The ERPA and Post-2012 Implications

Hannah Logan

Norton Rose (Asia) LLP 28 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:

reduction targets –

Financial buyers:

need to meet their binding emission CERs are bought and re-sold in the carbon market with a view to generating profits – Increasing interest in debt structures and equity stakes 3

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, documents, licences, permits and consents corporate – Buyer: own knowledge of market and previous transactions

Key Findings

– Project Owner operates the CDM project lawfully – Project Owner owns project assets and CERs 4

CDM Project Risks

(some…)

Licensing/Regulatory

appraisal (PDD) registration (CDM Exec Bd) certification verification

Technology

performance monitoring crediting period

Cost/Delay

compliance cost completion delay

Political Risk Financial

currency price

ERPA Counterparty

credit 5

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) 6

• • • • • • • •

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 7

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 8

3. Introduction to the ERPA

• • • • •

E mission R eduction P urchase A greement

– Purchase and sale of C ertified E mission R eductions (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 9

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 10

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 11

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 12

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 13

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 14

Post 2012 CERs: Options

• • • • •

What are Post 2012 CERs?

Option:

request – creates a right to purchase underlying CERs upon 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 15

• • •

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

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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 17

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 18

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 19

•

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 20

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 21

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) 22

• • •

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 23

4. Post-2012 Issues

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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 24

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 25

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 26

•

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 27

Further information

• • • Contact details: Hannah Logan – Senior Associate Norton Rose (Asia) LLP Singapore [email protected]

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 28

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