Introduction to Legal and Contractual Aspects of CDM Projects

1. Introduction to Legal and Contractual Aspects of CDM Projects University of Twente 21 March 2006 Robert O’Sullivan Climate Focus

2. Content • Nature of Emissions Rights • Project Structuring • Basic legal documentation • Emission Reduction Purchase Agreement • Scenario • Conclusions

3. Nature of Emission Rights

4. Sources of emission rights • International treaties • Regional, national and state legislation or codes • Contracts • Common law and equity

5. 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)

6. 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?

7. 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

8. Creation of VERs and CERs Carbon Contract CERs $$ Issuance by EB VERs Verification (by DOE) Verification by DOE Approval of Methodologies , approval of the project, registration Creation of GHG Reductions (measured in tonnes of CO2e)

9. 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

10. Project Structuring

11. 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

12. Parent Company CDM Project Structures Equity investor Technology Supplier € €? CERs? € Tech Bank € € € CERs e Approval Local $ CER Buyer Construction O&M Access Affected people etc Government Electricity purchaser

13. 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?

14. 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?

15. Ownership of Emission Reductions Project Example: Landfill Project I Power Purchase A. Carbon Contract Municipality Owns the land Operates the landfill Collects the waste Sells the Electricity

16. Ownership of Emission Reductions: Project Example: Landfill Project II Power Purchase Agreement Carbon Contract Shareholder Agreement Power Generation License Special Purpose Company Loan Agreement Environmental License Construction Agreement Landfill Gas Transfer Agreement Grid Connection Agreement Landfill Concession Agreement Operations- and Management Agreement Use of Land Agreement

17. Basic Legal Documentation for Carbon Projects

18. 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

19. 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)

20. 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

21. 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

22. Emission Reductions Purchase Agreement

23. 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

24. “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

25. 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

26. 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

27. 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”

28. 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”

29. 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”

30. Price: Different Approaches in Practice Market Price Simple Indexed Price Fixed Price Indexed Price with Floor & Ceiling

31. 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?)

32. 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

33. 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)

34. 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 Yearinto the registry account nominated by the Buyer”

35. 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 Yearinto the registry account nominated by the Buyer until a total of X CERs have been delivered”

36. 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 2008into 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 Yearinto the registry account nominated by the Buyer”

37. Volume and Delivery: Fixed vs. % Fixed Default Amount Fixed with acceleration Default Amount Green may or may not be default depending on seniority % with Default Amount Default Amount

38. 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

39. 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

40. 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%.”

41. 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”

42. Remedies: Intentional Breach • Normally have strict damages remedies for defaults that are the result of intentional misconduct or gross negligence

43. Remedies and Pricing Default Default Market Price Simple Indexed Price Fixed Price Indexed Price with Floor & Ceiling

44. 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?

45. Elements of Risk in Carbon Deals Key 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

46. 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

47. Risk Mitigation Tools • 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)

48. Risk Mitigation Tools • 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)

49. Scenario • Just agree on basic terms that will be carried over to the ERPA • No need for “legal” drafting

50. Conclusions