Legal Aspects of the Emission Reduction Purchase Agreement

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Legal Aspects of the Emission Reduction Purchase
Agreement

• CDM Financial Mechanism Training Course
• Climate Change Information Center
• Manila Observatory

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The Kyoto Protocol is not yet in force, the
exact nature of domestic legal regimes governing
reductions in emissions of Greenhouse Gases
(GHGs) is (in most countries) still not known,
there is no regulated scheme for transactions
involving project based emission reductions and
the market for such emission reductions (ERs) is
not yet liquid. As such, the proper drafting of
contracts for the transfer of ERs from one party
to another party is vitally important.
IETA Discussion Paper 02-02 Carbon Contracts
Cornerstones
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Legal Context
Ownership of Atmosphere The Property Rights
Issues

• Atmosphere is a global common property
• Atmosphere is a scarce resource
• Utilization of the resource is skewed
• New area of law that is unique and
  cross-jurisdictional in nature combining
  principles of public international law
• Limitation of property regime definition
• Long-term Emissions Regime issues

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Legal Context
The Role of Carbon Contracts

• Provide a documented framework within which
  emission rights are bought, sold, acquired,
  transferred
• Negotiated outcomes that will determine the
  allocation of risk and which will be critical in
  determining issue of price and bankability of
  project against which to raise further
  debt/equity/financing

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Legal Context
Nature of Carbon Contracts

• Springs out of current efforts by Government and
  institutions developing contracts with clear
  pricing and risk profiles
• Standard contracts will increase with
  standardized rights (CERs, AAUs)

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Legal Context
Ownership of Emission Reductions (ERs) and Legal
Process of Transfer

• Emission Reduction (ER) has an international
  origin under Kyoto Protocol
• ER is a product of a CDM/JI Project
• If Project is legal in domestic jurisdiction
  and ERs are certified and verified by
  authorized agents, then ERs are legal commodities
• Distribution of ERs is a contract among
  stakeholders
• Rules pertaining to export of a legal commodity
  in a country are applicable for transfer to an
  international agent

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Legal Context
Would specific law be needed in Non-Annex I
Countries?

• ERs are new commodities, but not different.
• Therefore, present laws/rules may be applicable
• State/Central government laws/rules
• Project clearances
• Project contracts/agreements (complex
  structure)
• However, the existing structure is complex,
  thereby creating high transaction costs.

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Legal Context
Domestic Incorporation of CDM
For ERs , new rules may have to be added.
Question is whether these can be handled within
existing machinery or is a new institution needed
(e.g. Independent CDM Authority)
Policy guidelines will be useful in developing
contracts, whether standardized or as contracted
individually.
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What is an ERPA?

• Emission Reduction Purchase Agreement

• Carbon Purchase Agreement - this is the contract
  between the carbon buyer and seller.

• Purpose

• Record agreement
• Identify responsibilities
• Establish rights
• Manage risk

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Legal Agreements for PCF Projects
Host Country
3. Host Country Agreement
National Legislative Framework / Agreement /
Authorization
1. Letter of Project Endorsement
2. Letter of Intent
PCF Trustee
Project Entity
4. Emission Reductions Purchase Agreement
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Basic framework under PCF
Emission Reductions Purchase Agreement
Purchase Price
PCF Trustee
Project Entity
Exclusive Right of Certification and Verification
of purchased ERs (ERs)
Transfer of ERs
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Main Elements of Emission Reductions Purchase
Agreement (ERPA)

• Purchase of ERs from the Project Entity / Payment
  for achieving ERs
• Arrangement for initial and periodical
  verification, validation and certification.
• Transfer of ERs

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Key Contractual Provisions

• Parties

• Those with a potential claim to any ERs and
  possibly others who have key obligations or
  responsibilities in relation to the project (e.g.
  host government)
• Private contracts public participation?
• If State is a party, special provisions will
  apply for the contracts enforceability (e.g.
  The State may not be sued without its consent.
  under Section 3, Article XVI, 1987 Philippine
  Constitution)

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Key Contractual Provisions

• Parties

Contracts take effect only between the parties,
their assigns and heirs, except where the rights
and obligations arising from the contracts are
not transmissible by their nature, or by
stipulation or by provisions of law. x x x
(Article 1311, Civil Code of the Philippines)
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Key Contractual Provisions

• Recitals or Whereas Clauses
• Definition of Terms

• Vital to contain clear and concise definition of
  what exactly is being bought or sold
• Does it give rise to a legislative right or
  contractual right? Must clearly identify the
  nature and scope of the rights as they have been
  agreed between the parties.

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What is an ER?

• Emission Reductions or ERs means reduction in
  emissions of Greenhouse Gases generated by the
  Project and monitored in accordance with the
  Monitoring Plan and the relevant guidelines,
  modalities and procedures under the regulatory
  framework of the UNFCCC and/or the Kyoto
  Protocol, and in absence thereof any other
  regulatory framework as agreed between the
  Parties. (Definition PCF)

• Emission Reductions or ERs means the GHG
  Reductions achieved by a Project and verified by
  an Independent Third Party or an Operational
  Entity as meeting a set of standards consistent
  with those contained in the regulatory framework
  of the UNFCCC and/or the Kyoto Protocol.
  (Definition CDCF)

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Key Contractual Provisions

• Definition of Terms

• Baseline level of GHG emissions from which GHG
  ERs resulting from the project activity are to be
  measured
• Greenhouse Gas maybe as defined in the Kyoto
  Protocol
• Unit of Measurement specify the measurement in
  which the emissions are to be acquired
• Kyoto Protocol should include any amendments
  made to it and decisions

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Key Contractual Provisions

• Sale and Purchase

• Define and specify the number and the vintage
  (i.e. year in which the Project or source
  activities will reduce GHG emissions that are the
  basis for the ERs) of ERs arising from the
  project activity to be sold to the Buyer
• Specify clearly what rights the parties have to
  future ERs or to other environmental benefits or
  values resulting from the project.

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Key Contractual Provisions

• Delivery

• Necessary to determine when the defined rights
  will accrue to the Buyer

• Timing both of accrual and delivery is highly
  important to the potential value of ER and the
  Buyers capacity to sell either the base product
  or a derivative

• Determine whether to set out a delivery date or
  rely on a trigger event for the rights to accrue

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Key Contractual Provisions

• Delivery Mechanism and Transfer of Title

• The legal mechanism used to transfer the ERs will
  depend on the type of rights being transferred

• The contract must specify the point at which
  title is transferred. Possibilities include upon
  execution of the contract, payment being made, or
  upon change of ownership being entered on a
  register.

• If involve future delivery of ERs, contract must
  specify the mechanism needed to ensure that
  delivery occurs, taking into account possible
  changes in legislation.

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Key Contractual Provisions

• Shortfall or Failure to Deliver

• Need for appropriate arrangements to ensure that
  the specified quantity of ERs is indeed delivered

• If CERs not created/transferred, giving rise to
  non-performance of obligations, appropriate
  remedies should be considered, particularly in
  the event that the ER rights never materialize.

• Should have an option to manage shortfalls
  through an number of mechanisms (e.g.physical
  replacement of the volume of the shortfall of ERs
  from other projects or future years, repayments)

• Appropriate indemnities should be incorporated

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Key Contractual Provisions

• Evidencing the validity of the ERs being
  contracted

• Documentation showing that the emission
  reductions, the subject of the contract, actually
  occurred

• Must be clear as to who is responsible for
  carrying out initial and ongoing validation of
  the project and for the associated costs.

• Whether third party verification is required
  should likewise be specified, including an
  outline of the criteria for this

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Key Contractual Provisions

• Evidencing the validity of the ERs being
  contracted

• At the moment, the evidentiary burden is usually
  discharged via a demonstration that, when
  measured against an appropriate baseline, the
  particular project activity has delivered real
  and measurable reductions of GHG emissions

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Key Contractual Provisions

• Baseline Measurement, Verification and
  Certification

• Clauses should ensure that there is an
  appropriate baseline measurement and there is a
  procedure for independent verification of the
  practical emission reduction process

• May need to include conditions for a verification
  report

• May need to include definitions for such terms
  like real reductions, measurable reductions,
  surplus reductions, additionality

• Might be advisable to set out appendices to the
  contract as to third party verification

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Key Contractual Provisions

• Changes to the Scientific Processes for
  Quantifying and Verifying ERs

• To take account of scientific uncertainties, the
  contract could include a reopener clause
  permitting the recalculation of tonnes if
  different numbers are adopted by relevant
  authorities

• Specify measurement and assurance standards that
  are to be used.

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Key Contractual Provisions

• Risk

• Elements of Risk in Carbon Deals

• Finance, Approvals, Construction, Production
• Has impact on existence of the Project therefore
  existence and production of ERs
• Issue what if CDM EB rejects the project

• Host Country approval,compliance, eligibility,
  transfer
• Has impact on existence and compliance of ERs and
  price
• Issue what if carbon assets are nationalized

• Project Risk

• Protocol Risk

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Key Contractual Provisions

• Risk

• Acceptance of the resultant risk is a commercial
  issue to be determined between the parties
  therefore, important to identify all risks and to
  carefully and clearly allocate them between the
  parties involved (i.e. Buyers risks, Sellers
  risks

• Risk is best allocated to the party most able to
  bear it

• Need to provide risk mitigation strategies such
  as insurance

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Key Contractual Provisions

• Price and Terms of Payment

• Set out the price to be paid for the ERs may
  vary

• If any ERs are covered by an option, the price
  thereof should be set out, as applicable

• Terms and method of payment need to be clearly
  stipulated. May take several forms (e.g. full
  upfront payment, option, payment triggered by an
  event)

• Credit risk, issues such as penalties for late
  payments, increases for inflation and other
  charge related items should also be addressed

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Key Contractual Provisions

• Warranties and Representations

• Warranties should include, among others

• Usual commercial warranties of corporate power
  and creation
• Creation of the ERs and Title to the ERs
• Rights being free of any encumbrance
• Validity of the rights
• Undertaking of the ER activity
• Certainty that the activity has not been used to
  generate any other form of ER
• Reduction is permanent

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Key Contractual Provisions

• Warranties and Representations

• Should also address the timing of representations
  (e.g.representation true for the entire term of
  the agreement)

• Seller may wish to exclude any warranties as to
  the merchantability or fitness for a particular
  purpose of the ERs

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Key Contractual Provisions

• Liability and Indemnities

• Parties will have to determine to what extent, if
  any, the liability of either or both parties
  should be limited.

• Damages may arise out of or by reason of breach
  of obligations, events of default, negligent act
  or omission, representations and warranties

• May include a waiver of special damages

• Should decide whether indemnities are required,
  including indemnities relating to carbon debits
  and potential losses relating to leakage

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Key Contractual Provisions

• Default, Termination and Remedies

• Specify Events of default such as termination
  of business or bankruptcy, material breach of
  representation, failure of Seller to deliver ER
  rights, failure of Buyer to make payments when
  due, failure of Seller to comply with
  validation/verification obligations, failure to
  secure HC approval or to satisfy requirements
  under Kyoto Protocol for CDM projects

• Consequences of an event of default should be set
  out, may be to include provision for payment of
  damages

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Key Contractual Provisions

• Default, Termination and Remedies

• In case of remedies, there is a range of options
  including good-faith cooperation or negotiation,
  designation of early termination date,
  withholding of payments by non-defaulting party

• Might need to consider whether contract remedies
  are exclusive for events of default or whether it
  is in addition to any other remedy available by
  law

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Key Contractual Provisions

• Progress Reports and Audit Rights

• Given the long term nature of the ERPA

• Only reasonable way for Buyer to be able to
  assess whether the Seller will be able to perform

• Buyers right to terminate contract in the event
  that reports prove unsatisfactory

• Interim reports may reveal a higher level of
  reduction than anticipated thereby being
  beneficial to the Seller

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Key Contractual Provisions

• Confidentiality

• Parties to determine and define what constitutes
  confidential information in respect of the
  agreement

• Determination should include what obligations to
  impose and whether confidentiality obligations
  are mutual or falling only on one party

• Should address the term of the confidentiality
  obligation, among others

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Key Contractual Provisions

• Arbitration and Dispute Resolution

• Due to uncertainties concerning carbon
  transactions, important to set out procedures for
  dispute resolution

• Parties may develop their own dispute resolution
  or adjudication process

• Identify place of the arbitration and the
  arbitration system to be used

• Optional Rules for Arbitration of Disputes
  Relating to Natural Resources and/or the
  Environment (Permanent Court of International
  Arbitration. Go to www.pca-cpa.org)

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Key Contractual Provisions

• Taxes, Levies and Charges

• Often arise from the registration and transfer of
  rights

• Determine what fees to be paid for the creation
  and registration of ERs and who bears the cost of
  any transfer fees or cost of compliance

• Issue of taxation related to pricing (whether
  price is inclusive or exclusive of goods and
  service tax and other charges)

• Should address issues concerning local taxes,
  future legislation imposing taxes or charges on
  ER transactions

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Key Contractual Provisions

• Taxes, Levies and Charges

• Should address the possibility of future
  legislation imposing various taxes or charges on
  ER transactions

• Important note CDM projects under Kyoto Protocol
  will have to direct a particular share of
  proceeds to specified funds to cover
  administrative expenses as well as to assist
  developing countries that are particularly
  vulnerable to the adverse effects of climate
  change to meet the costs of adaptation (Article
  12, para 8, KP)

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Key Contractual Provisions

• Force Majeure

• Determine what constitutes a force majeure
  event and the consequences of such an event

• Parties may, however, decide not to assert a
  claim of force majeure or any similar claim to
  excuse any non-performance of their duties and
  obligations under the agreement

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Key Contractual Provisions

• Third Parties

• Clear provision as to whether third parties have
  right to enforce or take benefit from the terms
  of the ERPA.

• Involvement of third parties in contracts for
  sale of ERs may include roles as facility owner,
  verifier, reducer, financier, government
  authorities, NGOs

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Key Contractual Provisions

• Third Parties

• Consider due diligence checks and attaining
  assurances from the third party to address
  possible issues on permanence, competing claims
  and access rights

• If a contract should contain some stipulation in
  favor of a third person, he may demand its
  fulfillment provided he communicated his
  acceptance to the obligor before its revocation.
  A mere incidental benefit or interest of a person
  is not sufficient. The contracting parties must
  have clearly and deliberately conferred a favor
  upon a third person. (Article 1311, 2nd
  paragraph, Civil Code of the Philippines)

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Key Contractual Provisions

• Miscellaneous provisions (Boiler Plate clauses)

• Entire agreement
• Governing law and enforceability
• Variation/amendments
• Severability
• Waiver
• Survival
• Notice

• Assignment
• Jurisdiction
• Successors and Assigns
• Delay or Omissions
• Public Relations

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Key Contractual Provisions

• Domestic law

• Trading Licenses
• Taxation
• Corporate securities
• Philippine Energy laws
• Philippine Environment legislation

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Future Legal Dynamics

• Emerging innovative structures (e.g. forward
  sales and option arrangements, creation of carbon
  pools, CER bonds and warrants, tax-driven deal
  structures)

• Ability to understand and interlink and
  manipulate regulatory regimes is key

• Liability and opportunity driven by emerging
  legal regimes

• Demand, supply and price will be driven by
  project success and market liquidity

• Range of drivers reallocation of insurable
  risks, redirection and revaluation of
  investments, climate litigation, shareholder
  expectations, etc.

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Future Legal Dynamics

• Should start to put in place a regulatory
  framework for the Transfer and Trade in ERs

• Definition of ERs
• Establishment of original ownership of ERs
• Regulations on the transfer of ERs
• Putting in place registries
• Taxation
• Others.

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Conclusions

• CDM Project operates within the domestic
  jurisdiction, therefore all the dynamics of the
  domestic regime will influence ERs
• Domestic legal regimes need to establish explicit
  laws/rules/institutions/authorities to recognize
  ER legally
• International regime needs to take into account
  the diversity of domestic legal systems
• Harmonization of international and domestic legal
  regimes apart, the near-term the effectiveness of
  ERs and ER transactions can best be achieved by
  overcoming barriers by contracting and
  arbitration process

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Thank You!
Atty. Angela Consuelo S. Ibay Program
Coordinator Climate Change Information
Center Manila Observatory, Ateneo de Manila
Campus Tel [phone] Fax 63 2
426-0847 gia_at_observatory.ph