Canada: The Carbon Market & Tax Considerations In The Trading Of Carbon Credits

The concepts of carbon risk and carbon value may still not be well understood in North America. This will certainly change as provincial, state and federal governments begin to regulate the emissions of green house gases ("GHG"), as has recently been done in Québec and California with the creation of Cap-and-trade schemes/systems ("Cap-and-trade"). There is also a growing interest from businesses to reduce their carbon footprint in efforts to demonstrate they are good corporate citizens.

The Québec government started regulating GHG emissions January 1, 2013 with the entry into force of the Regulation respecting a cap-and-trade system for greenhouse gas emission allowances¹ (the "Regulation"). This new regulation creates Cap-and-trade to enforce and encourage reductions in GHG emissions of large emitters, being those enterprises with greater than 25,000 tons of carbon dioxide equivalent ("CO₂") emissions per year.

While Cap-and-trade is certainly an added cost for these enterprises, the system also presents an opportunity to capture value through improved efficiency and potential profits in an emerging, yet regulated, carbon market.

1. COMPONENTS OF THE CARBON MARKET

1.1 The Carbon Market: Summary

What is a carbon credit/emission allowance?

A carbon credit represents a permanent reduction of GHG emitted in the atmosphere.

Under Cap-and-trade, emission allowances are issued at no-charge to emitters or sold at auction by the government and are gradually reduced over time to enforce compliance with a pre-established ceiling of GHG emissions.

How much does it represent?

Each credit is a unit of measure equivalent to one metric ton of CO₂.

In Québec, emission allowances are in electronic form and recorded in the Cap-and-trade tracking system known as the Compliance Instrument Tracking System Service ("CITSS"), identified by their type and the year of their creation. There are three types of emission allowances, as follows:

• Emission units distributed free of charge, auctioned off or sold by mutual agreement by the government;
• Offset credits stemming from GHG emission reductions in sectors not subject to the Cap-and-trade system;
• Credits for early reductions.

To whom does it apply?

In Québec and California, GHG regulations identify particular industries to which Cap-and-trade applies. These regulations require each enterprise responsible for annual GHG emissions in a quantity equal to or greater than 25,000 metric tons CO₂ to participate in the system by registering on CITSS.

In Québec, the registration deadline for most emitters subject to the GHG regulation was September 1, 2013. However, fossil fuel distributors have been given until September 1, 2014 to register.

Other persons interested in participating voluntarily in Cap-and-trade can also do so by registering on CITSS. Certain entities may be interested in showing that they have a zero or reduced carbon footprint.

What is carbon value and how is it captured?

In Cap-and-trade, carbon value is the economic value that can be gained by an emitter from a reduction in GHG emissions.

Carbon value is created by improvements (whether to equipment, materials or processes) made by an emitter that have the effect of reducing its GHG emissions. This value can also be created by purchasing carbon or offset credits related to reductions of GHG achieved by third parties. In this manner emitters can effectively offset their GHG emissions.

The publicity of the efforts of an emitter or enterprise to reduce its carbon footprint can also have an effect on its brand or business image, thereby enhancing its value in the eyes of consumers.

What is carbon risk?

Carbon risk is the risk associated with a current or future regulatory obligation that an emitter will have to face in reducing its GHG emissions.

In Québec, the Regulation requires each enterprise responsible for annual GHG emissions in a quantity equal to or greater than 25,000 metric tons CO₂ in a calendar year to have at least as many emission allowances as verified emissions. The first compliance period started January 1, 2013 and ends December 31, 2014. For the first compliance period, only the industrial and electricity sectors are subject to the system. During the second compliance period (2015-2017), fossil fuel distributors will also be subject to the system.

Emitters will have until November 1, 2015 to accumulate emission allowances to cover their emissions for the first compliance period.

The failure to cover emissions can be subject to stiff sanctions. Emitters who exceed their targeted GHG emissions in a given compliance period will need to purchase additional emission allowances in order to avoid these sanctions. In Québec, this constitutes a current carbon risk.

In other jurisdictions where GHG emissions are yet to be regulated there is a future carbon risk to emitters that similar regulations will lead to added costs.

1.2 The Carbon Market: Capturing Value and Managing Risk

How is carbon value captured?

Carbon value is created by the conversion of a GHG emission reduction into a tradable commodity, which can have various names but which we will generically refer to as a carbon credit or an offset credit under Cap-and-trade.

Carbon under Cap-and-trade

Some geographic restrictions apply under the current Québec system: only a resident of, or municipality within, Canada may register as a participant or an emitter in the system. If an application is made by a person who does not live in Québec, the name and contact information of a Québec resident who is designated to represent the applicant must be provided.

In Québec, the Ministère du Développement durable, Environnement, Faune et Parcs ("MDDEP") creates emission allowances by:

• An annual free allocation of emission units to certain emitters which effectively represents their emissions reduction target;
• A quarterly auction of emission units subject to certain limits;
• A transfer by mutual agreement;
• Recognition of early reduction credits for reductions in GHG emissions made from January 1, 2008 and ending on December 31, 2011;²
• Issuance of offset credits for GHG emission reduction projects that began on or after January 1, 2012.

Cap-and-trade requires regulated emitters to reduce their GHG emissions to achieve their emission reduction targets. If emitters have excess emission allowances at the end of a compliance period, they can sell those allowances over-the counter within the system to other emitters that have not achieved their targets.

If the free allocation of emission units is not sufficient, emitters can participate in auctions or purchase emission units over-the-counter (both are described in more detail below). Emitters can also implement or sponsor projects that reduce GHG emissions and thereafter obtain offset credits from the MDDEP. The conditions for the allocation of credits are described in the Regulation.

Cap-and-trade auctions

Auctions and reserve sales are open to all emitters and other participants registered with the CITSS. Currently, the MDDEP has planned to auction emission units four times each year.

The auctions are announced at least 60 days before they are held, and participants must register at least 30 days prior to the auction and provide a financial guarantee, such as a deposit, in order to participate. The minimum price for 2013 is C$10.75 per unit, which will be increased at a rate of 5% plus inflation every year until the end of the third compliance period in 2020.³

Western Climate Initiative Inc. ("WCI Inc."), a not for profit entity constituted in the state of Delaware for the purpose of managing cap‑and‑trade in California and Québec, will review and process the applications for auction registration and will also manage the auction settlement process. The results of the auctions must be approved by the MDDEP before they are made public.

Reserve sales

If emitters have difficulty acquiring enough emission units to meet their compliance obligations, the MDDEP has created a mechanism referred as "reserve sales", which may be held up to four times a year.

To be eligible for such reserve sales, emitters must not hold emission units in their general account that can be used to cover GHG emissions for the current compliance period. Furthermore, emission units acquired through reserve sales cannot be resold over-the-counter. These last two conditions will be enforced to ensure these sales actually benefit emitters who do have difficulties acquiring emission units.

The reserve is divided into tiers, and a price is set for each tier (CAD$40-$45-$50 per unit in 2013) and are available to emitters that do not have sufficient emissions units and offset credits to satisfy its obligations for the applicable compliance period. These prices will increase annually by 5% plus inflation until 2020. Like for the auction sales, the reserve sales will be managed by WCI Inc., and are subject to the MDDEP's approval.

"Over-the-counter" sales

Cap-and-trade creates a secondary market, where emission units purchased can be resold over-the-counter in order for buyers to meet their emission targets if the primary market does not meet for their needs. However, sellers of emission units must not sell any units acquired through reserve sales.

"Other participants", such as banks, financial institutions, funds and others, may benefit from the secondary market by trading emission units "over-the-counter" in order to profit from changes in prices.

The California connection

Considering their current regulation and similar systems, the state of California and the province of Québec are in the process of harmonizing their respective systems for Cap-and-trade.

As recently as April 8, 2013, the Governor of California approved linking the California and Québec systems. This will allow, as of January 1, 2014, the California and Québec auctions to be held jointly. Provisions have already been included in the Regulation in anticipation of this linkage. At the present time, participants in the Québec program must have an establishment in Canada and similarly, voluntarily associated entities in the case of California must be located in the United States. Also, promoters of the GHG emission reduction projects for the Québec program must have an establishment in Québec. By linking the two programs, there will be a mutual acceptance of compliance instruments, which ensures fungibility.

Cap-and-trade systems for Québec and California will allow all registered emitters and participants to enter bids at the auctions. The inter-jurisdictional auctions will be managed by WIC Inc., which currently manages the Québec program. Mechanisms will also provide for the conversion of currency, in order to establish the price.

Who are the acquirers of carbon value?

The industries initially targeted by the Regulation as requiring carbon value to offset their emissions are the following sectors: aluminum; lime; cement; chemical and petrochemical industry; metallurgy; mining and pelletizing; pulp and paper; manufacturers of glass containers, electrodes, gypsum products and some agri-food establishments and petroleum refining. These industries must comply with their emission obligations by the end of the first compliance period.

The compliance obligation of Fossil fuel distributors will commence with a second compliance period.

In the voluntary market, carbon credits are generally being purchased by three groups of entities: enterprises that believe they will have a compliance obligation in a future regulatory framework, investors who want to benefit from price fluctuations, and enterprises that are currently offering "greening" and carbon neutrality services or are looking to go "carbon friendly" or neutral on their own.

1.3 Carbon Market: Capital Projects in the Voluntary Market

In Canada, carbon credits can be recognized as a result of capital projects that lead to a permanent reduction in GHG emissions once implemented. The carbon credits are recognized based on a verification of the real-time emission reductions of GHG from these projects in accordance with international standards. Once created, the carbon credits and their associated project can be listed on a registry such as the one maintained by the Canadian Standards Association ("CSA").

Such a project is simply: 1) the definition of a scope of GHG emissions that emanate from a defined source, such as a landfill or hog farm; 2) the application to the defined source of a change in technology or process that has been described in a scientific protocol; 3) the measurement of the defined scope of emissions after the application of the scientific protocol to the defined source; and 4) the verification of the application of the scientific protocol and the measurements by an independent third party.

If a project proponent wants to have the credits from a project registered on a project registry such as the CSA, then the project will need to be validated according to the rules of the registry and the verification will have to be done by an entity accredited for such purpose by the registry. If the project meets the registry's standards, the GHG reductions that are created by the project will then be serialized (assigned a number) and will appear on the registry. Often, projects are validated and run for several years and the emission reductions are verified on an annual basis. Once the emission reductions have been verified for a specific year, they can then be registered on the registry. Once the credits are registered, they can be transferred between account holders on that registry and or retired (i.e. taken out of circulation).

Two things are important to note in relation to the process described above. First, it is not necessary for emission reductions to be registered or even verified for them to have a market value. Second, the verification standard that is used for the project is a key element to determining what the value of the credits generated will be. Different standards have different market values and it is important for a company that feels that it has potential carbon value to determine what standard it will use to monetize that value.

1.4 Managing Carbon Risk

Carbon risk can take various forms. Under Cap-and-trade, the most significant carbon risk is being subject to sanctions related to regulatory annual emission limits.

Evaluating emissions that will have accumulated by the end of a compliance period cannot be easily determined ahead of time. Emitters are therefore faced with uncertainty and have an interest to manage this risk that becomes more urgent as the deadline to offer GHG emissions for the first compliance period (November 1, 2015) approaches.

Hedging and insuring against carbon risk

Emitters can mitigate their carbon risk by entering into certain derivative contracts. A forward contract or a call option on carbon credits can secure the emitter's right in the future to emission allowances or carbon credits while setting their price today. In such a hedging instrument, the underlying asset or interest is the emission allowance or carbon credit itself.

Another tool to manage carbon risk is insurance. Emitters can subscribe to specialized insurance contracts, which in return for a premium will indemnify emitters in the event their GHG emissions exceed their limits.

M&A transactions

An entity which does not appropriately address its carbon risk can encounter difficulties. For example, in the context of the sale of business, a buyer will factor in these liabilities in order to reduce its offer.

Banks, lenders or investors that do not conduct proper carbon due diligence fail to completely analyze the business that they are financing or acquiring.

Protecting IP

Sponsors of projects for which offset credits are provided or voluntary emission reductions are recognized have an interest to protect the intellectual property rights that are behind these generators of carbon value.

The patent application processes in both Canada and the U.S. are a good start to protecting IP.

What do businesses need to do?

Businesses need to begin to develop internal processes and tools for recognizing carbon value and risk both internally and externally, since such projects involve novel technologies.

In Québec, as a first step, emitters and participants must ensure they are registered on CITSS. This process requires provided detailed information about associated entities and can take some time. Therefore, both participants and emitters should plan ahead. It is also recommended they seek advice from legal counsel.

Gowlings is familiar with the existing carbon markets and draft regulatory frameworks proposed across Canada and elsewhere and is able to advise its clients with respect to best practices for the recognition of carbon value and its monetization and for the identification of carbon risk and protection against it.

1.5 Gowlings Can Assist Emitters and Participants to Capture Value and Manage Risk

The members of the Climate Change Group at Gowlings are familiar with many of the situations in which carbon value can be captured and can provide expert advice to emitters and participants in Cap-and-trade as well as those in the voluntary market. The process of creating carbon value at the project level is in part a scientific one. Gowlings has developed a network of professional contacts in this area and can guide clients to reliable resources for the performance of the analysis of the emission baselines, the development or choice of reduction protocol and the verification of any reductions.

2. TAX CONSIDERATIONS IN THE TRADING OF CARBON CREDITS

2.1 The Initial Allocation of Emission Allowances and Tax Considerations for the Buyer and Seller of Emission Allowances and Offset Credits

In both Canada and the United States, markets for GHG emission credits and allowances governed by regulated systems ("Allowances") have already been established and broader markets have emerged, (such as the ones for Quebec and California) or are projected (China). This article addresses the main Canadian tax consequences of receiving, buying and selling Allowances and Offsets. Other tax consequences may also arise from emission reduction efforts that a company must undertake in order to generate an Allowance or Offset. This article does not address other tax considerations related to "green" initiatives, such as investment in plants, equipment and research and development.

The Government Just Gave Me an Allowance: Will I Get Taxed?

Tax Treatment of the Initial Allocation of an Allowance

An Allowance is a right analogous to a permit or a quota that is issued by the regulating authority because it confers on the holder the right to emit a certain quantity of GHGs. In a capped emissions setting, a GHG emitter having emissions which exceed its regulatory threshold will have to either reduce its emissions to the allocated level or buy additional Allowances to cover the emissions in excess of the threshold.

The tax rules are not settled, but at present the value of Allowances granted likely will be included in income for tax purposes under paragraph 12(1)(x) of the Income Tax Act ("ITA") as an amount received from a government, municipality, or other public authority.

For income tax purposes, to the extent carbon credits are not sold, the initial allocation of an Allowance generally would not have any direct acquisition cost, but may have indirect costs that would be considered to form part of the cost of the Allowance. Certain of these indirect costs may be fully deductible under subsection 20(1)(cc) of the ITA as representing the costs of obtaining a permit, license, depending on the specific nature of the cost.

For purposes of the goods and services tax ("GST"), harmonized sales tax ("HST") and Québec sales tax ("QST"), the allocation of Allowances will likely be characterized as an exempt supply as the Allowances will be granted by a federal or provincial government for no consideration.

Purchase of Carbon Credits: Capital or Current Expenditure?

Income Tax Consequences to the Buyer

The tax consequences to the buyer of carbon credits will depend on the nature of the assets being purchased.

The purchase of additional Allowances in the secondary market will have an identifiable purchase price and acquisition cost which will typically be set out in a contract for the purchase and sale of the Allowances along with the purchase volume and the timing and method of delivery. With the enforcement of the Regulation, purchase of carbon credits on the primary market has now been regulated and the prices are either set in an auction process or through contracts in reserve sales.

Offsets can be acquired in the primary market directly through the Cap-and-trade system established and managed by the MDDE or in the secondary market from various dealers.

From an income tax perspective, the expenditure to acquire an Allowance or Offset is generally on account of capital where such expenditure is made once and for all and with a view to bringing into existence an asset of enduring benefit to the business.

Conversely, the purchase price of an Offset or Allowance is generally considered to be a current expense if it is incurred for the purpose of gaining or producing income from the business. The CRA considers that the purchase price for carbon credits would usually be a current expense for companies that are required to reduce the GHG emissions relating to their operations.

The CRA is of the view that an expenditure is on account of capital where the benefit from the expenditure will last longer than one year or an operating cycle (which may be the case if the Allowances or Offsets are banked). In practice, if the Allowance or Offset is retired within the year it is purchased, the benefit is received within the year after it is purchased and cannot be used more than once. In such a case, the benefits received from these credits do not last longer than one year or an operating cycle. This leads to the situation where the same Allowance or Offset, if retired within a year, may be a current expense, and if banked or carried forward to a subsequent year to cover emissions for that year, may become an expense on account of capital.

Businesses have been and will be purchasing Allowances or Offsets either as required by regulation or voluntarily in response to pressures to make them more responsible towards the environment. In either case, the expense may be necessary to continue the day-to-day business operations of the enterprise; namely, to allow the enterprise to compete in the marketplace or operate at its regulatory environment in order to face its obligations, something which it might not be able to do without acquiring the Offsets or Allowances. In appropriate circumstances, such expenditures may be seen as being in respect of the ongoing operations of a business and not a permanent addition to the basic structure of the business.

If the facts of a particular situation support the position that a capital asset has been acquired, the classification of the capital asset must be determined. In brief, Allowances or Offsets could be included in Class 14 as a "license for a limited period". A license is a right that enables the holder to carry on its business and may include Allowances and Offsets, provided that the Allowance is in respect of a company and qualifies for Class 14 treatment. If the applicable provincial and federal emissions trading systems provide that Allowances and Offsets will be bankable for long periods of time, the price of the carbon credits might be deducted proportionally over the life of the credit. Alternatively, expenses for Allowances or Offsets that would not meet the Class 14 conditions may be considered "eligible capital expenditures".

Income Tax Consequences to the Seller

For a seller of carbon credits, the tax treatment will generally depend on two factors: (i) the tax treatment that was given to the initial cost of acquiring the Allowance or Offset; and (ii) whether the seller makes it his business to sell Allowances or Offsets. In addition, the CRA has acknowledged that the tax treatment of the purchase and sale of Allowances or Offsets mirror each other (e.g. there could be a current deductible business expense for the purchaser and a gain on capital account for the seller). The facts and circumstances will thus be important in every transaction to properly determine the tax consequences for each party.

GST, HST and QST Treatment

For GST, HST and QST purposes, the supply of an Allowance or Offset should be characterized as a fully taxable supply of intangible personal property under the Excise Tax Act ("ETA") or incorporeal movable property under An Act respecting the Québec sales tax ("QSTA").

Accordingly, the supplier of the Allowance or Offset should be required to collect GST, HST and QST, depending on the place of supply, QST on the supply of the Allowance or Offset. A GST and QST registered recipient of an Allowance or Offset should be entitled to claim input tax credits and input tax refunds to recover the cost of the GST and QST incurred on the acquisition to the extent the recipient is acquiring the Allowance or Offset for use or supply in the course of making GST or QST taxable supplies.

2.2 Taxation of the Sale of Carbon Derivatives

Income tax

If a market participant registered with the CITSS is engaged in the business of trading carbon derivatives (i.e. hedge, swap and other derivates), the analysis of the tax consequences of the purchase and sale by it of such derivatives could be similar to the analysis of the tax consequences of any other commodity trading activity. Expenditures made to acquire emissions instruments could be treated as the cost of goods sold and the revenue generated by the purchase and sale of the underlying commodity itself (the carbon credit) could give rise to fully taxable business income.

The distinction between an enterprise that is a trader and dealer in carbon derivatives and an enterprise that is investing in derivatives for the purposes of complying with environmental regulations may be difficult to make and will depend as always on a review of all of the relevant facts of each case.

Sales tax on carbon derivatives

CRA's administrative policies related to commodities may apply for carbon derivatives as well. No sales tax should apply if the derivative contract (a commodity future or option contract) is cash settled on recognized commodity exchange. However, sales tax should apply if the underlying carbon credits are in fact physically delivered.

With the enforcement of the Regulation and the Cap-and-trade system now being used for the trading of carbon commoditiess, the over-the-counter system which was previously applicable has been put aside and the commodities are now cash settled on recognized commodity exchanges. Therefore, no sales tax should apply to such transactions made under the Québec Cap-and-trade system.

Hedging instruments

For income tax purposes, a Canadian emitter entering into derivative contracts for the purpose of hedging its emissions may be taxed on its income or loss on account of business income (rather than on account of capital), since the underlying asset or interest is the emission allowance or carbon credit itself.