1 introduction to legal and contractual aspects of cdm projects university of twente 21 march 2006...
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1
Introduction to Legal and Contractual Aspects of CDM
Projects
University of Twente 21 March 2006
Robert O’SullivanClimate Focus
2
Content
• Nature of Emissions Rights• Project Structuring• Basic legal documentation• Emission Reduction Purchase
Agreement• Scenario• Conclusions
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Nature of Emission Rights
4
Sources of emission rights
• International treaties• Regional, national and state legislation or
codes• Contracts • Common law and equity
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A taxonomy of what is traded• Units defined by the Kyoto Protocol:
– Assigned Amount Units (AAUs)– Certified Emission Reductions (CERs, tCERs, lCERs)– Emission Reduction Units (ERUs)– Removal Units (RMUs)
• Units defined by EU and national legislation:– EU Allowances– UK Allowances and Credits– Australian Abatement Certificates and Sequestration Rights– US SOx and NOx Allowances– Other
• Units defined by contracts:– Verified Emission Reductions (VERs)
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What are they?• Treatment and characteristics of units is more
important than whether or not they are ‘property’– Represent a right to be used as a compliance unit,
and emit one tonne of GHG in this context? – Transferable?– Ownership and possession by entities?– Clearly defined?– Irrevocable/indefeasible once issued?– Protection of 3rd party interests such as charges?
(restricted transfer on this basis?)– Treatment as financial services?– What conditions are imposed on any of the above?
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Contractual Rights• Emission Reductions
– ‘any right, interest, credit, entitlement, benefit or allowance to emit (present or future) arising from or in connection with any GHG Reduction by the Project and includes any right that may be created under any regulatory or legal regime as a result of the GHG Reductions whatsoever’
• Verified ERs– ERs which have been verified and certified by an
independent auditor, but have not been formally issued
• So what are ERs and VERs?– Not as secure as other emission units– Still of value
Creation of VERs and CERs
Creation of GHG Reductions Creation of GHG Reductions (measured in tonnes of CO2e)(measured in tonnes of CO2e)
Verification by DOEVerification by DOE
VERsVERs
Approval of Methodologies , Approval of Methodologies , approval of the project, approval of the project,
registrationregistration
CERsCERsCarbon Carbon ContractContract $$$$
Issuance by EB
Verification (by DOE)Verification (by DOE)
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So what is used in contracts?• Depends on what the project produces• Early World Bank CDM and JI contracts were
for VERs• Most CDM and JI contracts are for CERs and
ERUs• VER contracts tend to be restricted to the
voluntary market
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Project Structuring
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Project Structuring
• Initially the CDM anticipated direct investments into projects
• Today the most common form of a carbon contract is forward contract in the form of an Emission Reductions Purchase Agreement (ERPA)– An ERPA is a long term off-take agreement
• An increasing number of developers are also choosing to sell on the spot market
• Equity investments are being seen
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Equityinvestor
Bank
Technology Supplier
CER BuyerElectricity purchaserGovernment
€? CERs?
CERs€
€
Tech€
€
Local $€
eConstruction
O&MAccess
Affected peopleetc
CDM Project Structures
Approval
Parent Company
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Project Structuring Issues• Who owns the project, who generates the
CERs?– Establish initial CER ownership.
• Do other parties have an interest in the CERs?
• Who do I want as project partner?– Buyer: who to buy from– Seller: work through an intermediary, partner,
parent vs. directly with buyer?
• Who are the other Project Participants, and how are they involved?
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2 Case Studies:
• Landfill Projects generating ERs through capture of methane [and electricity generation]
• Generally public projects or public private partnerships
• Contractually flexible as different rights and obligations get easily separated [waste, land, landfill gas, CERs..]
• Example for necessary due diligence?
Ownership of Emission Reductions Project Example: Landfill Project I
MunicipalityMunicipality
Carbon ContractCarbon Contract Power Purchase A.Power Purchase A.
Owns the landOwns the land
Operates the landfillOperates the landfill
Collects the wasteCollects the waste
Sells the Electricity Sells the Electricity
Ownership of Emission Reductions: Project Example: Landfill Project II
Shareholder Shareholder AgreementAgreement
Power Power Purchase Purchase
AgreementAgreement
Grid Connection Grid Connection AgreementAgreement
Carbon Carbon ContractContract
Power Generation Power Generation LicenseLicense
Environmental Environmental LicenseLicense
Use of Land Use of Land AgreementAgreement
Landfill Gas Landfill Gas Transfer AgreementTransfer Agreement
Loan AgreementLoan Agreement
Construction Construction AgreementAgreement
Operations- and Operations- and Management Management AgreementAgreement
Landfill Concession Landfill Concession AgreementAgreement
Special Purpose Special Purpose CompanyCompany
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Basic Legal Documentation for
Carbon Projects
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Letter of Endorsement / No-Objection• Not required under Kyoto, but can be useful• Between Seller/Buyer and Host Country• Expression of Support / Non Objection• Evidence that the Host Country has been
informed and endorses the project • No binding endorsement which does not
create a right to any future approval
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Letter of Approval
• Required under Kyoto• Between the Host Country and the Project
Developer• But also: between the Buyer and an Annex I
country• Should be unconditional• Not clear whether the approval can be
withdrawn• Not clear how the Letter of Approval would
be treated in a dispute (double intl’/ natl’ nature, may grandfather rights)
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Letter of Intent / Exclusivity Agreement
• Between Seller and Buyer• Early legal document• Secures exclusivity• Cost recovery in case the project sponsor
unilaterally decides not to move forward with the negotiations
• Helps the project sponsor to obtain financing• Gives comfort to the Buyer to start spending
money on due diligence and contract drafting and negotiation
• May include some basic or key terms regarding the transaction that will appear in the ERPA
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CER Transfer Contracts
• Assignments– To equity holders– As part of a technology supply agreement
• Spot contracts– Standardized sale of CERs after issuance– Not project specific
• Forward contracts– Emission Reduction Purchase Agreements– Project specific
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Emission Reductions Purchase
Agreement
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ERPA: Purpose
• Record agreement
• Identify responsibilities
• Establish rights
• Manage Risk
Requires understanding of CDM rules, so tend to
be complex and difficult for unspecialized
lawyers
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“CERSPA” initiative
• Sponsored by Inter-American Investment Corporation
• Objective to produce a balanced CER Sale and Purchase Agreement template and explanatory Guidance Document– Open source, freely available – Contain more detailed information, plus
translations into a number of languages (Spanish, Portuguese, Chinese)
– Will be online soon at www.cerspa.org
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ERPA: Key Terms
• Conditions of effectiveness (conditions precedent)• Price
– Upfront payments?
• Volume and delivery• Listing as Project Participant and Communication
with EB• Damages/default• Monitoring and Verification• Governing Law, Costs, Force Majeure
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ERPA: Conditions of effectiveness• Cross effectiveness of other contracts
– Financial closure– Power purchase agreement
• Project Commissioning• Legal opinions • LoA, validation, registration
• Useful for buyer to be able to drop a non-performing project without default proceedings
• Useful for a seller to avoid liability if the project is not registered
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Price: Fixed Price
“The Buyer agrees to pay the Seller €X for each CER delivered to the registry account of the Buyer before 1st March, 2013”
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Price: Simple Indexed Price
“The Buyer agrees to pay the Seller X% of the Market Price of [an EU Allowance] [CER Spot Market Price] for each CER delivered into the registry account of the Buyer before 1st March 2013”
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Price: Simple Indexed Price with Floor and Ceiling
“The Buyer agrees to pay the Seller X% of the Market Price of an EU Allowance for each CER delivered into the registry account of the Buyer before 1st March 2013, except that irrespective of the Market Price of an EU Allowance the price paid for each CER shall never be greater than €X per CER and shall never be less than €X per CER”
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Price: Different Approaches in Practice
Market Price Simple Indexed PriceFixed Price Indexed Price with Floor & Ceiling
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Pricing: Factors that Affect the Starting Price• Bargaining• Demand• EUA price
– weather• EU policy developments• Timing of payments and delivery• Delivery “guarantees”/ remedies for under delivery• Who pays share of proceeds for EB admin expenses
($0.10/0.20 per CER) and other taxes• Risks
– Regulatory (baseline, additionality, registration) – Project (underlying project risks inc. technology, financing etc) – Host country (LoA) – Counter party (capitalization, experience)– Reputation (resettlement?)
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Upfront payments
• Generally only given if required to complete financing
• Security questions:– What kind? (L/C, parent guarantee, amortized
equity)
– How to get it? - Lenders probably won’t share it.
• Discount of CER price
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Volume and Delivery• When• Where (to an from)• How
– primary transfer (Art. 6/12)– secondary transfer (Art.17)– Communication rights with the EB
• How much– CDM: share of proceeds for adaptation (2%)
• Seniority (these issues won’t necessarily appear
together in the same clause)
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Fixed Annual Volume
“Before the 1st February each year the Seller agrees to deliver the first X CERs generated by the Project in the previous Year into the registry account nominated by the Buyer”
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Fixed total amount with “Acceleration”
• Combined with seniority and fixed total delivery obligations
“Before the 1st February each year the Seller agrees to deliver 100% of the CERs generated by the Project in the previous Year into the registry account nominated by the Buyer until a total of X CERs have been delivered”
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Percent: Total and Annual
“Before the 1st March 2008 the Seller agrees to deliver X% of the CERs generated by the Project before 1st January 2008 into the registry account of the Buyer”
“Before the 1st February each year the Seller agrees to deliver % X of the CERs generated by the Project in the previous Year into the registry account nominated by the Buyer”
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Volume and Delivery: Fixed vs. %
Default Amount
Fixed
Fixed with acceleration
% with Default Amount
Default Amount
Default Amount
Green may or may not be default depending on seniority
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Project Participants and Communication with EB• “Project Participant” is someone authorized to
participate in a CDM project pursuant to a LoA. • Listed in A.3 of the PDD• PPs have a number of rights re. a project including:
– Right to tell the EB where to send CERs when they are issued
• To be realized, PP must be named as communication focal point in modalities of communication
– Right to receive CERs when first issued by the EB– Right to receive notification and respond to any request
for review• “Party Involved” is an Annex I or non-Annex I party to
KP that has issued a LoA. They have a number of rights:– To be listed as a PP– To request a review at registration and issuance
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Project Participants and Communication with EB
• Issues that arise from this:– Who is listed as a PP?
• Most buyers want to be listed, so that they can get CERs directly from EB without going through art. 17 transfer.
– Who has communication rights with EB?• Most buyers want this as security that they will
receive their CERs• May be problematic for Seller if there are multiple
buyers• Joint communication is possible
– Make sure buyer is removed from being a PP after they have all their CERs
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Remedies: Delivery Default“If the Seller fails to deliver the Default Amounts the Buyer may;
Require the Seller to provide replacement CERs to the Buyer
Recover damages from the Seller
Require the Seller deliver additional CERs in the following Year in an amount equal to the difference between the amount delivered and the Default Amount
Terminate the Agreement and recover from the Seller any outstanding Advance Payment and other outstanding costs plus interest of X%.”
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Remedies: Payment default“In the event of a Payment Default interest payable to the Seller shall accrue to the Buyer at a fixed rate of X% per annum
If the Buyer has not remedied a Payment Default within the cure period, the Seller may recover damages from the Buyer
If the Buyer has not remedied a Payment Default within the cure period, the Seller may recover CERs already delivered to the Buyer but not paid for
If the Buyer has not remedied a Payment Default within the cure period, the Seller may terminate the agreement”
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Remedies: Intentional Breach• Normally have strict damages remedies for
defaults that are the result of intentional misconduct or gross negligence
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Remedies and Pricing
Market Price Simple Indexed PriceFixed Price Indexed Price with Floor & Ceiling
Default Default
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Force Majeure
• “Events beyond the control of a party”• Absolves an affected party from liability re.
obligations affected by a FM event (e.g. delivery, payment)
• Issue of what is included/excluded– EB decisions?– Biological processes?– Wind/water availability?
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Elements of Risk in Carbon DealsKey Issues:
– Market/Price Risk– Project Risk
• Finance, Approvals, Construction, Production• Has an impact on:
– Existence of Project– Therefore existence and production of CERs
• Needs management for the long term– Kyoto Protocol Risk
• Host Country Approval, Compliance, Eligibility, Transfer• Has an impact on:
– Existence and compliance of CERs/ERUs– Price
• Needs management for the long term
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Risk Allocation
• Principle: Assign risk to the party best able to bear it
• Investors/creditors/seller assume most project risks
• Buyer or Seller take Kyoto Protocol related risks
• Market risk is often shared
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• Market/Price risk:– Selling/purchasing CERs of different seniority– Flexible pricing– Option contracts (put or call)
• Kyoto risk: – Host country agreement or letter of approval– Using approved methodologies– Entering into an ERPA after project registration– Securing the right to communicate with the EB– Obtaining Host Country and Annex I country approval
(+authorization)
Risk Mitigation Tools
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• Project and delivery risk– Ensure management and operational capacity of the
counterpart – Secure stable financing of the project– Ensure resource availability– Ensure legal compliance – Using conservative CER projections– Sell from a pool – Ensure the senior right to the CERs (buyer)– Establish reporting obligations (buyer)
• Seller payment/receipt of CER risks– Credit check– Alternative registries/delivery = issuance– Escrow agent (see CERSPA guidance document)
Risk Mitigation Tools
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Scenario
• Just agree on basic terms that will be carried over to the ERPA
• No need for “legal” drafting
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Conclusions
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Lessons Learned
• The Carbon Prices do not have a big impact on IRRs of Energy Projects
• High transaction costs, but they are coming down• Not all countries welcome CDM/JI investments• Rulings and interpretations of the international regulator
often not predicable and ambiguous• We are running out of time
BUT:
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Lessons Learned
• Additional Income Stream – An ERPA secures an additional income stream for the project
• Additional Environmental Benefits – An ERPA monetizes the global environmental value of a project
• Additional Knowledge Generation – Developing an ERPA provides a learning experience to all parties
• Additional Due Diligence – An ERPA may lead to additional scrutiny and risks assessments of the project
• Forming Additional Partnerships – An ERPA broadens the stakeholder basis and the support for a project
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Summary
• Risk profiling of a project is key• Removal of risks comes at a price• Interests of the Parties need to be clear• Individually negotiated contracts are more
complicated but more stable than standardized agreements
• Harmonizing ERPA with lending agreements increases the robustness of both agreements
• Timing is key
