The EU Emissions Trading Scheme, launched in 2005, is by far the world's largest carbon market, comprising 73 percent of global value in 2008. For purposes of applying the value added tax ("VAT"), transfers of EU emissions allowances between taxable persons are treated as a supply of service, subject to VAT in the customer's jurisdiction.

However, only domestic transfers of EU allowances were subject to VAT, and transactions between parties located in different EU member states were exempted. As previously described in The Climate Report, this resulted in numerous instances of VAT "carousel fraud" over the past couple of years involving EU allowances.  

In a typical carousel fraud, a dishonest trader purchases EU allowances in one EU member state without having to pay VAT and then sells those allowances to local customers in another country with a VAT regime, such as France, Germany, the Netherlands, or Spain. Such local sales are subject to VAT (paid by the customer to the trader), which the trader is required to subsequently pay over to the relevant tax authorities, but never does. After a period of time, the trader disappears, never having remitted any VAT to the appropriate tax authority.

The European police agency, Europol, estimates that carousel fraud has cost governments throughout Europe up to €5 billion. In France, four persons suspected of carousel fraud were arrested in December 2009 with an estimated loss to the French Treasury that exceeded €150 million, and seven people were arrested in London in 2009 for alleged carousel fraud amounting to £38 million. In Norway, three people were charged in March 29, 2010, with alleged carousel fraud and money laundering amounting to 260 million Norwegian crowns ($43 million). On March 30, 2010, Spanish police arrested nine people and charged two more with avoiding €50 million in taxes linked to trading in carbon credits.

To prevent further VAT carousel fraud, several EU countries (France, the United Kingdom, and the Netherlands) have taken unilateral measures. In June 2009, the French tax authorities began treating carbon credits as "securities" and exempting carbon credit transactions from VAT, and UK tax authorities implemented a zero tax rate for carbon credit trades.

In July 2009, the Dutch tax authorities introduced a "reverse charge" mechanism for transactions relating to emission allowances, including local transactions. Under such a mechanism, the transfers remain subject to VAT, but the seller of credits/allowances does not charge the VAT. Instead, the buyer is required to directly remit the VAT on the sales price to the relevant tax authorities. Norway (which participates in the EU-ETS but is not a member of the EU) has adopted the same approach.

To harmonize the VAT treatment of EU allowance trading, and thus combat VAT carousel fraud, the EU Economic and Financial Affairs Council adopted EU Directive 2010.23 on March 16, 2010. The directive allows EU member states to implement (on an optional and temporary basis) a reverse charge mechanism for VAT on EU allowance transactions. The reverse charge mechanism will be effective until June 30, 2015.