While formal emissions trading under the proposed Carbon Pollution Reduction Scheme (CPRS) is not due to begin until at least 2010, companies can begin to trade carbon credits before the CPRS starts (click here for our legal update on the CPRS). A recent forward trade in carbon credits is a timely reminder to companies that a forward market for emissions permits is emerging as it becomes increasingly important to factor future carbon prices into decision making regarding carbon exposure. AGL Hydro Partnership's recent sale of Australian Emission Units (AEUs) to Westpac Bank demonstrates that carbon trading is occurring before formal commencement of the CPRS, indicates a carbon price signal, and highlights a number of general issues involving carbon contracting.

Carbon trading ahead of the CPRS

Advance private trading in carbon credits has begun before the CPRS has been implemented. On 13 May 2008, AGL Hydro Partnership sold 10,000 carbon credits to Westpac bank at $19 per tonne of carbon. Credit accumulation can provide a risk management mechanism for companies to make and implement informed decisions about early pricing opportunities, and will lead the way into full scale trading once the CPRS commences. The Australian Stock Exchange predicts that within 18 months, Australian companies will have a robust and transparent carbon trading market to underpin early forward price trading.

Forward sale agreements for carbon pollution permits (CPPs)

A forward sale contract is an agreement between two parties to buy or sell an asset (in this case CPPs/AEUs1) at a pre-agreed future time. The trade date and delivery date are separated, so that no asset of any kind actually changes hands, until the completion date. Forward prices allow investors to make decisions with a higher degree of certainty about the prices that will prevail over the lifetime of their investment. To prepare its forward sale agreement AGL drew on standard carbon trading contracts published by the International Emissions Trading Association.

Until the CPRS begins, companies considering purchasing CPPs can ensure forward sale agreements provide some certainty by maximising flexibility, allocating risk, and considering alternative scenarios. Key elements of a forward sale agreement might include:

  • A settlement date post-2010 to allow for full implementation of the anticipated 2010 CPRS commencement date;
  • Automatic termination of an agreement if the CPRS is not in force at the time of completion, with at least 51% of CPPs for the scheme's first compliance period allocated by 1 July 2011;
  • The quantity and price of CPPs to be conditional on each CPP representing one tonne of carbon dioxide. Proportionate adjustment of tonnes per credit could be allowed if this is not the case;
  • Alternative scenarios should be covered if the scheme includes or omits a 'make whole' provision for failure to transfer all the required CPPs on the completion date; and
  • The risk of changes in tax law should be shared between the parties.

Carbon contracting

In the lead up to commencement of the CPRS, there are some key principles to consider in general carbon contracting.

Business value and reporting obligations

Fixing a price for greenhouse emissions makes carbon part of the value equation of a business. Where climate change and carbon pricing presents material and quantifiable risks or opportunities to a company, those risks may need to be addressed in corporate reports, market disclosures and investor documents prepared for the issue of securities. Where required by law, emissions must be reported under the National Greenhouse and Energy Reporting laws (click here for our legal update on the NGER regulations).

Operating in an international framework

International, regional and national carbon regulatory regimes continue to evolve. Where there is any overlap or inconsistency between different schemes, carbon traders should decide whether to purchase credits at the international, regional or national level and refer to the relevant scheme and/or governing law that a trade is regulated by in the agreement. The inclusion of some flexibility to adapt to changes such as increased unit pricing is recommended.

Legal character of carbon credits

The Government's Green Paper on the CPRS proposes to characterise CPPs as personal property. The legislation implementing the scheme would not provide any power to extinguish them without compensation and each permit would be date stamped with the year to which they belong. There would be unlimited banking of CPP's, meaning they could be used at any time after their issue. Anyone could purchase or hold these permits, to increase the liquidity of the market, and ownership would be tracked on a national registry.

Minimising the risk of forward selling

If there is a risk that emissions reductions for a project will result in less credits being available for delivery on the completion date, sellers can reduce risk by being conservative in the number of CPPs they trade on a forward basis. They can then offer the buyer an option to buy any remaining CPPs at an agreed price.

Failure to deliver

Agreements should address what happens if the seller fails to provide the number of credits promised on completion. For example, it may lead to a right to terminate, an obligation by the seller to obtain replacement credits, or no rights at all. These obligations may influence the credit price.

Determining Price

The price paid per credit will reflect the risk allocation between the parties. Pricing options could include:

  • Attachment of credits to a market price (such as the European Union Allowance carbon price index);
  • A fixed price for the agreement term; or
  • A combination of the above.

Recent market activity has put the price of carbon somewhere between $18 and $24 per tonne, which is about half the amount being paid for the same

transaction in the EU market on London's European Climate Exchange (EUR 26 / AU$40 per tonne). Up to the start of August, about 12 over-the-counter trades have happened so far in Australia.

Effective transfer of legal title

Buyers should ensure that credits are free of any encumbrances and third party rights to ensure that clear legal title is effectively transferred to the purchaser. The seller should warrant that it has full legal and beneficial ownership of the credits. Any grant of inconsistent rights to a third party may entitle the buyer to contractual remedies.

Carbon neutral claims

Buyers should be careful about 'carbon-neutral' claims based on future trades. The ACCC have indicated they will closely monitor such claims (click here for our article on the ACCC and carbon claims).

Conclusion

While we wait for more detail and the formal commencement of the CPRS, companies should focus on understanding and measuring their carbon footprint and consider opportunities to begin early trade in CPPs. In the meanwhile, Deacons can assist with working through the legal and technical details of carbon reporting and contracting.

Footnotes

1 The Green Paper indicates that Carbon Pollution Permits will be called Australian Emissions Units in the CPRS legislation.

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.