Carbon Report: Market growth hit by fraud

Some argue fraud in the carbon markets is an old story – but has the market fully recovered and will post-2012 changes to the legislative framework be sufficient to stem further cases? Katie Holliday reports

Perhaps because the notion of using financial markets to solve the problem of global warming is contentious in itself, it is not surprising that critics have seized upon incidents of fraud as an opportunity to dismiss the market's worth. Market participants, however, are adamant that the market has bounced back and such incidents are merely teething problems typical of the formation of a new market.

The most prevalent fraudulent activities have included: tax fraud such as missing trader intra-community (MTIC) fraud; fraud involving the issuance of recycled carbon credits re-entering the market; and fraud over the quality of the credits produced from emission reduction projects.

"We're sick and tired of hearing people talk about the negative aspects. The simple fact of the matter is that the carbon market has proven itself robust," says Simon Glossop, partner at UK carbon trading firm CF Partners.

Although it is difficult to assess the impact of fraud directly, most market experts agree that, in combination with other factors, such as uncertainty over future legislation, fraud has contributed to a reduction in liquidity levels and a dampened investor sentiment.

Investment in the United Nations' Clean Development Mechanism (CDM) dropped by 39% to $2.7 billion in 2009 according to the World Bank, and analysts say that a key factor behind the decline is the impact of fraud. The UNEP Risoe Centre on Energy, Climate and Sustainable Development, a government body that supports the UN, cut its supply estimate of carbon credits generated from CDM projects for the end of 2012 from 976 million certified emission reductions (CERs) to 954 million.

Analysts say these fraudulent incidents could have deterred countries from starting up their own domestic emissions trading schemes (ETSs).

"All these fraudulent activities, even if they are not directly related to the carbon market, create bad news," says Simone Ruiz, European policy director at the International Emissions Trading Association (IETA). "These incidents of fraud come at the wrong time in relation to other parts of the world where governments are considering starting carbon trading schemes, and they give the whole concept of emissions trading a negative taste. This fraud that emerged over the spring and summer of this year has been badly timed with regard to the US's legislative decisions on its cap-and-trade legislation, for example. It wasn't the main cause for the setbacks, but it definitely was a factor."

Teething problems

In some instances, the frauds were unrelated to the carbon market and analysts say the incidents were typical of any new, emerging financial market.

According to the UK's Department of Energy & Climate Change, the carbon market has "no more scope for fraud than any other traded commodity and financial fraud does not affect the environmental integrity of the system".

One of the most common carbon market frauds is MTIC fraud, whereby a fraudster takes advantage of different tax regimes across Europe. The fraudster buys a product in one country where value-added tax (VAT) is not applicable, sells it in a country where it is, and then defaults or disappears before repaying the tax to the government. MTIC fraudsters have attacked markets for computer chips, mobile phones and contact lenses.

MTIC fraud in the carbon markets has made headlines in recent years after unexpected spikes in volumes on France's BlueNext and Denmark's Climex exchanges prompted fears of fraudulent activity in summer 2009. The French, Danish and UK governments have since moved to change tax legislation to place the onus of paying the tax on the buyer rather than the seller, eliminating the possibility for this fraud.

"MTIC fraud has been caused by the non-harmonised VAT regime in the European Union (EU). VAT fraud is nothing new but the permits are ideal goods for this fraud because they are electronic and a virtual unit," says the IETA's Ruiz.

However, despite the potential for such fraud now being significantly reduced, the incidents were a shock to the market, say analysts.

"VAT fraud led to a distinct decrease in volumes in traded European Union emissions allowances (EUAs) and problems for some of the exchanges that had been thriving on the high volumes," says Axel Michaelowa, senior founding partner at Perspective, a subsidiary of carbon advisory firm Point Carbon.

However, analysts say the impact was temporary and the market has now fully recovered. "Yes, it was a shock to the market. People were nervous and wanted to ensure that they were dealing with legitimate people, but liquidity levels have now gone back to normal," says CF Partners' Glossop.

Double-counting

Other types of fraud that are more specifically related to the carbon market include the recycled CER scandal that involved the Hungarian government. Two million credits that had already been used by Hungarian companies to meet their compliance targets under the EU ETS were sold back into the market in March this year. As a result, several European carbon trading exchanges were forced to shut down temporarily. A list of surrendered CERs was made publicly available and the exchanges had to cross-check the serial numbers on their CERs with this list before reopening for business.

According to Glossop, as a result of these fraudulent incidents there has been a trend away from exchanges. "We've seen a migration from exchanges to the over-the-counter market after some of the issues associated with recycled CERs in particular," says Glossop.

IETA's Ruiz believes such fraud won't happen again. "There's no risk of it happening again because now, whenever a company surrenders a CER to a member state it goes straight to a cancellation account. So the member state no longer has access to those credits," she adds.

Despite the scandal, its impact on liquidity and market sentiment appear to have been minimal. "The impact of the double-counting scandal has been small," says Perspective's Michaelowa. "I would not say people have been put off the market. The only impact has been the volumes decrease, which led to trouble for exchanges."

CDM fraud

However, there are cases of fraud in the carbon markets that have not been resolved and that threaten the quality of the credits produced and consequently the reputation of the market. The CDM is one area of the market that has repeatedly prompted concerns over additionality.

The CDM was created by the United Nations in 2003 to allow emission reduction projects in developing countries to earn carbon credits equivalent to one tonne of carbon dioxide. Industrialised countries can buy these credits and use them to meet their compliance targets under the Kyoto Protocol. Since the programme's launch, CDM projects have generated almost 430 million offsets or CERs.

Additionality is defined as the requirement that the greenhouse gas emissions after implementation of a CDM project are lower than those that would have occurred in the absence of the project. If a CDM project takes over from a project that was going to be built anyway, or displaces a local tribe, for example, or causes damage to the environment, then it would not be perceived as additional.

In August this year, the CDM market came under scrutiny by the Environmental Investigation Agency (EIA), an independent non-governmental organisation, when controversy surrounded carbon credits associated with HFC-23 (trifluoromethane) destruction projects mainly based in India and China. The project developers were accused of overproducing the base gas HFC-22, in order to destroy the by-product HFC-23.

Under the CDM, preventing the emission of one tonne of HFC-23 gas in the atmosphere is equivalent to 11,500 tonnes of carbon dioxide and investors can receive credits valued at four to five times the value of what it costs to carry out the project. It was thought that the high profitability of these projects created a counterproductive incentive to produce the gas just to destroy it and receive a credit in return.

Although only 19 HFC-23 based projects exist worldwide, in 2009 they generated roughly 60% of total CERs. Currently the projects are under review by the UN, the body in charge of producing CERs, and the European Commission is planning to introduce quality restrictions on CERs as a way of monitoring the types of credits that are allowed into the EU ETS, in a direct response to the HFC-23 scandal.

"Non-governmental organisations (NGOs) and politicians are now alarmed because some specific type of credits might have given perverse incentives to overproduce and thereby enhance greenhouse gas emissions. Fraud allegations are now being investigated by the UN authorities. The cost of abatement in these cases is very cheap but if sold into the EU ETS, producers receive the same price as other CERs in the market - as they all are valid compliance credits," says the IETA's Ruiz.

Natasha Hurley, policy adviser at CDM Watch, a watchdog body responsible for monitoring abuse of the CDM process, says there are concerns as to how the UN will address this issue. "We can't rely on the UN to resolve this, as their internal processes tend to be long and tortuous and there are clear conflicts of interest within the CDM executive board. We are more optimistic about the move to introduce quality restrictions on these project types at EU level – the European Commission appears keen to address concerns about environmental integrity in the EU ETS."

Hurley says the impact of such fraud on the credibility of this market has been substantial. "This type of abuse discredits the whole system. There are CDM projects that demonstrate environmental integrity, but they are not in the same league in terms of the number of credits being produced by these HFC-23 projects that have flooded the market."

The European Commission is now proposing to restrict the use of these credits in the EU ETS to enhance higher-cost abatement projects in developing countries. "Whatever will be decided on that matter, markets now need certainty on what are the new rules to come and any retroactive changes that affect compliance in the current phase must be avoided," says the IETA's Ruiz.

However, Hurley argues that an investor can easily avoid buying credits from these types of projects, so the scandal should not put them off. "I don't buy the argument that taking action to crack down on gaming will damage investor certainty. From an investor's point of view, it is possible to identify which credits are of higher quality. It's an ethical decision and some companies do appear to be taking a more responsible approach than others – unfortunately they are in a very small minority," she says.

It is also important to put things into perspective, and consider the level of corruption in the CDM market in comparison with other types of investment projects, says Perspective's Michaelowa. "If you look at the CDM compared to large-scale investment projects in developing countries, it is significantly less corrupt because the CDM does have higher transparency and documentation," he adds.

A major impact that has emerged from the HFC-23 gas project scandal has been the widening of the spread between the price of EUAs and CERs. "This is because the CER price has been depressed as a result of the scandal. HFC-23 credits are queuing up to be approved for issuance. Although the CDM executive board has suspended them at the moment, once they are approved the market will be flooded with cheap credits between now and 2012," argues the IETA's Ruiz.

With the current uncertainty over the future of the CDM market post-2012, these fraud incidents have not been helpful. The format of the CDM and joint implementation (JI) mechanisms are unclear post-2012 and it is not certain what types of credits will be acceptable under the new framework.

"The post-2012 landscape for CDM is completely unclear. We don't know what the mechanisms will look like, we don't know which countries will be eligible, we don't know how the bilateral approaches will work, we are completely in the dark," says Perspective's Michaelowa.

A potentially fragmented landscape for the carbon markets post-2012 increases the potential for fraud. "The more fragmented the market, the less transparent it is and the more possibilities there are for shady deals behind the scenes, so that would call for having maximum transparency and maximum integration of the current markets for post-2012," he says.

The lack of an official body with responsibility to police fraud in the carbon market is a problem. The executive board, which is in charge of approving CDM projects, is highly political and its level of neutrality is often questioned. Other bodies integral to the CDM approval process, such as the Designated National Authorities (DNAs) and the validators, are paid by project developers to carry out their duties so neither are well placed to investigate incidents of fraud.

"There is no incentive to do this, there are only the NGOs that have the drive to uncover fraud. But in terms of official regulatory bodies, nobody wants to play the detective," says Michaelowa.

Uncertain future

Although market participants argue that fraud within the carbon market is merely a sign of ‘teething problems' common in the emergence of a new market, they have clearly contributed to falling confidence in the effectiveness of using market mechanisms to tackle climate change.

"The HFC-23 scandal has undoubtedly undermined confidence in the CDM and brought the entire system into disrepute. We are closely following developments both at UN level and in the EU and expect regulators to take assertive action to address the root cause of the problem based on the evidence that has been put before them," says CDM Watch's Hurley.

However, participants also say regulators have shown a strong ability to quickly resolve incidences of fraud and eliminate their chance of happening again in the future. And although the potential for new types of fraud remains, changes to the regulatory frameworks that govern both the EU ETS and the UN's carbon market mechanisms are being negotiated to address these issues.

"We need clarity on post-2012 legislation from the politicians. That's the most important thing in the market right now, particularly with regard to CDM and JI projects. We need to know which type of projects can be used and submitted," says CF Partners' Glossop.

Analysts stress that incidents of fraud have not caused people to shy away from the carbon markets. "Traders and companies understand the issue," says the IETA's Ruiz. "It has not put people off the market. The question is: what will emerge as a result of these frauds?"

According to Perspective's Michaelowa, the perception of the quality of the underlying commodities affected by fraud has not changed. "The overall trust in the quality of the underlying asset has not been doubted. There is no question that an EUA credit, for example, is a valuable commodity. However, when it comes to CERs produced from the CDM, this qualitative issue is more relevant."

Despite the damage that fraud might have caused to its reputation, the IETA is adamant it will not affect the existence of carbon trading in the future. Risk managers at European energy companies and utilities will continue to require risk management tools to hedge against the risks associated with mandatory compliance legislation in the future, it says.

"The carbon market makes headlines whenever fraud allegations are associated with it. This is where the NGOs come in and start claiming carbon trading is a waste of taxpayers' money. It's important to stress that carbon trading is here to stay and has proven, despite the criticisms, to reduce emissions over Phase I and II," says the IETA's Ruiz.

"Fraud will always exist and it's not because of the nature of the carbon market, but a market needs regulation and policing," says Perspective's Michaelowa. "A new market will always have to face the challenge of having a policeman that arrives after the criminals have left the scene. The problem with carbon is that unlike with a barrel of oil where you can check whether it's been tampered with or not, with a CDM credit it's not so easy."