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Tax Issues Associated with Climate Change
Legislation Robert M. Gordon, BP America
Inc. Matthew P. Haskins, PricewaterhouseCoopers
LLP James G. Rafferty, Harkins Cunningham,
LLP ABA Tax Section Energy Environmental
Taxes Committee September 25, 2009
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Agenda

• Carbon trading vs. carbon taxes
• Tax issues arising from carbon taxes
• Legislative developments
• Tax issues arising from emissions trading
• Hybrid approaches to emissions trading and the
  importance of applying tax analysis to emissions
  trading and corporate carbon strategy
• Energy tax incentives and climate change policy

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Background
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Background

• Consensus has developed that greenhouse gases
  (GhGs)particularly carbonemitted into the
  atmosphere by human activity contribute to
  climate change
• The Obama administration had made taking action
  against climate change a priority
• The UN Climate Change Conference in Copenhagen
  this December has added a sense of urgency
• Outlines of possible actions
• conservation
• reduce use of high-GhG fuels and (e.g., coal,
  high-sulfur oil) and shift to low-GhG fuels
  (e.g., natural gas) and renewable energy sources
  (e.g., solar, hydrogen fuel cells, etc.)
• increase carbon sinks (e.g., forests,
  sequestration, etc.)
• Government action vs. market solutions
• Market solutions cant work unless GhGs are
  priced
• Government must create a pricing mechanism either
  directly (through a tax) or indirectly (by
  limiting GhG supply)

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Carbon Trading vs. Carbon Taxes

• Carbon trading and carbon taxes both achieve the
  policy goal of establishing a carbon price that
  drives investment and consumption decisions
• Many economists and policymakers prefer the
  relative simplicity and transparency of a carbon
  tax over cap and trade systems
• Even some early devotees of a system of tradable
  emissions permits believe that it will not work
  for carbon dioxide, by definition a planetary
  problem. A straightforward tax on each ton of
  carbon dioxide emitted by any source, they say,
  would provide more a more predictable price and a
  simpler system to police.
• New York Times (17 May 2009), citing inter alia,
  Al Gore

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Carbon Trading vs. Carbon Taxes

• Advantages of Carbon Trading
• Greater certainty that emissions reduction
  targets will be achieved
• US political considerations favor enactment of
  cap and trade
• Ability to allocate allowances to ease transition
• Significant business support from US Climate
  Action Partnership
• Avoiding the T word
• International Cooperation
• Difficult under either approach
• Head start on trading systems (EU-ETS) may hold
  the promise of eventual inter-linkage

• Advantages of Carbon Taxes
• Reduced price volatility
• Lower transaction and administrative costs of
  trading systems
• Less complex and quicker to implement than
  trading systems
• Example British Columbia (Canada) introduced,
  adopted, and implemented a carbon tax in just six
  months.
• Absence of free allocations lessens distortions
  of domestic competition
• Ability to border adjust, consistent with WTO
  precedent
• Potential for green shift reductions in other
  taxes

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Tax Issues Arising From Carbon TaxRate of Tax

• The major advantage of a carbon tax over a
  cap-and-trade system is the ability to determine
  future costs with certainty. This advantage
  dissipates, however, to the extent that future
  rates vary with external circumstances
• Carbon tax bills in Congress
• H.R. 594 (Stark) increases the tax annually at a
  fixed rate until the year in which emissions
  targets are attained
• H.R. 1337 (Larson) imposes tax at a rate of
  15/tCO2e for 2009, increasing by 10/tCO2e for
  each subsequent year, but it increases by
  15/tCO2e for each carbon emissions target
  nonattainment year (determined two years in
  advance)

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Tax Issues Arising From Carbon TaxPoint of
Taxation

• Needs to balance the widest scope of coverage,
  the numbers of taxpayers, the ability to utilize
  existing taxing or other regulatory structures,
  overall administrative practicalities, and the
  transparency necessary to effect behavioral
  change by consumers
• For natural gas, tax could be imposed on receipt
  by local distribution companies and industrial
  end users
• Complexity arises in connection with transport
  fuels
• Refinery in-gate
• aligns with the collection point for the Oil
  Spill Liability Trust Fund Tax
• maximizes coverage of crude oil GhG content
• minimizes administrative difficulties for both
  taxpayers and the IRS (150 taxpayers)
• mechanism for exemption for non-GhG-emitting
  products?

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Tax Issues Arising From Carbon TaxPoint of
Taxation (continued)

• Retail pump
• closest to the emissions point
• easy to manage exemptions
• transparent to the consumer
• but, products that do not pass through the retail
  pump will require a separate point of taxation
• and would increase the number of taxpayers to
  several hundred thousand
• Combination approach
• refiners would pay the tax at the refinery
  in-gate but the tax could be recovered when the
  refined product is sold
• wholesaler (if there is one) would then recover
  the amount of the tax from the retail customer
• the tax would be transparent to the consumer
• Tax all sales in the absence of resale or
  exemption certificate (cf. sales use taxes)
• Other alternatives
• refinery out-gate
• terminal rack
• these are less desirable because they increase
  the number of collection points without a
  corresponding increase in transparency

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Other Tax Issues Arising From Carbon Tax

• Deductibility
• Tax should be fully deductible under either
  sections 162 or 164
• Clarify that not a fine or penalty under section
  162(f)
• Border adjustments to address risk that some
  businesses might move activities to countries
  without a carbon tax
• Credits
• A given molecule of GhG should be subject to tax
  only once this requires a credit or refund
• for sales subject to a prior tax, and
• where tax has been paid but no GhG is ever
  emitted
• Preemption required to ensure consistency with
  federal and state taxes, trading programs, and
  other legislation (e.g., Clean Air Act,
  Endangered Species Act, Renewable Fuel Standards,
  and Low Carbon Fuel Standards)

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Tax Aspects of Pending Legislation
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Waxman-Markey Bill Key design features of ACES

• Reduction Path
• GhG emissions reductions from 2005 levels 3 by
  2012, 17 by 2020, and 83 by 2050
• Scope of System
• Intended to cover 85 of GhG emissions
• Entities that emit less than 25,000 tons/year of
  CO2-equivalent are exempt
• Renewable biomass fuels are exempt
• Banking, Borrowing, Offsets, and Reserves
• Unlimited banking
• Borrowing permitted one year ahead
• Both domestic and international offsets (e.g.,
  CERs) are permitted up to 2 billion tons/year,
  split evenly between domestic and international
• EPA would certify qualifying international
  emissions allowances for U.S. use
• Strategic reserve of allowances established,
  and EPA granted authority to auction such
  allowances if prices rise faster than expected

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Waxman-Markey Bill Key design features of ACES
(continued)

• Border adjustments
• EPA authorized to issue rebates to certain
  industry sectors with both high carbon intensity
  and trade intensity or that are demonstrably
  subject to carbon leakage (migration of
  production to countries without carbon caps)
• Auctioning vs. allocation
• 85 allocation, including significant allocations
  to utilities (35) and natural gas distributors
  (9)
• Note Allocation to utilities indirectly cushion
  coal producers
• Other notable features
• Trading markets in allowances to be regulated by
  FERC derivatives to be regulated by the CFTC
• National renewable portfolio standard (RPS)
  requiring utilities to meet 20 of their demand
  with renewable energy by 2020
• Preemption of state cap-and-trade and RPS programs

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Waxman-Markey Bill Distribution and auction of
allowances under ACES

• Auction reserve price (in 2009 dollars) is 10
  indexed annually at 5
• Strategic Reserve auctions would have a reserve
  price (in 2009 dollars) of 28 indexed annually
  at 5. Starting in 2015, reserve price would be
  60 of 36 month rolling average.

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Waxman-Markey Bill Budgetary effect of ACES
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Tax Issues Arising From Emissions
TradingEnd-Users Perspective

• Does receipt of a freely allocated allowance
  create taxable income?
• US precedents from our Acid Rain Program say
  no, but with no analysis (Rev. Rul. 92-16 and
  Rev. Proc. 92-91)
• The Australian Tax Office proposed to treat such
  receipts as taxable but has since backed off
• What sort of asset is an emissions allowance?
  Intangible? Commodity? Something new?
• US private guidance calls it an operating
  intangible (PLR 200825009)
• This cures some issues (no passive income under
  US CFC rules) but creates others
• Does a company that voluntarily buys carbon
  credits to offset its emissions get a current
  deduction for the expense?
• Should carbon credits be treated as inventory?
• Does differing characterization across
  jurisdictions present double-tax risk that is
  unaddressed by treaties?

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Tax Issues Arising From Emissions
TradingFinancial Intermediarys Perspective

• Can investors trade in emissions allowances
  without creating a taxable permanent
  establishment?
• UK guidance extends its investment manager
  exemption to carbon trading
• US guidance on its trading safe harbor is
  unclear under current law, a favorable answer
  would require IRS to treat allowances as
  commodities
• What does it mean to become a dealer in
  emissions allowances?
• Should emissions allowances be characterized the
  same way for traders as they are for end users?
• Differing treatment may facilitate favorable
  rules for traders that provide depth and
  liquidity to emissions trading markets
• But differences in treatment also may facilitate
  tax arbitrage

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Tax Issues Arising From Emissions
TradingTransfer Pricing Perspective

• Many MNCs have operations both in CDM countries
  and in jurisdictions covered by a cap-and-trade
  system
• Example
• The MNCs CDM affiliate undertakes an offset
  project and sells the CERs generated to its EU
  affiliate
• The EU affiliate can use CERs for compliance (up
  to a cap), thus freeing up EUAs for sale in the
  market
• The market price differential between CERs and
  EUAs may make this an attractive trade, depending
  on transfer pricing

Third-party buyers
Sale of EUAs
Sale of CERs
Affiliate in CDM country
Affiliate in an EU country
Cash
Transfer price?
Facility
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Tax Issues Arising From Emissions TradingTax
Treaty Perspective

• There are no defined treaty terms relating to
  carbon trading and thus initial classification is
  a function of domestic law under OECD and US
  model treaties
• Possible treatments under OECD model include
  Article 7 (business profits) Article 13 (capital
  gains) Article 21 (other income) or Article 6
  (immoveable property)
• Other issues include transfer pricing and
  permanent establishment
• The OECD has opened a project on the tax aspects
  of cap and trade
• The project is primarily descriptive, seeking to
  identify common tax objectives and issues in cap
  and trade systems and potential best practices
  for treatment of tradable emissions permits
• OECD business-government consultation was held on
  September 17, 2009

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Hybrid Approaches and the Importance of Tax
Analysis

• Many of the price-certainty advantages of a
  carbon tax can be replicated (or nearly so) in a
  carbon trading system
• Reserve auction prices set a floor on the market
• Setting a penalty tax level or releasing
  additional allowances at a price ceiling
• Banking and borrowing also contribute to price
  stability
• US legislators appear to recognize this and have
  built several of these features into
  Waxman-Markey
• Technical tax issues also are important but
  underdeveloped
• Senate Finance Committee hearing on June 16, 2009
• Resolution of these issues is critical to
  ensuring that tax does not become a friction
  cost to implementing environmental policy

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Making the Case for a Green Shift

• Estimated revenue from Waxman-Markey with full
  auctioning
• (845 billion over 10 years)

a 10 reduction in corporate income taxes
a 7 cut in Social Security payroll taxes
Note Senate Finance Committee held a hearing on
the use of cap and trade revenues on August 4,
2009
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Magnitude of Policy Makes This a Tax Issue

• Based on estimated annual emissions of 25 billion
  metric tonnes of CO2 annually from industry,
  power and transport, a carbon price of 40
  creates both . . .

1.0 trillion in potential annual costs to global
businesses
and . . .
a 1.0 trillion annual opportunity to avoid
fiscal cost
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Whats Next in Energy Legislation

• House passed cap-and-trade and other energy
  provisions legislation on June 26
• Senate Environment and Public Works Committee
  initially targeted September for mark-up of its
  own climate change/carbon legislation but that
  timetable may slip
• In recent comments, Senate Majority Leader Reid
  has suggested the Senate may not act until 2010
• Several energy tax items considered in stimulus
  debate may resurface (smart grids, energy
  research credit, electrical grid upgrades)
• External factor Copenhagen conference in
  December 2009

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What Should a Tax Director Do Today?

Understand your companys strategy on
sustainability and climate change and how your
business models will change
Align the tax function with the businesses so
that tax planning is about minimizing activities
which cause carbon emissions
Assess how government policy will affect your
companys future costs and seek to influence
policy
Know how much your group pays in environmental
taxes worldwide now
Know which environmental taxes you pay now
Assess how much this may increase in the future
Monitor how much in environmental taxes you
collect on behalf of the government
Take advantage of all incentives built into the
existing tax systems
Implement controls over environmental taxes and
manage the cost
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Energy Tax Incentives And Climate Change Policy
Jim Rafferty, Alex Sundakov Kevin Richards
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Some Context for Our Discussion - I
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Some Context for Our Discussion II
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Background I A Brief History of Energy Tax
Incentives
Three Stages of US Energy Policy
Stage 1 Intensive development of Fossil fuel
industries
Stage 2 Oil shocks and the environmental movement
Stage 3 Post-1992 regime

• Promotion of domestic
• resources
• Cost depletion
• Percentage depletion
• Intangible drilling costs

• Diversification of
• domestic resources
• National Energy Act
• Qualified facilities
• Investment tax credit

• Energy Policy Acts
• Production tax credits
• Federal climate change
• policy

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Background II Objective of Energy Tax Incentives

• Energy incentives serve many masters
• Encourage the development of domestic industries
  and extraction of domestic resources
• Reduce the cost of energy
• Improve domestic energy security
• Protect the environment from fossil fuel
  pollution
• Reduce greenhouse gas emissions
• Promote U.S. technological and economic growth

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When Are Energy Tax Incentives Efficient?

• The Problem?
• Markets are inefficient when there are benefits
  (or costs) that are not reflected in the market
  price (e.g. national security and environmental
  costs)
• The Solution?
• A pricea tax or subsidyequal to the external
  cost or benefit.
• Critical to get the price rightthe amount of the
  tax/subsidy. Too much or too little will be
  ineffective or will encourage overconsumption of
  the subsidized resource
• Do incentives for renewable and conventional
  resources conflict?
• Where price is set by world market, domestic
  production subsidies for conventional resources
  reduce dependence on foreign supply while not
  encouraging overconsumption
• Where price is set by domestic market,
  conventional subsidies may conflict with those
  for renewables

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Getting the Price Right Carbon Tax vs.
Cap-and-Trade

• The optimal carbon tax on energy consumed in the
  US would
• Reflect the long-run marginal cost of CO2
  emissions
• Include the long-run marginal cost of imported
  conventional energy relative to domestic energy

• For a cap-and-trade scheme to produce the optimal
  carbon price it must
• Set a cap over time that reflects the optimal
  accumulated emissions
• Allow trade across time
• Recognize all viable emission reduction
  opportunities, from anywhere in the world

Efficient policy must reveal WHAT, WHERE and WHEN
is the source of marginal abatement?
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How will a Carbon Tax Interact with Existing Tax
Incentives?

• Carbon tax and conventional energy incentives
• A carbon tax is compatible with incentives when
  the market is characterized by import paritythe
  US is a price-taker in a global market
• In markets where tax incentives influence price,
  incentives for domestic production and a carbon
  tax will conflict
• Carbon tax and renewable energy incentives
• Production tax incentives and a carbon tax will
  pull in the same direction
• Accumulative policies may lead to an oversupply
  of renewables and excess carbon abatement. That
  is, the cost of avoiding climate change will
  exceed the cost of climate change itself

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How will Cap-and-Trade Interact with Existing Tax
Incentives?

• When marginal abatement under cap-and-trade
  occurs domestically
• Domestic incentives are fully priced into the
  scheme
• Tax incentives for renewable energy will lower
  the carbon price by the equivalent amount
• Existing tax incentives for conventional energy
  will widen the gap with non-carbon energy
  sourcesa higher carbon price will be needed to
  achieve the optimal level of carbon abatement
• When marginal abatement under cap-and-trade
  occurs internationally
• Domestic tax incentives will have no impact on
  the cost of abatement abroad
• Domestic renewable energy incentives will lead to
  excess abatement and failure to meet domestic
  green jobs goals
• Support for domestic conventional energy will not
  interact with cap-and-trade

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Summary of Key Considerations for Policymakers
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Questions Answers
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Contact Information

• Robert M. Gordon
• Assistant General Tax Counsel
• BP America Inc.
• Warrenville, IL
• [phone]
• robert.gordon_at_bp.com
• Matthew P. Haskins, Principal
• Sustainability Climate Change Tax
• PricewaterhouseCoopers, Washington National Tax
• Washington, DC
• [phone]
• matthew.haskins_at_us.pwc.com
• James G. Rafferty
• Harkins Cunningham, LLP
• Washington, DC
• [phone]
• jrafferty_at_harkinscunningham.com

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Additional Contacts

• Alex Sundakov and Kevin Richards
• Castalia is a multidisciplinary consulting firm
  that provides advice to governments and private
  clients in the energy, water and infrastructure
  sectors, including clean energy and climate
  change policy
• www.castalia-advisors.com
• Alex.Sundakov_at_castalia-advisors.com
• Kevin.Sichards_at_castalia-advisors.com