We have been buried in an avalanche of articles, newsstories, editorials and documentaries written on greenhouse gases and climate change. The UN’s Kyoto Protocol,1 the Intergovernmental Panel on Climate Change’s findings that global warming is anthropogenic, the European Union’s implementation of a carbon cap and trade system, the Supreme Court’s decision that U.S. EPA has authority to regulate carbon dioxide emissions,2 Al Gore’s “An Inconvenient Truth,” last fall’s email disclosures of climate change scientists trying to squelch opposing views,3 and December’s long-awaited but inconclusive Copenhagen summit, have generated a cottage industry of commentators, consultants, brokers, bureaucrats, developers, and, of course, law firm practice groups, around climate change. Perhaps it is not surprising that the leading U.S. legislation designed to address the dangers of global warming -- the Waxman-Markey bill passed by the House in June 20094 -- exceeds 1,200 pages.

By comparison, little has been written on climate change and white collar crime. This is certainly understandable. After all, thus far most participation of corporations in market-based cap and trade programs in the United States has been voluntary. Purchases of “carbon offsets” by individuals and organizations interested in reducing their “carbon footprints” have been on a voluntary basis. No federal laws currently limit emissions of carbon dioxide nor is there any carbon tax. While EPA has made a formal finding under the Clean Air Act that carbon dioxide endangers the public health and welfare, the agency has proposed but not yet adopted regulations to limit those emissions. Any regulations limiting emissions of carbon dioxide are likely to be delayed by court challenges. In the meantime, momentum for passage of climate change legislation by Congress has reportedly ebbed. With few legal standards in place to violate, consideration of fraud and white collar crime in connection with climate change seems premature. Why discuss this now?

In fact, there are compelling reasons. First is a concern about criminal activity already taking place. Markets for carbon emission allowances and carbon offsets are up and running, including in the European Union and in the United States through the Chicago Climate Exchange and the Regional Greenhouse Gas Initiative, among others. Many carbon transactions are also occurring over-the-counter outside any exchange. Globally, the carbon market is estimated to be worth well over one hundred billion dollars. Individual transactions often involve very large sums, and experience teaches that some level of fraud seems naturally to follow such large transactions. The newness of the markets and novelty of their subject matter make them especially susceptible to fraudulent schemes. While it is true that the voluntary nature of the markets in the U.S. means that legal obligations are contractual rather than based on statutes or regulations, the lack of government regulatory oversight can only increase the opportunity for those looking to make a quick fortune on an easy scam. Carbon market oversight mechanisms contained in pending legislation will be delayed as long as the legislation remains stalled. The experience of the European Union, which established a carbon trading market in 2004 that reportedly has been subjected to fraud, false statements and the involvement of organized crime, confirms the need to be alert to white collar crime. Clients can be victimized, and white collar lawyers should be counseling due care in entering carbon transactions.

Second is a potential gulf between theory and practice. In theory, a cap and trade program, in which carbon emission allowances and carbon credits are traded in a market, allows costs to be shifted to those that can achieve reductions in carbon dioxide emissions most cheaply, and thus is an efficient way to fight global warming. In practice, however, fraud and corruption can undermine the effectiveness of this approach. Again, the experience of the European Union serves as a caution, with many reports of “fraud,” “scams” and “profiteering.” The selection of approaches in the U.S. to combat climate change, and the fashioning of the details of those approaches, should be informed by these potential problems of implementation. Otherwise, policy choices may fall far short of objectives. The white collar bar can supply insights and experience needed to grapple with these very practical but fundamental issues.

Third is the scope of potential future criminal activity. Because it is perceived as the most costeffective alternative, there is still broad support for cap and trade systems relative to alternative systems for reducing greenhouse gases. Adoption of federal legislation or regulations mandating such a system would greatly expand the national and global markets for trading carbon allowances and carbon credits. The financial crisis and continuing recession demonstrate how even longstanding and long-regulated financial markets can be manipulated and are not sufficiently self-regulating to prevent near-catastrophic economic consequences. The nonprofit organization, Friends of the Earth, calls carbon trading “the new subprime.” What sort of investment strategies, financial instruments and counterparties can we expect in the carbon market? What new risk models, derivatives and trading mechanisms will we see? It is critical that legislators and regulators design the carbon market, and fashion adequate and effective oversight at the outset for the new market, to protect the public and our clients in the future.

The European Experience – Creation of the Carbon Trading Market

The European Union got a jump on the United States in establishing its mandatory cap-and-trade program, called the EU Emission Trading System. Unlike the U.S., European nations became signatories to the Kyoto Protocol, and the EUETS has been the principal vehicle for European companies to meet their obligations under Kyoto to reduce emissions of carbon dioxide and other greenhouse gases.5 The experience with the EUETS has been rocky and provides the U.S. with valuable lessons, including in the area of white collar crime.

The EU-ETS uses two mechanisms for cap and trade, each designed to reduce carbon emissions. First, the EU set an overall cap on total carbon emissions. Through its member nations, it issued “permits” to companies identified as major carbon emitters, and the permits in the aggregate equaled the total amount of the cap. The permits are known as “emission allowances” or “carbon allowances.” They are allocated for a defined time period and, most important, they are tradeable. A company that reduces its emissions below its allocated allowances for that time period can sell its unused allowances to a company that would otherwise exceed its own allowances. In each subsequent time period, the EU lowers the overall cap and allocates fewer allowances, thereby gradually reducing overall emissions.

The second mechanism used by the EU is the Clean Development Mechanism, a UN program under the Kyoto Protocol. The Clean Development Mechanism is a market-based so-called “flexible mechanism” that provides companies with an alternative to reducing their own carbon emissions. Under the CDM, projects are undertaken in developing countries that reduce or avoid the generation of carbon dioxide and other greenhouse gases. Examples of these projects include new hydroelectric facilities, solar projects, reforestation projects, and the like. The EU allows a European company that would otherwise exceed its own carbon allowances to offset this exceedance by, directly or indirectly, financing all or part of one of these carbon-offset projects. The process is implemented by assigning a “Certified Emission Reduction” credit, or CER, for each ton of carbon dioxide that the project will save. The CERs are tradable carbon credits, and the company buys the number of credits needed to offset its own emissions. In theory, the CDM lowers the costs for developed countries of reducing their carbon emissions and promotes economic efficiency, since a company is able to buy these carbon credits whenever doing so is cheaper than reducing the company’s carbon emissions at its own facilities in Europe. Environmentally, it does not matter where the carbon emissions are reduced or avoided – in a European or in a developing country --the environmental impact is the same. In addition, by encouraging these offset projects, the CDM also serves to promote sustainable development in developing nations.

The key to the CDM and carbon credits is the concept of “additionality.” A project is “additional” only if it would not be developed but for the company’s payment. Only projects that satisfy additionality are eligible for inclusion in the CDM. If additionality were not required, then the CDM would be counterproductive, undermining the goal of reducing carbon emissions; European companies can avoid having to reduce their own emissions by purchasing offsets, but without additionality there is no real offset since the projects would have been built anyway.

The European Experience – The New Carbon Markets Become Vehicles for Massive Fraud

The European approach illustrates how difficult it is to create a market system for reducing carbon emissions that is free of fraud and abuse. Relying on market mechanisms, and creating tradable instruments corresponding to both emission allowances and offset projects, the EU has encountered serious problems of implementation. Some of these problems relate to the initial design and administration of the carbon market. For example, for Phase I of the market, the overall emissions cap and allocated allowances were set so high that European nations and companies did not have to reduce their emissions to meet their targets. In fact, rather than a reduction, carbon emissions in Europe increased during this initial period, with certain industries reportedly receiving windfalls from the sale of unused allowances.6

Other problems fall squarely within the scope of white collar crime. For example, in July 2009, Her Majesty’s Revenue and Customs in the United Kingdom rather optimistically reported that it was not seeing an unusually high level of “carousel fraud” in connection with carbon credits. Carousel fraud consists of buying and importing high-value goods from another EU country so no Value Added Tax (VAT) is charged, selling the goods in a second EU country with VAT added to the price, and then keeping the VAT rather than paying it over to the government. Just one month later, however, in August 2009, seven individuals were arrested and twenty-seven locations searched by HM Revenue and Customs for carousel fraud involving carbon credits. The individuals allegedly traded large volumes of high-value carbon credits from overseas sources free of VAT, sold them to businesses in the UK charging VAT, but then did not pay the VAT to the government. The estimated amount of the fraud was approximately 38 million British pounds (approximately 62 million dollars).7

The fraud problem, from carousel fraud alone, has become giant. On December 9, 2009, Europol, the EU’s law enforcement agency, reported that carbon trading fraud has cost the EU governments the equivalent of $7.4 billion in lost tax revenue over eighteen months.8 Two days later, on December 11, 2009, the French government reportedly opened a criminal investigation of four additional individuals for carbon trading fraud estimated at 156 million Euros (approximately $230 million).9 On December 29, 2009, Belgian authorities arrested three more individuals for VAT fraud on carbon emissions permits. That alleged fraudulent scheme lasted several months and amounted to an estimated three million Euros.10 In December, the Danish government enacted a new law to try to counter the fraud problem in that country, and EU finance ministers met to discuss other proposals.11 According to the director of Europol, “These criminal activities endanger the credibility of the European Union emissiontrading system.”12

While VAT carousel fraud is a special problem to the EU, it suggests the nature and scope of criminal activity that can arise in carbon markets anywhere. Fraud has also reportedly plagued the Clean Development Mechanism and the purchase of carbon credits associated with offset projects. The fraud arises as a result of basic weaknesses in the market for carbon credits that has left it vulnerable to fraud and abuse. There is no reason to think that similar weaknesses are not present in the voluntary markets for carbon offsets currently in the United States.

These problems have become a focus of the European press. For example, after conducting a six-week investigation in early 2007, the Financial Times found “widespread failings in the new markets for greenhouse gases.”13 Specifically, the Financial Times reported cases of individuals and corporations buying “worthless credits” that yield no reductions in carbon emissions, brokers providing services of “questionable or no value,” large profits being made from carbon trading for actions that “would have [been] made anyway,” and companies and individuals spending millions on projects that “yield few if any environmental benefits.”14

Some of the problem consists of the most brazen fraud, including reports of “carbon cowboys” who sell non-existent carbon credits, sometimes multiple times.15 However, much of the problem is linked with lack of additionality – projects being included in the CDM that would have been built without the sale of carbon credits. When a project is registered under the CDM that would have been built anyway without funding from carbon credits, then a country and company in Europe are allowed to emit more carbon than their targets without causing any additional reduction of emissions on the ground where the project is located.16 There is no real offset, and the transaction generates what has been labeled as “fake” carbon credits.17

University researchers have found particularly strong evidence of this lack of additionality. For example, according to a University of California study, as of September 2008, 76% of all approved CDM projects were already completed and up and running at the time they were registered as CDM projects.18 It seems self-evident that a project that is already built does not need additional funding to be built. The study further reports that numerous project developers acknowledged that they would have built their projects without the funds provided under the CDM, and that deceptive project applications with forged and fraudulent documents and manipulated financial assessments are used to show that carbon credits are needed when in fact the projects are economical without the CDM subsidies.19 For instance, wind power projects in India were made to look uneconomical by omitting available tax credits. Other studies document hydroelectric power projects in China and India that were already being built without the CDM but which nevertheless were approved for CDM subsidies.20 Dr. David Victor, a carbon trading analyst at Stanford University, has found that between one-third and two-thirds of the carbon credits produced under the CDM from projects in developing countries do not reflect real reductions in carbon emissions.21 The violation of additionality “is undermining the effectiveness of the Kyoto Protocol.”22

Who Watches the Watchmen?23

These problems highlight the importance of verifying offset projects before they are included in the Clean Development Mechanism. The need was especially strong in light of the rapid growth of the market for carbon offsets. In 2006, the first year after the Kyoto Protocol became effective, approximately fifty carbon funds were trading CERs (the financial instruments corresponding to offset projects). While some sales were to companies seeking to offset their own carbon reduction requirements, there were also many brokers who recognized the opportunity for profits in trading the new commodity in carbon emissions. At the same time, private developers generated offset projects purportedly worth $30 billion. The Financial Times labeled the offset business as “a carbon gold rush.”24

By April 2007, there were over 60 firms offering carbon offsets and one fifth of all carbon credits traded in the EU were attributed to carbon offset projects.25 It was extremely easy for small companies to enter the market and set themselves up as carbon offset providers over the internet, but many of these companies were completely unfamiliar with accepted and required practices, including third-party verification of the projects.26 According to the Financial Times, many of the small brokers do not have projects verified by an independent third party.27 It is not surprising that in the absence of verification, the usefulness of projects would be overstated or even fictional.

UN officials confirm that project developers tend to overestimate the carbon credits that their projects will produce.28 Some of this is probably attributable to honest over-optimism about the projects, but some is simply exaggeration. As one analyst stated, “I would expect that about half of the credits would not come through in the end.”29

As it turns out, the weaknesses with verification are even broader than initially understood. The Kyoto Protocol requires countries to establish regulatory bodies, called Designated National Entities, to ensure that offset projects perform as proposed. However, since the DNEs are housed in the developing countries that receive funds for the offset projects, they lack incentives to enforce standards that might limit or delay the projects. Carbon projects are also supposed to be audited by independent third-party auditors. However, in November 2008, DNV, a Norwegian-based firm and then the single biggest auditor of carbon projects, was suspended for failures in performing its verifications. Less than one year later, in September 2009, SGS UK, another auditor, had its accreditation suspended by UN inspectors because it did not properly audit projects that were then approved for the CDM. Apparently, much of DNV’s caseload had shifted to SGS, which lacked the resources for the increased workload.30

There are several reasons why failures of verification and auditing are especially problematic in the carbon market compared to other commodities. First, many offset projects are located in very remote areas. This is particularly true of smaller projects more typical of the voluntary markets. It can be impractical for brokers or buyers of carbon credits to gather any information about the effectiveness or even the existence of these projects. Second, the “thing” underlying the trades is both amorphous and ubiquitous. Unlike other traded commodities, carbon dioxide and carbon dioxide emissions are everywhere, and the thing actually being traded is not the carbon dioxide itself but the absence of some estimated amount of carbon dioxide that is not being produced. As one Europol official explained,

It is clear that [carbon trading] fraudsters are fully aware of the potential that trading in intangible commodities has to further their ends. Such goods or services can be traded without the need to be physically moved or transported, which represents an obvious opportunity to frustrate Law Enforcement efforts to track and trace transactions.31

Third, while the EU and other established markets have registries to prevent emission savings associated with the same project from being counted more than once, the multiplicity of markets (and voluntary markets without registries) makes it easier for unscrupulous developers and brokers to double count or sell the same credits more than once. Fourth, with respect to additionality, determining when projects are truly additional versus when they would have been built anyway can be extremely difficult. Indeed, the International Emissions Trading Association, the carbon trading industry lobby group, acknowledges that it is “an almost impossible task.”32

An overarching issue is independence. The project verifiers are typically paid by the project developers. All parties to the paper transaction – the developer, the broker, the verifier and the company purchasing carbon credits to offset its own carbon emissions – benefit equally from the transaction regardless of the actual affect on reducing carbon emissions. To put it differently, none of the parties directly involved in the offset transaction appears to have an interest in policing the real environmental impact.

The American Experience

In the absence of federal action, a patchwork of state, regional and private groups have taken steps to establish their own market-based carbon emission reduction programs. Most notable in the northeast is the Regional Greenhouse Gas Initiative, or RGGI, consisting of ten northeastern and mid-Atlantic states. The ten states have capped their carbon emissions from the power sector and will require a ten percent reduction in emissions by 2018. The ten states issue emission allowances to regulated power plants, which can then trade the allowances throughout the region. A regional approach is also being pursued by states in the west under the Western Climate Initiative.

If Congress does not pass climate legislation, trading under state and regional programs may increase dramatically. California legislation, AB 32, mandates an economy-wide cap and trade program, and the Western Climate Initiative has developed the framework for a cap and trade program that would include seven western states and four Canadian provinces (encompassing approximately 80% of the Canadian economy). Other states may join the bandwagon.

The Chicago Climate Exchange (CCX) has established a voluntary carbon-trading market. Participation by corporations is voluntary, but by joining a corporation enters into a contract with CCX to reduce its emissions. Members can reduce their own emissions or purchase emission allowances, called Carbon Financial Instruments, from other members through CCX’s electronic trading platform. Offset projects are also traded through the CCX.

There are also over-the-counter purchases of carbon credits by institutions and individuals interested in reducing their carbon footprints. There is no reason to think that the fraud that has plagued the EU does not also occur in the carbon trading markets here. To the contrary, if anything, oversight is supposedly tighter for the EU-ETS. Not surprisingly, there is a growing number of reports of scams in the U.S. involving carbon trading, such as the Academy Awards buying carbon credits corresponding to a supposed offset project at an Arkansas landfill that investigators subsequently found would have been undertaken without the offset funding,33 carbon credits being provided for preserving existing forests that were not at risk of destruction,34 and landfills that earn carbon credits for collecting methane even though they had been collecting and selling the methane for more than a decade.35

Recognizing “the serious potential for fraud,” in January 2008 ten states requested that the Federal Trade Commission tighten its restrictions on carbon offset providers.36 The FTC agreed to investigate the offset business for, among other things, “double selling” and lack of additionality.37 More recently, Kroll and Deloitte summed up the risks associated with carbon trading markets, calling them “a fraudster’s dream come true” and “the white collar crime of the future.”38

Thus, white collar crime is an immediate problem in connection with greenhouse gas reduction programs. It is a problem that will grow as carbon trading becomes more widespread. The white collar bar should counsel clients to help them avoid becoming victims. Policy-makers would be well served to work with the white collar bar to fashion solutions that minimize the risk of criminal activity undermining the carbon markets and efforts to address the threat of global warming.