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Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional.

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Presentation on theme: "Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional."— Presentation transcript:

1 Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a partner means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an office means an office of any such law firm. Carbon Contracting Negotiating Emission Reduction Purchase Agreements Legal and Regulatory Capacity Building for Carbon Trading & CDM Investment Nairobi September 2010 Paul Curnow, Partner (Sydney) Global Environmental Markets, Baker & McKenzie

2 Negotiating ERPAs 2 Presentation Structure –CDM Project Structuring and Financing –Domestic Legal Issues –Spot and Forward Transactions –Delivery Obligations –Prices and Payment –Costs and Taxes –Default and Remedies –Dispute Resolution –Post-2012

3 Negotiating ERPAs 3 CDM Project Structures and Financing

4 Negotiating ERPAs 4 Degrees of Investor Involvement –Project Development Agreement (carbon & non- carbon) –Project Development Agreement (carbon) –Emissions Reduction Purchase Agreement (developer model) –Emissions Reduction Purchase Agreement (offtake only) Decreasing investor involvement

5 Negotiating ERPAs 5 PDA Model

6 Negotiating ERPAs 6 Buyer 1Buyer 2 Investor Project Owner Carbon finance & services Rights to CERs Non-carbon revenue Non-carbon commodity CERs CER revenue PDA Model (carbon only)

7 Negotiating ERPAs 7 PDA Model –Investor involved in project from early stages. –Provides carbon project development services only. –Carbon assets (CERs) vest initially in investor (project owner assigns its rights to CERs to investor). –Investor commercialises CERs independently, but developer and investor interests are aligned: achieve highest price. –Investor and project owner share carbon revenue stream only. –Project owner independently commercialises non-carbon assets and retains 100% of revenue.

8 Negotiating ERPAs 8 ERPA Developer Model

9 Negotiating ERPAs 9 CER payments Buyer 1 Project Owner Buyer 2 Carbon services CERs (2ndary delivery) 2ndary CER payment CERs ERPA Developer Model

10 Negotiating ERPAs 10 ERPA Developer Model –Buyer provides CDM project development services to project owner. –Title to CERs vests initially with project owner. –Buyer purchases CERs from project owner under an ERPA (contract for sale and purchase and provision of services). –CER payments under ERPA may be structured as upfront payments subsequently applied against CER deliveries. –Buyer will often on-sell to secondary buyer, and seek to match up primary and secondary ERPAs.

11 Negotiating ERPAs 11 ERPA Offtake Model

12 Negotiating ERPAs 12 CER payments Buyer 1Project Owner Buyer 2 CERs (2ndary delivery) 2ndary CER payment CERs ERPA Offtake Model

13 Negotiating ERPAs 13 ERPA Offtake Model –Buyer provides does not provide any project development services to project owner. –Title to CERs vests initially with project owner. –Buyer purchases CERs from project owner under an ERPA (contract for sale and purchase only). –CER payments under ERPA more likely to be made against delivery – upfront payments less likely. –Buyer will often on-sell to secondary buyer, and seek to match up primary and secondary ERPAs.

14 Negotiating ERPAs 14 Domestic Legal Issues

15 Negotiating ERPAs 15 Range of Host Country laws –Legal Status and Role of the DNA (what is legal status of a Letter of Approval under domestic law?) –Supplementary CDM laws may actively support CDM projects: –tax concessions for CDM projects or CER revenue –accelerated/simplified approval processes –funding support or impose additional requirements or restrictions: –restrictions on foreign ownership of CDM projects –restrictions on CER or revenue sharing arrangements –specific taxes and/or charges

16 Negotiating ERPAs 16 Complying with existing Domestic Laws –CDM projects must also be implemented in accordance with existing Host Country domestic laws –The following types of domestic laws can affect CDM projects (positively or negatively): –property laws (title to land, assets and resources, CERs) –tax and investment (including foreign investment) laws –financial services laws –environmental and planning laws (EIA etc.) –Changes in domestic laws are also relevant: sovereign and regulatory risk

17 Negotiating ERPAs 17 Spot and Forward Transactions

18 Negotiating ERPAs 18 Spot Transactions –Spot trade = sale of CERs and immediate delivery of CERs already issued and held by seller. –Only possible where CERs already issued, i.e. relative late in project implementation. –Spot trades usually for fixed volumes with guaranteed delivery. –Relatively low risk for buyers, therefore willing to pay higher prices in spot market. –Host Country sellers only likely to sell spot for unilateral CDM projects (no forward ERPA).

19 Negotiating ERPAs 19 Forward Transactions –Project owners often sell CERs in primary market in forward streams: –ERPA agreed prior to project commissioning or registration; –parties may include conditions precedent, such that no purchase obligations until project registered and operating; –forward CER volumes unknown and subject to regulatory and performance risks, so sellers may refuse to accept guaranteed delivery obligations; –higher non-delivery risks may mean buyers negotiate lower prices for CERs in forward ERPAs (cf. to spot sales) –Forward sale agreement can be used to obtain project financing (debt and equity)

20 Negotiating ERPAs 20 Negotiating ERPAs

21 21 Negotiating and Structuring ERPAs –Buyers and sellers can negotiate a range of different ERPA structures, terms and conditions: –spot or forward CER transaction; –guaranteed or non-guaranteed CER volumes; –fixed or floating prices –prepayments with escrow/security arrangements; –responsibility for costs and taxes; –default and remedies; –dispute resolution.

22 Negotiating ERPAs 22 CDM-Specific Terms

23 Negotiating ERPAs 23 CDM-Specific Terms –CDM projects involve several unique risks and responsibilities: –project development and costs; –approval as Project Participants; –Focal Point and delegation of authority; –registry accounts, the ITL and Suspension Events.

24 Negotiating ERPAs 24 CDM Project Development –Seller and buyer may share responsibility for project development. –Particularly common where ERPA negotiated early in the development of a project. –Tasks include: –drafting of PDD, monitoring plans and other documentation; –obtaining Letters of Approval; –validation and registration of project; –also ongoing verification and certification of GHG reductions. –Responsibility for costs of each must be allocated.

25 Negotiating ERPAs 25 Project Participants –Main advantage: can take direct delivery of CERs from CDM pending account – mitigates delivery risk. –Buyers and secondary buyers may wish to become Project Participants to take direct delivery. –Must obtain DNA Letter of Approval to become a Project Participant. –Addition/removal of Project Participants requires approval of existing Project Participants, but can be delegated to Focal Point. –Buyer may seek right under ERPA to add additional Project Participants e.g. secondary buyers wishing to take direct delivery.

26 Negotiating ERPAs 26 Focal Point –Every CDM Project requires one or more Focal Points. –Focal Point = party authorised by Project Participants to communicate with Executive Board and UNFCCC Secretariat in respect of a CDM project. –Focal Points appointed using standard form Modalities of Communication which sets out: –number of Focal Points; –nature of authority (sole, shared or joint); and –scope of authority.

27 Negotiating ERPAs 27 Focal Point –Sole Focal Point: exclusively authorised to communicate with Executive Board and Secretariat (within scope of authority). –Joint Focal Point: multiple parties authorised as Focal Points, all must sign off on communications. –Shared Focal Point: multiple parties authorised as Focal Points, any one may sign off on communications. –Parties not appointed as Focal Point not entitled to communicate with Executive Board and Secretariat.

28 Negotiating ERPAs 28 Focal Point –Scope of Focal Point authority may include: –instructions for forwarding CERs; –addition and removal of Project Participants. –Authority to instruct CER forwarding means power to control CER deliveries. –Buyers often seek to be Focal Point in order to control delivery, particularly where pre-paying. –Sellers may seek to be Joint Focal Point in order to retain control over deliveries: cannot occur without seller sign off.

29 Negotiating ERPAs 29 Focal Point –ERPA should: –specify which party(ies) will be Focal Point(s), and scope of authority; –include obligations to do things required to appoint Focal Point(s). –require Focal Point to perform role in accordance with ERPA, i.e. to procure delivery as required; –require Focal Point to forward copies of communications to other Party(ies). –ERPA may provide for: –3rd party e.g. consultant or 2ndary buyer to be Focal Point; –change of Focal Point if ERPA terminated or the party appointed as Focal Point defaults.

30 Negotiating ERPAs 30 Registries, Accounts and Suspension Events –CERs held in, and transferred between, accounts within national registries established by Annex 1 Parties. –Every issuance and transfer of CERs monitored by UNFCCC International Transaction Log. –Malfunction in international registry system may prevent delivery = Suspension Event. –ERPAs should address use of international registry system, such that: –where delivery impossible due to a Suspension Event, the seller is not liable for delivery failure; –ERPA may be terminated for prolonged suspension.

31 Negotiating ERPAs 31 Delivery Obligations

32 Negotiating ERPAs 32 Delivery Obligations –ERPAs can provide for CERs to be sold either: –in fixed volumes with the seller guaranteeing delivery of a certain number of CERs –in non-guaranteed volumes, with the buyer buying all or a certain % of CERs from a project such that the volume sold depends on project performance. –Non-guaranteed delivery is market standard in primary market transactions. –Also common in secondary market - secondary sales often pass through CERs received in primary purchases. –Each approach has different risks and benefits for buyers and sellers.

33 Negotiating ERPAs 33 Guaranteed Delivery Obligations –Guaranteed delivery obliges seller to deliver a fixed volume of CERs to buyer. –Examples of guaranteed delivery provisions: –Fixed guaranteed volume specified in Delivery Schedule: With respect to each Verification Period, the Seller shall sell and deliver to the Buyer a number of CERs equal to the volume for the Verification Period specified in the Delivery Schedule.

34 Negotiating ERPAs 34 Guaranteed Delivery Obligations –100% purchase including minimum guaranteed delivery: The Seller shall sell and deliver to the Buyer all CERs generated by the Project, subject to a minimum quantity of 500,000 CERs. –Guaranteed volume with priority right to first CERs generated (excess CERs may be sold to other buyers or subject to a call option): The Seller shall sell and deliver to the Buyer the first 500,000 CERs generated by the Project.

35 Negotiating ERPAs 35 Breach of Delivery Guarantees –Failure to deliver guaranteed volume typically default requiring remedy e.g. damages, replacement CERs. –Example of remedy provision for breach of delivery guarantee: –In the event of a Delivery Shortfall, the Project Entity shall either: –Deliver to the Buyer a volume of Replacement CERs equal to the Delivery Shortfall; or –pay to the Buyer a cash amount equal to the Buyer's Replacement Costs with respect to the Delivery Shortfall.

36 Negotiating ERPAs 36 Breach of Delivery Guarantees –Default for breach of delivery guarantee may be subject to: –remedy within a certain period, or make-up at following delivery date; –cumulative threshold over multiple delivery dates such that default only arises if threshold breached during term of ERPA; –requirement of negligence or intentional breach to be default.

37 Negotiating ERPAs 37 Mitigation of Delivery Risk –Risk of breach of guaranteed delivery obligations can be mitigated by: –guaranteeing only a proportion of CERs to be generated: e.g. calculate guaranteed volume as % of PDD volume; –using conditions precedent to manage project risks: e.g. no delivery obligation unless project commissioned in accordance with specific standards and registered; –where possible, pooling CERs from multiple projects to spread risk (e.g. where local developer owns multiple projects): e.g. ERPA covers multiple projects with guaranteed volume calculated as % of total CERs expected from all projects

38 Negotiating ERPAs 38 Non-Guaranteed Delivery –CER volumes sold under primary forward ERPAs often determined by project performance i.e. volume of CERs generated. –Examples of non-guaranteed delivery provisions: –Buyer purchases all CERs from the project: The seller shall sell and deliver to the buyer all CERs issued with respect to greenhouse gas reductions achieved by the Project prior to 1 January 2013.

39 Negotiating ERPAs 39 Non-Guaranteed Delivery –Buyer purchases all CERs from the project, subject to maximum volume: The seller shall sell and deliver to the buyer all CERs generated by the Project up to a maximum of 500,000 CERs. –Buyer purchases % of CERs from the project (remaining % may be sold to other buyer or subject to call option): The seller shall sell and deliver to the buyer 60% of the CERs issued with respect to greenhouse gas reductions achieved by the Project prior to 1 January 2013.

40 Negotiating ERPAs 40 Prices

41 Negotiating ERPAs 41 CER Prices - Fixed –CER prices may be fixed or floating – will affect price risk exposure. –Fixed prices: –protects buyer from price spikes and seller from price drops; –precludes realisation of benefits from favourable market movements e.g. if market price rises above fixed price, seller must sell below market price and cannot capture price increase. –Fixed prices common in early carbon markets. –Fixed prices have become less common as markets and players have become more sophisticated. –Pricing mechanisms often similarly sophisticated.

42 Negotiating ERPAs 42 CER Prices – Floating –Floating prices: –mitigates exposure to market volatility; –enable partial capturing of favourable market movements. –Floating price may be pegged to market price. –Development of liquid exchange platforms has meant Market Price commonly defined by exchange prices:

43 Negotiating ERPAs 43 CER Prices – Floating Prices Market Price means the average arithmetic mean of the closing prices of the CER forward contract traded on the ECX which delivers closest to but at least 6 Business Days after the relevant Delivery Date, calculated over the fifteen (15) Business Day period beginning twenty (20) Business Days before and ending five (5) Business Days before the relevant Delivery Date. –Market Price may also be defined by reference to broker quotes.

44 Negotiating ERPAs 44 CER Prices – Revenue Sharing –Floating prices may incorporate upside sharing: –primary buyer on-sells to secondary buyer; –primary seller takes % of profit from higher price under secondary sale. –This revenue sharing mechanism combined with another price component, fixed or floating: Unit Price = α (β - α) where α = fixed component, β = SERPA price –Enables primary sellers to access higher prices of secondary market. –But also exposes primary sellers to secondary price risk.

45 Negotiating ERPAs 45 Payment

46 Negotiating ERPAs 46 Payment Options –CERs payments under forward ERPAs typically made before or after delivery. –Simultaneous payment and delivery is difficult to arrange. –Payments before and after delivery of CERs create different risks for buyers and sellers.

47 Negotiating ERPAs 47 Payment After Delivery –Payment after delivery is more common than prior payment, particularly in primary market. –ERPAs typically negotiated to require payment within certain time (e.g days) after delivery. –Payment after delivery: –mitigates buyer exposure to seller delivery risk (buyer never required to pay if seller never delivers); but –increases seller exposure to buyer credit risk (buyer may take delivery but not pay). –Sellers may use increased risk exposure to justify a higher price.

48 Negotiating ERPAs 48 ERPA Prepayments

49 Negotiating ERPAs 49 Payment before delivery – prepayments –CDM projects may entail significant upfront costs: –capex for acquisition of equipment and supplies (including monitoring facilities); –third party costs (EPC contractors, carbon specialists, lawyers); –project development costs: PDDs, approvals, validation, registration.

50 Negotiating ERPAs 50 The need for prepayments –Host country developers and specialist carbon businesses may not have the balance sheet to meet these costs. –A prepayment can help cover initial costs and make a project feasible. –Simply to meet the demands of project entities or sellers. –But entails risk exposure for buyers.

51 Negotiating ERPAs 51 Prepayment risks: approval –Project approval risk exposure depends on stage at which prepayment or prepayments made: –before Host Country approval; –before validation; –before registration. –If project falls at one of these hurdles, will prepayment be lost, or refunded to buyer? –Regulatory uncertainty: CDM post-2012, demand levels, REDD framework.

52 Negotiating ERPAs 52 Prepayment risks: performance and delivery –If project underperforms, risk that deliveries inadequate to return value of prepayment. –If seller default risk (failure delivery despite credits being issued). –Role of negligence, intentional breach, fraud? –EU Emissions Trading Scheme Phase III compliance risk for buyers?

53 Negotiating ERPAs 53 Prepayment protection mechanisms Before payments are made –Conditions precedent to prepayment obligations: –useful for mitigating exposure to project approval risks; –incorporate due diligence, execution of related documents. –Payment milestones conditioned on approval processes: –can mitigate exposure to approval and performance risks (e.g. milestones for registration, commissioning, issuance). –Escrow structure with funds drip fed for application to a purpose: –additional cost of escrow agent, complexity of documentation.

54 Negotiating ERPAs 54 Prepayment protection mechanisms After payments are made –Payment clawback mechanism: –may be triggered by approval failure, shortfall, default; –will recourse affect status of payment on balance sheet? –Security over project assets purchased using prepayment: –mortgages/liens commonly granted to financiers. –Guarantees/LCs – whether parent or bank (though bank credit support may be expensive for sellers).

55 Negotiating ERPAs 55 Prepayment protection mechanisms General contractual mechanisms –Limited buyer events of default: key obligation (payment) performed upfront. –Buyer obligations conditional upon continuing seller performance. –Step-in rights to progress project approval: –commonly granted to financiers. –Cross default under separate prepayment or other agreement. –Indemnities for costs/loss not covered by security.

56 Negotiating ERPAs 56 Programmatic CDM

57 Negotiating ERPAs 57 Negotiating ERPAs 57 Key CDM rules –Managing/Coordinating Entity: –responsible for coordinating project development –also Focal Point (though this can be shared) –Rather than PDD, following documents must be submitted to CDM EB: –CDM-DD-POA (POA-wide PDD equivalent; Registration) –CDM-DD-CPA (CPA-level design document for one CPA; Registration) –CDM-DD-CPA (for each CPA added to the POA after Registration; must be notified to CDM EB when added)

58 Negotiating ERPAs 58 Negotiating ERPAs 58 Key project and contracting risks –Control of CERs: –buyer cannot be sole Focal Point –Title to CERs: –CPA-PEs, M/C Entity or other involved entities could all seek to claim title – extra layer of title risk –CPA-PEs: –particularly their compliance with CDM-POA-DD and CDM- POA-CPAs –Project roll-out risk: –financing; M/C Entities often require financing to roll out –deployment and monitoring systems important

59 Negotiating ERPAs 59 Negotiating ERPAs 59 Programmatic CDM – Contracting –Ensure seller has and passes clear title to CERs: –seller clear title obligations in ERPA –review terms of seller / M/C Entity agreements to ensure CPA-PEs pass clear title to seller –Ensure M/C Entitys Focal Point obligations clearly specified, and if possible, circumscribed –Ensure seller has clear obligations to procure that CPA- PEs: –implement CDM-CPA-DD terms –follow Monitoring Plan

60 Negotiating ERPAs 60 Costs and Taxes

61 Negotiating ERPAs 61 Costs and Taxes –CDM projects and CER transactions may involve a range of costs and taxes. –Examples of costs and fees: –preparation of PDD and other project documents; –validation and registration of project, verification of emission reductions; –registry fees to establish accounts and trade CERs.

62 Negotiating ERPAs 62 Costs and Taxes –Examples of taxes and other levies: –Adaptation Share of Proceeds (2% of CERs issued); –specific Host Country taxes on CERs or CER revenues; –general taxes e.g. VAT, corporate income tax, land tax. –Responsibility for costs and taxes must be allocated between the parties e.g. will buyer be required to gross up for VAT? –Allocation of responsibility for costs and taxes may affect price negotiations.

63 Negotiating ERPAs 63 Default and Remedies

64 Negotiating ERPAs 64 Events of Default –Parties may include specific events of default in ERPAs. –Events of defaults most commonly included in ERPAs are: –breach of material obligations (e.g. delivery failure by seller, payment failure by buyer); –breaches of representations and warranties; and –insolvency. –Parties may allow a "cure period" under an ERPA (limited period in which to rectify the default) e.g. where a buyer fails to make payment due to administrative error. –Intentional breach may be addressed separately.

65 Negotiating ERPAs 65 Remedies Following Default –Parties may include specific remedies in ERPA for events of default not rectified within the cure period. –Remedies typically include: –right of seller to make up any shortfall within following year or delivery replacement CERs; –right for non-defaulting party to terminate the ERPA; –right to receive damages from the defaulting party.

66 Negotiating ERPAs 66 Remedies Following Default –ERPA may provide for defaulting party to pay: –liquidated damages: calculated in accordance with agreed formula set out in ERPA (more transparent but potentially limited in scope) – typically buyer or sellers replacement costs to go into market and replace the contract –unliquidated damages: calculated as non-defaulting partys loss (less transparent but broader in scope). –Amount of damages due may depend on difference between ERPA unit price and CER market price.

67 Negotiating ERPAs 67 Dispute Resolution

68 Negotiating ERPAs 68 Governing Law –It is more common for ERPAs to be governed by the law of the buyers jurisdiction –Typically driven by buyers jurisdiction –Although we do see ERPAs governed by the Host Country law –Most important to choose governing law seller is comfortable with: –in Africa, could be English law or French law –many jurisdictions in Africa will be familiar given the inheritance of English common law or French civil law

69 Negotiating ERPAs 69 Dispute Resolution –ERPA disputes generally resolved through negotiation and arbitration. –Quicker, simpler and cheaper than litigation. –ERPA arbitration provisions need to specify: –rules governing arbitration e.g. ICC Rules, LCIA Rules, UNCITRAL Rules; –location of arbitration (should be a neutral location); –language of the arbitration (often English, but should be reasonable for both parties); –number of arbitrators (typically one or three arbitrators); and –means by which the arbitrator(s) are appointed.

70 Negotiating ERPAs 70 Further Reading

71 Negotiating ERPAs 71 Further Reading –CDM Rulebook: –Implementing CDM Projects: A Guidebook to Host Country Domestic Legal Issues –CERSPA carbon contract template: –CCH Global Climate Change Law Guide

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74 Negotiating ERPAs 74 –Publicly accessible and free online commentary explaining and extracting the vast body of CDM rules and procedures –Information on the CDM and developments in CDM rules and procedures –Material on the site is organised in terms of stages of the CDM project cycle for large-scale projects, small-scale projects, forestry projects, and programmatic CDM activities –Extensive information on the bodies involved in the CDM process

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77 Negotiating ERPAs 77 Any questions? Paul Curnow, Partner Global Environmental Markets Practice

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