On 20 June 2016, the South African National Treasury published draft Carbon Offsets Regulations (“draft regulations”), intended as a component of the proposed carbon tax. The draft regulations mark the next step in the process of bringing the carbon tax into operation by early 2017. Treasury is also expected to publish a second draft of the Carbon Tax Bill in August 2016, in time to submit the Bill to Parliament once its proceedings resume after the recess aimed at accommodating the municipal elections. The draft regulations have been widely anticipated by industries that will be subject to the carbon tax and the local carbon market. It is expected that the local carbon market will experience a revival as a result of the inclusion of offsets as a means to comply with part of a carbon tax liability.

The Explanatory Note to the draft regulations (“Explanatory Note”) sets out the rationale for the inclusion of offsets in the carbon tax scheme. This effectively creates the potential for hybrid carbon tax/emissions-trading activities, as opposed to a pure carbon tax, and also sets out some international context. The design of the carbon tax follows that of carbon pricing schemes internationally, including the European Union Emissions Trading Scheme (“EU ETS”), and initiatives in California and the Canadian province of Alberta. The carbon offsets system is intended to serve a dual purpose, as:

• a flexibility mechanism that will enable industry to deliver least-cost mitigation, with a view to lowering their carbon tax liability; and
• a means of incentivising mitigation in sectors or activities that are not directly covered by the tax and/or benefiting from other government incentives, especially transport, agriculture forestry and other land use and waste management.

An issue requiring in-depth analysis is the scope of the rule in the draft regulations that states that taxpayers may derive offsets from projects in respect of activities that are not subject to the carbon tax. This leaves open the possibility that taxpayers who conduct a combination of both carbon tax liable activities and non-carbon tax liable activities being able to generate offsets from those activities that are not subject to the carbon tax.

Given that the draft regulations have been in the making for some time and were preceded by a number of rounds of stakeholder consultation, which excavated some of the detail required for a viable and credible offsetting component to the carbon tax scheme, it is interesting to note that some of the more important elements of the consultation process have been addressed. The following is a preliminary reflection on some of these:

• The draft regulations continue to exclude offsets generated under the Renewable Energy Independent Power Producer Procurement (“REIPPP”) Programme from eligibility for use against a carbon tax liability. This is consistent with Treasury’s previously stated position that REIPPP Programme projects already receive a benefit from government in the form of committed Power Purchase Agreements (“PPAs”) supported by a cost-premium paid for their renewable energy, and that granting carbon tax eligibility to carbon offsets generated by REIPPP Programme projects will amount to a doubling of benefits to such projects. In contrast to this position, strong arguments have been made (for eg, by renewable energy industry groups) that REIPPP Programme projects are subjected to a competitive bidding process and, consequently, securing a PPA under the REIPPP cannot be regarded as a benefit. These groups argue that granting carbon tax eligibility to carbon offsets generated by REIPPP Programme projects will not, therefore, amount to a double benefit. In recognition of this debate, the press release accompanying the draft regulations indicates that this blanket exclusion could be revaluated after the issue is considered in more detail in discussions between Treasury and the Independent Power Producer office of the Department of Energy.
• Draft regulation 4(3), limiting use of offsets in the carbon tax scheme, provides: “A taxpayer conducting an activity in respect of the destruction of industrial gases trifluoromethane (HFC-23) and nitrous oxide (N2O) from adipic acid production, may not receive the allowance in respect of an offset in respect of that activity” (our emphasis). This text concludes a longstanding debate between Treasury and industries that have the potential to generate carbon offsets from the mitigation of industrial gas emissions. The limitation of the exclusion for use in the carbon tax scheme, in draft regulation 4(3), only to offsets generated by adipic acid projects, is an important concession by Treasury that brings the South African scheme in line with the practice in the EU ETS, where offsets from adipic acid projects are ineligible for use, unlike those from non-adipic acid projects, which are eligible.
• The draft regulations deal with three time periods during which offsets are generated. Each period has different consequences for the use of the offsets under the carbon tax:
• Offsets generated after 1 January 2017 (the intended date of implementation of the carbon tax scheme) by a project activity registered after this date have full eligibility for use in the carbon tax scheme.
• Offsets in existence prior to 1 January 2017 may only be used in the carbon tax scheme until 31 December 2017.
• Offsets not in existence prior to 1 January 2017, but which are generated by project activities that were registered before 1 January 2017, may be used in the carbon tax scheme for a period of six months after the offsets came into existence.

The importance of the draft regulations for the future development of a vibrant South African carbon market cannot be underestimated. Current estimates are that the implementation of the carbon tax, with a fully operational carbon offsets allowance, will create an annual demand of approximately 20-million tonnes of carbon dioxide equivalent in the local market. This has the potential to insulate the domestic market from the currently dysfunctional international market by creating a local demand, and will therefore create a price signal for the purchase and sale of carbon offsets generated locally under the abovementioned standards. Prevailing market wisdom is that if the cost of generating such offsets is below the level of carbon tax liability, it will be attractive for tax liable entities to purchase such offsets in order to comply with part of an overall tax liability.

The closing date for submitting written comments on the draft regulations is 29 July 2016. These should be submitted to offsetcomments@treasury.gov.za, while questions for clarification can be directed to Dr Memory Machingambi at Memory.Machingambi@treasury.gov.za. A copy of the draft regulations is available here.

For more information, or if you require assistance in drafting comments on the draft regulations, please contact: Andrew Gilder, climate change and carbon markets specialist, environmental, agilder@ENSafrica.com, +27 82 382 6279; Mansoor Parker, executive, tax, mparker@ENSafrica.com, +27 83 680 2074; or Olivia Rumble, climate change and carbon markets specialist, environmental, orumble@ENSafrica.com, +27 82 788 0864