Australia: Carbon Reforestation Schemes May Not Be All Blue Skies

If the Carbon Pollution Reduction Scheme Bill 2009 (Cth) is introduced into law "liable entities" will need to acquire "Australian Emission Units" (AEUs) in order to satisfy their obligations to surrender those AEUs in compliance with the CPRS legislation.

AEUs will be able to be purchased from the Australian Climate Change Regulatory Authority (Authority). The Authority will also be able to issue AEUs under special schemes to assist the coal industry and trade-exposed industries. Alternatively, liable entities will be able to acquire AEUs from entities who have AEUs for sale.

After 15 December 2016 the Authority will only be able to auction AEUs, the idea being that the cost of auctioned AEUs will increase in line with market demand for them over time.

The Authority will also be able to issue free AEUs for reforestation schemes or the destruction of synthetic greenhouse gases. Over time these free AEUs will likely become much more commercially attractive than AEUs purchased from the Authority.

Carbon sequestration businesses

Synthetic greenhouse gas emissions stem from the use of commercial and household equipment such as refrigeration, air-conditioning and high-voltage electrical equipment. For the foreseeable future the destruction of synthetic greenhouse gases is likely to amount to a very small part of Australia's carbon pollution reduction.

For those liable entities outside the coal industry or ineligible for trade-exposed assistance, opportunities to obtain significant numbers of AEUs without buying them at market rates will, at least initially, come from reforestation schemes.

Most liable entities, however, will not be interested in undertaking their own reforestation schemes as such schemes will require significant capital investment to create and ongoing expense to run and will lie outside their core business. This creates opportunities for third-party commercial enterprises (Carbon Companies) to create reforestation schemes, procure free AEUs from the Authority and deliver those AEUs to liable entities.

Insolvency and counterparty risk generally

In any commercial arrangement it is always important to keep in mind that a contractual counterparty may be unable to perform its obligations for any number of reasons, including an intervening insolvency. Even so, many commercial risks can be minimised with careful negotiation of the terms of the contract.

The appointment of a receiver, voluntary administrator or liquidator to a party to a contract can have catastrophic consequences for a counterparty to that contract. Receivers, voluntary administrators and liquidators generally have no obligation to cause a company over which they have been appointed to continue to perform existing contracts, although they might continue to perform if there is a commercial benefit for the company. Liquidators in particular have only limited ability to continue to trade and also have power to disclaim the contracts and property of the company over which they have been appointed.

Generally, the right of an unsecured creditor of an insolvent company is limited to completing a proof of debt and lodging it with the administrator or liquidator. Sometime later the unsecured creditor might then receive x˘ in the dollar for its loss, or nothing at all.

Secured creditors have rights which, generally, are to sell the security property or keep the rents and profits of the security property. A secured creditor does not ordinarily get to keep the security property in lieu of the debt.

Before entering into any commercial contract it is always sensible to ask the question, "What happens to me if my counterparty becomes insolvent at the worst possible time?" If the answer to that question presents an undesirable outcome then an alternative legal structure should be considered. Sometimes it is not possible to completely remove insolvency risk.

Insolvency issues for reforestation schemes

In 2008 and 2009 the Timbercorp, Great Southern and Environinvest tree plantation schemes all collapsed in insolvency. The scale of individual investor losses in those schemes are typically several hundred thousand to a few million dollars. The scale of potential individual losses for carbon reforestation schemes will likely be in the tens of millions to hundreds of millions of dollars. This is not intended to indicate that all reforestation schemes are doomed to insolvency. It is intended to indicate that insolvency in reforestation schemes is an issue that warrants consideration at the point of negotiation and before contracts are signed.

Broadly, there are 2 approaches that Carbon Companies can adopt to structure their carbon reforestation activities:

  1. the Carbon Company could plant trees on land that a liable entity owns so that the liable entity obtains the free AEUs directly from the Authority; or
  2. the Carbon Company could plant trees on land in which the Carbon Company itself has an interest, with the AEUs being issued to the Carbon Company and then delivered to liable entities.

The first approach has the benefits of simplicity and certainty. An intervening insolvency of the Carbon Company is likely to pose few difficulties because the AEUs are issued directly to the liable entity. If the Carbon Company became insolvent the liable entity could (if the contract allows) terminate the contract with the Carbon Company and find a new Carbon Company to take over the role of planting trees. However, the practical reality with the first approach is that few liable entities will have sufficient land, or will be willing to acquire sufficient land, to implement this approach on a worthwhile scale.

The second approach has converse benefits and drawbacks to the first. The second approach allows liable entities to obtain AEUs without the cost (both in terms of ongoing expense and capital deployment) of having interests in significant areas of land unrelated to their core business. However, the AEUs are issued to the person with the carbon sequestration right, which might be the Carbon Company or the owner of the land. An intervening insolvency of the person to whom the AEUs are issued will likely result in those AEUs not being passed on to the liable entity.

Liable entities and Carbon Companies engaging in the second approach should give very careful thought to the legal structures they adopt. The insolvency of a Carbon Company will likely mean that its contractual obligations to deliver AEUs will not be performed. Despite that insolvency, affected liable entities will still need sufficient AEUs to discharge their obligations under the CPRS legislation. The liable entity may have to acquire AEUs at the then-prevailing market price. Depending on the scale of the insolvency event, the market price might increase as every other liable entity affected by a Carbon Company's insolvency enters the market at the same time. This creates significant uncertainty and may expose the affected liable entities to very significant expense. If sufficient AEUs are not obtained the liable entity will breach the CPRS legislation and may also suffer reputational damage.

The insolvency risks of the second approach can be addressed through the use of appropriate security arrangements, such as charges, mortgages and security trusts. These insolvency risk mitigation tools are often complicated and will add to the cost of setting up, entering into and operating a reforestation scheme. They are also robust legal structures that have been used by lenders for centuries to provide security for the repayment of debts.

From a Carbon Company's perspective, offering liable entities robust security arrangements for AEU delivery could be a point of differentiation from competitors.

Corporations Act issues for reforestation schemes

If the interests of a number of liable entities in a reforestation scheme are pooled in any way the scheme will likely be a managed investment scheme (MIS) under the Corporations Act 2001 (Cth). If that MIS has more than 20 members or is promoted by a person in the business of promoting MISs then the MIS will need to registered unless all members of the scheme are wholesale clients (as defined in the Corporations Act).

Registered and registrable MISs are regulated by Chapter 5C of the Corporations Act. Such regulation brings with it the requirements to have a responsible entity with an Australian Financial Services Licence, a constitution and a compliance plan, amongst other things. Should an unregistrable scheme become registrable after its creation, the legal structure required by Chapter 5C will have to be implemented at that time or the MIS will be wound up. Imposing constitutions and compliance plans on existing scheme members may not be something that is easy to negotiate.

A reforestation scheme that is promoted in Australia can still be a MIS regulated by Chapter 5C even if the scheme's reforestation projects are all outside Australia.

AEUs will also be financial products under the Corporations Act. If a Carbon Company provides AEUs to a retail client (as defined in the Corporations Act) then the Carbon Company will have to have an Australian Financial Services Licence and clients will need to be given a product disclosure statement that complies with the requirements of the Corporations Act.

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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