Regulations overdue for nascent carbon markets


November was an eventful month. We had the United States midterm elections and the start of the World Cup, which runs into December, but perhaps the most important highlight was the COP27 summit that took place in Egypt.

There, world leaders gathered for the 27th time to explore ways of combatting what is perhaps the biggest threat to our existence. Climate change!

Unlike the previous conferences, this one was held in Africa hence concentrating the discussions around the plight of developing nations in dealing with climate change.

Of special focus was the creation of a loss and damage fund to help developing countries recover from the effects of climate change and the need for the establishment of a global carbon market to price the impact of emissions.

The commodification of carbon credits has already gained a global consensus as one of the solutions to taming huge emitters by capping carbon emissions and requiring those who exceed the limit to offset the same at a cost.

In a broader sense, the cap-and-trade model for carbon credits is a carbon tax requiring emitters to meet the costs of their pollution with the difference being that rather than the payments going to the government, they are channelled to those who generate the carbon credits.

However, as developed countries lead the way in carbon market regulations and the establishment of compliance markets, the slow growth of carbon markets in Africa should be cause for concern.

First, the absence of compliance markets has left developing countries to sell their carbon credits on the voluntary markets which are unregulated.

The main difference between compliance markets and voluntary markets is that the former are regulated by national or regional authorities which mandate emitters to comply with specific requirements.

The voluntary market on the other hand goes beyond regulatory measures and is used by businesses and other entities seeking to voluntarily align their Environmental Social Governance (ESG) goals.

While the voluntary markets are flexible, the absence of a regulatory framework is a drawback to the long-term sustainability goal for businesses.

This is important because environmental compliance gives businesses a competitive market advantage due to increased consumers’ inclination towards environmentally friendly products and services.

A proper compliance market will not only serve to ensure compliance but also trigger environmental consciousness among businesses for long-term sustainability goals.

As for the voluntary markets, the absence of a regulatory framework to guide the sale of carbon credits has subjected persons wishing to participate in the market to further confusion about the regulatory and tax implications of the same.

Additionally, the nascent nature of the voluntary market has left room for price exploitation.

In Kenya, noting the intangible nature of the carbon credits, a supply of the same will be treated as a supply of a service for VAT purposes.

In the absence of proper regulations, the sale of carbon credits will be subject to the standard rate VAT if sold locally or abroad. Additionally, income from the sale of carbon credits is subject to the standard rate of corporate income tax rates.

The absence of tax incentives on the sale of carbon credits is a deterrent to their original purpose since the generation of carbon credits from any economic activity is already a positive externality.

Incentives towards such externalities should be encouraged to increase further investments in the sector. For instance, the Indian government offers tax cuts on the income earned from the sale of carbon credits into the international market from 30 percent to 10 percent which has resulted in massive climate action by businesses.

Additionally, as with all assets, owners of carbon credits may wish to use them to acquire financing. The recognition of carbon credits by regulatory authorities will open other sources of financing, especially for small businesses which are key drivers of growth in developing economies.

It is important to note the efforts by the Government of Kenya in promoting investments in carbon markets. Recently, the Finance Act 2022 provided a 15 percent corporate tax incentive for companies operating a carbon market exchange or emissions trading system under the Nairobi International Financial Centre.

However, in the absence of proper regulations and incentives to deal with the sale carbon credits, businesses and stakeholders can only speculate.

Kennedy Mugambi is a Tax Adviser with KPMG Advisory Services ([email protected] ).

PAYE Tax Calculator

Note: The results are not exact but very close to the actual.