Energy and Utilities Alert
December 21, 2009
Authors:
Gregory M. Luloff
greg.luloff@klgates.com
+1.206.370.6577
Eric E. Freeman
eric.freedman@klgates.com
+1.206.370.7627
K&L Gates includes lawyers practicing
out of 35 offices located in North
America, Europe, Asia and the Middle
East, and represents numerous GLOBAL
500, FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies,
entrepreneurs, capital market
participants and public sector entities.
For more information, visit
www.klgates.com.
Mitigating Change in Law Risks in Trading of
Emissions Allowances and Renewable
Energy Credits
The rapid growth of energy trading since the 1970s coupled with recent efforts to
curb greenhouse gas (GHG) emissions has given rise to a robust and volatile
emissions allowance and environmental attributes trading sector. Today, viable cash
markets exist for carbon dioxide, sulfur dioxide, nitrogen oxide and other emissions
allowances, renewable energy credits/renewable energy certificates (RECs), and
other emissions-based and environmental products. Trading of emissions allowances
and other environmental products has evolved into a major tool in global efforts to
tackle climate change and achieve energy independence. While there is tremendous
investment potential in emissions allowance and other environmental products
trading, the markets for such products remain in their infancy, and thus are likely to
be challenging and unpredictable in the near term. Energy trading itself has proven to
be a risky business, as demonstrated by the recent failures of Amaranth Advisors
LLC and MotherRock LP, and the emissions allowance and REC trading markets
can present even greater price volatility. A central cause of this volatility is the
uncertainty over the future of climate change legislation and regulation both in the
near future and in the long term. Despite this uncertainty, there are steps that
investors can take to mitigate the risks they face in this market.
Carbon trading markets have developed as a direct response to the efforts of nations,
individually and collectively, to curb their GHG emissions through legislation.
Carbon markets are essentially emissions trading markets with both allowance and
credit features. Cap-and-trade programs characteristically involve the distribution to
GHG emitters, either by allotment or auction (or a combination of the two), of
allowances permitting the emission of a unit of a particular emission up to an
aggregate cap. In baseline credit programs, an entity earns credits for reductions in
its emissions beyond a specified baseline. Some programs also permit credits to be
acquired for offsets that capture or remove certain emissions beyond a specified
baseline. There is no single framework established protocol for GHG emissions
trading, and most trading to date has been conducted under transitional and
experimental programs. In order to achieve their environmental objectives, emissions
allowances trading programs must establish carefully crafted regulations concerning
how regulated entities can apply emissions products to satisfy regulatory
requirements. Emissions products have value only so long as they can be used to
meet the credit requirements of an applicable regulatory scheme.
Markets also exist for trading transactions in renewable energy credits and energy
efficiency credits. Renewable portfolio standards (RPS) or renewable energy
standards (RES), which have so far been adopted only at the state level in the United
States, are requirements that utilities procure from qualifying renewable resources a
minimum percentage of the power that they use to serve their retail customers in the
applicable state. In almost all of the states that have adopted RPS, utilities can satisfy
the RPS either with renewable energy or RECs.
Energy and Utilities Alert
A qualifying renewable energy resource is deemed
to generate one REC for each megawatt of
renewable energy that it generates. The REC
represents the environmental benefits resulting from
the generation of the energy by the renewable
resource as opposed to a fossil-fueled resource.
The emissions allowance and REC markets may
differ substantially in terms of their products, but
they are similar in the sense that they are essentially
a response to regulatory drivers. The products that
can be used, and therefore traded, to satisfy an
emissions cap program or RPS or RES requirement
are defined by the legal regime that establishes them,
and the operation of that legal regime gives the
products their value. Since all of these regimes are in
a developmental stage, there is a risk that regulatory
change can deprive established products of some or
all of their value. For example, there is currently no
federal mandatory carbon emissions regime in the
United States. Although the Regional Greenhouse
Gas Initiative (“RGGI”) is the first mandatory
carbon cap-and-trade regime in the United States, it
covers only power plants in 10 states located in the
Northeast and Mid-Atlantic. In addition to the
probability of future federal regulation of GHG
emissions, there will no doubt be further adjustments
to state and regional GHG regulation. Similarly,
although RPS and RES regimes have so far been
adopted only at the state level, there is likely
eventually to be a federal RES, and the adoption of
such federal legislation may affect the value of REC
contracts that are entered into today.
This regulatory uncertainty is at odds with the nature
of the markets for carbon credits, RECs, and similar
products, which are often sold under long-term
forward contracts. Currently, investors have several
standardized contracts under which they can
document their trading transactions. The ISDA U.S.
Emissions Allowance Annex (the “ISDA Emissions
Annex”), the Verified Emissions Reduction
Purchase and Sale Agreement (the “VER
Agreement”) and the Master Renewable Energy
Certificate Purchase and Sale Agreement (the
“Master REC Agreement”) can be used to document
emissions allowance and REC transactions between
parties. As a result of the variety of applicable
regulatory regimes, and the evolving nature of those
regimes, many of the products that are traded under
these agreements are subject to change. Changes in
the regulatory regimes defining the products can
cause products to change or disappear altogether. In
addition, if new government regulations were to
implement a new REC, repeal an existing REC, or
substantially change the definition of an existing
REC, the market value of existing RECs could be
altered substantially. The base approach to
allocation of liability in the ISDA Emissions Annex
and the Master REC Agreement places this change
of law risk squarely on the shoulders of the buyer of
emission allowance credits or RECs. For example,
under the Master REC Agreement, a seller warrants
the compliance of the underlying REC with
applicable law as of only the trade date, and not as
of the date of delivery of the REC. The Master REC
Agreement assumes that change of law will not
excuse the parties’ performance obligations.
Therefore, if a buyer were to enter into a long-term
REC transaction with a seller based on a current
definition of a REC under an existing regime, and
the definition were to change under a new federal
law or a change under the RPS so that the REC
failed to meet the new standard and was rendered
worthless, the buyer would nonetheless not be
excused from the transaction.
Similarly, the ISDA Emissions Annex provides that,
unless the parties agree otherwise, the emissions
product to be transferred and delivered must comply
with the relevant regulatory scheme and any law or
regulations applicable to the use of the emissions
product on the date that the transaction is entered
into but not at the time of delivery. Under this
provision, a change in law or regulation following
entry into a transaction will not affect the buyer’s
obligations under the transaction.
It is difficult to project the course of federal
legislation as well as the question whether future
legislation will preempt state laws that address and
define emissions allowances and RECs. But there
are steps buyers can take to protect themselves
against the regulatory uncertainty. Buyers should
attempt to ensure that the product definitions used in
their contracts satisfy the requirements of as many
potentially applicable regulatory regimes as
possible. In addition, buyers should insist on a
further assurances clause that would obligate the
seller to take all action reasonably necessary to
ensure that the purpose and intent of the transaction
are maintained following a regulatory change. To
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Energy and Utilities Alert
the extent feasible, buyers should limit their
transactions to shorter-term transactions that will
alleviate the risk of a change in regulations. Finally,
a buyer should diversify its portfolio and enter into
transactions governed by different regimes. If
legislative or regulatory changes affect some, but not
all, of the regimes, this diversification of
transactions will help the buyer to mitigate its losses.
In addition, the ISDA Emissions Annex, the VER
Agreement and the Master REC Agreement each
offer specific contractual options to limit a buyer’s
exposure to change in law risks. For example, under
the Master REC Agreement, the buyer can require
the seller to warrant that the RECs are sold as
“Regulatorily Continuing”, meaning the seller
warrants that the RECs comply with the applicable
regulation not only as of the trade date but also as of
the delivery date, such that the seller assumes the
change in law risk. Similarly, in the case of the
ISDA Emissions Annex, the parties can agree that
the seller will warrant the compliance of the
Emissions Product with the applicable regulatory
scheme both on the trade date and at the time of
delivery. The ISDA Emissions Allowance also
permits the parties to elect what consequences will
apply if the applicable regulatory scheme is
abandoned after entry into the transaction but before
delivery. One option provides that if the applicable
emissions regime is terminated prior to the
scheduled delivery date, either party may terminate
the affected transactions and the obligations of the
parties under the transactions. The parties may elect
that, in the event of any such termination, the party
that is “out of the money” under the affected
transactions on the termination date will make a
termination payment, in an amount equal to the
difference between the contract price and the market
price for the applicable allowances, to the party that
is “in the money” under the transactions. The parties
also have the option to elect to terminate the
affected transactions without payment of a
termination payment. Under this second option, the
seller is required to refund, with interest, any
payments made with respect to the affected
transactions prior to the termination date.
Sellers will likely resist assuming a change in law
risk or may limit the risk mitigation strategies
mentioned above. Ultimately, the pricing of the
underlying product will take into account the
change in law risk allocation between the buyer and
seller.
In the United States, we seem to be moving to a
broad consensus that climate change represents a
real and dangerous threat, and that the curbing of
the GHG emissions and using renewable energy
sources are essential in combating this danger. This
environmental policy has created a parallel financial
opportunity to create a new and viable emissions
allowance market and environmental attributes
trading sector. However, the absence of clear
federal regulation, and the uncertainty of federal
preemption of state and regional initiatives, creates
a high level of risk for market participants. While
some of these risks may dissipate when federal
legislation is enacted, investors will continue to face
change in law risks as both U.S. regulations and
international regimes are amended to combat
climate change more effectively. An understanding
of how to identify and mitigate these risks will
assist investors to successfully participate in this
new and expanding market.
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GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market
participants and public sector entities. For more information, visit www.klgates.com.
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Energy and Utilities Alert
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon
in regard to any particular facts or circumstances without first consulting a lawyer.
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