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Climate Change, Carbon Trading, and Thievery – Crooks Give “Carbon Capital” New Meaning

| Thursday August 27th, 2009 | 6 Comments

thief-with-money-bags-cartoonApparently, the carbon trading market – which has grown to more than $100 billion, the Washington Post reports – is attracting more than just businesses seeking viable ways to manage their CO2 emissions. Crooks, too, are drawn to carbon permit trading, as evidenced by last Wednesday’s arrest by British customs agents of nine people in the London area suspected of a £38 million ($63 million) “carousel” carbon permit fraud. (This was the first carbon scam British Customs has uncovered.) What are the implications of this development on sustainability and business?

The problem stems, in part, from the fact that nowadays, carbon dioxide is more than just a gas. Instead, CO2 is viewed as a pollutant, the monitoring of which can have significant environmental benefits. Accordingly, the European Union has limited the amount of CO2 many industries can produce, and companies must obtain permits to produce CO2. Companies that exceed their CO2 limit can purchase carbon credits from other companies that haven’t exceeded theirs – a system known as “cap-and-trade.” As a result, permission to produce CO2 has become something of a tradable commodity.

The carbon fraud problem also stems from taxation loopholes in the system of value-added tax (VAT)-free commerce between countries. In this system, a company imports goods without tax and sells them domestically with VAT to another domestic company, which then exports the products to a third country. The importing company should then repay the VAT to the government. In the “carousel” fraud, the thieves pocketed the VAT instead of paying it to the government. (The government became suspicious in May, when the volume of carbon trade on the Paris BlueNext reached 186 million tons – an increase of almost 159 million tons in just six months. The next month, the British government established a zero VAT rate for carbon trading to prevent future VAT-fraud attempts.)

One important implication of carbon permit fraud for sustainable businesses could be its potential impact on the passage of Obama’s climate and energy policies, which feature a cap-and-trade bill. I can already see opponents to the bill (*cough* oil industry supporters) staking their claim: if passing climate legislation could encourage crime, it shouldn’t be passed. (Carbon fraud could have a similar impact on the passage of an international climate change agreement – the topic of the UN Climate Change Conference in Copenhagen in December.) In fact, the problem gives rise to a whole host of additional issues. For example, are cap-and-trade systems even effective if (a) companies can still over-produce CO2 (can trading carbon permits really trim a country’s overall CO2 production?) and (b) crooks can chip away at the money a country makes through its clean tech investments and policies?

What do you think the bigger-picture ramifications of fraud in carbon trading could be?


▼▼▼      6 Comments     ▼▼▼

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  • Keiron Allen

    A few points:

    The first point to make is that this type of fraud CANNOT happen within the United States – as you have no VAT system. So this does not apply to the climate legislation at the Senate.

    VAT fraud has been in existence in the EU since the early 70s and many commodities markets have suffered.

    It is therefore absolutely wrong to make any ‘unique’ connection to the carbon market, climate legislation and this kind of wrongdoing.

    The European cap and trade system is working – in 2008 carbon emissions were reduced by 3% (Source: European Commission).

    Finally as a clarification, it was the French Government after working closely with Bluenext for several months, to remove VAT from carbon first.

    I feel in other words that you have over-stated the relevance of this event to the carbon market and the climate as a whole.

    Happy to discuss this further.

    • Nick Aster

      Keiron – thanks for the clarification. It seems like there’s potential for folks to scapegoat carbon trading as prone to fraud when it fact it’s no different from any tradeable commodity in that regard. We should keep this in mind when folks raise the issue.

    • DUTCH TAXMAN

      The VAT fraud on carbon permits is not as any other VAT fraud previously seen it menace to broke steal billions of €. The total corruption of the system obligued in three months to the EU to take position against VAT on this, which is really a record. France, The Netherlands and UK closed the problem by avoiding taxation on carbon permits. It has been a really big problem.

  • Johnny Come Lately

    Carbon trading firms may face scrutiny of KYC protocols in VAT probe: experts

    London

    UK-based carbon trading firms and the UK government may be headed for a showdown over the strength of the trading companies’ so-called ‘know your client’ due diligence protocols in relation to an ongoing investigation in the country into VAT fraud in the carbon market, several VAT experts said Friday.

    The UK Revenue and Customs office arrested nine people August 19 in connection with an alleged £38 million (€44 million, $62 million) VAT fraud scam operating in the country in the Greater London area, which the agency said in a statement involved members of an organized group “operating a network of companies trading large volumes of high-value carbon credits.”

    Carbon traders and brokers in London August 20 said that they suspect that the amount of money stolen from market participants and the UK government may be in the low hundreds of millions or possibly billions of pounds, and they said that many firms in the city may have knowingly dealt with the alleged fraudsters under the assumption that standard KYC mandates regulated by the Financial Services Authority would protect them from culpability in the scam.

    A UK government spokesman said Thursday that HMRC has estimated that the total pound sterling amount tied to the carbon VAT fraud scam in the UK could be “in the low hundreds of millions of pounds.”

    If suspects recently arrested in the UK in connection with an ongoing investigation into missing trader intra-community or carousel VAT fraud implicate legitimate carbon trading firms, then the UK government may struggle to prove that those companies are culpable in the fraud scam because EU legal precedent states that the UK government cannot refuse to grant VAT rebates to innocent third parties caught up in the scam, the experts said.

    As such, the UK government would likely need to level criminal charges against the carbon trading companies if they were found to have dealt with the arrested suspected fraudsters, which would be challenging for the government if the companies being questioned in connection with the fraud scheme fall into the regulated sector of the market, the experts said.

    HMRC said in an August 19 statement that the alleged fraud in the UK was carried out by a network of companies that bought carbon credits outside of the UK without paying VAT on the contracts. The fraudsters then allegedly added VAT to the price of the carbon credits and sold them on to other companies in the UK.

    The scammers then ceased to operate their company fronts and disappeared before paying the VAT to the UK government.

    In July, the UK government changed the VAT rating on carbon contracts traded in the country to zero, effectively exempting carbon trades in the country from the tax.

    The move by the UK government to exempt VAT charges on traded carbon contracts followed moves by the French government and the Dutch government in June and July respectively to end VAT charges on EU Allowances and UN Certified Emission Reductions traded in their borders over concerns of a carousel fraud scheme operating in the EU.

    Unregulated companies operating in the carbon market in any way in the EU would prove easier targets for the UK government investigation — which is being led by HMRC — because the KYC requirements in that section of the market are murkier, the VAT experts said Friday.

    HMRC’s ability to investigate potentially innocent third parties caught up in the scam is important because many carbon traders and brokers have said that there is large-scale concern in the market as a result of August 19 arrests that regulated financial houses may become embroiled in the government’s investigation.

    “It is really important that all involved in this are found because everyone in the market is worried to be caught up in this mess unknowingly,” a London-based trader said Friday.

    David Sweeting, a VAT fraud expert who is the head of VAT consultancy at accountancy firm RSM Bentley Jennison, said Friday that the fact that HMRC has already made arrests in relation to the suspected scam could mean that it will be easier for authorities to track the trail of fraud. “Usually [authorities] never get the fraudsters; that’s the problem” with carousel fraud, he said. “What [authorities] do is disrupt the reference trade by stopping the tax deduction down the chain if the chain is tainted with fraud. That’s how it catches the honest trader, and that’s how it puts people out of business.”

    Another senior carbon market trader warned August 20 that the spectre of VAT fraud in the carbon markets is unlikely to disappear as a result of a handful of arrests in the UK, particularly given that not all EU member states have taken steps to deal with the threat.

    “With VAT still being applicable [to carbon trading] in Spain and Germany, and no action or arrests anywhere else in Europe, it does suggest that this is not the end of the story, but that the UK has got a grip on it,” the senior trader said.

    Sweeting said Friday that innocent firms could be drawn into the HMRC investigation if they were found to have dealt with the fraudsters, even if they did so unknowingly. He said this probability raises the prospect that companies may not recover VAT from purchases associated with trades implicated in carbon VAT fraud.

    “If HMRC sees it has a tax loss, then they will look up the chain to see who [the innocent third party] sold the commodity to and that company will have reclaimed the VAT that they have paid for. And [HMRC] will then say to that innocent company ‘what checks did you do upon your supplier to ensure that it was a legitimate transaction and that it wasn’t tainted by fraud?'” Sweeting said.

    “If [HMRC] can show that the customer who reclaimed the VAT had not done enough due diligence in relation to the transaction, then … the courts have said that the trader involved in the transaction … should have known the transaction was linked to fraud and HMRC will refuse to pay the tax back to the honest customer and that’s how [HMRC] gets its money back.”

    Sweeting added that if innocent third party carbon trading firms in the UK are caught up in the HMRC investigation, then the firms’ level of knowledge of the activities of their fraudulent trading partners will represent the difference between innocence and guilt in the government’s eyes. “It’s not whether you knew, it’s whether you should have known,” he said.

    Clifford Chance VAT specialist Etienne Wong said Friday that, in previous carousel VAT fraud cases in the UK, HMRC has attempted to place the burden of the tax loss on innocent third parties caught up in the scam chain.

    Hunton & Williams corporate tax solicitor and VAT expert Leigh Lisk and Wong said Friday that a European Court of Justice case stemming back to 2006 has set EU legal precedent for treatment of innocent parties caught up in a VAT carousel fraud scheme.

    In that case, HMRC refused to repay VAT to innocent third parties trapped by a carousel fraud scam involving electronics products because the agency said that the transactions in the scam were a non-economic activity for VAT purposes and thus no rebates were necessary.

    But the ECJ overturned the agency’s interpretation of the law in a court case by ruling that HMRC must prove that trading companies under investigation intended to trade illegally with the fraudsters. If a trading company was unaware that it was dealing with counterparties intent on engaging in VAT fraud, then the trading company is innocent in the eyes of the law and HMRC cannot refuse to repay lost VAT, the court ruled.

    “Effectively, HMRC will only be able to deny the recovery of VAT by an ‘innocent’ purchaser if they can show that the purchaser did not take all proportionate steps available to it to ensure that, on a balance of probabilities, no aspect of the transaction is connected with any other party involved in a fraud on the [HMRC] through the VAT system,” Hunton & Williams’ Lisk said in an e-mail Friday.

    Wong said that regulated carbon trading companies trading in a regulated market such as the EU Emissions Trading Scheme would likely expect a trading counterparty to pay a VAT bill to the government if the counterparty passes the firm’s KYC tests. “In respect to what organization you are, there isn’t a lot of obligation on your part to look into my bona fides because I think that in most commercial situations … if [a firm has a VAT bill to pay] they’ll just pay it because in that sense VAT is not much different from corporation tax or any other form of tax. When you enter into a transaction [with a company] you don’t ask whether [it] will pay [its] corporation tax,” he said.

    Wong added that HMRC does not typically assume guilt on the part of trading firms they suspect may be caught up in a VAT carousel fraud scam because “there is absolutely no reason if you are trading on a regulated market for you to actually have a higher due diligence obligation than a [fraudulent] company.”

    “Why should someone who just happens to be in a regulated sector have a higher due diligence bar than someone who is not?” Wong asked.

    Recent allegations of VAT fraud have come at a politically sensitive time given that the EU has put significant resources into building the EU ETS as a tool to reduce CO2 emissions at lowest cost. Similar moves to establish cap-and-trade schemes are under way in Australia, New Zealand, the US and other nations ahead of UN talks that aim to build a successor agreement on reducing greenhouse gas emissions to replace the Kyoto Protocol.

    A senior carbon trading source said August 20 that there was no risk of carousel fraud in the US because VAT is not applicable there, and US state-level taxes are levied on retail goods only and not on goods transferred wholesale between businesses.

    Russell Dinnage

  • Matthew Holtry

    VAT issues aside, CO2 trading has one unique trait: Credits can be purchased and then purposely “retired” from trading. I have seen NGOs purchase carbon credits simply to reduce the number available in the marketplace (which, if economics works properly, should increase their price).

    Granted, they could also buy enough shares of Exxon to get a seat on the Board of Directors, but that would just lead to some awkward meetings.

  • Mr I Groan

    Carbon Trading? Is this the ‘New Pig in a Poke’ scam being run by governments to raise more tax Dollars, Pounds Euros or whatever?

    Would you buy a ‘Bag of Air’? Is carbon trading buying into the ‘Great Nothing’. Is this all a bit like governments trying to impose a tax on the air people breath, because we all expel CO2.

    Goverment’s might as well also tax their citizens for flatulence. Now that would a nice little earner for Finance Ministers, maybe we should be taxed on our sex lives as well.