Emissions trading is a mechanism that provides countries, companies, and environmentally-conscious individuals with flexible cost-efficient means to meet greenhouse gas emission reduction goals. Emissions trading operates similarly to commodities markets, with purchase and sale contracts defining the rights and obligations of the parties and allocating risk. In a series of articles, ClimateIntel will discuss significant issues arising under these emission reduction purchase agreements.

There are two legal frameworks for emissions trading: compliance-based trading (mechanisms developed under the Kyoto Protocol or other governmental regulatory schemes) and voluntary transactional activity (sales and purchases of verified emission reductions). The largest compliance-based trading program today is the European Union Emission Trading Scheme (EU-ETS), accounting for approximately 70% of all trades (volume) in the first half of 2008. Under the EU-ETS, EU Member State governments agree to allocate emissions allowances to regulated facilities, as well as monitor, report and verify the actual emissions during each year. Under some regulatory schemes, an emitter may meet its compliance obligations by purchasing offsets or certified emission reduction credits. The best known carbon offset standard is the Clean Development Mechanism (CDM), which was created under the Kyoto Protocol. CDM projects generate Certified Emission Reductions (CERs), which must be certified by the CDM Executive Board, an entity administered by the United Nations. In 2007, over 3,000 projects were in the project pipeline, with CDM representing the vast majority of project-based transactions (at 87% of volume and 91% of value).

Emission reductions can also be generated on a voluntary basis. Voluntary emission reduction credits (VERs) are verified pursuant to a third party carbon offset standard. There are at least seven voluntary standards in place today, including the Gold Standard, the Voluntary Carbon Standard, and the Chicago Climate Exchange Standard. Unlike the CDM, adherence to voluntary standards is not monitored by a governmental or quasi governmental body such as the CDM Executive Board. Compared to the compliance market, trading in the voluntary market is much smaller (accounting for only 0.5% of the total global carbon market value in 2007); however, voluntary transactional activity has accelerated dramatically over the past couple of years.

Contracts for the purchase and sale of registry-listed credits generally adhere to an accepted, standard form. This means that buyers generally do not need to conduct an extensive review of project data and methodology. In some circumstances, such as when a buyer makes a long-term commitment to purchase ERs from a specific project, the buyer will find it necessary to ensure that the project sponsor is continuing to follow the approved project development plan. Alternatively, many buyers will enter into forward purchase contracts with a project sponsor to purchase ERs before any have been actually generated, and before the validation process has occurred. A buyer may prefer this approach if the project offers significant co-benefits, while a project developer may prefer this approach where it is relying on buyer’s investment to implement the project activity. This is the riskiest transaction for the buyer because it will generally bear the risk of any shortfall in the number of ERs ultimately generated. In these cases, the project developer or the facility in question will be required to provide detailed project information to the buyer, who will often insist upon reviewing confidential and proprietary data related to the project’s ER generation and ongoing compliance with the chosen standard.

A project developer’s need to protect its data will depend upon the type of activity it engages in; as a general rule, the greater the developer’s proprietary interest in its data, the more stringent the confidentiality provisions required. A buyer’s interest in this data, on the other hand, will depend upon whether the certification or verification process has been initiated and whether any ERs have already been generated at the time of investment. The buyer also has a greater interest in ensuring that relevant data is disclosed to the certifying or verifying third parties. Conversely, the project developer or the facility in question may want to limit the amount and type of information it reveals, as the project documents will become public and be reviewed by other parties, including the host country and local stakeholders who will have a chance to ask questions regarding the project activity and processes. While information deemed proprietary or confidential may be excluded from disclosure under CDM and other standards, project developers and facilities must be careful not to withhold too much and risk being deemed noncompliant with the standard or causing excessive delays in generating ERs.

The industrial facilities where the emission reductions actually occur face the greatest risks here, and need to pay significant attention to the information they are willing to disclose. Third-party certification and verification processes, while necessary to bring the credits to market, are inherently intrusive. Facility owners must understand the magnitude of the risks created by allowing outsiders to observe proprietary processes and other forms of valuable intellectual property. While revenue from credit generation can be enticing new revenue stream, business owners must seriously assess whether the potential loss of trade secrets and other confidential information is too high a price to pay in return.

For further information about this topic, please contact Akin Gump.