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The Viewpoint The Politics and Economics of Carbon Market – An Indian Perspective

The Viewpoint The Politics and Economics of Carbon Market – An Indian Perspective

Bar & Bench

By Ajay Sondhi and Siddharth Srivastava


The first commitment period under the Kyoto Protocol is set to expire this year. Though significant progress has been made in the Durban Climate Change Conference (including in relation to the  second commitment period which would commence from January 01, 2013 and end either on December 2017 or December 2020), still a lot is required to be done in terms of safeguarding the interests of the developing countries in the future climate change deliberations. It is however important to understand the dynamics of Kyoto Protocol and in particular the Clean Development Mechanism (CDM) since viable environment management has emerged as one of the most important challenges for governments across the globe.

Financing Sustainable Development

The environmental costs are not factored into the traditional pricing models of the goods since air, water etc., are free goods for which the producer does not have to pay any charge and consequently irresponsible exploitation of the same does not result in any increase in the input costs. Such costs in economic terms are referred to as externalities. As environment is a public good that is freely available, it is not possible to internalize its cost without some sort of government intervention. Further, since environment is not a local factor but rather common to mankind as a whole, obviously it is not possible to address the issues at local or national level alone and some form of international and regional consensus is required. For developing countries, the challenge is to ensure development while ensuring inter-generational equity, therefore, access to finance and technology at affordable prices is of critical necessity for such countries. Significant funds are required to return GHG emissions to current levels – according to a UNFCC estimate it could be as high as US$ 200-210 billion in additional annual investment globally by 2030. Adaptation costs in developing world alone may entail an expenditure of upto US$ 67 billion. Since per capita emission in developed world far exceeds the per capital emission in developing world, it is only fair that the developed world should subsidize the preservation of environment, a global commodity. Though significant progress has been made at last over the past two decades but, as we shall see later, there is a significant dichotomy between theory and practice.

Environment pollution, particularly reduction of greenhouse gases (GHG), has presented significant challenges for the policy makers and given rise to some very innovative international and regional frameworks. The carbon tax in EU and Australia and CDM under the Kyoto Protocol for trading of Certified Emission Reductions, a certificate which represents reduction of one metric tonne of carbon dioxide equivalent, (CERs) between the developed countries (the Annex I countries) and the developing countries (the Non-Annex I countries) are but examples of regional and international initiatives for reduction of GHG emissions. The Kyoto Protocol is aimed at tackling the threat of climate change by establishing an efficient regulatory framework that sets an international price on GHG emissions and provides an incentive to the project developers in the developing countries for using environmentally cleaner technologies. Under the Protocol, Annex I countries have made binding commitments to reduce the level of their current GHG emissions to 4.2% (since US has not ratified the Protocol, the emission reduction percentage has been reduced to 4.2% from 5.2% now) below their 1990 levels by 2012 through adoption of certain market based mechanisms (including CDM).

CDM Process

To be eligible for CERs under CDM, one has to follow the prescribed cycle under the Kyoto Protocol. The project developers, besides satisfying the ‘additionality’ and ‘sustainable development’ criteria, are also required to follow certain steps which are unique to emission reduction activities pursued under CDM. The issuance of CERs involves the following steps – submission of the project design document (by the developer), validation (by designated operation entity (DOE)), a letter of approval (by National CDM Authority – Ministry of Environment and Forests in India), registration (by CDM Executive Board), project monitoring (by DOEs), verification, certification (by DOEs) and Issuance of CERs (by CDM Executive Board). Requirement of the numerous parties and various compliances at different stages of the project together with the costs associated with them make the validation and registration process quite cumbersome and leads to a high transaction cost.

Financing Models

Besides the traditional form of financing by way of debt and/or equity, projects having the potential to generate CERs are also financed from CERs buyer pursuant to the terms of Emission Reduction Purchase Agreement (ERPA). Depending on the payment structure, ERPA can be in the form of a spot agreement (payments are made on delivery), upfront payment, options (put and call option – an option is granted to purchase/sell the contracted quantity of CERs at a later date), forward contract at fixed price and forward contract at floating price. In connection with ERPA, the banks and financial institutions in India have also started playing  an important role by providing comfort to the CERs buyer through issuance of security (in the form of a letter of credit or guarantee) for securing delivery of CERs against an upfront payment made by the CERs buyer.

Although the option of upfront payment under ERPA is fairly popular in the carbon market, yet it has its own set of limitations. Like a typical buyers’ credit facility, under the upfront payment mechanism, the CERs buyer tend to charge relatively high rate of interest or arrive at discounted valuation of CERs or take additional security. This may result in reduction of returns for the CERs seller. Further, forward transactions are not very popular in India. Due to uncertainties involved in the issuance of CERs, the project developers usually prefer a non guarantee model for forward CER transactions. This necessitates discounted pricing of CERs in such transactions.

Certain multilateral mechanisms of the UNFCCC are also in place to support the funding gap of the CDM projects in the event the domestic financing falls short. Global Environment Facility is one such mechanism which provides grants to the developing countries for CER generating projects which require additional funding support. Further, pursuant to the Durban Conference, it has been decided that starting from 2013, a Green Climate Fund will come into effect pursuant to which the developed countries would provide funds to CDM projects.

Initiatives in India

The Government of India (GoI) has taken steps to encourage the project developers to undertake CDM projects. In 2008, pursuant to its ‘National Action Plan on Climate Change’, a National Mission for Enhanced Energy Efficiency (NMEEE) was launched under which a Partial Risk Guarantee Fund has been created for providing banks with a partial coverage of risk exposure against loans made for CDM eligible projects. Further, GoI has asked the Governments of all the States in India to prepare state level climate change action plans. GoI has also started levying cess on certain types of minerals such as raw coal, raw lignite and raw pete under the Clean Energy Cess Rules, 2011 the proceeds of which will be utilised towards the development of CDM projects. These funds have the potential to plug the financing gap in CDM projects and help in risk management/ reducing the viability risk of CDM projects. It is estimated that an amount of Rs 10,000 crore will be generated by 2015 from the clean energy cess on coal. This has provided comfort to the banks to reduce their risk perception in providing financial assistance to such projects. Other incentives include lower customs duty on LEDs and solar lanterns and subsidies to renewable energy projects.

Banks and financial institutions in India have also shown interest in providing financial assistance to the projects with the potential of generating CERs. In this regard certain unique products and funds are already in the market. For instance, IDFC Private Equity and IFCI Venture Capital have set up exclusive carbon funds for investment in CDM projects. SBI has signed certain MoUs with certain companies and consultancy services to jointly provide one stop solutions to industries engaged in CDM projects. ICICI has also signed a $300 million deal with Japan Bank for International Co-operation and Sumitomo Mitsui Banking Corp to support renewable energy and energy efficiency projects in India.

 Challenges and Outlook

Post Durban Conference there is still considerable risk on account of uncertain international demand of CERs beyond 2012. Certain reports indicate that EU has already decided to buy CERs from the emission reduction projects registered post 2012 from the least developed countries. Since EU is a major buyer of CERs from India, this new shift of policy will have an adverse impact the growth of carbon market in India. Further, the outcome of the Durban Conference leaves some unresolved issues and challenges for India which include- conversion of targets of second commitment period into unconditional quantified emissions limitation and reduction objectives (QELROs);unclear identification for sources and channels of long term finance by the developing countries for development of CDM projects; addressing inclusion of aviation sector in the EU Emission trading Scheme etc.

The magnitude of investments envisaged to curtail GHG reductions by domestic finance is unlikely to be sufficient. Further, the public sector will have to play a lead role and private finance can at best be a supplementary source of finance. There have been international commitments such as the Green Climate Fund and the Cancun commitment of developed countries for mobilizing US$ 100 billion per year by 2020. However, though US$ 30 billion was pledged by the developed world in COP 15 in Copenhagen for the period 2010- 12, the actual flow of monies was only US$ 2.7 billion. Further, though the Advisory Group on Climate Change Finance has identified some sources of finance (including aviation and shipping tax) to generate the required commitment of US$ 100 billion, it is important to ensure that there is no real incidence of such charges on the developing countries. Unilateral actions like the carbon tax (levied on the carbon content of fuel) imposed by the European Union on airlines operating in its airspace has adversely affected the international environment dialogue between the countries. A host of countries including India and US have lodged strong protest against the proposed EU carbon tax. Similarly other identified sources of finance such as carbon export tax and carbon offsets can potentially derail the international environmental framework in the absence of measures for refund or other compensatory mechanism for developing world. These may also be in violation of the principles of ‘Common But Differentiated Responsibilities’.

Another possible deterrent for the project developers undertaking CDM project is the levy of taxes on their project revenues. The proposed Direct Tax Code bill (the Code) envisages levy of tax on the consideration accrued or received from transfer of carbon credits (i.e., business income of the developer). From a developers’ point of view, the revenues generated from CERs compensates them for the additional cost undertaken in the multi-step CDM process. It is an incentive to cause the project developers to invest money in finding new ways/technologies for generation of CERs. Any reduction in this new found source of income would only discourage the project developers to undertake such projects. Malaysia has already provided income tax exemptions from the sale of CERs. Therefore, instead of imposing tax on the proceeds of CERs, as envisaged in the Code, GoI should provide for tax rebates and other fiscal concessions, in line with the initiatives considered under NMEEE for promotion of energy efficiency, which would reduce the tax liability of CDM projects and would consequently encourage adoption of energy-efficient business practices by the project developers.

 Ajay Sondhi and Siddharth Srivastava are Associates at Luthra & Luthra Law Offices. The views expressed in this article are the personal views of the authors and do not represent the views of the firm. It is informational and not an expression of opinion or advice. The authors acknowledge the guidance of Mr. Piyush Mishra and research assistance provided by Jayantika Singh, student, IV year, National Law University, Jodhpur and Gaurav Mankotia, student, IIIrd Year, MBA-LLM, National Law University, Jodhpur.