Offsets as a New Asset Class and Challenges

Chapter 8 The “Unique” Challenges Faced by Project

B. Offsets as a New Asset Class and Challenges

Because of their somewhat uncertain nature, offsets as project outputs inject a fresh risk dynamic to project financings where any significant amount of the financing is premised on future cash flows from offsets. Project lenders have largely responded to the uncertainties implicit in offsets and that dynamic by refusing to lend against offsets except in very rare cases.

1. Distinguishing Offsets from Traditional Commodities Traditional commodities have many variable features, such as viscosity for oil, purity for metals, and bean grade for coffee. 60 Which of those features are relevant is a function of the use to which the commodity will be put, or the technical specifications in the contract pursuant to which it is being sold. If crude oil is sold pursuant to an offtake agreement, for example, then the quality, quantity, and delivery specifications in that offtake agreement will be of paramount importance. Likewise, when delivering against an exchange-traded futures contract, the quantity, quality, and delivery specifications in, or required to be satisfied pursuant to, that contract would be the relevant frame of reference. In each of those cases, however, an actual tangible product is being created or extracted, and then deliv- ered. There is, of course, risk that construction of the project could be delayed or that such outputs are not produced. Such risks are generally associated with some event or

59 See Jad Mouawad, Recession Cuts Europe’s Carbon Emissions , N.Y. TIMES , April 1, 2009.

60 For common coffee grades see Tokyo Grain Exchange, Grading Table: Arabica Coffee Futures, http://www.tge.or.jp/english/contract/cont_g_ara.shtml (last visited Mar. 22, 2010); for an example of gold purity specifi cations see CME Group, http://www.cmegroup.com/trading/

metals/precious/gold_contract_specifi cations.html (last visited Mar. 22, 2010); for an example of crude oil specifi cations, see (last visited Mar. 22, 2010). CME Group, http://www.

cmegroup.com/trading/energy/crude-oil/light-sweet-crude-contracts-specifi cations.html .

nonoccurrence of an event interfering with production or where outputs produced are not to specification. Certainly, those same kinds of risks exist with respect to offsets.

Offsets are consumable by regulated emitters for compliance purposes. Other market participants may trade offsets in the secondary market for whatever price other market participants will pay or accept, and still others may simply choose to retain them to offset their own GHG output even though not legally required to do so. In that sense, offsets are not dissimilar from other project outputs that can be bought, sold, or con- sumed in some way although the universe of potential consumers is somewhat more restricted with offsets than most commodities.

2. Offsets as Hypothetical Units of Measure As discussed throughout this chapter, offsets are simply a unit of measure of net reductions in GHG emissions against a pro- jected “business as usual” base case scenario. Which is all really just a fancy way of saying that an offset represents the amount of hypothetical reductions from what we project “business as usual” GHG emissions would have been, i.e., hypothetical net reductions against hypothetical business as usual emissions. 61 Effectively, an offset represents emissions that do not happen due to an identifiable action or inaction, e.g.

construction of a particular type of project versus construction of a project of unknown type. That notion of additionality, which is what gives offsets as a project output value for CTS purposes, is critically important. Crude oil that is not to specification can still be sold at some price. Bullion and metals not meeting purity requirements still have intrinsic value. Supply and demand may fluctuate in respect of such assets, but the assets are still able to be consumed. Thus, they have intrinsic value. If offsets lack additionality, they have no value; indeed, an offset not having additionality is not prop- erly an offset.

3. Additionality Not a Science Additionality is not an exact science because it relies on myriad assumptions about a hypothetical base case and a panoply of other variables. 62 Many projects yield less than expected net reductions in GHG emissions and thus, less offsets than initially expected. There are certainly analogs in various project financing contexts, but, in the case of offsets, the asset itself is virtually by definition an uncertain thing. By way of comparison, imagine a power production facility generating electrical output whose value was determined based on how much power would have been produced by a different type of power production facility based on a hypothetical model. Add to that the possibility of the process being derailed, as is always a possibility in project financings, and the risk profile can be quite difficult to model accurately. And, remember, the process being detailed here implicates all of the usual problems associated with project finance as well as offset-specific problems.

Additionally, unlike allowances, offsets are project specific, and many CTSs impose limits on when and by whom certain types of offsets may be used. 63

61 For further discussion, see Section II and related footnotes, supra.

62 For instance, see Sections II and III.D.2 and related footnotes, supra.

63 See also discussion and footnotes under Section III.C.2, supra.

OFFSET RISK PROFILE IN PROJECT FINANCINGS

4. Scheme Selection Because of those offset specific idiosyncrasies and the nature of offsets generally, the threshold issue and challenge to consider at the outset of any project financing involving offsets is under what scheme the project will seek to have offsets issued. Once the relevant scheme is determined, the process for offset issuance under such scheme must be indentified. Other considerations include: whether such offsets can be used in other schemes; what if any other limitations might apply to their use for compliance purposes or otherwise; how long will issuance take and what are the requirements; who will oversee the process; how is additionality measured; how is the base case determined; what is the verification and monitoring process; how many different levels of approvals are needed; how and in what form is beneficial ownership tracked and confirmed; and, of course, who bears the risk if the offsets are not issued?

5. Applicable Law and Related Matters, e.g., Title, Security Interests, etc. 64 Project lenders will have the benefit of a defensive security interest in the offtake arrange- ments (as would be the case for offtake agreements respecting other project outputs) and the offsets themselves if at all possible. Perfecting security interests in contractual rights, including in respect of offtake agreements, is a fairly common occurrence in many jurisdictions. However, where the underlying asset to be created and sold exists pursuant to a particular jurisdiction’s laws, or is held in a particular jurisdiction, issues arise in respect of how legal and beneficial ownership is tracked, recorded, or evidenced under those laws. 65 These issues further arise in respect of how to perfect a security interest in the offsets and the contractual arrangements in respect of such offsets. This will be a function of the scheme under which the offsets are generated, as well as where and how such offsets are held, including the nature of the relevant registry and the manner in which offsets are conveyed and held within the framework of that registry. Those facts will dictate which jurisdiction’s security interest regime will govern, although other factors may also come into play.

For example, in the United States, to take a security interest in an offset, the parties need to agree how it should be characterized and treated for purposes of the Uniform Commercial Code (UCC) (assuming one takes the view that offsets fall under the UCC). 66 This will vary from jurisdiction to jurisdiction, and it is important to note that the contractual arrangements in respect of the offsets may be governed by a different law than the offsets themselves, which may affect how and under what law security interests in both are perfected. This will depend also on what law applies to whatever system or registry the offsets are held in, and may require consideration of the identity of the administrator as well as any other factors which could implicate the laws of different jurisdictions.

64 For a discussion of the recourse vs. non recourse distinction between project fi nancings and traditional corporate bank lending, see Section IV.B.1, supra.

65 See supra Section IV.B.5.

66 For a detailed discussion of security interests in carbon credits, see Chapter 14.

6. Impermanence The prospect or possibility of impermanence can also pose sig- nificant risks. Impermanence refers to the concept that the net GHG reductions attrib- utable to a particular project and set of offsets may turn out not to have been permanent.

As is the case with all the other risks discussed here, it effectively comes down to a question of risk allocation and who is willing or can be convinced to bear that risk. 67 For example, in the case of the Kyoto Protocol and the CDM, once offsets are issued, they are issued. A subsequent discovery that reductions previously certified were less than or different from what was actually certified will not affect offsets that have already been issued. How this is dealt with from scheme to scheme can vary. This is particularly a concern in the voluntary market, given the lack of a universal standard for dealing with risk of this nature. Typically, impermanence is considered of utmost importance in respect of offsets to be generated from carbon capture and sequestration (CCS) projects. 68 CCS involves the idea of capturing GHG emissions and storing or

“sequestering” them in the earth. 69

7. Force Majeure As in all project financings and with respect to all product outputs, force majeure is a risk to be considered. In respect of offsets, it can arise in terms of settlement (e.g. a problem with the registry) and in terms of traditional force majeure (e.g., earthquakes, acts of God, etc). Other possible interference with delivery or receipt beyond force majeure will need to be dealt with as well. As discussed above in respect of offtake agreements, force majeure risk can manifest itself in a variety of different ways, such as whether the occurrence of a force majeure event will excuse perfor- mance under the offtake agreement, and if so under what circumstances and with what consequences (i.e., damages, no damages, etc.). It also arises in terms of the actual project from which the offsets are to be generated. If a force majeure event (e.g., war, flood, act of God, etc.) precludes the project from ever becoming operational, or inter- rupts operation very early on, it may well mean that the actual amount of offsets gener- ated is less than the amount of offsets projected to be generated. Force majeure can also arise in respect of the ability of the project to deliver offsets to the offtaker as a function of the relevant registry being inoperative, inaccessible, or otherwise unavail- able. For example, in most CTSs, ownership is tracked through registries. 70 If those registries are inoperative or inaccessible due to a force majeure event, it may preclude effective delivery of the offsets at the time and place agreed in the offtake agreement, and it is possible that no delivery of the offsets could take place even outside the time and date specifications contained in the offtake agreement. The consequences of this

67 See TINSLEY , supra note 37, at 89–91 (treatment of risk division in general).

68 This can include in salt mines, empty oil wells, under the ocean, or in other ways yet to be ascertained.

69 Keywan Riahia et al., Technological Learning for Carbon Capture and Sequestration Technologies , 26 ENERGY ECON ., 539–564 (2004).

70 For a list of national registries, see U.N.F.C.C., Registry Websites, http://unfccc.int/kyoto_protocol/

registry_systems/registry_websites/items/4067.php (last visited Mar. 23, 2010). For information on the CDM Registry, see U.N.F.C.C. CDM Registry, http://cdm.unfccc.int/Registry/index.html (last visited Mar. 23, 2010).

OFFSET RISK PROFILE IN PROJECT FINANCINGS

will vary based on the terms of the offtake agreements; force majeure risk in project financings is fairly well developed and can be the subject of negotiation.

8. Environmental Liability Risk allocation and indemnification for environmental liability may also need to be considered depending on the applicable scheme and jurisdiction. As the Exxon Valdez incident made unforgettably clear, the severity, both fiscally and reputationally, of consequences stemming from environmental disas- ters can be incalculable. 71 Particularly where legal regimes have liability under all- encompassing provisions (such as the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA)) 72 that can sweep even those with de minimis contacts with the relevant source within their ambit. Accordingly, who bears the risk of environmental liability stemming from the activities resulting in the offsets can be a major concern depending on what industry and activities the proj- ect is involved in. As noted above, offtakers may seek extensive indemnification in respect of all such liability. Project sponsors will generally have no choice but to agree to such provisions given that the project’s activities are generally unrelated to and completely outside the control of the offtaker, which makes it hard to argue that the offtaker should bear such risks. The vast majority of market participants who function in the offtaker role, particularly in respect of offsets stemming from projects engaged in activities having the potential to generate significant environmental liability, are simply unwilling to agree to accept that risk. 73

9. Regulatory Considerations Selling or offering to sell offsets can potentially raise regulatory issues in some contexts. Such considerations vary from jurisdiction to juris- diction and, in some cases, may depend on other factors, including the nature of the project and the identity of the project participants. For example, if offsets are consid- ered securities, they could potentially be subject to regulation under the applicable jurisdiction’s securities laws. 74 It is also theoretically possible, if offsets are construed

71 The Exxon Valdez incident cost Exxon an estimated $3.8 billion in cleanup costs and damages, and this does not include any damages awarded due to class-action lawsuits. Doug Struck, Twenty Years Later, Impacts of the Exxon Valdez Linger , YALE ENV’T. 360 (Mar. 24, 2009), available at http://e360.yale.edu/content/feature.msp?id=2133 .

72 42 U.S.C. § 9601 et seq (2009).

73 See infra Section V.B.12.

74 In the United States, for example, Section 5 of the Securities Act of 1933, as amended (1933 Act) precludes the offer or sale of a security through the means or instrumentalities of interstate commerce unless a registration statement has been fi led. Thus, if offsets were considered secu- rities for purposes of the 1933 Act, selling or offering to sell them in the United States or to U.S. persons without fi ling a registration statement would generally be prohibited absent an exemption. Section 2(a)(i) of the 1933 Act enumerates categories of instruments comprising securities, e.g., “any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certifi cate of interest or participation in any profi t-sharing agreement, collateral- trust certifi cate, preorganization certifi cate or subscription, transferable share, investment con- tract, voting-trust certifi cate, certifi cate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certifi cate of deposit, or group or index of securities (including any interest therein or based on

as securities, that a project company or offtaker could be considered a broker or dealer, or both. In such case, it or they could be subject to regulation under the applicable jurisdictions’ broker-dealer or equivalent regime. 75 In addition, each jurisdiction has different administrative bodies or other relevant regulatory bodies governing com- modities and commodity futures trading that could potentially regulate offset trading in or with respect to the relevant jurisdiction. 76 Furthermore, the project company is

the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument com- monly known as a ‘security,’ or any certifi cate of interest or participation in, temporary or interim certifi cate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” Whether an exemption is available is a fact specifi c inquiry. See 15 U.S.C. § 77d (2003). However, because offsets do not actually represent any right or interest or otherwise denote ownership in an enterprise, or comprise an investment contract yielding a return in exchange for a capital investment or any of the other categories of instruments com- prising a security under Section 2(a)(i) of the 1933 Act, it is rather unlikely, in our view, that offsets should be considered securities under the 1933 Act. Offsets do not fall squarely within any of the enumerated categories of securities under Section 2(a)(1) of the 1933 Act. However, federal courts have historically attributed a very broad scope to the defi nition of “security,” and have interpreted the term “investment contract” as a “catch-all” phrase for instruments not fall- ing within the other enumerated categories of “securities.” Howey established a three-part

“economic reality” test for determining whether an interest in an enterprise constitutes an

“investment contract” and thus a “security.” Applying this test to offsets suggests that they should not qualify as “investment contracts,” because they do not represent an investment in a common venture, are not premised on a reasonable expectation of profi ts and such profi ts are not to be derived from the entrepreneurial or managerial efforts of others.

75 In the United States, for example, Section 15(a) of the Securities Exchange Act of 1934 (1934 Act) makes it unlawful to act as a broker or dealer in securities through the means or instru- mentalities of interstate commerce unless registered with the Securities and Exchange Commission (SEC) or exempt from registration, 15 U.S.C. § 78o (2000). “Securities” for pur- poses of the 1934 Act are defi ned in Section 3(a)(10) thereof with virtually the same defi nition as contained in Section 2(a)(1) of the 1933 Act. See 15 U.S.C. § 78c(a)(10); compare with 15 U.S.C. § 77b(a)(1). Thus, if a project company is a broker or dealer for purposes of the 1934 Act, selling or offering to sell offsets would be prohibited unless the project company was registered with the SEC or found to be exempt from registration. Whether or not an exemption is available would be a fact-specifi c inquiry. However, because offsets are unlikely to qualify as securities under the 1934 Act, it is unlikely that this would arise as a serious concern in practice.

76 In the United States, Section 2(a)(1) of the Commodity Exchange Act (CEA) grants the Commodity Futures Trading Commission (CFTC) exclusive jurisdiction “[over] transaction[s]

involving contracts of sale of a commodity for future delivery traded or executed on a contract market designated or derivatives transaction execution facility . . . or any other board of trade, exchange or market and transactions subject to regulation by the Commission . . . .” Thus, if offsets are commodities contracts for future delivery of offsets, they will be regulated by the CFTC absent any exemption or exception, which could theoretically encompass some kinds of offtake arrangements. As offsets should qualify as commodities for the purpose of the CEA under 7 U.S.C. § 1a(4), because contracts for the delivery of offsets are the subject of trading on regulated markets, contracts for future delivery of offsets would be subject to regulation by the CFTC. However, the ambit of the CEA does not extend to contracts for deferred delivery of a cash commodity, i.e., what are commonly known as forward contracts. Even where offtake arrangements could theoretically fall within the scope of the CEA, the vast majority of such