Canada: Constructing Carbon Contracts – The Building Blocks Of An Emissions Trading Contract

Last Updated: May 8 2006

Article by Selina Lee-Andersen, ©2006 Blake, Cassels & Graydon LLP

This article was originally published in Blakes Bulletin on Energy - Oil & Gas, March 2006

Under the Kyoto Protocol, emissions trading is one of the key market mechanisms by which countries can meet their emission reduction targets. With the Kyoto Protocol in force, emissions trading systems are either underway or will be implemented shortly in many countries around the world.

The Canadian Domestic Offsets System, which is backed by the Climate Fund Agency, will be implemented in early 2006. Beginning on March 31, 2006, the Climate Fund Agency will purchase credits created by the Domestic Offsets System as well as international credits sanctioned under the Kyoto Protocol. To date, one billion dollars has been allocated for purchases by the Climate Fund Agency, which could yield reductions of between 75 and 115 megatonnes annually between 2008 and 2012. Canada’s reduction goal under the Kyoto Protocol is 270 megatonnes. For more information on emissions trading, please see Emissions Trading under the Kyoto Protocol: Giving Credit where Credit is Due, Blakes Oil & Gas Bulletin, December 1, 2005.

To ensure clarity and to properly allocate risk, parties to an emissions trade will rely on contractual terms to protect their interests. A transaction for the purchase and sale of emission products carries with it inherent risks and challenges which are unique to the carbon market. The form of contract can be tailored to address these aspects and the following issues are often considered in articulating the terms of the contract:

One. Participants to the transaction
Two. Nature of the commodity being traded
Three. Terms of purchase, sale and delivery
Four. How emission reductions and compliance will be evidenced
Five. Representations and warranties
Six. Potential risks and uncertainties
Seven. Dispute resolution

Setting the Tone

The preamble should clearly set out the purposes of the contract, which will help to ensure that the terms of the contract are consistent with those purposes. Such purposes may include complying with a company’s emission reduction obligations, retiring emission rights, obtaining financing for emission reduction projects, or trading in certain emission markets.

The Players

On the surface, the identification of parties may appear to be a simple task, but the proper identification of parties to the transaction could be complicated by the fact that various entities may have a potential claim to the emission rights being traded. In identifying the parties, regard should be had to any entities with potential claims arising from their involvement with associated land, people, facilities, equipment, services and investments. Where a number of potential claimants exist, the parties may find comfort through representations and warranties as to the title of the emission rights, or through disclosure provisions. Parties may also wish to obtain waivers or assignments of title from third parties with potential interests in the rights.

The Nature of Emission Rights

In emissions trading, the legal nature of the emissions right will depend on the type of emissions trading system being implemented. Broadly speaking, an emissions right may be classified as either a legislative right or a contractual right. A legislative right is one that is allocated under legislation (such as those created under the Canadian Domestic Offset System) or a right generated by an activity approved by a regulatory authority in accordance with a set of rules (such as the "certified emission reduction" under the Clean Development Mechanism of the Kyoto Protocol). A contractual right arises from emissions reduction activities outside of established trading regimes, such as a voluntary trade between two private parties. Attempts to define the nature of emission rights may be complicated by the existence of wide-ranging standards under varying domestic emissions reduction regimes. From a buyer’s perspective, a broad definition of the commodity is preferable; but from a seller’s perspective, a narrower definition is preferable to reduce the risk of open-ended obligations.

Emission rights may be further characterized by the year in which they are created (the so-called ‘vintage’ of the right), the jurisdiction and trading system in which they are created, as well as the kind of compound being addressed. If reference is made to a particular system in the contract, provision should be made for the impact of changes to that system or its rules. Furthermore, it will be necessary to determine which gases will be included under the category of greenhouse gas emissions and whether the trading system limits trading to any particular category of gases. Finally, emission rights will need to incorporate a definition of a baseline from which the emission rights resulting from the project will be measured. Methodologies for calculating baselines can be addressed in the provisions pertaining to reporting and verification, however parties may wish to include a baseline in the definition of emission rights itself in order to ensure greater certainty in the scope of any calculation.

The Terms of the Trade

The terms of an emissions trading contract generally address the following:

Delivery date. The delivery date or trigger event by which the emission rights will accrue to the buyer, which may impact on the potential value of emission rights.

Mechanism for timing and delivery. The mechanism by which the emission rights will be transferred will depend on the type of rights being transferred. Where the right is a legislative one, the requirements of the regime should be taken into consideration as there will likely be pre-defined methods of delivery and transfer of title. If the right is a contractual one, the risks associated with delivery should be taken into account in designing the delivery mechanism. Part of this risk may be shared or minimized through the use of a clearing house or registry. The contract should specify the point at which title is transferred, which may occur upon execution of the contract or upon a change of ownership being registered. If the right does not exist yet, the delivery of such future rights should take into account any legislative changes, whether domestic or international, which may impact on the creation of rights and the transfer process.

Shortfall or failure to deliver. Appropriate arrangements should be included to address the management of shortfalls under the contract. These may include: physical replacement of the volume of shortfall of emission rights from other projects or from future years; payment to the buyer in the form of repayment of any up-front payment funds or the cost to the buyer of purchasing replacement rights; and a frustration clause in the event that the emission rights never materialize.

Terms and method of payment. The price of the emission rights should be set out in the contract, and can be tailored to the vintage of the rights or the nature of the rights involved. In addition, the terms of payment should be clearly stipulated in the form of full payment, an option, or a payment on the occurrence of a future event (e.g., such as the issuance of a certificate from the relevant regulatory authority).

Representations and Warranties. Apart from the standard commercial warranties of corporate power, creation and capacity, the parties should include warranties relating to title to the emission rights, security over the rights, creation of the rights, validity of the rights, compliance with environmental regulations, and the undertaking of emission reduction activities.

Security. Forms of security or guarantees, where applicable.

Financial penalties. Penalties for shortfalls or failure to deliver should include provisions for timing, calculation methods and responsibility.

Taxes, levies and charges. Provisions should be included for any current or future taxes, fees, levies or charges (including calculation methods and responsibility).

Default, termination and remedies. The parties should specify what constitutes an event of default and the consequences of such a default. In addition, the parties may wish to consider the consequences of the seller failing to comply with verification obligations or failing to secure host country government approval. The range of remedies can include immediate termination of the contract, the right to a reduction in purchase price, the repayment of amounts paid upfront or the payment of liquidated damages.

Evidencing the Validity of Emission Rights

The main obligation under an emissions trading contract is the delivery of the product. As a result, one of the most significant issues to be agreed between the parties is how delivery will be evidenced. In the current market, the evidentiary burden is usually discharged by demonstrating that real and measurable reductions of GHG emissions have been achieved when measured against a baseline. Where legislative rights are concerned, the form of evidence will likely come in the form of government issued certificates that can be traded or tracked through a central registry. The validation of contractual rights involve more steps and require independent verification of emission reductions. There should be clear provisions for who will be responsible for carrying out initial and ongoing validation of the project, as well as who will be responsible for the costs of verification. If a third party will be involved in verifying the emission reductions, the criteria for such verification should be specified.

The nature of emissions is unique in that the scientific processes which are used to quantify emission reductions are not static and are being improved continuously to produce more accurate results. Scientific uncertainties can be addressed by including a clause which permits the calculation of tonnes to be revisited if different numbers or methodologies are developed or adopted by the relevant authorities.

Managing the Risk

Given the uncertainties associated with the nature and measurement of emissions, certain inherent risks exist. These risks may be categorized as follows:

Project or delivery risk. Any emissions trading transaction carries with it the risk of a shortfall in delivery. The incorporation of remedy clauses can help to alleviate concerns about shortfalls or issues with verification.

Scientific risk. The science of measuring emission reductions is evolving, and changes in baseline calculations or the quantification of emissions may affect the ultimate number of reductions in a project. To mitigate this risk, parties may consider binding themselves to fixed standards or agreeing to re-assess the methodologies at regular intervals.

Counter Party Risk. Over the term of the contract, risks associated with a party’s credit rating or ability to provide credit support may intensify, particularly in the case of small businesses. Parties may wish to include terms of access to financial reports and criteria for prudential requirements, customize financial representations and warranties, define conditions of assignment and survivability, or define events that would constitute a force majeure.

Sovereign and regulatory risk. Where the parties operate outside established systems, there is no certainty that the emission reductions will be recognized or valued. Sovereign risks include expropriation of emission rights by host governments, unilateral actions taken by governments that have a direct effect on the transaction, and the imposition of additional taxes on a project by a host government. While there is little the parties can do to prevent the impact of sovereign and regulatory risks, the contractual terms may be drafted to anticipate regulatory change and limit the liability of the parties in the case of such extraordinary event.

Dispute Resolution

An emissions trading transaction is fraught with uncertainty, and the contract should set out clear dispute resolution procedures in the event that the transaction does not unfold as anticipated. This is particularly important in cross-border transactions where differences in legal systems make it impractical for parties to resolve disputes through domestic courts. International commercial arbitration has become the preferred dispute resolution mechanism for international business transactions and international resource development contracts. The Permanent Court of International Arbitration encourages the use of the Optional Rules for Arbitration of Disputes Relating to Natural Resources and/or for the Environment for settling emissions trading disputes.

Looking Ahead

With a newly-minted Conservative minority government in Ottawa, the fate of the Canadian Domestic Offsets System, as well as funding for climate change initiatives, is uncertain. However, emissions trading is already taking place in jurisdictions around the world within both regulated and voluntary systems. With the Kyoto Protocol in place – and until a new process for commitments beyond 2012 is adopted – emissions trading will continue to be one of the key mechanisms by which countries will achieve their Kyoto targets.

A well-drafted contract, designed to anticipate certain externalities which are peculiar to the carbon market, can serve to mitigate risks while creating economic and environmental benefits to all those involved.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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