ESG Blog series: Carbon markets and transfer pricing

Carbon markets have today become a key tool in attempting to mitigate the impact of carbon emissions.

Carbon markets have today become a key tool.

Kevin Perry, Senior Manager |

6 min read

What are carbon markets?

Carbon markets have today become a key tool in attempting to mitigate the impact of carbon emissions. Carbon markets enable carbon credits (one tonne of CO2 that is removed from the environment or stopped being produced) to be bought and sold to support net-zero emissions ambitions.

Carbon credits can be categorised into two different types:

1) avoidance, for activities that prevent carbon emissions, and

2) removal, for activities that remove carbon emissions.

Carbon markets on which such carbon credits are traded operate on the basis that different companies have different costs in reducing their CO2 emissions. A carbon emitter is therefore able to offset CO2 emitted by purchasing a carbon credit from a company that has a surplus.

There are two types of carbon markets: “compliance” carbon markets and “voluntary” carbon markets.

Compliance carbon markets operate a “cap” and “trade” system, under which a multinational is required to purchase carbon credits to offset its emissions so that it is under a cap. Under the EU ETS, companies are allocated fee allowances, with further allowances available to purchase via government auctions. These allowances can then be traded. The EU ETS covers high-emitting sectors such as energy, aviation industries – and since 1 January 2024 the maritime industry.

Voluntary markets operate to support multinationals’ net-zero targets by enabling the purchase of carbon offsets that are underpinned by a specific carbon offset project. The nature of these is wide-ranging, from forestry offset projects to sponsoring cook stoves and other carbon reduction technologies. Carbon offsets sold on voluntary markets are accredited by independent organisations; however, questions have been raised around the effectiveness of such offsets, as there are concerns that the credits may not always accurately report the carbon emissions that have been offset – the emissions cuts would have happened anyway, or the emissions were moved elsewhere for example.

Why are carbon markets important for MNEs?

Carbon markets are important for MNEs, as they may be legally required to purchase credits or are a key tool in a multinational’s net-zero ambitions.

Multinationals’ targets for reducing their carbon emissions are driven by a number of different factors. They will be monitored on their carbon footprint by shareholders, external bodies and suppliers and customers. Certain multinationals have been proactive in aiming to understand and control their carbon footprint, but others will find themselves at a competitive disadvantage should they not be able to show progress in doing this. This expectation sits alongside greater disclosure requirements for businesses in relation to their carbon emissions and decarbonisation strategies. For example, for financial year 2024, companies operating in the EU will be required to report on sustainability matters in a structured and standardised manner, including hundreds of data points on climate change and carbon emissions. Despite the above concerns, carbon markets remain a key (and more straightforward) way in which businesses can show progress towards their net-zero ambitions.

Multinationals that operate in carbon-intensive industries may have obligations on compliance markets – there are compliance markets in over 30 jurisdictions.

Due to the nascent nature of voluntary markets, and the interaction of compliance markets with other taxes, there are frequent changes and developments in carbon markets. Recent developments in this space include:

The phase-out of free allowances under the EU ETS, accompanied by the phase-in of CBAM[1]

Microsoft striking the largest carbon removal transaction on record, committing to purchase 8 million carbon credit offsets, generated by forest restoration projects in Latin America [2]

The SBTI releasing a new opinion on carbon credits, raising doubts on their effectiveness in realising carbon mitigation goals, and appearing to push back against its own board’s proposal to allow the use of carbon credits for businesses’ scope-3 emissions[3].

But what is the link with transfer pricing?

Carbon markets and transfer pricing

In isolation, a company purchasing credits on the compliance or voluntary markets has no interaction with transfer pricing. It is a transaction with an external party. That company can then retire the carbon credit. Practically, though, in a multinational business, the expertise in managing the group’s carbon footprint and any entity level obligations may not be at the level of the emitter. If multinationals have set up departments supporting the business on its journey to net-zero, such a department would typically have a group-wide or regional remit, responsible for tracking and quantifying emissions generated, determining the group’s position in relation the thresholds on compliance markets, management of internal carbon prices in addition to purchasing, or advising on the purchase of carbon credits.

There are considerable responsibilities to offsetting a group’s carbon footprint beyond the purchase of carbon credits, specifically relating to tracking and quantifying emissions generated, not to mention, if applicable, the management of any internal carbon prices. Where a department is performing these activities for the benefit of group entities, these activities should be priced and charged to operating entities on an arm’s length basis.

There may not be, at the level of the emitter, the expertise to purchase carbon credits on either voluntary or compliance markets. Where this is advised by a central function, this would form part of any service fee, as mentioned above.

A more involved central team responsible for managing the purchase and sale of carbon credits results in further transfer pricing considerations.

The central team can take a buy/sell role, purchasing credits and selling them to emitters. This is a separate intercompany transaction that requires pricing.

To the extent that the central entity will hold and pool credits, the pricing of these credits when transferred to operating companies, and how market risk is borne requires further consideration, as does any cost related to the holding of such credits on the balance sheet. There are also further tax and accounting considerations if carbon credits are being held on the book of a central entity for a period of time.

The pricing of voluntary markets credits in a buy/sell transaction is a challenge here given the relative illiquidity of the market, especially if these are sourced from a related party.

The centralised function may also be a full-trading model, under which of the purchases and sells carbon credits to third parties, under which the entity is exposed to the profit and loss on its activities. Here, transfer pricing considerations related to trading desks – allocation of risk, profit-split models arise also.

Conclusion

Despite an occasionally bumpy journey, carbon credits remain a key tool for multinationals on their journey to net zero. This, combined with wider activities being pursued by multinationals in managing its carbon footprint raises interesting and new intercompany transactions for tax departments to consider. Getting a handle on this will also ensure that the tax team is alert to tax and transfer pricing considerations as multinationals look to manage their activities driving net zero in a comprehensive way, through internal carbon prices for example. [4]