern anmid-Atlantic states under a mandatory

RGGI carbon cap-and-trade program for utilities.

Like their counterparts under the Kyoto Protocol, EUAs cviewed as a permit, right, or allowance to emit, free of peone ton of CO

2or its equivalent.

During Phase I, approximately 12,000 utilities and

industrial GhG emitters were granted by each EU memberan initial allocation of specific rights to emit EUAs based onemissions and governmental pollution reduction goals. In PII of the EU-ETS, which began in 2008, GhG emitters in industries were required to bid for EUAs at auction, anoverall cap on EUAs has been reduced.9 In other signrespects, however, the EU-ETS trading mechanism is expto remain unchanged until the currently slated expiration Kyoto Protocol in 2012.

The EU-ETS is backstopped with a penalty tax on the ethe measured emissions of a regulated emitter exceed its EIn Phase I, the penalty tax for each ton of CO

2or its equi

emitted without a corresponding surrender of an EUA wasin Phase II, the penalty tax is 100 per ton of excess emiss

The EU-ETS contemplates that a regulated business

avoid penalties either by engaging in the reduction of emisto an amount not exceeding its allotment of EUAs, purchasing (directly or indirectly) additional allowancesother regulated businesses that have excess allowancfinancial intermediaries (brokers and investors). Thusregulated business is able to abate its own pollution anexcess EUAs as a result, it may sell any surplus EUanother person. The EU-ETS contemplates and permitstrading.

When the market price for EUAs is higher than the cpollution reduction, a regulated business may be expectincur the cost of abating its emissions, and recouping the with a profit, by selling its resulting surplus of EUAs. Convewhere the cost of abating emissions for a particular busexceeds the market price of EUAs, that business maexpected to forgo abatement, and instead simply incur the

of purchas-ing additional EUAs as necessary to negatimposi-tion of a fine. To avoid the imposition of a fine, a

9See generally http://ec.europa.eu/environmentemission/2nd_phase_ep.htm. In implementing Phase II, the EU Commhas exercised its authority to reduce national caps proposed by mstates.


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regulated business must surrender EUAs representing theamount of its measured emissions for the relevant period. Theimposition of fines and the possibility that some emitters may beable to abate their level of emis-sions at a lower marginal costthan the per-ton level of fines has led to active trading in EUAs.

B. Credits From Developing Countries

Although developing countries have no binding GhG emissionreduction targets under the Kyoto Protocol, they may participate

in the CDM under which govern-ments and companies indeveloped countries help fi-nance GhG emissions reductionprojects that can be certified as achieving measured levels ofemissions re-ductions (CERs). Another of the Protocols flexiblemechanisms involves JI programs, typically in Eastern Europe,that can be issued certificates for successful implementations(known as ERUs).

Importantly, CERs and ERUs may be used to meet aspecified percentage of an EU emitters need for carbon creditsand also may be used in other non-EU jurisdic-tions. (Althoughthis percentage varies, it typically falls between 10 percent and15 percent in most EU member states.) This creates anopportunity for EU GhG emitters to import credits associatedwith developing country projects and provides financialincentives for both GhG emitters and third-party project

developers to manage and fund CDM projects.C. Verified Emissions Reductions

Projects that are not certified by either the EU or the UN maymeet the certification criteria set by some nongovernmentalorganizations as verified emissions reductions (VERs).However, VERs cannot be used to meet compliance obligationsoutlined in the Kyoto Pro-tocol or the EU-ETS.

There is no official registry system for VERs to trackownership, but there are new initiatives to establish such asystem. Also, a wide variety of organizations either have, or arecurrently developing, standards for the issuance of VERs. Forexample, voluntary carbon units (VCUs) certified under theInternational Emissions Trad-ing Associations Voluntary CarbonStandard10 have emerged as a market standard for trading inVERs. Another emerging standard is the WWFs Gold Stand-ard.11 If a project fulfils the requirements of a particular standardsetter, a certificate may be granted.

For current participants in the VER market, the pri-maryeconomic motivations appear to be either an intan-gible benefitto their corporate images as taking action to addressenvironmental issues (that is, achieving carbon neutrality) or ananticipation that current participants in

10The International Emissions Trading Association is a non-profitorganization composed of 175 member companies that seeks to establishan international framework for trading in GhG emissions reductions. Seehttp://www.ieta.org/ieta/ www/pages/index.php?IdSitePage=1152.

11The Gold Standard Foundation is an outgrowth of efforts

by the WWF

(formerly known as the World Wildlife Federation) to facilitate voluntary GhGemissions reductions. See http:// www.cdmgoldstandard.org/index.php.

the voluntary markets may be rewarded with allocations ofcarbon credits in an eventual U.S. cap-and-trade system(precompliance investors).

D. Regional Greenhouse Gas Initiative

On September 25, 2008, the first U.S. auction of carbonemissions rights was conducted by the Regional Green-house GasInitiative (RGGI). Under RGGI, utilities in 10 Northeastern and mid-Atlantic states will be required to submit allowances sufficient to

cover their CO2

emissions beginning in 2009.12 The September

RGGI auction raised a total of $38.5 million for the participating

states, as 59 bidders participated in the auction.13 RGGI reporapproximately 80 percent of the bidders at the September awere compliance entities, that is, utilities and other fasubject to RGGI compliance requirements and that demaallowances exceeded the auctioned supply by a ratio of fo

one.14

Numerous other programs are under development at theregional, and international levels. Of particular interest tobased companies, Californias Global Warming Solutions A2006 (also known as Assem-bly Bill 32 or AB 32) pCalifornias Air Re-sources Board (CARB) to adopt a mand

statewide cap-and-trade system for CO2.15 In October, 2008, issued a report outlining its scoping plan for implement-ing Aincluding adoption of a cap-and-trade system that would be

2012.16 That system would be inte-grated with the broader W

Climate Initiative that also is scheduled to launch in 2Similarly, the Midwestern Greenhouse Gas Reduction Accordfor the establishment of a regional cap-and-trade program in s

Midwestern states and Canadian provinces.18

At the national level, New Zealand is in the proceimplementing a mandatory cap-and-trade system for CO

2

Australia plans to adopt a similar system beginning in 2010

12The 10 participating states are Connecticut, Delaware,Maryland, Massachusetts, New Hampshire, New Jersey, New York, Island, and Vermont.

13See Timothy B. Wheeler, Emissions Auction Runs SmoothlyBaltimore Sun (Sept. 30, 2008), accessible http://www.baltimoresun.com/news/local/bay_environment md.auction30sep30,0,2887416.story.

14Seehttp://www.rggi.org/docs/Auction_1_PostSettlement_Report_from_Market_Monitor.pdf.

15California Global Warming Solutions Act of 2006, Calif.Health &Code Division 25.5.

16CARB, Climate Change Proposed Scoping Plan (Oct.2008) at 30, available athttp://www.arb.ca.gov/cc/scopingplan/document/scopingplandocument.htm.

17The Western Climate Initiative encompasses seven U.S. staArizona, California, Montana, New Mexico, Oregon, Utah, and Was and four Canadian provinces British Columbia, Manitoba, Ontar

Quebec. See http:// www.westernclimateinitiative.org.18Illinois, Iowa, Kansas, Manitoba, Michigan, Minnesota, andWisc

are participating in this effort. Three additional states Indiana, Ohio, and South Dakota are observers in the procSee http://www.midwesternaccord.org/index.html.

19See Barry Critchley, Australias Cap-and-Trade Plan,Financial Post (Nov. 6, 2008); available at http://www.

(Footnote continued on next page.)


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IV. The Emerging Spectrum of Green Tradables

Carbon credits are only one portion of an emerging spectrumof green tradables. The genie is out of the bottle on applyingmarket mechanisms to environmental policy issues, and thismay be one of the most fertile grounds for the development ofnew financial instru-ments and products over the next decade,as illustrated by the following catalog of existing green tradables,each of which are currently tradable or monetizable:

0 Renewable Energy Certificates (RECs). More thanhalf the states now have renewable portfolio stan-dards, requiring that a designated portion of thestates total electricity generation come from renew-able sources.20 In some states, electric utilities canbuy tradable RECs from developers of renewableenergy projects to comply with the renewable port-folio standards. A recent report from the Depart-mentof Energy stated that an estimated 10.5 billionkilowatt-hours of renewable energy was sold throughRECs in 2007.21

0 Energy Efficiency Certificates (EECs). Connecticut,Pennsylvania, and Nevada now require energy effi-ciency efforts as part of their renewable portfolio

standard and permit a secondary market in EECsgenerated by those projects.22 Pennsylvania allowsutilities to buy EECs for projects done outside the statebut in the Pennsylvania-New Jersey-Marylandtransmission area; Connecticut allows utilities to useEECs only for in-state projects. Some market observ-ers expect that a national market for EECs eventu-allywill develop.

0 Water. Although water rights are not widely tradedatpresent, many environmental observers believe

climatechange.govt.nz. For a useful summary of existing and proposed

emissions trading schemes worldwide, see http://www.climatechange.govt.nz/emissions-trading-scheme/ international-examples.html. Although beyond the scope of this article, a valuablediscussion of the Australian tax issues arising from the implementation of acap-and-trade system is contained in chapter 11 of the Australiangovernments recent Green Paper on its carbon pollution reduction plan.That publication can be accessed at http://www.climatechange.gov.au.

20A useful summary of state renewable portfolio standardsmay be foundat the Database of State Incentives for Renew-ables & Efficiency, which ismaintained by the North Carolina Solar Center at North Carolina StateUniversity. See http://www.dsireusa.org/documents/SummaryMaps/RPS_Map.ppt.

21Lori Bird, Claire Kreycik, and Barry Friedman, GreenPower Marketingin the United States: A Status Report, Na-tional Renewable EnergyLaboratory, U.S. Department of En-ergy (Oct. 2008), at 19. One marketparticipant has estimated the value of such trading as exceeding $250

million in 2007. See Andrew Ertel, president and CEO of Evolution MarketsLLC, Global Overview of Emissions & Renewable Trading, Power-Pointpresentation for the 2008 Wall Street Green Trading Summit (Apr. 2, 2008).

22For more information about EECs,seeSterling Planetsdescription ofits proprietary White Tags program avai lable at http://www.sterlingplanet.com/upload/File/Sterling_Planet_White_Tags_Fact_Sheet.pdf.


an active market in water rights will develop in the comingyears, particularly in the West.23

0 Biodiversity and Forestry. Demonstrating the po-tential reach and scope of green trading concepts, anAustralian-based investment management com-pany,New Forests Pty., recently entered into a venture with

the Malaysian state of Sabah to estab-lish a biobNew Forests manages eco funds designed tocompetitive returns through un-locking the value

ecosystem services provided by forests.24 Undbiobank plan, public and private capital will be use to preserve a Malaysian forest habitaorangutans and rhinos. New Forests wcompensated through its ability to sell biodicredits to other users of forest assets, such as pa

producers.25

V. Secondary Markets for Carbon CreditsMany industrial companies and investment funds have b

trading in EUAs. In 2008, market research firm Point Cestimated that trading volume under the EU-ETS would $68 billion in 2008 and that the overall global carbon mwould grow by 56 percent in 2008.26 A recent World Bank found that carbon trading volume doubled between 2002007.27 CERs, ERUs, and even VERs also trade in secomarkets. (Because VERs are not standardized or usefcom-pliance, the value of VERs is usually significantly than the value of CERs or EUAs.)

Carbon trading now occurs through a number of exchaand bilateral contracts in both the United States and Eudetailed below.

A. European ExchangesThe largest carbon trading exchanges in Europe are the Lo

based European Climate Exchange (ECX), the Leipzig-

European Energy Exchange and Oslo-based NordPool.28 The

offers futures contracts in

23For a brief description of the arguments in favor of tradablewaterights, see Michael Greenstone, Tradable Water Rights, DemocracyJournal of Ideas (Spring 2008), reprinted at http://www.brookings.edu/articles/2008/spring_water_rights_ greenstone.as

24See generally http://www.newforests.com.au.25SeeNew Forests in Sabah Conservation Deal,The Aus-tralia

28, 2007), accessible at http

theaustralian.news.com.au/story/0,25197,22836267-20142,00.html.26Keith Johnson, Market Making: Carbon Keeps Growing,

Wall Street Journal Environmental Capital Blog, Feb. 26, 2008:http://blogs.wsj.com/environmentalcapital/2008/02/26/ market-macarbon-keeps-growing/trackback/.

27World Bank, State and Trends of the Carbon Market 20082008, accessible at http://carbonfinance.org/docs/ State___Trenformatted_06_May_10pm.pdf. See also Fiona Harvey, World Trading Value Doubles, Financial Times (May 8, 2008) at p. 27.

28See http://www.europeanclimateexchange.com http://www.nordpool.com. The ECX (ECX)/International Cli-mate Exc(ICE) is a member of the Climate Exchange group of companiesmanages the product development and marketing for ECX Carbon FiInstruments listed and

(Footnote continued on next page.)


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both EUAs and CERs. NordPool offers both spot and forwardcontracts in EUAs and forward contracts in CERs.

B. U.S. ExchangesU.S.-based carbon trading occurs on three exchanges

regulated by the Commodities Futures Trading Commis-sion(CFTC):

0 Chicago Climate Exchange (CCX). The CCXwas launched in 2003 and describes itself as

North Americas only active voluntary, legallybinding integrated trading system to reduceemissions of all six major greenhouse

gases.29 The CCX now has over 300members, including industrial companies thathave pledged to make carbon emissionsreduc-tions and liquidity providers such asproprietary traders. Trading on the CCXincludes the carbon financial instrument(CFI), which is a VER that meets certaincommon market standards. The CCX isregulated as an exempt contract market by theCFTC; it is subject to less restrictive regulationthan a retail-oriented designated contract

market but available for trading only topredetermined mem-bers, rather than to thebroader public.

0 Chicago Climate Futures Exchange (CCFE).TheCCFE is a wholly owned subsidiary of theCCX that offers standardized futures andoptions contracts over emissions allowancesand other environmental products, includingCFIs.30 The CCFE is regulated as adesignated contract market by the CFTC.

0 The Green Exchange. The GreenExchange is a joint venture of NYMEX,Evolution Markets, and a num-ber of otherfinancial institutions. It opened for trading onMarch 17, 2008, as a members-onlyexchange but currently is being certified as aretail-oriented designated contract marketunder CFTC rules.31 The Green Exchangehosts trading in EUAs and CERs. However,it plans to add trading in VERs in thefuture.32

3. Other Trading Platforms

The Environmental Resources Trust operates theEcoRegistry trading platform in the United States, which isintended to encourage transactions in VERs and to develop

market liquidity in these instruments.33 The

admitted to trading on the ICE Futures electronic platform, which is a

European energy exchange for futures and options. The ChicagoClimate Exchange (discussed below) is also a member of the ClimateExchange group of companies, and enables its members to buy and sellcredits for emission reductions. Seehttp://www.chicagoclimateexchange.com.

29See http://www.chicagoclimateexchange.com/about/pdf/CCX_Overview_Brochure.pdf. See generally http://www.chicagoclimateexchange.com.

30Seehttp://www.ccfe.com/about_ccfe/products/cfi/CCFE_CFI_Overview.pdf.

31See http://www.greenfutures.com.32It is likely that the Green Exchanges standards for VERswill closely

resemble those for VCUs (VERs certified under the Voluntary CarbonStandard, supra note 9). VCUs currently trade only via principal-to-principalcontracts.

33See http://www.ert.net and http://www.ecoregistry.org/.

EcoRegistry has approximately 30 corporate members. It isa CFTC-regulated exchange.

D. Bilateral ContractsIn addition to exchange trades, transactions in all typ

carbon credits, including total return swaps over carbon cmay occur via bilateral transactions that take place oexchange or other market mechanism. Several companiesfacilitate over-the-counter trans-actions in EUAs.34

VI. EU PrecedentsDespite the EUs head start in implementing carbon tra

there is relatively little harmonized guidance within Eregarding the appropriate income tax treatment of ccredits. For example, while the United Kingdom has proguidance allowing carbon trading to occur under the investment manager exemption (a concept similar to thetrading safe harbor of section 864(b)(2)),35 other incomissues are resolved by analogies to principles of establishelaw or by reference to accounting treatments, whichthemselves evolving and subject to significant uncer-taintyother EU jurisdictions, guidance has been similarly piecemreliant on accounting treatment.37

In contrast, the European Commission has moved relaquickly to ensure consistency of VAT treatment to faccross-border trading within the EU. Under this guidtransactions in EUAs are treated as the provision of a sewithin the meaning of the EU VAT Directive.38 As a resultEU businesses engaged in carbon trading with EU busingenerally should not incur VAT, while EU-based recipieEUAs self-assess VAT and then recover it on their VAT ret

VII. U.S. Tax Analogies for Green Trading

The taxation of carbon credits and other green tradpresents a number of novel issues. Existing pre-cedents psome useful analogies but may be hard to generalize acrosspectrum. As is the case with many efforts to characterizefinancial instruments using the existing tax cubbyholestechnical result that seems most persuasive may depend ostarting analogy.

34For an example of one such company, see Natsource LLCsWeat http://www.natsource.com.

35See Her Majestys Revenue & Customs Statement of PSP1/01. An explanation for this change to the applicable U.K. regucan be found in the 2007 U.K. Budget.http://www.hmrc.gov.uk/budget2007/bn47.htm.

36See Iain Calton, Helen Devenney, and Sarah Nolleth, Ac-coand Taxation, Climate Change: A Guide to Carbon Lawand Practiceat 143-156.

37For a good summary of tax treatment across EU jurisdic-tions, sPricewaterhouseCoopers report, Taxation of emissions trading witEU: From (non)existing regulation to daily practice and opportuavailable at http

pwc.com/extweb/pwcpublications.nsf/docid/F2F77C97055F980E85256F3F006808AE/$File/Emission%20Tax_200406.pdf.38Seehttp://ec.europa.eu/environment/climat/pdf/vat_guidelines.p

(summarizing TAXUD/1625/04).


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A. SOx and NOx Permits

As noted above, under the EPAs Acid Rain Program, bothutilities and financial investors trade SOx and NOx permits. TheIRS has accommodated this program through administrativeguidance. In Rev. Proc. 92-91,39 the IRS concluded that thecosts of acquiring allowances must be capitalized. Those costsconstitute the utilitys basis in its allowances. A utility willgenerally recover its basis in an emission allowance in one of

two ways. If the allowance is applied against emissions in aparticular year, the utility in most cases will deduct the basis inthat year. If the allowance is sold or exchanged, the utility willrealize capital gain or loss to the extent of the differencebetween the amount realized in the transaction and the utilitysbasis in the allowance. Under Rev. Proc. 92-91, allowances arenot subject to depreciation, because an emission allowancehas no ascertainable useful life over which it could bedepreciated. However, Rev. Proc. 92-91 interpreted a priorversion of reg. section 1.167(a)-3 and also predates theenactment of section 197. Amend-ments to reg. section1.167(a)-3 in 2003 created a safe harbor for certain intangibleassets that permits 15-year amortization in manycircumstances.40

Also, Rev. Rul. 92-1641 holds that a utilitys receipt of allocatedallowances will not be treated as gross income within the meaningof section 61. As a result, those allowances receive a zero basisand income is recognized when they are sold. This ruling, however,contains no legal analysis supporting the reasons for this treatment.

While the Acid Rain Program guidance may provide a startingpoint for evaluating the treatment of other green tradables, it isunclear whether that guidance may be generalized beyond theprogram and industry for which it was issued. In particular, it isdifficult to apply this guidance to VERs, which typically need notbe surren-dered to any governmental or nongovernmentalorgani-zation and, indeed, may be resold in the secondarymarket. Moreover, the absence of analysis in Rev. Rul. 92-16suggests its issuance may be best viewed as a policyaccommodation to another federal agency, that is, the EPA.42 Itis unclear whether the same policy consid-erations apply to non-U.S. green trading programs.

391992-2 C.B. 503.40Compare reg. section 1.197-2(c)(13) (generally excluding from

treatment as a section 197 intangible any license, permit, or other rightgranted by a governmental unit if the right has either a fixed duration of lessthan 15 years or a fixed amount of value); reg. section 1.197-14(c)(2) and (3)(providing cost recov-ery rules for items described in reg. section 1.197-2(c)(13)).

411992-1 C.B. 15.42The IRS has made similar accommodations to other gov-ernmental

agencies. For example, in Rev. Proc. 2002-49, 2002-2 C.B. 172, Doc 2002-15494, 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 thatutilities undergoing deregu-lation need not treat as gross income the receiptof a statutory property right to recover stranded costs of capital expendi-tures through rate surcharges even though that right could be immediatelysecuritized. Similarly, GCM 39606 (Feb. 8, 1987) concludes that an airlinesinitial acquisition of an airport landing slot from the Federal AviationAdministration, whether

(Footnote continued in next column.)


B. Treatment as an IntangibleOn June 20, 2008, the IRS released its first private letter ruling

on carbon trading issues. In LTR 200825009,43 the IRS considereda situation in which a taxpayers EU affiliate was granted allowancesunder the EU-ETS and sold off its surplus allowances. The IRSruled that the taxpayer need not treat the income from those salesas current subpart F inclusions on the grounds that the allowances

were intangible property held for use in a trade or business than property held to generate passive income. The rulinnotes, however, that the IRS is currently studying whether it mappropriate to treat emissions allowances as commodities, leopen the possibility that they may be so characterized either subpart F or other provisions of the code.

Similarly, it may be appropriate to treat purchases of VEvoluntary purchases of RECs as creating a marketing intarelating to the purchasers environ-mental branding and ima

C. Treatment as a Commodity

Because many types of carbon credits trade on com-momarkets, it may be possible to characterize their tax treaby reference to existing authorities. In Rev. Rul. 73-158,Service held that even bilateral trans-actions in propertcould be traded on an organized commodities exchange (case, sugar) could qualify for the trading safe harbor of s864(b)(2). The U.S. trading safe harbor excludes tradininvesting in stocks, securities, or regulated commoditieones own account from the definition of a trade or buswithin the United States. More specifically, section 864(b)(ii) provides a safe harbor for trading in commodities fotaxpayers own account, whether by the taxpayer oemployees or through a resident broker, commission acustodian, or other agent, and whether or not any employee or agent has discre-tionary authority to decisions in effecting the transactions. This commodities trsafe harbor is premised, however, on the relevant commobeing the type of commodities that are of a kind customdealt in on an organized commodity exchange and onlycommodities transactions are of a kind customconsummated at such place.45

Although the application of the trading safe harbor to ctrading is unclear, there are compelling argu-ments that cemissions rights should be treated as commoditiespurposes of the U.S. trading safe harbor and other provisiothe code. Chief among these is that a CFTC-regulated mhas arisen for carbon credits in the United States andtreating carbon credits like other commodities or secwould facilitate depth and liquidity in the carbon markets.

through grandfathering privileges, lottery, or some other methodnot result in the realization of gross income, despite the gprinciples of section 61 and Commissioner v.Glenshaw Glass CoU.S. 426 (1955).

43LTR 200825009 (Mar. 7, 2008),Doc 2008-13707, 2008 TNT12441973-1 C.B. 337.45See section 864(b)(2)(B)(iii).


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Commodities treatment also would open the possibility ofallowing traders in these emerging markets to make a mark-to-market election under section 475(f), so that their carbon bookscould be treated similarly to their positions in other market-traded assets.

The commodities analogy, however, may be more difficult tosquare with the language of reg. section 1.954-2(f)(2)(i), whichdefines a commodity as consisting of tangible personalproperty.

D. Treatment as an ExpenseIn some cases, it may be appropriate to analogize the costs of

acquiring carbon credits (particularly VERs) to other section 162

expenses. For example, in Rev. Rul. 2000-4,46 the IRS addressedthe tax treatment of costs incurred by companies to obtain,maintain, and renew certification under ISO 9000, a series ofinternational standards for quality management systems. While ISO9000 certification is often a contractual requirement for doingbusiness with many organizations, it is never-theless voluntary (thatis, not required by any govern-mental authority). The IRS concludedthat the costs related to ISO 9000 certification, except to the extentthey create an asset with a useful life substantially beyond thecurrent tax year (for example, a quality manual), can be deducted inthe year incurred, reasoning that the ben-efits derived from ISO

9000 certification are akin to the current benefits derived fromadvertising, training, and similar expenditures incurred in . . .improving the over-all quality or attractiveness of the taxpayersbusiness operations. Similar arguments can be made regarding thepurchase of VERs. Depending on the nature of the underlying VERproject or issuer, it also may be possible to analogize the purchaseof a VER to a charitable contribution that is deductible under section170.

E. Treatment for Special EntitiesThe current-law treatment of carbon credits in the hands of

certain special entities under the code also is unclear. For example,if an environmentally oriented tax-exempt organization undertakes aproject within its exempt purpose that also generates carbon credits,it is unclear whether the sale of those credits may give rise to

462000-1 C.B. 331,Doc 2000-1084, 2000 TNT 5-3.

unrelated business taxable income. Similarly, although the IRShas shown some flexibility in defining the term real property forreal estate investment trust testing purposes, it is unclearwhether carbon credits qualify as real property for purposes ofapplying the 75 percent asset test applicable to REITs undersection 856(c)(3).47

VIII. Conclusion

Even in the absence of U.S. federal climate changelegislation, many U.S.-based companies and investors havecrossed the green frontier into trading in both compliance-oriented and voluntary carbon markets. These activities raise ahost of federal income tax issues that are difficult for clients andtheir advisers to resolve at strong levels of comfort underexisting authorities. While the issuance of PLR 200825009represents a useful start by the IRS in coming to grips withcarbon trading, more guidance will be required to facilitate bothU.S.-based carbon trading and the participation of U.S.-basedfirms in existing cap-and-trade systems.

Looking ahead, because President-elect Obama and manyleaders in Congress have publicly supported cap-and-tradelegislation, many observers anticipate Con-gress will giveserious consideration to such legislation soon. A review of

existing cap-and-trade programs sug-gests a variety opolicy issues that must be consid-ered both to adapt the codeal with the emerging markets in green tradables afacilitate the potential implementation of additional fpolicies in this area. Also, as policymakers move toward gllinked cap-and-trade systems, it may be advisable for the Oor other multilateral bodies to provide guidance on devel-the tax rules applicable to such trading systems sodifferences in national tax treatment do not hinder efcarbon trading.

47For example, in LTR 200813009 (Mar. 28, 2008), Doc 20082008 TNT 62-35, the IRS ruled that when a resort hotelsintangibles sits trade names, brand names, and goodwill were inextricably linkethe real estate so that those intangibles could be treated as real assets and the license fees from those intangibles would qualify asfrom real property for purposes of section 856(c). However, no guidance has been issued regarding carbon credits.

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Carbon Trading 0109 2