Legal Aspects of the Emission Reduction Purchase Agreement

1. Legal Aspects of the Emission Reduction Purchase Agreement CDM Financial Mechanism Training Course Climate Change Information Center Manila Observatory

2. “The Kyoto Protocol is not yet in force, the exact nature of domestic legal regimes governing reductions in emissions of Greenhouse Gases (GHGs) is (in most countries) still not known, there is no regulated scheme for transactions involving project based emission reductions and the market for such emission reductions (ERs) is not yet liquid. As such, the proper drafting of contracts for the transfer of ERs from one party to another party is vitally important.” IETA Discussion Paper 02-02 “Carbon Contracts Cornerstones”

3. Legal Context Ownership of Atmosphere: The Property Rights Issues • Atmosphere is a global common property • Atmosphere is a scarce resource • Utilization of the resource is skewed • New area of law that is unique and cross-jurisdictional in nature combining principles of public international law • Limitation of property regime definition • Long-term Emissions Regime issues

4. Legal Context The Role of Carbon Contracts • Provide a documented framework within which “emission rights” are bought, sold, acquired, transferred • Negotiated outcomes that will determine the allocation of risk and which will be critical in determining issue of price and bankability of project against which to raise further debt/equity/financing

5. Legal Context Nature of Carbon Contracts • Springs out of current efforts by Government and institutions developing contracts with clear pricing and risk profiles • Standard contracts will increase with standardized rights (CERs, AAUs)

6. Legal Context Ownership of Emission Reductions (ERs) and Legal Process of Transfer • Emission Reduction (ER) has an international origin under Kyoto Protocol • ER is a product of a CDM/JI Project • If Project is “legal” in domestic jurisdiction and ERs are “certified” and “verified” by authorized agents, then ERs are legal commodities • Distribution of ERs is a contract among stakeholders • Rules pertaining to export of a legal commodity in a country are applicable for transfer to an international agent

7. Legal Context Would specific law be needed in Non-Annex I Countries? ERs are new commodities, but not different. Therefore, present laws/rules may be applicable • State/Central government laws/rules • Project clearances • Project contracts/agreements (complex structure) However, the existing structure is complex, thereby creating high transaction costs.

8. Legal Context Domestic Incorporation of CDM For ERs , new rules may have to be added. Question is whether these can be handled within existing machinery or is a new institution needed (e.g. Independent CDM Authority) Policy guidelines will be useful in developing contracts, whether standardized or as contracted individually.

9. What is an ERPA? • Emission Reduction Purchase Agreement • Carbon Purchase Agreement - this is the contract between the carbon buyer and seller. • Purpose • Record agreement • Identify responsibilities • Establish rights • Manage risk

10. Legal Agreements for PCF Projects Host Country 3. Host Country Agreement National Legislative Framework / Agreement / Authorization 1. Letter of Project Endorsement 2. Letter of Intent PCF Trustee Project Entity 4. Emission Reductions Purchase Agreement

11. Basic framework under PCF Emission Reductions Purchase Agreement Purchase Price PCF Trustee Project Entity Exclusive Right of Certification and Verification of purchased ERs (ERs) Transfer of ERs

12. Main Elements of Emission Reductions Purchase Agreement (ERPA) • Purchase of ERs from the Project Entity / Payment for achieving ERs • Arrangement for initial and periodical verification, validation and certification. • Transfer of ERs

13. Key Contractual Provisions • Parties • Those with a potential claim to any ERs and possibly others who have key obligations or responsibilities in relation to the project (e.g. host government) • Private contracts – public participation? • If State is a party, special provisions will apply for the contract’s enforceability (e.g. “The State may not be sued without its consent.” under Section 3, Article XVI, 1987 Philippine Constitution)

14. Key Contractual Provisions • Parties “Contracts take effect only between the parties, their assigns and heirs, except where the rights and obligations arising from the contracts are not transmissible by their nature, or by stipulation or by provisions of law. x x x” (Article 1311, Civil Code of the Philippines)

15. Key Contractual Provisions • Recitals or Whereas Clauses • Definition of Terms • Vital to contain clear and concise definition of what exactly is being bought or sold • Does it give rise to a legislative right or contractual right? Must clearly identify the nature and scope of the rights as they have been agreed between the parties.

16. What is an ER? • “Emission Reductions or “ERs” means reduction in emissions of Greenhouse Gases generated by the Project and monitored in accordance with the Monitoring Plan and the relevant guidelines, modalities and procedures under the regulatory framework of the UNFCCC and/or the Kyoto Protocol, and in absence thereof any other regulatory framework as agreed between the Parties.” (Definition –PCF) • “Emission Reductions” or “ERs” means the GHG Reductions achieved by a Project and verified by an Independent Third Party or an Operational Entity as meeting a set of standards consistent with those contained in the regulatory framework of the UNFCCC and/or the Kyoto Protocol.” (Definition –CDCF)

17. Key Contractual Provisions • Definition of Terms • Baseline: level of GHG emissions from which GHG ERs resulting from the project activity are to be measured • Greenhouse Gas: maybe as defined in the Kyoto Protocol • Unit of Measurement: specify the measurement in which the emissions are to be acquired • Kyoto Protocol: should include any amendments made to it and decisions

18. Key Contractual Provisions • Sale and Purchase • Define and specify the number and the vintage (i.e. year in which the Project or source activities will reduce GHG emissions that are the basis for the ERs) of ERs arising from the project activity to be sold to the Buyer • Specify clearly what rights the parties have to future ERs or to other environmental benefits or values resulting from the project.

19. Key Contractual Provisions • Delivery • Necessary to determine when the defined rights will accrue to the Buyer • Timing both of accrual and delivery is highly important to the potential value of ER and the Buyer’s capacity to sell either the base product or a derivative • Determine whether to set out a delivery date or rely on a trigger event for the rights to accrue

20. Key Contractual Provisions • Delivery Mechanism and Transfer of Title • The legal mechanism used to transfer the ERs will depend on the type of rights being transferred • The contract must specify the point at which title is transferred. Possibilities include upon execution of the contract, payment being made, or upon change of ownership being entered on a register. • If involve future delivery of ERs, contract must specify the mechanism needed to ensure that delivery occurs, taking into account possible changes in legislation.

21. Key Contractual Provisions • Shortfall or Failure to Deliver • Need for appropriate arrangements to ensure that the specified quantity of ERs is indeed delivered • If CERs not created/transferred, giving rise to non-performance of obligations, appropriate remedies should be considered, particularly in the event that the ER rights never materialize. • Should have an option to manage shortfalls through an number of mechanisms (e.g.physical replacement of the volume of the shortfall of ERs from other projects or future years, repayments) • Appropriate indemnities should be incorporated

22. Key Contractual Provisions • Evidencing the validity of the ERs being contracted • Documentation showing that the emission reductions, the subject of the contract, actually occurred • Must be clear as to who is responsible for carrying out initial and ongoing validation of the project and for the associated costs. • Whether third party verification is required should likewise be specified, including an outline of the criteria for this

23. Key Contractual Provisions • Evidencing the validity of the ERs being contracted • At the moment, the evidentiary burden is usually discharged via a demonstration that, when measured against an appropriate baseline, the particular project activity has delivered real and measurable reductions of GHG emissions

24. Key Contractual Provisions • Baseline Measurement, Verification and Certification • Clauses should ensure that there is an appropriate baseline measurement and there is a procedure for independent verification of the practical emission reduction process • May need to include conditions for a verification report • May need to include definitions for such terms like real reductions, measurable reductions, surplus reductions, additionality • Might be advisable to set out appendices to the contract as to third party verification

25. Key Contractual Provisions • Changes to the Scientific Processes for Quantifying and Verifying ERs • To take account of scientific uncertainties, the contract could include a “reopener” clause permitting the recalculation of tonnes if different numbers are adopted by relevant authorities • Specify measurement and assurance standards that are to be used.

26. Key Contractual Provisions • Risk • Elements of Risk in Carbon Deals • Finance, Approvals, Construction, Production • Has impact on existence of the Project; therefore existence and production of ERs • Issue: what if CDM EB rejects the project • Host Country approval,compliance, eligibility, transfer • Has impact on existence and compliance of ERs and price • Issue: what if carbon assets are nationalized • Project Risk • Protocol Risk

27. Key Contractual Provisions • Risk • Acceptance of the resultant risk is a commercial issue to be determined between the parties; therefore, important to identify all risks and to carefully and clearly allocate them between the parties involved (i.e. Buyer’s risks, Seller’s risks • Risk is best allocated to the party most able to bear it • Need to provide risk mitigation strategies such as insurance

28. Key Contractual Provisions • Price and Terms of Payment • Set out the price to be paid for the ERs; may vary • If any ERs are covered by an option, the price thereof should be set out, as applicable • Terms and method of payment need to be clearly stipulated. May take several forms (e.g. full upfront payment, option, payment triggered by an event) • Credit risk, issues such as penalties for late payments, increases for inflation and other charge related items should also be addressed

29. Key Contractual Provisions • Warranties and Representations • Warranties should include, among others: • Usual commercial warranties of corporate power and creation • Creation of the ERs and Title to the ERs • Rights being free of any encumbrance • Validity of the rights • Undertaking of the ER activity • Certainty that the activity has not been used to generate any other form of ER • Reduction is permanent

30. Key Contractual Provisions • Warranties and Representations • Should also address the timing of representations (e.g.representation true for the entire term of the agreement) • Seller may wish to exclude any warranties as to the merchantability or fitness for a particular purpose of the ERs

31. Key Contractual Provisions • Liability and Indemnities • Parties will have to determine to what extent, if any, the liability of either or both parties should be limited. • Damages may arise out of or by reason of: breach of obligations, events of default, negligent act or omission, representations and warranties • May include a waiver of “special” damages • Should decide whether indemnities are required, including indemnities relating to carbon debits and potential losses relating to leakage

32. Key Contractual Provisions • Default, Termination and Remedies • Specify “Events of default” such as termination of business or bankruptcy, material breach of representation, failure of Seller to deliver ER rights, failure of Buyer to make payments when due, failure of Seller to comply with validation/verification obligations, failure to secure HC approval or to satisfy requirements under Kyoto Protocol for CDM projects • Consequences of an event of default should be set out, may be to include provision for payment of damages

33. Key Contractual Provisions • Default, Termination and Remedies • In case of remedies, there is a range of options including good-faith cooperation or negotiation, designation of early termination date, withholding of payments by non-defaulting party • Might need to consider whether contract remedies are exclusive for events of default or whether it is in addition to any other remedy available by law

34. Key Contractual Provisions • Progress Reports and Audit Rights • Given the long term nature of the ERPA • Only reasonable way for Buyer to be able to assess whether the Seller will be able to perform • Buyer’s right to terminate contract in the event that reports prove unsatisfactory • Interim reports may reveal a higher level of reduction than anticipated thereby being beneficial to the Seller

35. Key Contractual Provisions • Confidentiality • Parties to determine and define what constitutes confidential information in respect of the agreement • Determination should include what obligations to impose and whether confidentiality obligations are mutual or falling only on one party • Should address the term of the confidentiality obligation, among others

36. Key Contractual Provisions • Arbitration and Dispute Resolution • Due to uncertainties concerning carbon transactions, important to set out procedures for dispute resolution • Parties may develop their own dispute resolution or adjudication process • Identify place of the arbitration and the arbitration system to be used • Optional Rules for Arbitration of Disputes Relating to Natural Resources and/or the Environment (Permanent Court of International Arbitration. Go to www.pca-cpa.org)

37. Key Contractual Provisions • Taxes, Levies and Charges • Often arise from the registration and transfer of rights • Determine what fees to be paid for the creation and registration of ERs and who bears the cost of any transfer fees or cost of compliance • Issue of taxation related to pricing (whether price is inclusive or exclusive of goods and service tax and other charges) • Should address issues concerning local taxes, future legislation imposing taxes or charges on ER transactions

38. Key Contractual Provisions • Taxes, Levies and Charges • Should address the possibility of future legislation imposing various taxes or charges on ER transactions • Important note: CDM projects under Kyoto Protocol will have to direct a particular “share of proceeds” to specified funds to cover administrative expenses as well as to assist developing countries that are particularly vulnerable to the adverse effects of climate change to meet the costs of adaptation (Article 12, para 8, KP)

39. Key Contractual Provisions • Force Majeure • Determine what constitutes a “force majeure” event and the consequences of such an event • Parties may, however, decide not to assert a claim of “force majeure” or any similar claim to excuse any non-performance of their duties and obligations under the agreement

40. Key Contractual Provisions • Third Parties • Clear provision as to whether third parties have right to enforce or take benefit from the terms of the ERPA. • Involvement of third parties in contracts for sale of ERs may include roles as facility owner, verifier, reducer, financier, government authorities, NGOs

41. Key Contractual Provisions • Third Parties • Consider due diligence checks and attaining assurances from the third party to address possible issues on permanence, competing claims and access rights • If a contract should contain some stipulation in favor of a third person, he may demand its fulfillment provided he communicated his acceptance to the obligor before its revocation. A mere incidental benefit or interest of a person is not sufficient. The contracting parties must have clearly and deliberately conferred a favor upon a third person. (Article 1311, 2nd paragraph, Civil Code of the Philippines)

42. Key Contractual Provisions • Miscellaneous provisions (“Boiler Plate” clauses) • Entire agreement • Governing law and enforceability • Variation/amendments • Severability • Waiver • Survival • Notice • Assignment • Jurisdiction • Successors and Assigns • Delay or Omissions • Public Relations

43. Key Contractual Provisions • Domestic law • Trading Licenses • Taxation • Corporate securities • Philippine Energy laws • Philippine Environment legislation

44. Future Legal Dynamics • Emerging innovative structures (e.g. forward sales and option arrangements, creation of carbon pools, CER bonds and warrants, tax-driven deal structures) • Ability to understand and interlink and manipulate regulatory regimes is key • Liability and opportunity driven by emerging legal regimes • Demand, supply and price will be driven by project success and market liquidity • Range of drivers: reallocation of insurable risks, redirection and revaluation of investments, climate litigation, shareholder expectations, etc.

45. Future Legal Dynamics • Should start to put in place a regulatory framework for the Transfer and Trade in ERs • Definition of ERs • Establishment of original ownership of ERs • Regulations on the transfer of ERs • Putting in place registries • Taxation • Others….

46. Conclusions • CDM Project operates within the domestic jurisdiction, therefore all the dynamics of the domestic regime will influence ERs • Domestic legal regimes need to establish explicit laws/rules/institutions/authorities to recognize ER legally • International regime needs to take into account the diversity of domestic legal systems • Harmonization of international and domestic legal regimes apart, the near-term the effectiveness of ERs and ER transactions can best be achieved by overcoming barriers by contracting and arbitration process

47. Thank You! Atty. Angela Consuelo S. Ibay Program Coordinator Climate Change Information Center Manila Observatory, Ateneo de Manila Campus Tel + 63 2 426-5921 Fax + 63 2 426-0847 gia@observatory.ph