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The ERPA and Post-2012 Implications

Hannah LoganNorton Rose (Asia) LLP28 August 2009

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Content

• Commercial drivers• Importance of due diligence• The ERPA

– Commercial context– Legal principles– Clause specific review

• Post 2012-implications

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1. Commercial Drivers

• Commercial strategy drives transaction targets, documentation and risk mitigants

• Post 2012 considerations

• Seller Opportunities

– Additional CER revenue stream from the project

• Potential Buyers

– Compliance buyers: need to meet their binding emission reduction targets

– Financial buyers: CERs are bought and re-sold in the carbon market with a view to generating profits

– Increasing interest in debt structures and equity stakes

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2. Due Diligence – Key Issues

• Key Objective

– risks are identified and reflected in the commercial terms

• Key Focus

– Legal, regulatory, technical, financial and commercial

• Key Sources

– Seller: responses to due diligence questions, site visits

– Legal: Host Country laws and regulations, corporate documents, licences, permits and consents

– Buyer: own knowledge of market and previous transactions

• Key Findings

– Project Owner operates the CDM project lawfully

– Project Owner owns project assets and CERs

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CDM Project Risks (some…)

Licensing/Regulatory

appraisal(PDD)

registration(CDM Exec Bd)

certification

monitoring

creditingperiod

verification

Political Risk

regulatorychange tax

change

host countryapproval

TechnologyCost/Delay

compliancecost

completiondelay

Financial

currency

price

ERPACounterparty

credit

performance

regulatorychange tax

change

host countryapproval

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Why do DD?

• What risks to Buyer during term of ERPA:

– Does Seller exist (no Seller no ERPA)?

– Does Seller own the assets (who should be Seller?)

– Is Seller operating legally (could Seller be shut down during term)?

– Maximising delivery

– Additional Risks: Litigation/insurance/corruption/reputation

• Better understand Seller (valuable for ERPA negotiation):

– State owned: Profit less important, less transparent, more political;

– Private Co: More commercial and transparent, profit motive

– Where is power within the company (who makes decisions)

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Legal due diligence• Ownership of host facility / land – e.g. ERPA is not with entity

which actually owns asset

• Relevant permits (operation, construction, environmental, feasibility study) - e.g. no construction permit for original facility, old environmental permit

• Lawsuits and disputes – e.g. land ownership disputes

• Mortgages and encumbrances – e.g. bank has first lien over power generation equipment

• Liabilities impacting ability to carry on business – e.g. unpaid creditor can initiate a winding up if debt is not repaid

• Anti-corruption – e.g. reputation for corrupt practices

• Tax – e.g. transaction structure is tax efficient

• Legal authority to enter into contracts – e.g. understanding who is entitled to enter into contracts on the company’s behalf; enforceability opinion

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Regulatory due diligence

• Post 2012 regulatory framework – international negotiations• Project construction and operational approvals - e.g. project conflicts

with local development or environmental goals• Methodology risk - e.g. project does not use an approved methodology• Host country LoA risk - e.g. China does not support flaring-only LFG

projects• Buyer country LoA risk - e.g. UK will not authorise participation in large

hydro projects unless they comply with World Commission on Dams criteria• Validation risk - e.g. reason to believe the project may run into problems

with validation for reasons different than above• Registration risk - e.g. reason to believe the EB may request a review of

the registration application

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3. Introduction to the ERPA

• Emission Reduction Purchase Agreement

– Purchase and sale of Certified Emission Reductions (CERs)

• Most common legal instrument used in carbon market

• Tend to be standardised

• Usually English law governed

• Hybrid between:

– Project development agreement

– Services agreement

– Commodity contract

– (sometimes) Finance document

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ERPA: Legal v Commercial Parameters

• Delivery risk

• Consequences of breach

• Contractual v extra contractual protections

• Risk allocation & liability

• Enforceability

• Interaction of local law & other transaction agreements

• Requirements of DNAs

• Long term management

• Closing v not closing the deal

• Meeting volume targets or compliance requirements

• Relationship

• Keep it simple & concise

• Flexibility

• Performance incentives e.g. commercial alignment

• Distribution e.g. monetise the asset

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English law: legal principles

• Clear body of contract law familiar to Buyers and internationally-recognised

• Freedom of contract: parties best placed to allocate risk

• Certainty of terms: if fundamental terms (e.g. price) have not been agreed or are unclear, ERPA may be unenforceable

• Agreements to agree: generally not enforceable

• Interpretation: unclear wording construed against party seeking to rely

• So: where contract is drafted in accordance with English law, changing the governing law can have significant consequences

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ERPA: Conditions Precedent

• Transfer/Purchase Obligations not binding until, e.g.:

– Completion of due diligence to the satisfaction of the Buyer

– Listing of Buyer as a Project Participant in the PDD

– Issuance of Letters of Approval

– Registration of the Project with the Executive Board

– Submission of the Statement of Modalities of Communication to the Executive Board

– Legal Opinion from Host Country law firm

– Commissioning of the Project

• Right to walk away

– If CPs not satisfied within an agreed timeframe

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ERPA: Sale and purchase of CERs

• Seller must transfer and Buyer must purchase:

– Pre-2012 CERs: Binding obligation to purchase all or agreed portion of CERs

– Post-2012 CERs: Obligation or option of Buyer

• Volume

• Price

• Payment structure: Prepayment, payment against delivery or set-off, structure as a loan

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ERPA: Delivery

• Delivery: all rights in and to CERs and underlying ERs transferred and assigned to Buyer upon Delivery

– constituted by transfer of CERs into Buyer’s Account

– Limit scope for Seller to argue cannot deliver in line with ERPA

• “Hard ERPA”: Minimum delivery obligations

– Seller must deliver minimum delivery volume per Verification Period by a fixed date

– Delay/failure to deliver – Event of Default

• “Soft ERPA”: (or one where Buyer has control)

– Volume and delivery more flexible

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Post 2012 CERs: Options

• What are Post 2012 CERs?

• Option: creates a right to purchase underlying CERs upon request

– Buyer exercises control over price and the time of purchase

• Early approach: free option over post 2012 ERs at Contract Price

• Existing contracts: negotiating strategy when to exercise

• New contracts: Firm Post 2012 pricing either for:

– All ERs (come what may)

– Only CERs that can be used for compliance

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What does this mean for new contracts?

• If retain option approach:

– Consider enhancing detail of option itself

– When and how should it trigger?

– How to price in the case of early termination

• Delivery of all ERs

– enhance capacity to control verification etc to capture alternative markets

– provide for minimum fallback to ensure delivery can occur without any argument as to certainty

• Delivery of compliance CERs

– Careful drafting re trigger of rejection rights

– What follows trigger? Walk away?

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Post 2012 CERs: right of first refusal

• Right of First Refusal: before a Seller sells Post 2012 CERs to a third party they must first offer them to Buyer on the same terms

– Buyer has no control over price, terms or time it buys CERs (dependent upon third party offer)

– If market dropped may be preferable to Option

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ERPA: Project Participant and Focal Point

• Project Participant: parties involved in the Project

– Only a Project Participant can buy and sell CERs

– Buyer may introduce new Project Participants in order to on-sell

• Focal Point: manages communications with the Executive Board

– Can be sole or joint and cover:

• Communication

• Distribution of CERs

• Adding and removing Project Participants

– Tends to be Buyer role - experience communicating with the EB

– Role of Focal Point should be returned to Seller upon termination of ERPA

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ERPA: Costs, Monitoring, Verification and Certification

• Monitoring of Project, Verification and Certification of CERs

– Parties must communicate to maximise CERs generated

– Selection of DoE (Buyer) and assistance to DoE (Seller)

– Seller must keep Buyer informed as to status of the Project

• Costs

– Costs split in accordance with the agreement between the parties

– E.g. ERPA, PDD, Registration, EB, development, MVC

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ERPA : Representations, Warranties & Undertakings• Both parties make statements of fact or undertakings about the

Projects (complements Due Diligence)

– Due incorporation and authorisation

– Seller owns the CERs it sells

– Seller won’t transfer the CERs or Project Assets to a third party

– Seller will operate the Projects in a prudent fashion (licences, maintenance, insurance)

– No litigation

– Seller will keep Buyer updated as to any changes which may affect its ability to deliver CERs

– Buyer will pay Seller on time

– Buyer will purchase all CERs

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ERPA : Event of Default

• Step 1 – Events of Default, e.g.

– Failure to transfer CERs or under-delivery of CERs by Seller

– Failure to pay for the CERs by Buyer

– Breach of provisions of ERPA

– Insolvency of a party

– Misrepresentation

• Step 2 – Notice of EoD• Step 3 – Cure the Breach

30 days to cure default, depends on breach Seller delivers replacement CERs (from other projects or goes

into market to buy CERs) Buyer pays the outstanding amount to cure default

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ERPA : Event of Default

• Step 4 – Terminate ERPA

– If breach not cured, other party can terminate on notice

• Step 5 – Pay damages based on innocent party’s loss Include mechanism for calculating loss in ERPA Seller Loss: Agreed Purchase Price minus CER market price

(Seller’s Replacement Cost) Buyer’s Loss: Market price minus Agreed Purchase Price

(Buyer’s Replacement Cost)

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ERPA: Enforcement• Arbitration most common dispute resolution

– Less formal means of resolving disputes

– Less expensive than courts and normally quicker

• New York Convention on the Enforcement of Arbitral Awards

– If both UK and Host Country are a party, neither has jurisdiction and so will not accept case regarding the ERPA

• Two step process to enforce:

– Step 1: Go to seat of arbitration (e.g. Singapore) to get award;

– Step 2: Get award enforced by Host Country courts against Seller assets in Host Country (assuming no assets elsewhere)

• Theory: Host Country should not review the award but should enforce it

• Practice: Can differ between jurisdictions

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4. Post-2012 Issues

• What do developments at EU and international level mean for contracting strategies?

– Depends on outcomes of Copenhagen

– Likely that a high level international agreement will be reached

– Hard to predict what the flexible mechanisms such as CDM will look like under the agreement

– Risks: volume limits, qualitative limits, new mechanisms

– Big picture: emission reduction commitments, climate change, new emission trading schemes, Obama factor

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What conclusions can be drawn?• Strong likelihood that the CDM, broadly in its present form,

will continue post-2012

• CERs from projects registered before 2012 can continue to be used in Post 2012 market

• Likely to be some form of sectoral and/or NAMA-based crediting mechanisms with an agreed timetable for further development of such mechanisms (under an international agreement)

– Country-specific focus on:

• advanced developing countries that are significant contributors to greenhouse gas emissions, e.g. China and India; and

• countries which are strong supporters of sector or country-wide NAMAs, e.g. Korea and Mexico.

• Safety net: post-2012 Carbon Credit Fund

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SE Asia has post-2012 advantages

• China and India probably less attractive post-2012

– China in particular, risk may have obligations to reduce emissions (steel and cement)

– China imposes floor price on post-2012

• Ex China/India, e.g. Philippines: greater possibilities for post-2012

– Lower risk will have obligations

– No floor price, so prices can reflect post-2012 risks

• Buyers need to diversify portfolios away from India/China

• Going forward, more project financing involving CDM in Asia

– Greater certainty as to post-2012

– CER revenues as security

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So…• There is sufficient certainty to develop post-2012 strategy,

e.g.

– Look for pre-registered projects

– Be wary of industrial gas projects

– Consider diversifying away from advanced developing countries (e.g. China and India)

– Consider partnering with others to manage risk profile (e.g. equipment/technology providers)

– Alternative business models

– Hedge against price falls by taking equity stake and floating price

– Engage with DNA: an efficient and informed DNA is a great benefit

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Further information

• Contact details:

Hannah Logan – Senior Associate

Norton Rose (Asia) LLP

Singapore

hannah.logan@nortonrose.com

www.nortonrose.com• Handouts:

– Global climate change and carbon finance– Asia clean energy and carbon– Clean energy production and supply– Others on request

• Newsletter and updates

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Presentation

1 No individual who is a member, partner, shareholder, employee or consultant of, in or to any constituent part of Norton Rose Group (whether or not such individual is described as a “partner”) accepts or assumes responsibility, or has any liability, to any person in respect of this presentation.

2 Any reference to a partner means a member of Norton Rose LLP or a consultant or employee of Norton Rose LLP or one of its affiliates with equivalent standing and qualifications.

3 This presentation contains information confidential to Norton Rose Group. Copyright in the materials is owned by Norton Rose Group and the materials should not be copied or disclosed to any other person without the express authorisation of Norton Rose.

4 This presentation is not intended to give legal advice and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and practice in this area. Readers must take specific legal advice on any particular matter which concerns them. If you require any advice or information, please speak to your usual contact at Norton Rose Group.

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