This is the second in a series of articles discussing significant issues arising under emission reduction purchase agreements (ERPAs). For background information, please see the previous article in this series.

One of the critical issues in drafting an ERPA is defining the concept of delivery of the emission reduction unit. The delivery terms will vary based on the type of credit being traded. For Certified Emission Reduction (CER) credits sold within a compliance regime, the program regulations will generally dictate how to effect delivery. However, for Voluntary Emission Reductions (VERs), which are contractually created as part of a voluntary scheme, the parties will need to negotiate the mechanism by which the credits will be transferred from seller to buyer, bearing in mind the risks associated with transfer of title and any shortfall or delivery failure.

The ERPA must specify the point at which title is transferred. For VERs that have been created, verified, and are already sitting in the seller’s account, delivery can occur upon execution of the contract. When the VERs have not yet been created, delivery should not be considered accomplished until (i) the buyer has received a “verification report” prepared by an independent entity assessing the number of credits to be generated in accordance with the standard under which the VERs will be registered, and (ii) the seller delivers to buyer a “delivery confirmation notice” specifying the project description and certifying as to the exact number of VERs to be transferred.  If possible, the sale should be submitted to a carbon registry, which allows for more transparent transactions and better functioning markets.  However, existing registries cannot yet accommodate all types of VER transactions, so some transactions will need to go unreported for the time being.

The above measures are necessary to ensure that the buyer receives legal and beneficial title to the VERs clear of any encumbrances. The parties may also wish to set in writing the possibility of any legislative changes that could impact the delivery process and future rights.

Contracts purchasing and selling future rights are rife with uncertainties, particularly when the volume of emission reductions are not yet fixed. Delivery failures and credit shortfalls are significant risks, and appropriate arrangements should be made to address these concerns. Possible approaches include an extension of the delivery schedule, physical replacement of the emission rights from other projects or from future years, or where replacement is not possible, a payment to buyer to cover the cost of purchasing credits from another source. The parties may also want to negotiate liquidated damages or other frustration costs associated with delivery breaches and should include carve-out provisions for delivery failure arising as a result of force majeure.

One of the most significant issues to be agreed by the parties to an ERPA is actual evidencing of the transaction. Within compliance schemes, a government (or other regulatory body) issued certificate will serve as evidence that can be tracked and traded through a registry. However, validating contractual rights requires more steps and the parties will need to clearly document (i) what constitutes delivery, and (ii) what responsibilities each party has undertaken to achieve the transfer of emission rights. If problems arise with the transaction, parties may have difficulty establishing and vindicating their rights without the proper evidence at hand.

ERPA’s, basically unheard of a mere five years ago, are becoming commonplace in the financial world.  These contracts allocate and mitigate risk in innovative ways, and call for exactingly drafted provisions designed to prevent disastrous consequences in the future.  By ensuring that issues such as titling, delivery, and evidencing the transaction are handled properly, these risks can be reduced significantly for clients who need to buy and sell emission reduction credits.

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