A Global Market For Emissions Trading
The potential exists for a cross-border market for emissions trading. Among factors facilitating the development of this market are the impending requirement to hold sufficient assigned amount units (AAUs), removal units (RMUs), certified emission reductions (CERs) and emission reduction units (ERUs) under the Kyoto Protocol and allowances under the EU emissions trading scheme and the recognition of the ability to trade in such units, in particular the ability to transfer such units relatively freely.
Although the emissions trading market is still in its infancy, trades are beginning to materialise. Shell Trading and Nuon Energy Trade & Wholesale announced in February last year the completion of a forward sale of a "significant volume" of first commitment period EU allowances. The sale of 200,000 AAUs by the Slovak Republic to a major Japanese trading house was also reported in March 2003 and in Q4 2003, the Dutch government purchased emission reduction units representing more than 400,000 tons of CO2 from Bakony Power Plant Plc, a Hungarian power producer.
Given that the EU scheme does not start until January, these trades are inevitably for forward settlement and the focus to date has been on physical settlement. Given the uncertainty over the Kyoto scheme and the unclear role of CERs and ERUs in the EU emissions trading scheme, pricing is at best opaque and a cash settled market has therefore yet to develop. Whether exchange trading, centralised clearing or both will follow is still an open question, although the innate standardisation of these assets would lend itself readily to such developments.
To date, market participants have been governments and emitters impacted by the EU emissions trading scheme or those likely to be affected by Kyoto, but banks and other financial institutions are increasingly visible in the market, either as proprietary traders or using their trading desks to integrate emissions allowances and credits into their financing products.
Documentation For Emissions Trading
Initially, the market relied on in-house or bespoke documentation for emissions trading but as the volume of trades and participants increased, international trade associations began to publish standard form agreements for the documentation of emissions trades.
International Emissions Trading Association (IETA), has published an EU Allowances Emissions Trading Master Agreement to document the sale and purchase of allowances under the EU emissions trading scheme. It is also working on a draft EU Allowances Single Trade Emissions Agreement to document one-off transactions.
The International Swaps and Derivatives Association has set up an Emissions Working Group to look into the legal and regulatory issues attendant on emissions trading and are currently in discussions with IETA to publish a jointly-sponsored document. Consultations are currently being made with members of ISDA in respect of a draft confirmation for an over-the-counter physically-settled EU emissions allowance transaction. This could be a precursor for other template confirmations for other types of derivative transactions in emissions allowances to be included in the proposed new ISDA commodity derivatives definitions.
Commercial, Legal & Documentation Issues
What are the key commercial and legal issues to consider and document in an emissions trade? A derivatives lawyer's check list might include:
What is being sold must be clearly defined. In other words, whether it is an AAU, RMU, CER or ERU under the Kyoto Protocol scheme or an allowance under the EU emissions trading scheme. It may also be necessary to set out the vintage (i.e. the year of issue or generation) of the particular allowance or unit and the acceptability of substitutes.
The price for the allowance or unit being sold should either be specified, or if not specified, the manner in determining the price should be spelt out with any necessary fallback provisions.
Where the transaction is being settled by physical delivery, in the current absence of clearly defined rules relating to national registries and in view of the lack of any established market practice, the timing and method for delivery should clearly be set out. This should cover how delivery should be achieved (e.g. to and from specified registries) and when delivery is considered to have taken place, especially when moving between legal regimes and across boundaries.
Parties will also need to consider whether a payment-versus-delivery arrangement is desirable or practicable, given that national registries will not be clearing and settlement systems. If not, then parties will need to agree whether payment or delivery should come first and whether any grace periods for payment, delivery or both should be built in, as well as the acceptability of partial settlements.
Parties also need to consider the consequences of the seller's failure to deliver in accordance with the terms of the agreement. This could be due to several factors, including those within the buyer's control, those within the seller's control or factors outside the control of either party (i.e. as a result of force majeure or illegality). Where the failure to settle is due to factors within the control of either party, parties need to consider if this should give rise to an event of default on the part of the delinquent party, allowing the other party to terminate this and possibly other unrelated transactions and the measure of any liquidated damages that may be payable.
As the failure to settle may not necessary mean that a party is wilfully delinquent in its obligations, parties may wish to consider providing for non-fault based terminations and possibly limit termination to affected transactions only. How any resulting payments should be calculated, including, when relevant, how to value the price of the undelivered allowances or units, would need to be agreed and documented.
Parties will also have to consider what the consequences should be where settlement is prevented by factors outside the control of either party. Force majeure or settlement disruption clauses should be carefully drafted to clearly set out the circumstances in which they apply. If an agreement employs more than one such provision it will need to state clearly the order of their precedence and the methodology of any differing commercial consequences.
Another point to consider is the consequences of any legislation or regulatory change affecting the relevant emissions trading scheme or the allowances or units being traded. As the emissions trade may be done well before the entry into force of the relevant scheme, consideration needs to be given to what happens if the scheme, for one reason or another, fails entirely to come into effect or is delayed, or if the scheme comes into effect but in a different form from that contemplated at the time of the trade. When such a change in law clause overlaps with any force majeure or settlement disruption provision, a clause will need to be included to provide whether the force majeure or settlement disruption provisions apply or the change in legislation provisions apply. At this point care must be taken to avoid creating "agreements to agree."
In view of the nature of the contract, in particular its subject matter, parties should consider whether any dispute should be resolved in court and if so which courts, or whether disputes should be submitted for arbitration, expert determination or some other form of alternative dispute resolution.
Parties should consider the ambit of any representations, warranties and covenants to be included. Possible relevant covenants include covenants in respect of the maintenance of the parties' respective registries and conduct in accordance with the rules of the relevant scheme and any licences that may apply. The buyer may also wish to require the seller to give a representation as to good ownership of the relevant allowances or units.
Challenges In Emissions Trading
One of the biggest challenges faced by players in the market remains the legal risk arising from uncertainty. Firstly, the uncertainty, particularly with respect to the Kyoto Protocol, as to when and whether its scheme will come into effect. Secondly, the risk that, pending finalisation of the detailed regulations and rules, legislative changes could alter the nature and mechanisms of the scheme or the nature of the allowances being traded, and thirdly, pending the finalisation of national legislation implementing the international and regional rules, how the different schemes will work together. Further, as the subject matter of such trades is wholly a creature of legislation, the legal nature of allowances and the rights and obligations in respect of them remains unchartered waters. In Europe, the future scope of financial licensing for the trading of emission rights and derivatives on them remains open pending finalisation of the replacement legislation for the Investment Services Directive.
As it stands, emissions trading schemes under the Kyoto Protocol and the EU emissions trading scheme have not yet come into force and the allowances and units to be traded have not come into being. The lack of a liquid market in such allowances and units has given rise to opacity in pricing. However, such mere "details" have not stopped trading commencing. On the other hand, as more participants join the market, it will become easier to find counterparties for making such trades with resulting increases in standardisation and liquidity. But, the growth of the market will also lead to the creation of systemic risk.
Where there is demand, there will be supply. As opportunities in this budding market become apparent to a greater numbers of players and as such opportunities begin to outstrip the challenges, the emissions trading market is sure to create demand. It remains for legislation to create an adequate supply.
This week's learning curve was written by Lena Goh, associate, and Claude Brown, partner, at Clifford Chance in London.
