I- Background of Carbon Credits:
Carbon Credits have their origins in the Kyoto Protocol of 1997, where they were proposed as a mechanism to combat climate change. The primary focus was on preventing, capturing, or reducing Greenhouse Gas (GHG) emissions. This is achieved through the conservation or reforestation of long-term forests, equivalent to not emitting or capturing one metric ton of CO2 in the environment.
The initiative aimed at having companies, emitting GHGs, pursue two objectives: reducing or offsetting GHG emissions by acquiring certified credits that guarantee environmental mitigation.
Some of the benefits sought through credit emissions included funding these projects. For example, in the case of forests, promoting the conservation of existing ones or encouraging the use of land for planting new forests that capture CO2. For other projects, such as renewable energy generation or those focusing on waste collection and use, these credits provide financial support that can be attractive to developers, not only for income but also for other non-financial benefits in project development.
II- Current Mechanism of Carbon Credits:
In the Central American region, given the potential for renewable energy generation, many developers and operators have chosen to qualify their projects with various carbon credits. In recent years, driven by the goals set in the United Nations Sustainable Development Goals, many countries emitting GHGs have agreed to reduce them. During this time, they seek to offset emissions with green bonds.
Among the most recognized bonds are Renewable Energy Certificates (RECs). These certificates represent 1000 kilowatt-hours of energy generation from renewable sources, involving a registration and certification process. Developers can subsequently sell these bonds in different markets where needed to offset GHGs.
III. Incentives in the Central American Region:
Also, as part of the incentives for renewable energy projects in the Central American region, the following are noteworthy:
Decree 52-2003, Renewable Energy Promotion Law, along with its regulations, stipulates incentives for renewable energy generators, including:
- Value Added Tax (VAT) Exemption: Exemption from Value Added Tax, import duties, charges, and consular fees on the import of machinery and equipment used exclusively for energy generation in the area where renewable energy projects are located.
- Income Tax (ISR) Exemption: Exemption from Income Tax (ISR) for ten (10) years from the start of delivery (FEI). This is granted only to individuals and legal entities directly developing renewable energy projects and only for the portion corresponding to that project.
- Ownership of Emission Reduction Certificates: Emission reduction certificates belong to project owners, allowing them to benefit from the commercialization of these certificates. Certificates are issued by the competent authority based on the quantification of emissions reduced or displaced by the project.
As expressed at the beginning of this article, on May 9, 1992, in New York, the United Nations Framework Convention on Climate Change was adopted, recognizing the reality of climate change. The objective was to stabilize greenhouse gas emissions. However, it was not until the Kyoto Protocol (KP), held on December 11, 1997, in Japan, and entered into force in February 2005, that the agreements made in ’92 were put into practice.
In this context, El Salvador, along with other signatory countries, provides economic incentives for private companies to contribute to environmental improvement and regulate emissions generated by their production processes. The right to emit carbon dioxide is considered a tradable good with a market-established price. A carbon bond represents the privilege of emitting one ton of carbon dioxide, helping mitigate greenhouse gas generation.
Similarly, sustainable bonds have been developed as a debt instrument traded on the El Salvador Stock Exchange (BVES) under the “Guide for Green, social, and sustainable bonds for the stock market in El Salvador,” published in August 2021. The requirements for issuance include compliance with the Securities Market Law of El Salvador, adherence to guiding standards, and obtaining the opinion of an accredited independent third party to verify compliance.
Projects that can be financed with these bonds include:
- Renewable energy generation.
- Energy efficiency.
- Water management.
- Clean transportation.
- Food security.
- Access to services and affordable housing.
Regarding carbon bonds, El Salvador is considered a voluntary market that has adopted the Clean Development Mechanism (CDM), one of the flexibility mechanisms of the KP, and is the only one including countries not subject to formal commitments to reduce greenhouse gas emissions.
Since the appearance of Renewable Energy Certificates (CER) (also known as carbon bonds) as a new economic element of a company’s net worth, questions have been raised about their legality and how they are recorded in the entity’s accounts. This is especially true for expenses generated during CDM project stages and criteria for CER classification in financial statements to facilitate their recording.
The marketing of CER is documented through the Emission Reduction Purchase Agreement (ERPA), a binding purchase agreement signed between buyers and sellers of carbon offset at market prices. Therefore, CER is a negotiable security representing an effective means for carbon trading and embodying goods with economic value and certainty, complying with literalness and autonomy to exercise the rights they incorporate.
The approval and registration process of a CDM project consists of two instances, including a national review conducted by a Designated National Authority (DNA) of the host country and an international instance by the CDM Executive Board (EB). A project wishing to participate in the CDM, before applying for registration with the EB/CDM, must obtain confirmation from the DNA of the CDM, which in El Salvador is the Ministry of Environment and Natural Resources (MARN). This confirmation ensures that the project contributes to sustainable development, and the parties participate voluntarily in the CDM. The DNA has established a guide consisting of the following steps:
- Preparation of project design documents.
- Approval by the Designated National Authority.
- Validation by an Operational Entity.
- Registration with the CDM Executive Board.
- Monitoring by the project proponent.
- Verification and certification of emissions by the Operational Entity.
- Issuance of Emission Reduction Certificates by the Executive Board.
Carbon market prices are governed by those offered by the World Bank and the Dutch Government, the main buyers of CER. These prices are influenced by demand behavior and the climate and energy policies of countries annexed to the Kyoto Protocol. Transaction cost intervention is a decisive factor in determining the carbon market price.
A- Framework of Applicable Incentives and Taxes
- Income Tax Law
Regarding the Income Tax Law, the costs of registering the CDM project that will be capitalized include project design, validation by an Operational Entity, and registration with the CDM Executive Board. These costs are amortized using the straight-line method in proportion to the CER or bonds received. These costs are non-deductible but necessary to prove that the CDM project has reduced greenhouse gas emissions. Likewise, the costs of verification and certification before obtaining carbon bonds and marketing expenses are not capitalized and are non-deductible from income tax. In terms of territoriality, income is declared from the country of origin, and concerning customs regulations, it is an export with domiciled income because the negotiation of CER sales originates from the country of origin.
The Law of Fiscal Incentives for the promotion of renewable energies in Electricity generation, in art. 3, section c, grants an income tax exemption. The income obtained from the sale of carbon bonds is not taxed.
- Law on the Transfer of Movable Property and the Provision of Services (VAT)
For VAT purposes, carbon bonds are considered intangible movable property, as stated in art. 5 of the law. The acquisition of carbon bonds incurred transaction costs for project registration with the EB/CDM, and the verification and certification of greenhouse gas reduction by an Operational Designated Entity (ODE), which issues a report before formally applying for bonds to the EB of the CDM. The EB then issues a CER or bond for each ton of CO2 reduction, considering their acquisition as a transaction on a gratuitous basis. The sale of carbon bonds does not constitute a taxable event for VAT purposes because, according to art. 5 of the law, the transfer of ownership for valuable consideration of tangible movable property triggers VAT, and CER is not within that category.
- Law of Fiscal Incentives for the promotion of renewable energies in electricity generation
This law aims to promote investment in projects using renewable resources for electricity generation. Individuals or legal entities using renewable energy sources will enjoy the following tax benefits:
Total exemption from all income taxes derived directly from the sale of “Certified Emission Reductions” (CER) under the Clean Development Mechanism (CDM) or similar carbon markets obtained by qualified and benefited projects under this Law.
To benefit from the benefits, the beneficiary must comply with the following conditions:
- The projects must be duly registered and certified under the modalities and procedures of the Clean Development Mechanism (CDM) of the Kyoto Protocol.
- The owners of projects qualified under this Law must include in their income tax declaration details of issued CERs, income obtained from their sale, and stating the names of buyers.
- Present a copy of the Certified Emission Reduction Purchase Agreement (ERPA) detailing the quantity of reductions sold and their sale price.
- Provide a certificate from the Ministry of Environment and Natural Resources stating the quantity of CER issued.
In November 2022, engineer Lucky Medina, Secretary of State for Natural Resources and Environment (Mi Ambiente), announced the implementation of “sovereign carbon credits” at the 2022 United Nations Climate Change Conference (COP27). These credits are aimed at building climate-resilient infrastructure, restoration, and recovery of ecosystems, and preserving protected areas.
However, it is essential to consider that Honduras is one of the countries with the lowest greenhouse gas emissions. According to the World Bank, the country produced approximately 22,390 tons of greenhouse gases in 2019, significantly lower than the emissions of other nations such as China with over 12 million tons, the United States with over 6 million, and India with over 3 million in the same year.
Currently, through the National Congress, a special law is being promoted for the regulation of these carbon transactions by the State. This is different from the existing voluntary carbon market in the country, which is permitted. This legislation is awaiting discussion in its third and final debate, according to the available information.
The proposed law, known as the “Special Law on Forest Carbon Transactions for Climate Justice,” aims to align Honduras with climate justice and create a mechanism to counter the adverse effects of climate change. It also aims to control greenhouse gas emissions by distributing benefits and resources equitably and fairly.
However, despite the non-approval of this bill, there are some general ideas about the types of projects that typically generate carbon credits and could be implemented in Honduras:
- Renewable Energy Projects: Implementing renewable energy sources such as wind parks, solar plants, or small hydroelectric plants can generate carbon credits by reducing dependence on fossil fuels and decreasing greenhouse gas emissions.
- Energy Efficiency Projects: Initiatives that enhance energy efficiency in buildings, industries, or processes can generate carbon credits by reducing energy consumption and associated emissions.
- Forestry Projects: Conservation and restoration of forests, as well as sustainable forest resource management, can generate carbon credits by contributing to carbon capture and storage.
- Waste Treatment Projects: Proper waste management, such as capturing and utilizing landfill gases, can be an area where carbon credits are generated by avoiding the release of methane, a potent greenhouse gas.
Next, we detail, under the “Law for the Promotion of Electricity Generation with Renewable Resources” (Decree No. 130-2013) and its amendments, which offer a series of benefits and tax incentives for projects generating electricity using national renewable resources. These projects will enjoy benefits such as:
- Exemption from sales tax: All equipment, materials, spare parts, and any goods and services directly related to the infrastructure necessary for electricity generation with national renewable resources are exempt from sales tax. This exemption applies to individuals and legal entities developing, constructing, or operating the project. The exemption period ends on the day of contract or operating license expiration, as applicable.
- Exemption from import taxes: All taxes, fees, tariffs, and import duties on equipment, materials, spare parts, and other items acquired locally or abroad and directly related to the infrastructure for electricity generation with renewable resources are exempt.
- Income tax exemption: Exemption from income tax, temporary solidarity contribution, net asset tax, capital gains tax, and all related income taxes for a period of 10 years, equivalent to 120 months from the date of the project’s commercial operation commencement.
In Nicaragua, there is no specific regulation governing carbon credits. However, various regulations, including the Constitution, allude to the Nicaraguan government’s duty to promote a healthy environment, emphasizing preservation and conservation through state policies.
The General Law of the Environment and Natural Resources, in Article 4, establishes eight guiding principles for the country’s economic and social development. One of these principles states, “It is the duty of the State and all inhabitants to protect natural resources and the environment, improve them, restore them, and seek to eliminate unsustainable production and consumption patterns.”
As part of environmental management, incentives are established as instruments (Article 11). Additionally, art. 42 of the same legal framework states, “The State will establish and implement a policy of incentives and economic benefits directed at those who contribute through investments to the protection, improvement, and restoration of the environment.” There is also the possibility of obtaining fiscal benefits for companies implementing programs aimed at capturing greenhouse gases to improve environmental quality.
Beyond matters related to carbon credits, Nicaragua, in general, provides fiscal incentives for renewable energies. Law 532, “Law for the Promotion of Electricity Generation with Renewable Sources,” published in the Official Gazette No. 130 on July 14, 2021, and amended by Law 1143, “Law Reforming Law No. 532, Law for the Promotion of Electricity Generation with Renewable Sources,” establishes that projects for generating energy from renewable sources and new expansions of ongoing projects with renewable sources can benefit from fiscal incentives until January 1, 2028. These fiscal benefits include:
- Exemption from Import Duties (DAI): No payment of import duties on equipment, materials, spare parts, and other items acquired locally or abroad related to the infrastructure necessary for electricity generation with renewable resources.
- Exemption from Value-Added Tax (IVA): No payment of value-added tax on equipment, materials, spare parts, and other items related to the infrastructure necessary for electricity generation with renewable resources.
- Exemption from Income Tax (IR): No payment of income tax, temporary solidarity contribution, net asset tax, capital gains tax, and all related income taxes for a period of 10 years, equivalent to 120 months from the date of the project’s commercial operation commencement.
- Exemption from Municipal Taxes: No payment of all current municipal taxes.
- Exemption from Taxes on Natural Resource Exploitation: No payment of taxes that may exist for the exploitation of natural resources.
- Exemption from Fiscal Stamp Tax: No payment of fiscal stamp taxes.
It is worth noting that despite the absence of specific regulations governing carbon credits and similar mechanisms, Nicaragua has national plans aimed at the country’s sustainable development, including initiatives related to climate variability and climate change:
- The implementation of a program for emissions reduction on the Caribbean coast is planned, aiming to reduce approximately 11 million tons of carbon dioxide from deforestation and degradation, ensuring sustainable forest management and ecosystem protection.
- Mitigation of 15 million tons of CO2 is expected through actions protecting, managing, conserving, and restoring forests and degraded areas.
While there are no specific regulations, Nicaragua has accepted general principles regarding transactions of carbon credits among individuals. These transactions are generally characterized as a binding purchase agreement signed between buyers and sellers of carbon offsets at market prices.
Ongoing Projects in Nicaragua:
- Bioweather: Project Description: The project, “Integrated Climate Action to Reduce Deforestation and Strengthen Resilience in the BOSAWÁS and Río San Juan Biosphere Reserves (BIOCLIMA),” is valued at US $115.7 million. It aims to capture 47.3 million tons of CO2 over 20 years, benefiting 51,100 direct beneficiaries and over 614,721 indirect beneficiaries. The Banco Centroamericano de Integración Económica (BCIE) serves as the accredited entity.
- Forest Carbon Cooperative Fund: Project Description: Nicaragua has received approval for the Forest Carbon Cooperative Fund. This initiative involves rural communities and indigenous peoples residing in the forests of the Caribbean Coast, including BOSAWAS and Indio Maíz. The project aims to reduce deforestation and forest degradation, resulting in the reduction of 11 million tons of carbon dioxide over five years. In return, positive incentives totaling US $55 million will be provided. This goal represents 50% of the Caribbean region’s potential for emissions reduction. The project will be executed through the ENDE-REDD+ program of MARENA, with assistance from the World Bank.
In any case, it is known that, in general terms, the Nicaraguan legal framework acknowledges historical transactions of carbon credits among private individuals. These transactions are summarized as binding purchase agreements signed between buyers and sellers of carbon offsets at market prices.
In Costa Rica, the concept of Carbon Credits, also known as UCCs (Costa Rican Carbon Units), is regulated by Forest Law No. 7575, its regulation No. 25721, and the Payment for Environmental Services (PSA) Procedure Manual. The institution responsible for administering these credits is the National Forestry Financing Fund, known by its acronym FONAFIFO.
This public institution, belonging to the Ministry of Environment and Energy, is established with the aim of benefiting small and medium-sized producers through financing. It utilizes credit mechanisms and other tools to promote reforestation and the recovery of areas that have lost forest cover. Legally, it is entrusted to be a funding collector for the Forest Services Payment Program, commonly known as PSA, which is closely linked to carbon certificates. FONAFIFO is responsible for establishing the technical criteria that form the basis for issuing forest certificates.
These bonds or certificates use the properties of individuals containing forest resources, standing trees that translate into carbon capture, as collateral. FONAFIFO calculates this based on the guidelines set by the United Nations Framework Convention on Climate Change, where each carbon credit is equivalent to one unit of sequestered carbon dioxide, and the price is fixed at $7.5 US dollars per unit.
According to the Directorate of Development and Commercialization of Environmental Services in FONAFIFO’s Proposals Department, in the descriptive document of the carbon credit forest project to offset greenhouse gas emissions (2022), the quantity of these credits is calculated as follows:
“The amount of carbon credits available annually for sale in the domestic market is called Net Benefit (BN). This is composed of removals minus emissions, removals in the reference scenario, in addition to leaks, if applicable. Thus, net removals are the amount of CO2 equivalent captured in a given period in the project area, subtracting losses from mortality and thinning, as well as other emissions.”
The institution relies on the sale of these credits and other means to finance the Environmental Services Payment Program, which provides private property owners with economic compensation for maintaining the forest and not intervening. Thanks to this, the country has transitioned from an economic system where maintaining the forest was not financially viable (leading to deforestation for pastureland) to one where landowners are paid to preserve and protect areas that provide environmental services.
It’s worth noting that, through this system, Costa Rica has achieved a visible recovery of forested areas, which are valuable both individually and collectively. For several years, the country has promoted various environmental policies, including biological corridors (Decree No. 40043-MINAE), providing legal protection to forest patches that connect as “citizen-protected” zones.
Carbon Credits in Costa Rica are characterized by being part of a completely voluntary carbon market. The benefits for companies acquiring them focus primarily on commercial or brand differentiation, using them as a means to offset the greenhouse gas emissions already produced.
These credits can be directly acquired through the FONAFIFO website, making their purchase easily accessible.