Carbon Credit x Insolvency: Connecting the Future with the Present

The authors are Sannidhi Chakrala and Reyyi Sameera, students at Indian Institute of Corporate Affairs, Gurgaon

Rewinding to the year 1997 when the Kyoto Protocol was in its full swing, the spotlight fell on carbon markets. The Protocol emphasized international participation in these markets to achieve climate change goals through lower carbon emissions. India being the 3rd biggest greenhouse gasses (“GHG”) emitter in the world, had in 2022 submitted an updated climate pledge to reduce the emissions.

Before one properly understands what a carbon market means, it is necessary to understand ‘carbon credits’.

Carbon Credits: Conceptual Introduction

When a company buys one carbon credit, they gain permission to generate one ton of CO2 emissions. For instance, suppose a country has set a national-level target for emitting a certain quantity of GHGs, it can impose predetermined limits (within the national limit) on companies within its territory for emitting GHGs to which the companies must abide. If a company is unable to comply with this limit during its operations, it can ‘buy’ extra allowance to emit gases from another company that was able to save some of its own allowance. This allowance is what is known as carbon credit, which works like a permission slip for emissions. Alternatively, there is another concept known as ‘carbon offsets’, which are tradable rights or certificates linked to activities that lower the amount of carbon dioxide in the atmosphere. By buying these certificates, a person or group can fund projects that fight climate change, instead of taking actions to lower their own carbon emissions. In this way, the certificates offset the buyer’s CO2 emissions with an equal amount of CO2 reductions elsewhere. These measures monetarily incentivise persons to save on GHG emissions, and such saving is in the form of a tradable credit.

Carbon credits and offsets can be traded in the carbon market just like shares, debentures, etc. in the open market where both companies and individuals can trade them.

How Does This Work?

The actual aim of this system is achieved through something known as the ‘Cap and Trade system’. This method enables the regulator/government to lower the pollution limits in a phased manner (capping), and allow the entities to trade their carbon credits/offsets with others. The motive behind the cap-and-trade system is to gradually wean the pollutant companies off their environmentally unsustainable ways and encourage them to pursue alternate, healthier means of conducting their business operations. This strategy doubly incentivises the companies to participate in the carbon market. First, they can spend money on extra credits if their emissions exceed the cap. Second, they can make money by reducing their emissions and selling their excess allowances.

Illustration: A country has set an overall maximum limit of 1 billion tons of CO2 emission per year. To achieve this, it imposed an industry-specific limit of 5,00,000 tons. Following the cap-and-trade strategy, it would allow emission of 5,00,000 tons of CO2 in a staged manner. Gradually, it would start reducing (capping) this limit, to say 3,50,000 tons of CO2 as per the prevailing cap then. Resultantly, corporations that are unable to comply with their respective limits of emission, would feel the need to buy extra carbon credits from other companies.

India’s Commitment

In November 2021 during the COP26, India announced its target to achieve net zero emissions by 2070. India has promised to reduce the “emissions intensity” of its GDP to 45% below its 2005 levels. In December 2022, the Energy Conservation (Amendment) Bill was passed by the Parliament, and is currently awaiting Presidential assent. It amends the Energy Conservation Act, 2001 to empower the Central Government to specify a Carbon Credit Trading Scheme.

Rolling out the Carbon Credit Trading Scheme, 2023

On 28th June 2023, the Ministry of Power, Government of India, notified the Carbon Credit Trading Scheme 2023. This scheme purports to open gates for the first-ever carbon markets in India. It incorporates the offset markets in energy efficiency and renewable energy that currently operate in India. The market will be driven by setting GHG emission intensity reduction targets in line with India’s Nationally Determined Contributions (“NDCs”) for selected entities. The certificates can only be issued by the Indian government or agencies it authorises. The Indian government would notify the industry/industries to which the scheme shall apply. Non-obligated entities (entities exempted from the scheme) may also participate in this scheme and comply voluntarily.

The Bureau of Energy Efficiency will be the administrator and authority responsible for issuing carbon credits. The Central Electricity Regulatory Commission will regulate the trading of carbon credits, while the POSOCO (Power System Operation Corporation) will maintain a central register of obligated entities and record all trading transactions.

Carbon Credits and the IBC: A Futuristic Angle to the Code

The Insolvency and Bankruptcy Code, 2016 (“IBC”) was introduced with one of its main objectives being the development of the corporate bond market. But this makes one wonder as to what happens when a company defaults in the payment of carbon bonds.

Before the corporate insolvency resolution process against a company is triggered under the IBC, the Adjudicating Authority (NCLT) has to determine the existence of a debt. To determine a debt, it must be checked if there is a liability or obligation of the company in respect of a claim which is due to any person.

Debt includes a financial and an operational debt. According to the inclusive definition of Section 3(11), the buyer of the carbon bond has a liability or obligation to pay the agreed consideration to the seller, and defaulting on such payment leads to the creation of a debt. According to Section 3(12), default means:

“non-payment of debt when whole or part or installment of the amount of debt has become due and payable and is not paid by the Corporate Debtor” (defaulting company). 

From this definition, it can be inferred that non-payment of money owed to the seller of a carbon bond will constitute a default and such seller shall be a creditor. The next question is which type of creditor shall such a seller qualify as? 

In Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited vs. Axis Bank Limited., the Supreme Court observed that for a debt to become ‘financial debt’, the basic elements are that it ought to be a disbursal against the consideration for the time value of money. A carbon credit transaction is merely a sale agreement as the selling entity disposes of its carbon credits to the purchasing entity for a ‘price’, which is paid off as consideration by the latter. There is no ‘time value of money’ and thus, it does not amount to a financial debt. This is not to be confused with a typical bond which is a debt-instrument qualifying as financial debt. 

The carbon bonds cannot also fall under the category of operational debt as there is no provision of goods or services between the parties. The Supreme Court in the case of M/s Consolidated Construction Consortium Limited v. M/s Hitro Energy Solutions Private Limited., has interpreted the definition of ‘Operational debt’ under Section 5(21) to mean a claim in respect of provision of goods and services. The requirement therefore must bear a nexus with the provision of goods or services, without specifying who is to be the supplier or the receiver. The operational debt, according to the Bankruptcy Law Committee Report, “is in relation to operational requirements of an entity”. 

 Since carbon bonds do not satisfy the criteria of both financial or operational debt, they shall ostensibly fall under the compass of ‘remaining debts and dues’ as mentioned in Section 53(1)(f). These debts are not described anywhere in the Code. The legislative lacuna and absence of any ruling/observation of the Courts and Tribunals with respect to ‘remaining debts and dues’ make it a solid ground for presuming carbon bonds as ‘remaining debts and dues’.

Authors’ Remarks and Suggestions

Under Section 53 of the code, the IBC has envisaged a mechanism called the ‘waterfall mechanism’ where the proceeds of the liquidation estate of the corporate debtor are distributed among its creditors and other stakeholders in a hierarchy. Since carbon bond sellers come under the umbrella of ‘other creditors’, they rank very low in the waterfall. 

Such marginal placement of carbon bond sellers in the waterfall will leave them with little to no recovery. Another ramification is the impact of this provision on the uncommenced carbon credit market in India. This creates a situation of distrust in the upcoming carbon credit market which might result in the fall of bond prices. Fall in prices means a lower incentive to the companies participating in the market which can lead to passableness amongst them. The absence of protection for ‘other creditors’ implicitly affects carbon bond sellers leading to the early demise of the 2023 scheme. Recognising this, the authors suggest that there is a need for raising the position of carbon bond sellers in the waterfall to promote healthy trading in these instruments, and most importantly because there is no planet B. 

What is interesting about these credits is also that they can be a rather potent means of discharging creditors’ dues, both during the CIRP and liquidation. This is because the credits form a part of the asset corpus of the company which could maximise the value of the assets and consequentially, improve the chances of revival of the corporate debtor, or at least increase recovery rates of its creditors during liquidation. Thus, carbon credits can be seen as an excellent incentive from the government for companies to be environmentally diligent and accountable, making them an opportunity worth exploiting.

Conclusion

To sum up, the authors have attempted to highlight the imminent emergence of the carbon market in India, a country which emits a whopping 3.9 billion metric tons of CO2. This is a new lease of life. The carbon-credit market in India is at its nascent stage, and a lot is in the pipeline for the government to mull over and implement. Assuming that the market takes its flight in India, the gates to newer opportunities for investment open up. At the same time, these opportunities (carbon-credits), if used judiciously, will not only save the environment but also help companies expand their asset pool should they ever go insolvent.