As the international market infrastructure for trading carbon credits grows, it is inevitable that lenders will be asked to consider taking carbon credits as collateral.
To date, exchanges on which carbon credits trade accept those credits as collateral on margin accounts. Carbon credits are also pledged as credit enhancement in project financings for development of projects that generate reductions of greenhouse gas (“GHG”) emissions, in both developing and industrialized countries. But increasingly, companies that acquire, bank and trade carbon credits may wish to pledge them to secure their borrowings.
Lenders have traditionally not attributed value to carbon credits as collateral because of their so-called complexity, price volatility and lack of liquidity. The gradual acceptance of protocols, platforms and services designed to facilitate accounting, certification, trading and tracking of carbon credits may change this. Moreover, if the U.S. joins Europe and adopts a cap-and-trade system for regulating GHG emissions, and if the multiple protocols are consolidated and standardized, carbon credits may be accepted as a financial commodity among financial institutions, and the use of carbon credits as collateral for borrowing may become commonplace.
What are Carbon Credits?
Carbon credits are financial instruments which are tradable and fungible. There are four types, each equal to one metric tonne of carbon dioxide equivalent (CO2e):
EUAs – allowances for GHG emissions issued or auctioned under the mandatory European Union Emission Trading Scheme (EU ETS);
CERs – certified emission reductions issued under the Clean Development Mechanism (CDM) of the United Nations Framework Convention on Climate Change (UNFCCC) from qualifying projects under Article 12 of the Kyoto Protocol;
ERUs – emission reduction units generated by Joint Implementation (JI) projects under Article 6 of the Kyoto Protocol;
VERs – voluntary emission reductions issued by independent bodies for demonstrable reductions of GHG emissions. The applicable projects and VERs are verified by third parties. The verifier’s standards may be as strict as CDM (such as the Gold Standard) or not as stringent. Prices of VERs vary according to the quality of the verification standard. VERs may not be used for EU ETS or Kyoto compliance.
CERs, ERUs and VERs are sometimes called “offset credits.”
Where Do Carbon Credits Trade?
EUAs, CERs and ERUs have registry systems that track their location at all times. Governments which are parties to the Kyoto Protocol have national registries for Kyoto allowances and the UNFCCC Secretariat oversees the International Transaction Log (“ITL”), the central registry for CERs and ERUs to which the national registries are connected. These registries “settle” emissions trades (i.e., trades of carbon credits) by delivering units from sellers’ accounts to buyers’ accounts. On February 12, 2010 the national registry of Canada became the 36th registry linked to the ITL.
The EU ETS is the largest emission trading scheme in the world. EUAs are specific Kyoto allowances which have been designated for trading under the EU ETS. Transactions in EUAs are recorded automatically as transactions under the Kyoto Protocol.
VERs are tracked in unregulated registries such as (for example) the Gold Standard Registry and the American Carbon Registry. These registries track the full lifecycle of a carbon credit, including creation, serialization, transfer and retirement. They are designed to prevent fraud (e.g. double counting) and provide full audit trail capabilities.
Carbon credits (both allowances and offset credits) may take the form of futures which are contracts for guaranteed delivery in the future against an agreed price. Futures are exchange traded contracts between anonymous buyers and sellers, with delivery and payment risk guaranteed through a clearing house (such as ICE Clear Europe) and are standardized in order to ensure liquidity. They are marked to market daily, with profits and losses settled daily through margin accounts. Carbon credits may also take the form of forwards which are custom bilateral contracts for delivery in the future at an agreed price. Forward contracts are sometimes based on templates such as (in the case of CERs) the certified emission reduction sale and purchase agreement (“CERSPA”) template, and are designed to meet the specific needs of the contracting parties. Profits and losses occur on the expiration (delivery) date. Forwards trade over-the-counter (“OTC”), often through a broker. They are not very liquid. Carbon credits may also trade between brokers and other exchange members as commodities for immediate delivery under spot contracts. The recognized exchanges for trades of offset credits include the European Climate Exchange (“ECX”), the Chicago Climate Exchange (“CCX”) and the Montreal Climate Exchange (“MCeX”).
Taking Security in Carbon Credits
Each jurisdiction has its own legal regime governing collateral and securitization, and the creation, validity, perfection and enforcement of security interests. In Canada, each province has its own personal property security legislation. This paper looks only at the Province of Ontario.
A carbon credit in the form of a futures, forward or option contract is personal property governed by the Personal Property Security Act (Ontario) (the “PPSA”). If a borrower enters into an agreement granting to a lender a security interest in the borrower’s carbon credits, the security interest may be perfected by registration of a financing statement under the PPSA against the borrower if the borrower’s chief executive office is in Ontario. The security interest may also be perfected by the lender taking “control” over the carbon credits. A lender would have control of carbon credits in the form of a futures contract if the borrower (i.e. the owner of the futures contract), the futures intermediary (i.e. the broker facilitating the futures contract or the clearing house) and the lender enter into a “control agreement” under which the futures intermediary agrees to apply any value distributed on account of the futures contract as directed by the lender without further consent by the borrower. A security interest perfected by control generally takes priority over a security interest perfected by registration.
What if the borrower’s chief executive office is located somewhere other than Ontario? Perfection and priority of the lender’s security interest in a futures contract or futures account will be governed by the law of the futures intermediary’s jurisdiction. The PPSA rules for determining a futures intermediary’s jurisdiction require an examination of the agreement between the futures intermediary and the borrower to see if the parties specified a particular jurisdiction, governing law or office where the applicable futures account is to be maintained, failing which perfection will be governed by the jurisdiction in which the futures intermediary’s office identified in the borrower’s account statement is located or, if all else fails, where the futures intermediary’s chief executive office is located.
What about carbon credits which are not in the form of futures, forwards or option contracts? For example, CERs or VERs which are generated by a project owner but not yet traded or delivered. Or CERs or VERs which have been traded or delivered to a purchaser, but not yet retired by the purchaser (that is, not yet applied by the purchaser against the purchaser’s voluntary or mandatory GHG emissions reduction target). Under the PPSA those carbon credits would be intangibles. Perfection and priority of a security interest in intangibles is governed by the laws of the jurisdiction where the borrower’s chief executive office is located. Consequently, the lender would perfect by registering a financing statement under the PPSA if the borrower’s chief executive office is in Ontario. In addition, for maximum protection of its creditors’ rights, a lender may also wish to insist on a fiduciary transfer, namely, a transfer of registered ownership of the CERs and VERs on the applicable registry into the name of the lender or a mutually agreed collateral agent. This additional step may be disadvantageous to the borrower, since the change of registered ownership would constitute a transfer of the borrower’s control over the applicable carbon credits. Or if the borrower is the project owner, a lender may wish to take an assignment of the borrower’s interest in the applicable emissions reduction purchase agreement or otherwise securitize the revenue to be derived under that agreement as CERs or VERs are generated.
In a paper such as this it is impossible to anticipate all of the factors relevant to creation, perfection and priority of security interests in any particular loan and collateral scenario. Lang Michener LLP is of course prepared to advise and assist clients interested in the legal aspects of either taking or providing carbon credits as collateral.