Carbon trading opens up new avenues for fraud

To mitigate fraud, the OJK is expected to issue regulations limiting the movement of fraudsters in carbon trading. — The Jakarta Post

THE Financial Services Authority (OJK), the regulator and supervisor of the financial services industry, issued on Aug 23 OJK Regulation No. 14/2023 on Carbon Trading Through the Carbon Exchange to serve as a guideline for market operators organising carbon trading.

This is one of the government’s concrete efforts to combat rising pollution, as well as its commitment to supporting the reduction of greenhouse gas (GHG) emissions in the Paris Agreement.

Several countries such as the United States, Canada, the European Union (EU), Australia and Japan have set up carbon markets.

The United States launched its carbon trading programme in 2009 as part of the Regional Greenhouse Initiative.

The programme contributed US$699mil in net economic value to the United States in 2018-2020 and a GHG emissions reduction of 46% over the last 12 years.

Carbon trading also occurs in the EU under the European Union Emission Trading Scheme (EU ETS), with 30 European countries participating.

In practice, the EU ETS employs the cap and trade scheme, in which the cap is a limit or quota on the level of GHG emissions companies produce, to be gradually reduced over time.

Since its launch in 2005, the EU ETS has contributed to a 43% reduction in industry emissions.

Despite effectively reducing GHG emissions, carbon trading has imploded in several countries worldwide: It has become a new type of financial crime.

Carbon trading is described as “largely a sham” in Australia because it causes US$1bil of money lost. Public money is being misdirected because there has been no discernible reduction in carbon emissions.

Could this happen in Indonesia? Without a doubt.

For starters, carbon trading does not offer tangible products, which is the same as investing in cryptocurrencies or non-fungible tokens.

As a vehicle for carbon trading, the carbon market is subject to abuse due to a lack of regulations, transparency and oversight, just like other financial markets.

Early stages

This situation will be aggravated because Indonesia is still in the early stages of development, leaving several opportunities open to fraud and other illegal activities.

First, measurements can be manipulated to claim more carbon units. There are several ways to accomplish this but misreporting is the easiest.

Measurements can be distorted by only using certain variables, picking samples that benefit the company or using particular assumptions in calculations.

With the government’s limited ability to monitor company measurements, the movement of fraudsters is likewise becoming more fluid.

To mitigate this risk, reports must be validated by an independent party before they are submitted to the OJK.

However, in several countries, independent parties often blunder. For example, Det Norske Veritas (Norway) and SGS (Switzerland) were suspended as carbon accounting organisations by the United Nations after they were found guilty of committing errors in validating carbon measurements.

This inaccuracy was caused by a lack of knowledge and the substantial risk inherent in carbon measurements.

Second, there is a substantial risk of tax fraud. Cross-border carbon trading is legal under OJK rules.

This implies that carbon products may be obtained from other countries.

In this way, there are new challenges in imposing value-added tax (VAT) because the VAT system is not necessarily the same between countries.

The disparities in the VAT system create a loophole for fraudsters to evade taxes.

This hole will be enormous, because carbon trading involves purchasing digital rights that do not have a physical form, making their movement tougher to detect than tangible goods.

To illustrate, trading businesses reportedly imported certain carbon units VAT-free from other countries before putting them in the Indonesian carbon market, after marking up the price with VAT.

The market participants who acquired the licences may claim the VAT back from the government but the suspected perpetrators allegedly never reported that VAT revenue and instead pocketed it.

This type of fraud is known as missing trader fraud. According to a Europol report, the EU lost almost €5bil (US$5.29bil) in potential taxes in 2008-2009 due to this type of crime.

Third, carbon trading encourages arms-length transactions to exist. This occurs when two or more related entities trade carbon units.

Price manipulation

They may manipulate the registered price of the trade to cut the overall tax bill. This could assist a corporation in generating as much profit as is feasible with low to no taxes.

For example, a parent company employs a subsidiary company to purchase carbon units in Indonesia to facilitate its emissions. The parent company then sets up a shell company in another country with lower tax rates.

Because the subsidiary company sells the carbon units to the shell company at low prices, its profits and taxes are low.

The shell company then resells the carbon units back to the parent company in Indonesia. These three companies then collectively pay less tax than they should.

Last but not least, Indonesia could even face fraud stemming from digital crimes.

Cybersecurity flaws

According to an Interpol report, 1.6 million carbon units from a Holcim Ltd account registered in Romania were stolen in 2010. Criminals had exploited cybersecurity flaws in carbon registry systems to steal carbon units.

The electronic nature of carbon units and associated registries leaves the carbon trading system particularly vulnerable.

Although unique serial numbers can identify carbon credits, this may be at risk because of a lack of regulatory monitoring, especially when stolen units are exchanged across borders.

To mitigate fraud, the OJK is expected to issue regulations limiting the movement of fraudsters in carbon trading.

Aside from that, stringent oversight is required of enterprises registered on the carbon market in Indonesia, both within and outside the country.

The OJK could collaborate with independent institutions to assist with monitoring the carbon exchange to meet initial goals. — The Jakarta Post/ANN

Muhammad Rafi Bakri is a finance staffer at the Supreme Audit Board. Muhammad Husaini Fikri is a civil and environmental engineer at Mitra Agung. The views expressed here are the writers’ own.

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