Carbon Offset Trading – Managing Risk in a Time of Regulatory Uncertainty

By Joshua Belcher and David McCullough, Sutherland Asbill & Brennan – Special to The Digest.

Over the past decade, the market for carbon offsets has waxed and waned with the likelihood of a mandatory greenhouse gas reduction program being passed into law. Carbon offsets are credits that are generated through avoiding the emission of greenhouse gases—primarily by protecting large tracts of forest from development or through capturing methane from landfills or agricultural operations and subsequently using that methane as a source of energy. Until very recently, the demand for carbon offsets was almost exclusively driven by the desire of private entities and corporations to voluntarily commit to “green” their operations by reducing greenhouse gas emissions.

We now see existing compliance programs, such as California’s AB32 cap-and-trade regulation and the Regional Greenhouse Gas Initiative (RGGI) in the Northeast, take root and ramp up. Additionally, the Environmental Protection Agency’s (EPA) recently proposed Clean Power Plan would apply strict limits on carbon emissions from steam-generating and gas-fired electric utility generating units across the country.

These pressures are bringing the carbon offset market to the forefront and presenting significant opportunities through continued confidence in the markets. With those opportunities, both buyers and sellers need to be aware of a variety of issues and common pitfalls when trading in carbon offsets.

Master Agreement Versus Bespoke

At the outset, buyers and sellers need to decide whether they want to execute one-off agreements or enter into a series of trades over a long period of time. Master agreements establish standardized provisions for billing and payment, taxes, credit requirements, how trades are completed and other terms that will apply to a series of transactions over time. Many companies provide their own forms. Individual trades are executed in what are called “confirmations,” which outline only the most important terms, like the product being traded and the price. Because trades may occur over a long period of time, it is important to spend time getting the terms right. Bespoke agreements contain all of the essential terms and typically are used for isolated trades. While the risk is more limited, the provisions must still be crafted with care.

Product Identification

Product identification poses an important but easily overlooked issue. Product identification risk arises if the offsets to be traded are not properly defined. The parties must be clear about what is being traded, as with all environmental attributes. For example, those buying offsets to satisfy compliance obligations must take care to specify the product per the applicable compliance program. California allows for different types of offsets, including those that do not qualify for compliance purposes. Where compliance grade offsets are being traded, the buyer should consider asking for a certification from the seller, not only at the time of execution, but also when the offsets are delivered.

Invalidation

Risk of invalidation is an issue where it can be shown that an offset no longer qualifies under the applicable program. While this is a bigger concern for offsets used for regulatory compliance, voluntary programs also have an interest in ensuring market integrity. Both have protocol in place to address basic issues like permanence, additionality, leakage, enforceability, monitoring and verification. Sometimes the risk can persist for a long period of time following a trade. For example, California regulations allow for an eight-year period in which an offset could be invalidated. The law places this risk on the buyer, but it can be shifted to the seller. Parties have a number of tools to manage the risk, including representations, warranties and covenants. The best approach will depend in part on whether the parties are trading in the primary or secondary markets.

Regulatory Framework: Mandatory, Voluntary, State or Regional Programs

Do the buyer and the seller expect the offsets to be used in more than one state? Will multiple programs apply to the offsets, either now or in the future? The parties should consider including provisions that make it clear where the offsets were generated and with which programs they can/must comply. The parties should also consider how offsets might be qualified for use under new programs that arise and which party has the responsibility for any applications or certifications that may be needed.

Change in Law

Offset trading agreements also need to anticipate that the applicable carbon offset program(s) could be changed, cancelled or superseded entirely by another program. This situation is particularly true for agreements with several-year terms. Climate change remains a hot topic in the U.S. and the subject of continued debate among state and federal lawmakers. The EPA’s Clean Power Plan does not expressly provide for carbon offsets, and it is unclear how it may interact with existing programs, which may require a few modifications to be compatible. Parties need to consider in advance what to do if the offset requirements change or if the program is cancelled altogether, how that would affect any open positions, and who will bear any costs.

Delivery and Transfer Protocols

Risks associated with the actual mechanics of the trade are often overlooked. For example, each of the trading platforms for AB32’s cap-and-trade program and RGGI has different rules for how trades are effected and recorded. Specific steps must be taken by the buyer and the seller, and failure to adhere to the requirements may result in a failed transaction. To minimize this risk, the parties should include language that specifies in detail the steps each will take from initiating the transaction through confirming delivery. Each party then assumes only the risk of its own failure to perform.

Arbitration

When it comes to dispute resolution, many agreements indicate a boilerplate preference for arbitration. This approach is fine between sophisticated parties that anticipate a long-term trading relationship and want a less adversarial forum to address disputes. For more limited trades, the often costly arbitration process is less ideal. In fact, by retaining the ability to use the courts, the threat of litigation is often sufficient leverage to move the parties to an agreed resolution.

Planning a Path Forward

Carbon offsets finally seem poised to become the next big thing in tradable environmental compliance commodities. As with other environmental commodities that have taken hold over the past decade, understanding the market, your contractual terms and the underlying regulatory regime is critical to participate safely and profitably in this market.

David McCullough counsels producers, refiners, commodity traders and distributers on the physical movement and trade of crude oil, petroleum products and renewable fuels, including on the Renewable Fuel Standard (RFS), renewable identification number (RIN) trading, state low carbon fuel standards (LCFS), the Jones Act and shipping crude oil by rail. His extensive practice extends from policy analysis to commercial concerns and from regulation to enforcement proceedings.

Joshua Belcher advises clients in the utility, power and pipelines sectors on all manner of transactions, litigation, administrative proceedings and environmental compliance. With a focus on environmental, regulatory and general corporate law, he manages complex transactions such as mergers, acquisitions, divestitures and financings. Joshua has extensive experience in both the development and acquisition of utility-scale and customer-sited energy projects, including combined heat and power, wind, biomass and solar facilities, and advises clients on the negotiation of both physical and financially settled power purchase agreements. He also counsels clients on state and federal regulation of hazardous liquids transportation.