The Covid-19 pandemic created a rare opportunity for individuals, companies and governments to reassess their priorities and redefine their expectations for the near future. By withdrawing into social distancing, humanity became more aware that climate change is real, but also that alternative ways of organizing production and work, with lower emissions and less waste, are possible and are already largely within our reach, requiring a smaller sacrifice than absorbing the full impacts of uncontrolled climate change.

The latest IPCC report (AR6 Climate Change 2021), based on scientific evidence, unequivocally recognized human action as the cause of climate change. According to the same report, some effects would already be irreversible, while others tend to worsen over the next decade, causing serious losses. Humanity would be facing the last opportunity to adopt urgent, intensive and sustained measures to drive emissions reductions.

Among the main policies eligible for mitigating climate change, the creation and expansion of carbon markets stand out. This agenda gained strong momentum following the announcement of the Green Deal by the European Union and the inauguration of the carbon market in China, both of which occurred in July. COP 26, to be held in November in Glasgow, also raises expectations of further advances in the international regulatory framework on this topic.

In this context, new risks and opportunities emerge for Brazil, which may finally find in carbon credit markets, both mandatory and voluntary, national or international, important allies for meeting its emissions reduction targets. Let us consider how to position ourselves in light of these events and what the next steps might be.

European Green Deal

In July, the details of the European Green Deal (EGD) were released, which, if approved, will represent a true revolution in the European Union’s regulatory framework for meeting its climate change mitigation targets, aiming for a 55% reduction in greenhouse gas (GHG) emissions by 2030, relative to 1990 levels.

The major highlights of the EGD were the proposals for (i) expansion of the European Union’s Emissions Trading System (EU ETS) and reduction of GHG emission limits, (ii) amendment of the Energy Taxation Directive, (iii) establishment of the Carbon Border Adjustment Mechanism (CBAM), and (iv) creation of the Social Climate Fund. Let us briefly examine these points.

The ETS is a classic emissions control and reduction mechanism of the “cap and trade” type. This system is based on the setting of emission quotas for certain economic sectors and the permission for participating agents to trade their quotas among themselves (in the form of credits), encouraging emissions reductions, the trading of surpluses and the acquisition of credits by those for whom reduction through technological solutions proves unfeasible or excessively costly.

It is a market arrangement that has the virtue of incentivizing emissions reductions to be implemented by the agents that can do so at the lowest cost, thereby reducing the economic impact of the energy transition for society as a whole.

Since 2005, this system has been responsible for reducing by 42% the bloc’s emissions associated with energy generation and energy-intensive industries. The EGD is expected to expand the use of this instrument to new sectors, remove the free allowances currently granted to certain segments and, in general, reduce emission margins, as well as establish progressive annual targets, which tends to increase demand for carbon credits within the ETS and, eventually, also their price (even considering the price stabilization mechanism implemented since 2019).

The proposed amendment to the Energy Taxation Directive, in turn, will adjust the taxation on energy source consumption to the European Union’s new climate targets, imposing a higher burden on fuels with greater GHG emissions, while also adopting a taxation approach based on energy efficiency and pollution criteria.

The rates imposed on the various energy sources will be expressed in euros per gigajoule of energy produced (i.e., €/GJ instead of €/volume of product), in order to provide a more appropriate incentive structure and increase transparency of environmental costs so that market participants can make more informed choices.

In addition, the obsolete tax incentives for fossil fuels, no longer justifiable under current climate change conditions, will be withdrawn and replaced by the imposition of minimum rates across all countries in the bloc, in order to favor investments in renewable energy sources and other energy transition innovations.

The EGD also provides, in a pioneering manner, for the establishment of a border adjustment mechanism (Carbon Border Adjustment Mechanism – CBAM), in the form of a carbon-cost-based tariff levied on products imported from countries not committed to decarbonization targets similar to those of the European Union.

The CBAM seeks to equalize the production costs of certain goods imported from non-adhering countries, as a means of ensuring a level competitive playing field for producers established within the bloc.

From 2026 onwards, the CBAM will require European importers to compensate for the carbon cost of these products, through the acquisition from the government of certificates that will mirror the price of carbon credits traded internally within the European Union through the ETS. The sectors initially affected will be cement, iron/steel, electricity and fertilizers, but this mechanism is likely to be expanded to others as well.

The CBAM tends to constitute a typical “carbon club” mechanism, along the lines suggested by economist William Nordhaus, as a way of stimulating international cooperation and overcoming the free-rider problem in climate agreements.

However, as is common with any innovation in governance, many questions remain, both about its compatibility with the international norms of the Paris Agreement and the World Trade Organization, and about the possible transaction costs for all parties involved in terms of control and compliance.

For some members of the European University Institute, the CBAM would not violate the principle of “common but differentiated responsibilities and respective capabilities,” enshrined in Article 2 of the Paris Agreement, insofar as the mechanism would contribute to the objectives of the agreement itself by reducing the risk of carbon leakage through the relocation of production to more lenient jurisdictions as a way of avoiding reduction targets.

The same think tank argues that the CBAM does not constitute a protectionist mechanism, but that the European Union must strengthen its diplomacy with the WTO so that it opens a discussion on how to reconcile the rules of international trade with issues of climate change and sustainability. An even more problematic issue for the CBAM appears to be how to compare, and classify, the effectiveness of the different approaches adopted by countries with emissions reduction policies.

Despite these questions, given the European Union’s commitment to implementing this policy and the recent signaling from the United States of evaluating the adoption of similar mechanisms, it does not seem reasonable to overlook the risks that this measure poses for Brazil’s foreign trade and exports in particular.

The EGD also provides for the creation of a Social Climate Fund, with the objective of protecting the most vulnerable consumers in the face of rising costs of goods and services that make use of more polluting energy sources and technologies.

The Fund will provide financial support to low-income families so that they can access cleaner technologies and thereby also avoid the higher costs associated with the use of ecologically obsolete energy sources and technologies.

The Fund is expected to be reinforced by revenues generated through the expansion of the ETS and the implementation of the CBAM, and will be accessible to all European Union countries in order to ensure that no citizen of the bloc is negatively affected by the energy transition.

Changes in China and Expectations for COP 26

China, for its part, inaugurated its carbon market in July at the Shanghai Environment and Energy Exchange, which is already expected to become the largest in the world in terms of traded volumes.

Initially, the mechanism will cover only the energy generation sector (still heavily dependent on fossil fuels), but is expected to expand rapidly to other polluting segments as the Chinese authorities develop specific accounting rules and strengthen the enforcement apparatus.

The effectiveness of the model, however, will depend on the setting of carbon credit costs at levels sufficient to stimulate investments that generate effective changes in emission patterns.

At the international level, expectations also continue to build around COP 26, to be held in November in Glasgow. Meaningful progress in the regulation of the Paris Agreement is expected, particularly with regard to the emissions trading mechanism provided for in Article 6, although some technical controversies and a lack of political consensus on certain key aspects still threaten to frustrate the expectations of the international community.

Whatever the outcomes of COP 26, the fact is that the panorama in Europe, accompanied by new policies announced by the United States, and to a lesser extent in China, points to an irreversible trend toward the adoption of more aggressive GHG control and reduction measures by blocs of developed countries, in the form of “carbon clubs,” with potential repercussions for international trade and negative impacts on the competitiveness of countries that do not adopt similar targets and control and reduction mechanisms.

Carbon Credit Markets in Brazil

In this context, Brazil needs to prepare to accelerate the pace of regulation of its domestic carbon credit market, as well as the adjustment of its tax system, in order to implement its emissions reduction targets, independently of any eventual global agreements, since change will inevitably come, even if imposed by major consumer markets, as the European case already foreshadows.

Currently, carbon credit markets and other emissions reduction certificates in Brazil, with the exception of the successful RenovaBio experience, remain largely voluntary and unregulated.

Regulated Market – RenovaBio

RenovaBio is a policy for controlling and reducing emissions in the fuels sector, introduced as a reinforcement of the voluntary commitment undertaken by Brazil at COP 21, held in Paris in 2015. The policy established by Law No. 13.576/2017 is based on the setting of individual annual emissions reduction targets for fuel distributors (Article 7), to be achieved through reducing the proportion of fossil fuels commercialized and acquiring decarbonization credits, known as “CBIOs.”

CBIOs are originated by biofuel producers, who are also incentivized to improve the environmental efficiency of their production plants (in accordance with the efficiency rating or classification assigned to them by certifying entities), since the greater their environmental efficiency, the greater the volume of CBIOs originated annually.

In this way, the arrangement works simultaneously as an incentive for renewable energy production and as a disincentive for fossil fuel commerce by distributors, given that they must bear the cost of acquiring CBIOs and are subject to fines in the event of non-compliance with their individual targets (Article 9).

It is important to note that CBIOs are not legally classified as financial assets or securities and are therefore not subject to regulation by the National Monetary Council or the Brazilian Securities and Exchange Commission.

Indeed, from the definition in item V of Article 5 of Law No. 13.576/2017, combined with Paragraph 2 of Article 3 of the Regulation (Decree No. 9.888/2019), it is possible to characterize CBIOs as simple legitimacy certificates, i.e., documents issued in book-entry form, evidencing the ownership of rights of a regulatory and environmental nature, representing one metric ton of carbon dioxide equivalent for the purpose of meeting the emissions reduction targets of fuel distributors.

Given this peculiarity, the bookkeeping, registration, trading and retirement of CBIOs are currently regulated by Ordinance No. 419/2019 of the Ministry of Mines and Energy.

Thanks to a well-structured sector regulation and the strong demand from economic agents, both from obligated distributors and from those who voluntarily seek assets that contribute to advancing the ESG agenda, the CBIO market is in full expansion, with transactions carried out on an organized market, prospects for expansion to other sectors and even the creation of derivatives (futures markets).

Voluntary Markets

In Brazil’s voluntary carbon credit markets, the reality remains quite different. Voluntary markets are distinguished from mandatory ones precisely by being driven by spontaneous transactions, conducted for various reasons, such as conscious commitment, the pursuit of image and reputation consolidation, the listing of securities under sustainability seals issued by exchanges within the scope of self-regulation (ICO2 B3, ISE B3, DJ Sustainability Index, etc.) or, alternatively, requirements established by parent companies or counterparts abroad subject to more stringent legislation.

In Brazil’s voluntary carbon markets, the lack of minimum standards regulation, as well as the wide range of methodologies and certification standards, represent the greatest obstacles to their expansion.

The absence of standardization makes it difficult to compare the various carbon credits offered, as well as to effectively price these assets, creating information asymmetries and adverse selection risks that may, in the long term, undermine the effectiveness of this mechanism as a means of offsetting emissions. The lack of regulation also leads to fragmentation of trading environments, generating inefficiencies and reducing price formation transparency.

Ultimately, the gap in the regulatory framework ends up delaying the very development of the voluntary carbon credit market as an instrument for financing and monetization, par excellence, of conservation and environmental restoration projects, as well as of emissions reductions in general, with significant untapped potential in Brazil.

Bill No. 528/2021

With the aim of addressing this gap, Bill No. 528/2021 is currently under consideration in the Chamber of Deputies, the latest version of which corresponds to the substitute amendment presented by Representative Zé Vitor (PL/MG).

The bill largely adopts sound regulatory technique by proposing guidelines for the creation of a Brazilian Emissions Trading System (SBCE), based on the cap and trade logic, through the quantification of limits and allocation of Greenhouse Gas Emission Rights (DEGEE) among the various sectors of the economy, free of charge or through auctions.

It is important to emphasize that this mechanism is not tax in nature, but rather regulatory-environmental, based on the creation of an administrative obligation to reduce or offset emissions, subject to fines in the event of non-compliance.

The establishment of such an administrative obligation finds support in the fundamental right to an ecologically balanced environment and the corresponding duty, incumbent upon the Government and the community, to defend it, both enshrined in Article 225 of the Federal Constitution.

This is also the prevailing understanding abroad for analogous mechanisms, as exemplified by the recent decision of the Supreme Court of Canada, which declared the Greenhouse Gas Pollution Pricing Act of 2018 constitutional, considering that, notwithstanding the popular language that often labels it a “carbon tax,” it does not constitute a tax but rather a price for excess emissions.

Bill No. 528/2021 also establishes guidelines for the creation of a National Registry System for GHG Emissions Reductions and Offsets (SNRC-GEE), with the purpose of consolidating the registration of emissions reduction projects and the corresponding carbon credits generated (referred to as “Verified Emissions Reductions” or “RVEs”).

The SNRC-GEE will reinforce the credibility and security of transactions involving these assets, also favoring the export of RVEs, insofar as it will serve as an instrument of integration between the national and international accounting of transactions involving assets originated from Brazil.

The voluntary carbon credit market will also be broadly stimulated by the approval of Bill No. 528/2021, as the managing entity of the SNRC will hold the legal authority to accredit certification standards for RVEs originated from different types of projects, which may also be used for the fulfillment of voluntary corporate reduction targets, in Brazil or abroad, even outside international agreements and protocols.

The approval of certification standards by an official body, as well as the registration and supervision of independent auditors, tends to address issues of information asymmetry and adverse selection, boosting market participants’ confidence in the mechanism and driving the expansion of the voluntary market.

The creation of a centralized registry for RVEs also has the merit of reducing the risks of double issuance or double counting of credits, by ensuring that these assets are identified with serial numbers and permanently removed from market circulation after their purchasers use them to offset emissions.

Tax Aspects of Bill No. 528/2021

One point that deserves improvement in Bill No. 528/2021 is the taxation regime (Article 10). On the one hand, the proposal for broad and unrestricted exemption from federal taxes (IRPJ, CSLL, PIS and COFINS) on transactions involving RVEs seems difficult to accept in the current context of fiscal constraints. On the other hand, it is not desirable for high taxation or, worse still, legal uncertainty regarding the applicable tax treatment (as still occurs under RenovaBio) to hinder the development of these markets and reduce their potential contribution to decarbonization efforts.

In order to resolve this issue, we suggest adopting a simple, clear and rational taxation regime for all the economic agents involved, which would favor the originators of carbon credits with a lower fiscal cost.

For the first sale of RVEs by the original holder, we suggest adopting a withholding income tax regime exclusively at the source at a rate of 15% (in harmony with the rate applicable to CBIOs under Article 15-A of Law No. 13.576/2017), combined with an exemption from CSLL, PIS and COFINS, including to avoid the endless controversies regarding the possibility of taking credits under the non-cumulative regime.

For subsequent transactions involving RVEs in the secondary market, when carried out on exchanges, organized over-the-counter markets or other digital platforms authorized by the competent authority, we suggest establishing the same tax treatment as that applied to variable income investments, i.e., withholding income tax at source at a rate of 0.005%, with gains taxed at an income tax rate of 15% and at the standard CSLL rate (see Article 2 of Law No. 11.033/2004).

With regard to PIS and COFINS, for these same subsequent transactions, it would be desirable to provide for a unified regime, covering both the cumulative and non-cumulative systems, without entitlement to tax credits, with a total rate of 4.65% levied exclusively on the gain calculated in RVE trading transactions, in the same manner already established for transactions involving equity interests.

It would also be important for Bill No. 528/2021 to recognize the full deductibility of RVE acquisition expenses, both in the calculation of taxable income and the CSLL tax base, even for transactions carried out in the voluntary market, provided that they involve RVEs issued in accordance with certification and registration standards that meet the requirements of the law. Deductibility should be full or, alternatively, limited to a maximum percentage of the net profit calculated by the taxpayer in the financial year, should there be a perceived need to reduce the fiscal cost imposed by the measure.

The combination of a simple, clear, rational and low-cost tax regime for original issuers with the recognition of the deductibility of expenses for the acquisition of RVEs compliant with legal parameters would produce the virtuous effect of fostering and, at the same time, organizing the voluntary markets around environmental assets that demonstrably generate positive externalities for society in terms of effective emissions reductions or removals, thereby justifying the tax incentive granted to producing taxpayers.

It is important for legislators to be attentive to the critical nature of the tax aspect for the success of the objectives sought by the bill. The suggestion above seeks to offer a more balanced solution, as an alternative to simple total tax exemption, with the aim of obtaining the support of the Executive Branch, in particular the Ministry of Economy, and thereby avoiding a potential veto of the fiscal provisions.

Indeed, a veto would be the worst of all outcomes, not only due to the imposition of a higher tax burden on originators, but also due to the situation of uncertainty and legal insecurity that it would create for transactions in this new market, unfortunately still quite common in our complex and outdated tax system, which faces serious difficulties in adapting to innovative arrangements.

Organized Markets and Other Trading Platforms

With regard to exchanges, over-the-counter markets, digital platforms and other RVE trading environments, the objective signaled by Bill No. 528/2021 of promoting interoperability between the SNRC and these various systems is commendable.

Nevertheless, it would be desirable for the same bill to also expressly indicate the entity responsible for authorizing and supervising the operation of such trading platforms, with the CVM being a natural and appropriate choice in this regard, given its recognized technical expertise in the regulation of exchanges and over-the-counter markets.

The importance of minimum regulation over platforms and trading environments cannot be overlooked, considering the large volumes projected for these markets and the fundamental role of these structures in ensuring transaction transparency, reducing information asymmetries and optimizing fair price discovery by facilitating the interaction between sellers and buyers.

Rio de Janeiro Green Exchange

Some venues have already recognized the relevance of the topic and have moved ahead. The most emblematic case is that of the municipality of Rio de Janeiro, which, through Decree No. 48.995/2021, initiated feasibility studies for attracting investments aimed at implementing exchanges or trading platforms for carbon credits and other sustainable assets.

The City of Rio holds a series of comparative advantages, having been the seat of global climate change governance since the Rio 92 Conference, hosting the headquarters of the largest oil and gas companies, regulatory agencies and public development banks, as well as possessing an entire scientific and educational infrastructure dedicated to research and the dissemination of knowledge that will be essential for overcoming the challenges of climate change and the energy transition.

Nothing prevents other cities and states of the federation from joining Rio’s initiative, working together in a network to accelerate the implementation and development of carbon credit markets and sustainable finance in Brazil. All are welcome to this new industrial revolution. Let us go together.