CDM Legal Issues Second SSA Regional CD4CDM Workshop Maputo, 18 August 2004 Paul Curnow, Baker & McKenzie

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 2 Workshop Agenda Session VII: Introduction Session VIII: – Part I: CDM project structuring – Part II: CDM contract drafting and negotiation Session IX: – Part I: CDM project risk management – Part II: Conclusions on legal issues sessions

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 3 Session VII: Introduction

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 4 Overview of the Guidebook Purpose: to assist Host Country stakeholders understand key legal issues/risks in developing CDM projects and selling CERs Introduction sets out context of legal issues guidebook (i.e. the development of a new area of law under the Kyoto Protocol, which must also exist within the context of domestic legal regimes Legal Issues Guidebook builds on previous CD4CDM Guidebooks but with a focus on: Legal requirements of CDM Projects Interaction with domestic and international law Identifying and managing risks Creating and transferring CERs through contracts Potential structures for CDM Projects

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 5 Overview of Guidebook (cont.) Key Issues for Host Country Project Developers Complexity of developing CDM rules, limited Host Country expertise Establishment of DNA Attracting underlying finance to CDM Projects (i.e. addressing risk concerns of potential investors) Transaction costs Creating and transacting CERs (ownership of CERs etc) Interim period where Kyoto Protocol yet to enter into force

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 6 Overview of Guidebook (cont.) Chapter Two: Background to the CDM Development of CDM under international law – status of the Kyoto Protocol Brief summary of major CDM requirements Chapter Three: Role of CDM Entities Briefly explains the role of the CDM Executive Board, project participants, the DNA, DOEs and CER Purchasers and the risks which each of these presents for CDM Projects Focuses on considerations in establishing a DNA, including the requirements for DNAs under the Marrakech Accords and potential additional roles which DNA could fulfil to facilitate CDM projects

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 7 Overview of Guidebook (cont.) Chapter Four: Legal Steps in Developing CDM Project Legal requirements for CDM projects under Marrakech Accords, including major considerations at each stage of project cycle Chapter Five: Qualification as a CDM Project: Legal Requirements Key requirements for registration Who can participate? What types of projects are eligible? What are the key requirements Domestic law impacts on the CDM – foreign direct investment laws, environmental laws, property laws, securities and financial regulation A role for the DNA in facilitating CDM investment – various barriers to investment in Host Countries and means by which DNA can overcome these

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 8 Overview of Guidebook (cont.) Chapter Six: Certified Emission Reductions What is a CER? When can CDM Projects begin to generate CERs? How long can they generate CERs for? Legal ownership of CERs – includes discussion of establishing ownership to underlying GHG emission reductions – does the Host Country own CERs or do private project participants? Transfer of CERs through CDM registry system CER Pricing – includes brief discussion of current pricing and future potential

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 9 Overview of Guidebook (cont.) Chapter Seven: Structuring and Financing a CDM Project Project structure will depend on nature of project, number of project participants and role which CERs play in attracting finance or revenue Once appropriate structure chosen, risks will need to be considered and allocated Includes diagram of example CDM project structure including arrangements for project funding, sale of CERs, project construction, project operation and maintenance and off-take of commodities

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 10 Overview of Guidebook (cont.) Chapter Eight: Managing CDM Project Risks All CDM Projects entail a number of risks for project participants and investors. The Guidebook discusses means of identifying, allocating and assigning risks through project management practices, and contractual negotiations and provisions Discusses practical examples of various types of risk and appropriate mitigation strategies

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 11 Overview of Guidebook (cont.) Chapter Nine: CDM Contracts As with CDM project structures, CDM contracts can assign CERs in a variety of ways (e.g. spot transactions, forward sales and option arrangements) As registry accounts finalised and CDM Executive Board begins issuing CERs, CDM contracts transacting CERs are likely to become more simple and some types of contracts may be able to be standardised Current CDM market has been largely influenced by several major purchasers – the World Bank and the Netherlands Government. The chapter discusses the contracting approaches of these entities to date, but also provides alternative contracting approaches which may be utilised by Host Country project participants

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 12 Overview of the Key Legal Issues in the CDM Initial project legal arrangements Compliance with CDM Rules (authorisation, registration, sustainable development, no deviation from overseas development assistance etc) Impact of domestic legal issues on CDM projects Creating and owning CERs Transacting CERs

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 13 Session VIII - Part I: CDM Project Structuring

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 14 General Overview of Structuring CDM Projects Article 12 and Marrakech Accords do not specify how a project is to be structured Project structure will depend on nature of project, number of project participants and role which CERs play in attracting finance or revenue Once appropriate structure chosen, risks will need to be considered and allocated Generally existing legal and financial contractual forms are utilised but need to be modified to: take account of and contractually assign risks create and contractually assign unique CDM product - CERs

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 15 Overview of Structuring CDM Projects (cont.) Potential project structures include: Direct sale of CERs from a Host Country driven CDM Project Provision of debt finance in return for part payment in CERs Equity investment in return for revenue stream from CERs Non-recourse project finance Technology swap in return for CERs “Bundling” CERs with other commodities through off-take arrangements

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 16 Early Experience with the CDM Executive Board Decisions Significant risk in early CER sales has been whether early CDM project will be able to generate CERs Central issues faced by CDM Executive Board have been approval of baseline methodologies and additionality All 8 CDM methodologies presented in the first round were rejected - but Executive Board has now approved 9 methodologies: 3 methodologies for renewable energy 4 methodologies for landfill 1 methodologies for fuel switching 2 modification of production process Uncertainty presents unique risks to CDM project participants involved in CDM projects

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 17 Case study on key legal issues and project structuring: Mini hydro-electricity power station in Zimbabwe

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 18 Discussion of case study and participant experiences

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 19 Session VIII - Part II: CDM Contract Drafting and Negotiation

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 20 The Roles and Nature of Carbon Contracts Approaches to finding buyers and sellers of CERs: Competitive tender processes Buyers issuing a request from the market Sellers approaching potential buyers to propose investment Transacting through independent brokers Contracting approaches to selling CERs can include spot transactions, forward sales of CERs, or option contracts Final binding ERPAs often preceded by some type of Exclusivity Agreement or Letter of Intent which allows Buyer and Seller time to negotiate appropriate contractual provisions without binding them to reach agreement

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 21 Key legal issues in contract negotiations The key legal issues to be considered in drafting a contract to sell CERs are: Defining what is to be sold under the contract and how it will be delivered (i.e. only CERs delivered into a registry account or Verified Emission Reductions delivered through provision of a Verification Report) Establishing and transferring legal title to the CERs Negotiating price and payment terms Managing risks Warranties and indemnities Dispute resolution procedures and termination

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 22 Perspectives of CER seller and buyer CER Seller and Buyer are likely to have different interests and perspectives on many of the contractual issues The Guidebook provides an analysis of these differing perspectives and possible contractual approaches in relation to: Legal title to CERs (appropriate parties to the contract) and transfer of title Quantity of CERs being acquiredand purchase price Shortfall provision Payment of costs Liability and indemnities Force majeure Dispute resolution

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 23 Case study on legal problems in negotiation: Netherlands CERUPT Offer to purchase CERs from Chilean Energy Efficiency Project

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 24 Key lessons learnt in early contract negotiations World Bank Carbon Funds (i.e. PCF, BioCarbon Fund, Community Development Carbon Funds, Netherlands CDM Facility and country specific funds) Tender procurement process through the submission of Project Idea Notes Early contracts transferred “Emission Reductions” with an obligation to work together to create CERs when this was possible (i.e. World Bank took Kyoto Protocol risk) Seller required to follow Marrakech Accords procedures Emission Reduction unit price is fixed for the duration of the agreement Flexible arrangements to remedy shortfall (e.g. alternative delivery arrangements) World Bank generally provides upfront coverage of initial Kyoto Protocol costs which are deducted from future payments World bank retains immunities and privileges and no governing law clause

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 25 Key lessons learnt in early contract negotiations Netherlands Government Funds (CERUPT) Approach of each fund managed on behalf of Netherlands Government will vary, although are likely to be of a more commercial nature than World Bank contracts In CERUPT tender process, form of tender constituted offer to enter into binding legal contract New JI fund (ERUPT) has stringent penalties for shortfall – these may be incorporated into CDM contracts Netherlands Government is developing towards only purchasing CERs which are delivered into a registry account (i.e. Kyoto Protocol risk is on Seller) Dutch Civil Code doctrine of reasonableness and fairness will apply Project participants must comply with OECD Guidelines for Multinational Enterprises

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 26 Summary of Alternative Contracts in Guidebook Guidebook includes two types of contracts for use by Host Country project developers - different contracting approach from the current contracts used by major purchasers in the market: Contract for direct sale of CERs (where purchaser is not involved in underlying CDM Project); and Contract for projects where purchaser has underlying financial interest and CERs are only part of the contractual arrangements

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 27 Summary of Alternative Contracts in Guidebook Contracts have been drafted in a manner favourable to the Host Country project developer – commercial purchasers may insist on more stringent conditions Each CER transaction is unique and these “shell” contracts should be amended to suit each CDM Project and the particular considerations of the parties First contract (Appendix C) is a simple delivery of CERs – remedies for shortfall are to renegotiate delivery or terminate the agreement Second contract (Appendix D) could include security arrangements over the project assets (linked to the finance documents for the project), which could be called upon in the case of shortfall Second contract also example of assigning full legal and beneficial title to CERs and Emission Reductions

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 28 Case study on legal problems in negotiation: World Bank PCF negotiations for Brazilian CDM Cogeneration project

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 29 Discussion of case study and participant experiences

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 30 Session IX - Part I: Identifying and Managing CDM Project Risks

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 31 Identification of Key Project Risks Identifying, allocating and assigning risk in CDM Projects is a process which must be agreed upon commercially and then reflected in contracts The three main risk categories for a CDM Project are: Host Country Political and Sovereign Risks particular to the Host Country General project risks common to all projects Kyoto Protocol risks due to the developing nature of the legal framework

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 32 Host Country Political and Sovereign Risks Potential investors and project developers will carefully assess the perceived level of sovereign and political risk in a Host Country before becoming involved in a CDM Project. Many Host Country decisions or events can impact adversely upon a CDM Project (for example, change in law, currency fluctuations, excessive administrative burdens) which may be out of the control of all parties to a CDM Project The Host Country Government (e.g. the DNA) could assist potential investors to understand the nature and extent of Host Country political and sovereign risks by explaining issues such as the Host Country policy in relation to the CDM and relevant Host Country legal frameworks which will impact the project. Investors are likely to prefer Host Countries with an established legal and political system which clearly recognise and support CDM investment

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 33 General Project Risks These risks include the risk of force majeure events, the risk of project underperformance (e.g. due to human error or delayed construction) and the risk of cost overrun in developing and commissioning the CDM Project These risks are common to projects other than CDM Projects and Host Country project developers may have experience in managing and mitigating them Cost risk is particularly important to consider in the context of a CDM Project, which requires input from a number of consultants (e.g. DOEs) and the development of highly technical documents such as baseline methodologies Early purchasers have sometimes paid costs to develop and register a CDM Project upfront (with such costs deducted from later payments for CERs) but this practice may not continue as the CDM market develops

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 34 Kyoto Protocol Risks CDM Projects entail special Kyoto Protocol risks due to the fact that they will sell CERs, which are legal rights based on an intangible reduction in greenhouse gases, created under international law in a regime which has not yet entered into force Kyoto Protocol risks include: Kyoto Protocol will not enter into force or rules will develop in an unexpected manner Inability to develop baseline methodology acceptable to Executive Board Legal title disputes over CERs Incorrect monitoring of emission reductions CER market risk or Community or NGO opposition Risks should be dealt with in the preparation and management of the Project as well as contractually through agreements to sell CERs. Ultimately the level of Kyoto Protocol risk taken on by the Buyer will affect the price it will pay for CERs

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 35 Management of Key Project Risks Generally parties will allocate risk to the party which is best able to control that risk The allocation of risks which neither party is able to control should be reflected in the price paid for CERs Risk allocation can be dealt with through measures such as: Conditions precedent to the entry into force of a contract Guarantees from Host Countries or parent companies Force majeure clauses Laying off risks to third parties such as contractors or DOEs Warranties, indemnities and rights of termination in a contract

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 36 Contingencies in the CDM Project Cycle Whilst some risks (e.g. political risk) can arise at any stage of a CDM Project, every project will have to address certain contingencies (“what ifs”) at each stage of the project cycle. For example: Stage One: Developing Concept of CDM Project: How should the project be structured? What if the baseline methodology is rejected? Stage Two: Registering and Commissioning CDM Project: What if the project construction costs are significantly more than expected? What if the construction contractor fails to fulfil its obligations? Stage Three: Operating CDM Project: Monitoring and Verification: what if the emission reductions are not accurately monitored/ What if the underlying project is disbanded as it is not generating a profit? Stage Four: Entering into Contract to Sell CERs: What if the market price for CERs changes significantly? What if the Kyoto Protocol does not enter into force? Project participants must have an understanding of the contingencies at each stage of project development so as to properly assess the risks that the CDM Project presents for them

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 37 Discussion of participant experiences

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 38 Session IX - Part II: Conclusions

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 39 Summary of outcomes and experiences

CDM Legal Issues Guidebook ©2003 Baker & McKenzie 40 Issues going forward Whether the Kyoto Protocol will enter into force Unilateral CDM Projects Ability of Host Country private participants to hold registry accounts Ability of Host Countries to trade CERs Status of the “prompt start” of the CDM Establishment of DNAs Development of concept of “additionality” Interaction with Host Country laws

Contact: Martijn Wilder, Partner, Sydney Rodrigo Sales, Partner, Sao Paolo Paul Curnow, Sydney & Johannesburg UNEP Legal Issues Guidebook