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The subject of carbon credits is a vast area which may require a dedicated seminar on its own. However, this paper deals, in a summarised form, with the salient features of this fast-developing area of commercial activity.
This paper explains the general commercial rationale for corporate entities to generate and/or buy and/or sell carbon credits. However, the main focus of this paper is to highlight the impact that carbon credits may have in the financing of projects in future. This is addressed under four major sub-headings, being:
• What are carbon credits?
• International and National regulatory environment for carbon credits.
• Salient points about the legal nature and the contractual features of carbon credits.
• What opportunities do carbon credits present in terms of financing projects in South Africa?
What are carbon credits?
In a broad sense carbon credits are “units” that an entity acquires for developing or funding a project that assists with the reduction of Green House Gases (GHGs) in the atmosphere.
These “units” come in the form of tradable, intangible instruments and are issued in terms of three different international mechanisms, namely, the Clean Development Mechanism (CDM), the Joint Implementation Mechanism (JI) and the Emissions Trading Mechanism (ET).
The mechanism that is applicable to projects undertaken in South Africa (and other developing countries) is the CDM. These projects could be in energy, mining, agriculture, forestry, etc.
The reason why the South African market uses the CDM has to do with the regulatory framework governing carbon credits internationally.
The reason why the South African market uses the CDM has to do with the regulatory framework governing carbon credits internationally.
International and National regulatory environment for carbon credits.
Under the banner of the United Nations there are various instruments that have given rise to international efforts that seek to reduce the levels of GHGs in the atmosphere and thereby reduce and reverse global warming.
It is outside the scope of this paper to mention all the said instruments and what each of them exactly does. In order to set out the context within which carbon credits are dealt with, it is necessary to mention two international instruments, namely the United Nations Framework Convention on Climate Change (UNFCCC) and the Kyoto Protocol (Protocol).
There are other carbon credits that are dealt with under voluntary programmes but this paper specifically focuses on those regulated by the Protocol.
The UNFCCC is a treaty which provides a framework in terms of which parties that have adopted that treaty may agree specific goals that they want to achieve in terms of the programmes that will help reduce GHGs. Accordingly, the UNFCC does not set out any binding goals per se.
Binding targets in terms of reducing GHGs were first adopted by the members to the UNFCCC in 1997 in Kyoto under the Protocol. The Protocol sets out binding obligations in terms:
• the types of GHGs that are targeted to be reduced;
• the sectors and sources where these are found; and
• importantly, the specific targets that each listed country has to meet and the dates by which these targets have to be met.
The countries that have binding targets are mainly developed countries (bound countries, also referred to as Annex 1 countries). The developing countries (non-bound countries, also referred to as Non-Annex 1 countries) do not have binding targets under the Protocol. The distinction between bound countries and non-bound countries is significant because it explains the different carbon trading mechanisms mentioned under the first sub-heading, namely the CDM, JI and ET. It is for this reason that South Africa as a non-bound country should be using the CDM.
The UNFCCC is responsible for monitoring the implementation of the principles of the Protocol and it does so at an International level through different units within the UNFCCC.
The UNFCCC allows for two main players to be established at a domestic level to monitor the implementation of the Protocol, namely the Designated National Authority (DNA) and the Designated Operating Entity (DOE).
In South Africa, the DNA is housed in the Department of Energy, having been created in 2004 in terms of Section 25 of the National Environmental Management Act, 1998. The main function of a DNA is to give domestic approval for qualifying projects. On the other hand DOEs are private entities that get accredited by the UNFCCC and their function is to validate, verify and report on the technical aspects to determine measurable and tangible GHG emissions of projects to see if they meet the technical specifications in order to be awarded carbon credits.
The DNA and the DOE are just part of a number of parties in a project that are critical throughout the project cycle. The typical project cycle for a CDM project would entail project design, DNA approval, DOE validation, UNFCCC registration (through the executive board of the CDM) project financing, construction, commissioning, operation, monitoring and performance verification and certification.
Salient points about the legal nature and the contractual features of carbon credits
Because South African projects can only be processed through the CDM, this paper will focus on the certified emission reduction (CER).
The United Nations Industrial Development Organisation, in one of its publications on the subject, describes carbon credits as follows:
“Carbon credits are not physical goods, but rather units held in the national registries and in the CDM registry. Neither the Protocol nor the Marrakesh accords envisages any paper evidence of ownership of carbon credits, which are intangible and, by definition, transferable.”
International law and also our own legal system is not fully settled with regards to the exact legal nature of carbon credits.
For example in South Africa (and other countries) carbon credits are not regarded as financial instruments by the laws that regulate South African financial services and instruments. Currently in South Africa carbon credits are not exchange traded. It is anticipated that the JSE Limited will introduce a system of trading directly in carbon credits in the near future. Derivatives based on carbon credits are considered financial instruments and are currently exchange traded. There are countries that regard carbon credits as financial instruments on their own.
As far tax treatment is concerned, in terms of the Taxation Laws Amendment Act, 2009 two significant changes were introduced into our tax system. The first amendment provides that receipts from disposals of carbon credits which are now exempt. The amendment is now provided for in Section 12K of the Income Tax Act, 1962. The second amendment provides that carbon credit disposals are zero rated, provided they are sold to a non-resident.
Commercial activity in the area of carbon credits is increasing rapidly and the natural consequence of this development is for the law to also develop and catch up.
It is, however, important to conduct a proper legal due diligence in respect of each specific project to assess compliance with all the UNFCCC and host country legal technical requirements that have to be satisfied for any contractual arrangement that involves carbon credits to be valid and enforceable. In this area a general voetstoots sale is not good enough because the buyer of carbon credits buys them with the specific objective that they should provide that buyer with the benefits under the Protocol, which benefits have to meet that buyer’s specific Protocol requirements.
Some of the contractual features of carbon credits are discussed below.
In discussing the contractual features of carbon credit one has to briefly explain why entities enter into carbon credit contracts.
The South African DNA in its website explains the rationale as follows:
“The industrialised country [bound countries] starts by keeping a regularly updated inventory of its emissions. A national target for reduction of these emissions is set within the Kyoto Protocol. The industrialised country may then choose to allocate its national target across a number of domestic emitters.
The domestic emitter can then meet these targets through one of three methods:
• Mitigation activities within the country;
• Through the Joint Implementation Mechanism (another carbon trading mechanism within the Kyoto Protcol)[Not applicable in South Africa because South Africa uses the CDM mechanism]; and
• Through the CDM – where the emitter can invest in a project in a developing country [including South Africa] (thus gaining Certified Emissions Credits for themselves) or buy CERs from someone who has invested in such a project.
Requirements on the host country are fairly straightforward. For a host country to be eligible to participate in the CDM, it must:
• Ratify the Kyoto Protocol; and
• Designate a national authority to provide official host country approval of a project.”
The driver for carbon credit transactions is the need by bound countries or corporates operating in the bound countries to acquire enough credits to be able to carry on with their commercial activities within their stated emission limits. They acquire the credits by either funding qualifying projects or by buying carbon credits from participants in qualifying projects.
Contracts for the purchase and sale of carbon credits are largely standardised and usually incorporate the standard terms published by the International Emissions Trading Association. They also usually have a section that deals with the unique commercial terms of the parties. For the South African market the relevant contract is referred to as the (Certified) Emission Reduction Purchase Agreement (ERPA).
Carbon credits are not physical goods but rather intangible electronic units. This classification of carbon credits then raises the important issue of how delivery of the carbon credits is effected and how title is transferred following a sale agreement.
Delivery is effected by transferring the registration of the carbon credits from the account of the seller and entering same into the account of the buyer in the national registry held in the buyer’s country.
The Protocol does not state how title is transferred and this is a matter should be regulated in the agreement by saying that transfer of title will pass either upon full payment of purchase price or upon delivery as explained in the preceding paragraph.
Some contracts provide for the payment of the purchase price upfront before the CERs are issued. This can be useful for funding the project. But, because of the risks associated with the successful issue of the CERs there usually is a discount. Others contracts state that payment will occur upon delivery after the CERs are issued at a future date. It all depends on the commercial arrangement that suits the parties.
Warranties by the seller are an important requirement that a buyer would insist on. These would cover a wide range of issues including compliance with the Protocol requirements.
Because of the multinational nature of these contracts most parties choose English law as the governing law.
What opportunities do carbon credits present in terms of financing projects in South Africa?
The obvious answer is that the need on the part of bound countries or entities from bound countries to maintain their emissions levels creates an opportunity for investors from the bound countries to finance qualifying projects so that they can then get credits for such funding. In other words this increases the pool of potential funders for projects, especially in developing countries.
This pool is also enhanced by financing institutions who buy carbon credits with a view to on-selling to entities that require them.
The more interesting opportunity from a banking and finance point of view is that carbon credits may be used to enhance the bankability of a traditional project finance transaction by providing extra security for the project and also by providing additional revenue stream for the project.
Granting of security to support the project company’s payment obligations under a loan may be done through giving security over the CERs themselves. However, this approach may result in competing claims between the rights of the forward buyer of the CER and the lender to whom security is being granted by the seller.
There is a “cleaner” option, which is to give security through a cession of future cash flows from a forward sale of CERs under the ERPA. This can be managed by directing that the future cash flows be paid into a specified project account which can then be ceded in security in favour of the lender. It is also possible for a specified account which is controlled by the lender to be noted in the national registry as the account into which the buyer will pay the purchase price for the CERs and the lender can then deal with the amounts in that account in a manner agreed to with the seller (the borrower under the loan).
Things to consider from a bank’s point of view is the risk associated with the future generation of CERs and the payment risk by the buyer, who in most cases will be based offshore.
No doubt the agreements may also be structured such that the sale proceeds from the sale of CERs may be made available to the project to service debt, or to serve as reserves for future debt service or for other project requirements to enhance the liquidity of the project company.
A closer look at each specific project will enable parties to discover even more creative ways of using carbon credits to assist with the funding requirements of that particular project.
With the prospect of the an extension of the time lines beyond 2012, and also having more countries being bound to specified levels of emissions, the opportunities look great but lawyers need to make sure that all risks are covered in the documentation and should also drive the process of making sure that the law keeps up with the commercial and international legal developments in this area.
Written by: Sandanathi Gwina, Director, Deneys Reitz Inc.