Carbon markets and financial crime risks

At this week’s climate finance meeting in Abu Dhabi, there was renewed interest in strengthening and standardizing carbon pricing policy to redirect global investments commensurate with the scale of the climate challenge.

However, carbon pricing mechanisms have suffered serious set-backs in recent years, particularly the EU which has market stability problems arising from a surplus of allowances and historical massive carbon market fraud. According to conservative estimates, over €15 billion was lost in the EU from financial crimes associated with carbon emissions trades including VAT fraud, money laundering and theft.

The carbon market is commonly referred to as a “cap-and-trade” regime. A limit (or “cap”) is set for countries or industries on the total amount of greenhouse gas emissions they can emit. If they exceed the limit, they are required to buy carbon credits from others. Those industries with spare carbon credits may sell surplus credits to emitters (the “trade”).

Cap and trade regimes are based on mandated carbon emissions limits that result in the creation of a carbon exchange market where clean emissions entities list and sell unused allowances that are purchased by less-clean high emitting entities. The market theory behind cap and trade is that it will effect climate change because the listings and trades volume must decline over time as industries emit less. That’s because dirty industries will pay cleaner industries for the right to emit, theoretically creating an economic incentive for cleaner technology that does not harm the environment. Technology innovation and infrastructure investment would necessarily follow as industries strive to become sellers, and not buyers, of emissions allowances.

Until recently, carbon trading was the world’s fastest growing commodities market. According to the World Bank’s annual report on carbon markets in 2011, carbon was valued at $176 billion. The European Union Emission Trading Scheme is the largest regional carbon trading scheme and its value in 2011 was $148 billion.

Carbon credits are not actually a physical commodity. Rather, they are an intangible legal fiction created by lawyers. The fictional construct of carbon credits is poorly understood by participants in the marketplace which makes the regime extremely vulnerable to financial crime and results in little regulatory oversight.

B. Financial Crime Risks with Carbon Trading

Last summer, Interpol released an interesting report available here, describing some of the financial crime risks associated with carbon trading, as follows:

Money laundering 

Organized crime buys carbon credits to introduce illicit proceeds into the financial system, with subsequent trades used to hide the illegal source, making it difficult to trace the funds. They may, for example, use cash to purchase carbon credits through a broker, which are then re-sold, and the revenue deposited into a financial institution.

The lack of regulation in respect of carbon credits, and its fictional nature means that it is arguable in some jurisdictions whether anti-money laundering laws apply. That is because in some cases, the legal character of carbon credits remains undetermined. Anti-money laundering laws apply generally to money market instruments (cheques, bills, certificates of deposit, derivatives, etc.); foreign exchanges; exchange, interest rate and index instruments; transferable securities; and commodity futures trading and there is no consensus, legally speaking, that carbon credits fit within any of those criteria. As a result, at the national level, regulators do not necessarily consider carbon credit trades for money laundering purposes. In Canada, however, there are views that carbon credit are a securities under provincial legislation, and may be a financial instrument and thus the Proceeds of Crime (Money Laundering) and Terrorist Financing Act applies to all carbon credit trades in respect of persons and entities authorized provincially to engage in the business of carbon trades.

Manipulating measurements to fraudulently claim credits 

Clean development mechanism projects generate carbon credits based on the extent to which the project resulted in fewer emissions than would otherwise have occurred. By manipulating measurements in the projects, a person can obtain more carbon credits than they are entitled to by overinflating the estimate of the emissions or by claiming that the project reduced emissions to a greater degree than it did.

Sale of fake carbon credits

The intangible nature of carbon credits makes it difficult to attach ownership in carbon rights to a project. A oil refinery project for example, may be owned and managed by one company while another acquires the legal rights to trade in any carbon credits generated. Beyond a piece of paper filed in a register, there is no indication of the identity of the person who holds the carbon rights. When carbon credits are sold through several foreign exchange with different regulations and lax standards of monitoring, carbon credits can be fraudulently sold many times to multiple parties – a practice known as “double-counting” or credits that do not exist can be sold. The fraud is not detected until local law enforcement agencies monitor government carbon registries, however by then the perpetrators have disappeared and the transactions may be untracable.

Lack of regulation over carbon markets

The complexity of the carbon market makes it particularly difficult to regulate. In addition, there is an absence of legal regulation altogether over some aspects of the market and in some jurisdictions. The rapid growth of carbon market investments, coupled with no regulation and or lack of material oversight of the carbon markets increases its vulnerability.

Carbon credits may be generated in one country, sold to persons in another and traded through several carbon market exchanges before reaching the hands of the final owner. The more countries involved, the harder it is to trace the carbon credit from its origin to final purchaser, and the easier it is for criminals to take advantage of legal loopholes and differing regulations between national legislation and non-existent regulation. Law enforcement and regulators are often limited in their ability to work outside their own domestic legal jurisdiction, making enforcement of international carbon markets complicated and difficult without a global response.

Tax Fraud 

Carbon trading in the EU has been significantly targeted for tax fraud, particularly carousel fraud or missing trader intra-community fraud VAT fraud. MTIC fraud involves importing goods from a VAT-free jurisdiction and selling them in another jurisdiction with VAT added and collected but not remitted. France’s BlueNet carbon exchange was the target of a carousel fraud scheme that resulted in losses of €5 billion in 18 months.

Securities Fraud 

Securities fraud involves deceptive practices in the carbon market in violation of securities laws that induce investors to make decisions to purchase or sell carbon credits on the basis of false information. The price of carbon credits can be manipulated by large traders issuing buy/sell recommendations to their customers on the one hand, while doing the opposite with their own carbon credits. Another way to push up carbon credit prices is for those companies that publish commodity indexes to adjust their index weightings to include more carbon credits. The adjustment would result in an increase in demand, and investment into the carbon market, which could drive up the price.

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