A Clean Break: China and the Clean Development Mechanism

China's authorities are acutely aware of the country's environmental challenges and its dependence on energy imports. An increasingly complex backdrop of policy and investment considerations is making it an ever greater challenge for companies and planners to build a modern, clean and integrated energy infrastructure.

Officials and business leaders recognise that one opportunity to achieve this goal is by attracting investment through the Kyoto Protocol, the international treaty that sets targets for reductions in greenhouse gas emissions. Kyoto Protocol gives industrial companies in China a reason to team up with foreign companies. The protocol's Clean Development Mechanism (CDM) allows investors in developed markets to offset their excess emissions by funding carbon reduction initiatives in emerging economies.

China's size and its status as a developing economy give it potential to play an enormous role in the emerging carbon market. As of May 2009, more than 500 CDM projects in China were registered with the United Nations. These include a range of initiatives, from improving processes at existing power and industrial facilities, to greenfield investments in renewables projects.

The enthusiasm for CDM investments in China is understandable given the growth in industrial output and the potential to improve environmental performance. However, investors in China can face challenges in producing accurate financial analysis to project a target rate of return and a suitable contractual basis for the investment. The reason for this is that carbon credits, or Certified Emission Reductions (CERs), are only applicable to projects that may not be commercially viable, in other words, to turn an uneconomic project into an economic one.

"The Chinese government has set clear targets for renewable energy production and energy efficiency, so a key issue going forward will be demonstrating that CDM schemes are additional, in order to qualify," says Matthew Walker, head of KPMG's Global Infrastructure and Projects Group in China. "There are also questions around what will happen after the commitments required under the Kyoto Protocol end in 2012." For tax purposes, CERs are widely defined as intangible non-produced assets, but the way they are traded differs in different jurisdictions. In China, there are implications in terms of transfer pricing and the applicability of Business Tax (BT) are still being clarified and KPMG China has advised many companies on the tax and due diligence issues relating to CDM investments.