1. Introduction to Legal and Contractual Aspects of CDM Projects
University of Twente
21 March 2006
Robert O’Sullivan
Climate Focus

2. Content Nature of Emissions Rights Project Structuring
Basic legal documentation
Emission Reduction Purchase Agreement
Scenario
Conclusions

3. Nature of Emission Rights

4. Sources of emission rights
International treaties
Regional, national and state legislation or codes
Contracts
Common law and equity

5. A taxonomy of what is traded
Units defined by the Kyoto Protocol:
Assigned Amount Units (AAUs)
Certified Emission Reductions (CERs, tCERs, lCERs)
Emission Reduction Units (ERUs)
Removal Units (RMUs)
Units defined by EU and national legislation:
EU Allowances
UK Allowances and Credits
Australian Abatement Certificates and Sequestration Rights
US SOx and NOx Allowances
Other
Units defined by contracts:
Verified Emission Reductions (VERs)

6. What are they?
Treatment and characteristics of units is more important than whether or not they are ‘property’
Represent a right to be used as a compliance unit, and emit one tonne of GHG in this context?
Transferable?
Ownership and possession by entities?
Clearly defined?
Irrevocable/indefeasible once issued?
Protection of 3rd party interests such as charges? (restricted transfer on this basis?)
Treatment as financial services?
What conditions are imposed on any of the above?

7. Contractual Rights Emission Reductions
‘any right, interest, credit, entitlement, benefit or allowance to emit (present or future) arising from or in connection with any GHG Reduction by the Project and includes any right that may be created under any regulatory or legal regime as a result of the GHG Reductions whatsoever’
Verified ERs
ERs which have been verified and certified by an independent auditor, but have not been formally issued
So what are ERs and VERs?
Not as secure as other emission units
Still of value

8. Creation of VERs and CERs
Carbon Contract
CERs $$
Issuance by EB
VERs
Verification (by DOE)
Verification by DOE
Approval of Methodologies , approval of the project, registration
Creation of GHG Reductions (measured in tonnes of CO2e)

9. So what is used in contracts?
Depends on what the project produces
Early World Bank CDM and JI contracts were for VERs
Most CDM and JI contracts are for CERs and ERUs
VER contracts tend to be restricted to the voluntary market

10. Project Structuring

11. Project Structuring
Initially the CDM anticipated direct investments into projects
Today the most common form of a carbon contract is forward contract in the form of an Emission Reductions Purchase Agreement (ERPA)
An ERPA is a long term off-take agreement
An increasing number of developers are also choosing to sell on the spot market
Equity investments are being seen

12. CDM Project Structures
Parent
Company
CDM Project Structures
Equity
investor
Technology
Supplier €
€? CERs? €
Tech
Bank € € €
CERs e
Approval
CER Buyer
Local $
Construction
O&M
Access
Affected people
etc
Government
Electricity
purchaser

13. Project Structuring Issues
Who owns the project, who generates the CERs?
Establish initial CER ownership.
Do other parties have an interest in the CERs?
Who do I want as project partner?
Buyer: who to buy from
Seller: work through an intermediary, partner, parent vs. directly with buyer?
Who are the other Project Participants, and how are they involved?

14. 2 Case Studies:
Landfill Projects generating ERs through capture of methane [and electricity generation]
Generally public projects or public private partnerships
Contractually flexible as different rights and obligations get easily separated [waste, land, landfill gas, CERs..]
Example for necessary due diligence?

15. Ownership of Emission Reductions Project Example: Landfill Project I
Power Purchase A.
Carbon Contract
Municipality
Owns the land
Operates the landfill
Collects the waste
Sells the Electricity

16. Ownership of Emission Reductions: Project Example: Landfill Project II
Power Purchase Agreement
Carbon Contract
Shareholder Agreement
Power Generation License
Special Purpose Company
Loan Agreement
Environmental License
Construction Agreement
Landfill Gas Transfer Agreement
Grid Connection Agreement
Landfill Concession Agreement
Operations- and Management Agreement
Use of Land Agreement

17. Basic Legal Documentation for Carbon Projects

18. Letter of Endorsement / No-Objection
Not required under Kyoto, but can be useful
Between Seller/Buyer and Host Country
Expression of Support / Non Objection
Evidence that the Host Country has been informed and endorses the project
No binding endorsement which does not create a right to any future approval

19. Letter of Approval Required under Kyoto
Between the Host Country and the Project Developer
But also: between the Buyer and an Annex I country
Should be unconditional
Not clear whether the approval can be withdrawn
Not clear how the Letter of Approval would be treated in a dispute (double intl’/ natl’ nature, may grandfather rights)

20. Letter of Intent / Exclusivity Agreement
Between Seller and Buyer
Early legal document
Secures exclusivity
Cost recovery in case the project sponsor unilaterally decides not to move forward with the negotiations
Helps the project sponsor to obtain financing
Gives comfort to the Buyer to start spending money on due diligence and contract drafting and negotiation
May include some basic or key terms regarding the transaction that will appear in the ERPA

21. CER Transfer Contracts
Assignments
To equity holders
As part of a technology supply agreement
Spot contracts
Standardized sale of CERs after issuance
Not project specific
Forward contracts
Emission Reduction Purchase Agreements
Project specific

22. Emission Reductions Purchase Agreement

23. ERPA: Purpose Record agreement Identify responsibilities
Establish rights
Manage Risk
Requires understanding of CDM rules, so tend to be complex and difficult for unspecialized lawyers

24. “CERSPA” initiative Sponsored by Inter-American Investment Corporation
Objective to produce a balanced CER Sale and Purchase Agreement template and explanatory Guidance Document
Open source, freely available
Contain more detailed information, plus translations into a number of languages (Spanish, Portuguese, Chinese)
Will be online soon at

25. ERPA: Key Terms Conditions of effectiveness (conditions precedent)
Price
Upfront payments?
Volume and delivery
Listing as Project Participant and Communication with EB
Damages/default
Monitoring and Verification
Governing Law, Costs, Force Majeure

26. ERPA: Conditions of effectiveness
Cross effectiveness of other contracts
Financial closure
Power purchase agreement
Project Commissioning
Legal opinions
LoA, validation, registration
Useful for buyer to be able to drop a non-performing project without default proceedings
Useful for a seller to avoid liability if the project is not registered

27. Price: Fixed Price
“The Buyer agrees to pay the Seller €X for each CER delivered to the registry account of the Buyer before 1st March, 2013”

28. Price: Simple Indexed Price
“The Buyer agrees to pay the Seller X% of the Market Price of [an EU Allowance] [CER Spot Market Price] for each CER delivered into the registry account of the Buyer before 1st March 2013”

29. Price: Simple Indexed Price with Floor and Ceiling
“The Buyer agrees to pay the Seller X% of the Market Price of an EU Allowance for each CER delivered into the registry account of the Buyer before 1st March 2013, except that irrespective of the Market Price of an EU Allowance the price paid for each CER shall never be greater than €X per CER and shall never be less than €X per CER”

30. Price: Different Approaches in Practice
Market Price Simple Indexed Price
Fixed Price Indexed Price with Floor & Ceiling

31. Pricing: Factors that Affect the Starting Price
Bargaining
Demand
EUA price
weather
EU policy developments
Timing of payments and delivery
Delivery “guarantees”/ remedies for under delivery
Who pays share of proceeds for EB admin expenses ($0.10/0.20 per CER) and other taxes
Risks
Regulatory (baseline, additionality, registration)
Project (underlying project risks inc. technology, financing etc)
Host country (LoA)
Counter party (capitalization, experience)
Reputation (resettlement?)

32. Upfront payments
Generally only given if required to complete financing
Security  questions:
What kind? (L/C, parent guarantee, amortized equity)
How to get it? - Lenders probably won’t share it.
Discount of CER price

33. Volume and Delivery When Where (to an from) How How much Seniority
primary transfer (Art. 6/12)
secondary transfer (Art.17)
Communication rights with the EB
How much
CDM: share of proceeds for adaptation (2%)
Seniority
(these issues won’t necessarily appear together in the same clause)

34. Fixed Annual Volume
“Before the 1st February each year the Seller agrees to deliver the first X CERs generated by the Project in the previous Year into the registry account nominated by the Buyer”

35. Fixed total amount with “Acceleration”
Combined with seniority and fixed total delivery obligations
“Before the 1st February each year the Seller agrees to deliver 100% of the CERs generated by the Project in the previous Year into the registry account nominated by the Buyer until a total of X CERs have been delivered”

36. Percent: Total and Annual
“Before the 1st March 2008 the Seller agrees to deliver X% of the CERs generated by the Project before 1st January 2008 into the registry account of the Buyer”
“Before the 1st February each year the Seller agrees to deliver % X of the CERs generated by the Project in the previous Year into the registry account nominated by the Buyer”

37. Volume and Delivery: Fixed vs. %
Default Amount
Fixed with acceleration
Default Amount
Green may or may not be default depending on seniority
% with Default Amount
Default Amount

38. Project Participants and Communication with EB
“Project Participant” is someone authorized to participate in a CDM project pursuant to a LoA.
Listed in A.3 of the PDD
PPs have a number of rights re. a project including:
Right to tell the EB where to send CERs when they are issued
To be realized, PP must be named as communication focal point in modalities of communication
Right to receive CERs when first issued by the EB
Right to receive notification and respond to any request for review
“Party Involved” is an Annex I or non-Annex I party to KP that has issued a LoA. They have a number of rights:
To be listed as a PP
To request a review at registration and issuance

39. Project Participants and Communication with EB
Issues that arise from this:
Who is listed as a PP?
Most buyers want to be listed, so that they can get CERs directly from EB without going through art. 17 transfer.
Who has communication rights with EB?
Most buyers want this as security that they will receive their CERs
May be problematic for Seller if there are multiple buyers
Joint communication is possible
Make sure buyer is removed from being a PP after they have all their CERs

40. Remedies: Delivery Default
“If the Seller fails to deliver the Default Amounts the Buyer may;
Require the Seller to provide replacement CERs to the Buyer
Recover damages from the Seller
Require the Seller deliver additional CERs in the following Year in an amount equal to the difference between the amount delivered and the Default Amount
Terminate the Agreement and recover from the Seller any outstanding Advance Payment and other outstanding costs plus interest of X%.”

41. Remedies: Payment default
“In the event of a Payment Default interest payable to the Seller shall accrue to the Buyer at a fixed rate of X% per annum
If the Buyer has not remedied a Payment Default within the cure period, the Seller may recover damages from the Buyer
If the Buyer has not remedied a Payment Default within the cure period, the Seller may recover CERs already delivered to the Buyer but not paid for
If the Buyer has not remedied a Payment Default within the cure period, the Seller may terminate the agreement”

42. Remedies: Intentional Breach
Normally have strict damages remedies for defaults that are the result of intentional misconduct or gross negligence

43. Remedies and Pricing Default Default Market Price Simple Indexed Price
Fixed Price Indexed Price with Floor & Ceiling

44. Force Majeure “Events beyond the control of a party”
Absolves an affected party from liability re. obligations affected by a FM event (e.g. delivery, payment)
Issue of what is included/excluded
EB decisions?
Biological processes?
Wind/water availability?

45. Elements of Risk in Carbon Deals
Key Issues:
Market/Price Risk
Project Risk
Finance, Approvals, Construction, Production
Has an impact on:
Existence of Project
Therefore existence and production of CERs
Needs management for the long term
Kyoto Protocol Risk
Host Country Approval, Compliance, Eligibility, Transfer
Existence and compliance of CERs/ERUs
Price

46. Risk Allocation
Principle: Assign risk to the party best able to bear it
Investors/creditors/seller assume most project risks
Buyer or Seller take Kyoto Protocol related risks
Market risk is often shared

47. Risk Mitigation Tools Market/Price risk: Kyoto risk:
Selling/purchasing CERs of different seniority
Flexible pricing
Option contracts (put or call)
Kyoto risk:
Host country agreement or letter of approval
Using approved methodologies
Entering into an ERPA after project registration
Securing the right to communicate with the EB
Obtaining Host Country and Annex I country approval (+authorization)

48. Risk Mitigation Tools Project and delivery risk
Ensure management and operational capacity of the counterpart
Secure stable financing of the project
Ensure resource availability
Ensure legal compliance
Using conservative CER projections
Sell from a pool
Ensure the senior right to the CERs (buyer)
Establish reporting obligations (buyer)
Seller payment/receipt of CER risks
Credit check
Alternative registries/delivery = issuance
Escrow agent (see CERSPA guidance document)

49. Scenario
Just agree on basic terms that will be carried over to the ERPA
No need for “legal” drafting

50. Conclusions

51. Lessons Learned
The Carbon Prices do not have a big impact on IRRs of Energy Projects
High transaction costs, but they are coming down
Not all countries welcome CDM/JI investments
Rulings and interpretations of the international regulator often not predicable and ambiguous
We are running out of time
BUT:

52. Lessons Learned
Additional Income Stream – An ERPA secures an additional income stream for the project
Additional Environmental Benefits – An ERPA monetizes the global environmental value of a project
Additional Knowledge Generation – Developing an ERPA provides a learning experience to all parties
Additional Due Diligence – An ERPA may lead to additional scrutiny and risks assessments of the project
Forming Additional Partnerships – An ERPA broadens the stakeholder basis and the support for a project

53. Summary Risk profiling of a project is key
Removal of risks comes at a price
Interests of the Parties need to be clear
Individually negotiated contracts are more complicated but more stable than standardized agreements
Harmonizing ERPA with lending agreements increases the robustness of both agreements
Timing is key

54. Questions? Robert O’Sullivan Climate Focus +31 10 217 5992