The purpose of this bulletin is to set out the main implications of the Carbon Reduction Commitment (CRC) for the private equity sector, and to highlight what steps in practice private equity funds and their general partners/fund managers and portfolio companies should be considering now and going forwards.
A summary is set out below. In addition, we cover the following topics in the full text of this bulletin:
- Application to private equity funds
- Special considerations
- Application to portfolio companies (and other companies within the organisation)
- Preparation and next steps
The draft Order to implement the CRC proposes that the scheme will operate on a single macro corporate organisation basis, rather than on a site, company, portfolio company or UK GAAP accounting basis. As such, it makes the application of the CRC to the private equity funds sector potentially the most complex and burdensome of any of the affected sectors. The draft Order constitutes the single body that participates in the CRC as that comprising a parent and its subsidiary undertakings as defined by section 1162 of the Companies Act 2006 (known as the "CRC organisation" or "combined participant").
This could mean that funds, general partners/fund managers and portfolio companies will be required to participate in the CRC as a single organisation and aggregate their respective energy consumption/emissions. This presents a number of practical problems - not least the determination of the combined participant and intra-group responsibilities, costs and other liabilities. The CRC will then require managing across the organisation and including potentially across portfolio companies that have very different management structures and business operations.
The requirement to participate in the CRC as a single organisation entails a number of material considerations:
- Ascertaining which entities within the private equity organisation are CRC regulated: This is discussed in some detail below but the first step (under current proposals) that needs to be ascertained is whether the CRC applies to individual entities only or, whether because of the parent-subsidiary undertaking definition employed by the CRC, this will require a much wider aggregation of emissions – eg, all portfolio companies under each fund, or where a fund is in reality a series of parallel funds, all funds taken together as a single CRC organisation. A further complication can arise where, due to overlapping investment strategies, different funds managed by the same general partner/fund manager may invest in the same portfolio company. The determination of the relevant CRC organisation(s) for qualification for the first phase of the scheme is based on the organisational structure as at 31 December 2008.
- Calculate energy use at local level then aggregate: Electricity consumption measured through half hourly meters during 2008 will need to be aggregated across the CRC organisation for the purpose of assessing whether the organisation meets the 6,000 MWh qualification threshold. This electricity consumption (regardless of whether met the 6,000 MWG threshold) will need to be calculated and reported (together with a mass of other data) prior to the end of the registration period in September 2010.
- Determine number of allowances to be purchased: Energy use emissions will need to be projected across the entire CRC organisation for the purpose of calculating the amount of carbon allowances that are required to be purchased in the annual sales/auctions of allowances. Annual (April to March) emissions will need to be calculated and reported by July 2011 for the first year of the scheme and then each following July.
- Apportion costs (and benefits) across the group: The cost of allowances (and other costs associated with compliance) and recycling payments (including any penalties and bonuses) ideally would need to be apportioned between the various entities in the CRC organisation fairly and lawfully. This will not be straightforward (if even possible) given that financial resources are usually ring-fenced between portfolio companies and certainly between funds.
- Joint and several liability (criminal and civil): The draft Order states that responsibility and liability as between the members of a CRC organisation is joint and several. Accordingly, a default in CRC obligations by one entity in the CRC organisation might result in another entity (eg, the general partner/fund manager or directors and officers of the parent or subsidiary undertakings) incurring civil and criminal penalties for wider group defaults. Managing this risk will entail a new, unique, layer of corporate governance.
- Skewed CRC performance and cost impacts: If a particular portfolio company or other CRC organisation company fails to reduce, or increases, its emissions, this could adversely affect the performance of the wider CRC organisation, its ranking in the league table, and the amount of bonus or penalty payments received by the organisation. Poor performance by one group company could therefore increase costs across the whole organisation.
- Administration across the group: Compliance with the CRC will need to be managed across the organisation as a whole. For private equity sponsors, this is likely to present a significant administrative burden in terms of monitoring and reporting emissions, appraising how many and when CRC allowances should be purchased, surrendered or traded. In addition, due diligence and management procedures may need to be put in place to address the consequences of future acquisitions and divestments in terms of CRC liabilities and reporting requirements.
- CRC performance nominee ("primary member"): An entity within the group (this would be either the ultimate parent or a nominated entity, including an SPV created for CRC purposes) will be required to be responsible for contact with the Environment Agency (the CRC administrator) for compliance purposes on behalf of the whole group.
- Non-UK resident parent companies: In cases where the ultimate parent is an overseas company, the CRC organisation must nominate a UK-based member as the primary member. Overseas companies are taken into account for the purpose of ascertaining group structure, but only UK energy use emissions will be accounted for under the CRC. This extra-jurisdictional reach could present certain investment funds with some difficult issues in terms of CRC compliance.
- Impact of commercial growth: Performance in the CRC league table will be mainly based on the percentage reduction in an organisation’s emissions compared against a rolling year average baseline (based on average emissions of up to five years). This baseline will not be updated between scheme phases to take account of organic growth or growth via acquisitions except on the acquisition or divestment of a "principal subsidiary" where both the seller's and the buyer’s baseline emissions against which CRC performance are calculated will be updated (see further below). Some weighting (20% in the introductory phase, 25% in subsequent phases) will be given to the growth metric for league table purposes but this may prove to be of marginal benefit for high growth/acquisitive companies. The impact of acquisitions will be a further governance issue for the private equity sector.
- How much work should be undertaken now? The CRC rules are not yet final and one has to question whether the application of the proposed regime to private equity is in fact workable (particularly for the more complex fund structures), and what degree of wait and see can still sensibly be taken in terms of certain preliminary steps. However, working on the assumption that the scheme will be introduced as proposed, some private equity sponsors will have a huge amount of work to undertake before the relevant deadlines and preparatory steps should not be left too late.
The British Venture Capital Association (BVCA) has submitted a response to the recent consultation on the draft Order that speaks to many of the concerns set out above. A copy of the response is available here. The BVCA suggests that UK GAAP or another accounting standard be used to define an organisation, so that portfolio companies will only be required to participate with funds and fund managers as a single organisation where they are also consolidated for accounting purposes. This at least is a structure that the industry already understands and would ease some of the administrative burden, allowing efforts to be spent on energy management efficiencies across an understood corporate grouping rather than the significant amount of time that is otherwise going to have to be spent on operating the CRC in the way currently proposed. To assert, as has been the case by certain parties, that the existing proposed corporate grouping eases the administrative burden, demonstrates a fundamental misunderstanding of the private equity sector.
Application to private equity funds
Depending on the particular fund structures in place, it is possible that general partners/fund managers, funds and portfolio companies will be required to participate as a consolidated organisation on the basis of parent/subsidiary undertaking relationships between them.
There is no common structure in terms of how the organisation bundling will work for private equity ventures. What is clear is that in a number of cases the position could be very complex. In accordance with the relevant provisions of the Companies Act 2006, an undertaking is a parent undertaking in relation to another subsidiary undertaking if:
- it holds (or controls alone or pursuant to an agreement with other members or shareholders) a majority of the voting rights in the subsidiary undertaking;
- it is a member of the subsidiary undertaking and has the right to appoint or remove a majority of its directors;
- it has the right to exercise (under provisions in the subsidiary undertaking's articles or a control contract) or actually exercises a dominant influence over the subsidiary undertaking; and/or
- it and the subsidiary undertaking are managed on a unified basis.
For a typical UK private equity fund, comprised of one or more English limited partnerships, the shares in the portfolio companies will usually be held by the general partner on behalf of the limited partnership(s) or alternatively held by a holding company set up for this purpose. The holding company may be held by the general partner on behalf of the limited partnership(s). The general partner (or the fund manager if a separate entity has been set up to conduct investment management activities) will exercise voting rights, appoint or remove directors, and will be able to exercise other rights to which the limited partnership(s) is entitled on its behalf in relation to the portfolio companies invested into by the limited partnership(s). Although this presents a risk that the general partner could be treated as a parent undertaking, the general partner (or any fund manager to whom rights have been delegated) may well benefit, at this level at least, from the Companies Act exemption that rights of control and influence held by a person in a fiduciary capacity shall not be treated as held by that person. All rights exercised by the general partner should not however be assumed to fall within this fiduciary exemption.
If the general partner has Companies Act controlling rights over the limited partnership(s), it will be the parent undertaking of the limited partnership. Separate considerations will apply as to the fiduciary nature of this relationship if the general partner has delegated rights to manage the investment portfolio of the limited partnership to a fund manager, as to whether the fund manager is also a parent undertaking. This will include consideration as to whether its functions are exercised solely as agent for the general partner (as is commonly the case) or extend beyond that. Whether the general partner or fund manager in these circumstances is also then a parent undertaking of the portfolio companies will depend, in part, on the limited partnerships' relationships with the portfolio companies, as described above. Any non-fiduciary relationships that could potentially arise, for example via a directorship, between the general partner and the portfolio companies would also be relevant in determining whether the portfolio companies classify as subsidiary undertakings of the general partner.
The potential for a general partner or fund manager to be in a parent/subsidiary relationship with the portfolio companies may or may not be relevant for all funds but is clearly possible. If it does arise, this could result in aggregation of portfolio companies within a fund or even across different funds.
Potentially controlling rights may need to be considered above this level, though any material CRC impacts at higher levels are likely to be rare:
- any non-UK resident holdcos are likely to be special purpose, such as Guernsey or Cayman Island SPVs or charitable trusts;
- investors in a private equity fund would not usually be entitled to exercise sufficient control or influence over the limited partnerships or the portfolio companies so as to satisfy any of the Companies Act tests. The exception to this being if it is a key investor in the fund and has agreed special rights to manage or control either the fund or portfolio companies (for example, it may have secured rights to appoint and remove the fund manager or portfolio company directors or to have a veto over investments/divestments).
With respect to any holdings by nominee companies, the Companies Act is clear that rights held by a person as nominee for another are treated as held by that other entity.
Where different funding structures to the types described above are used, or where there are changes made to an investment structure, these must also be considered against the tests set out in the Companies Act. It remains possible that in certain cases direct and indirect parent/subsidiary undertaking relationships exist between portfolio companies, funds, and fund managers such that they constitute a single organisation for CRC purposes. How the parent/subsidiary relationships are constituted (and whether there is more than one) is the first point for verification.
For a plain vanilla fund structure, the analysis may prove to be "relatively" straightforward. But some private equity sponsors will need to address additional complicating features such as:
- substantial general partner commitment via the limited partnership or co-investment at the portfolio company level;
- significant co-investment arrangements with co-investment vehicles;
- funds that in reality are a series of parallel limited partnerships, each holding a small stake, but collectively a large majority stake in a portfolio company and which grant the general partner rights and influence (for example veto rights or rights over board appointments) over portfolio companies to such an extent that may be classified as controlling for Companies Act purposes;
- multiple fund entities used to invest funds from investors located in different jurisdictions or used to used to structure investments in a tax efficient manner.
In such cases, the same Companies Act analysis will need to be performed but will be much more complicated and require more time and resources to complete. Funds may have such extensive and complex investment structures that complying with the CRC will be nigh on a practical impossibility. Aside from the extent of the obligation, general partners acting on behalf of a number of different beneficial owners may find themselves in a position of conflict as between different beneficial and equity interests.
Applications to portfolio companies (and other companies within the organisation)
Having established the existence of any parent subsidiary relationships, and all relevant CRC organisation groupings, the precise energy use for which each particular entity is responsible under the CRC will need to be identified and assessed (then aggregated on an organisation basis). For certain types of businesses, this may not be straightforward:
- Landlord and tenant: Where a company is a landlord or tenant of property, special considerations apply in respect of emissions deemed to result from energy consumed in the relevant property. Responsibility for emissions as between landlord and tenant under the CRC rests with the party that is the counterparty to the relevant energy supply contract and not automatically the party that consumes the energy. As such, a tenant company which is not the counterparty to the energy supply contract (directly or through any agent) will not have to have this part of its energy use assessed for the purpose of its, and in turn, the group's overall energy emission calculations.
- Franchises/vertical distribution agreements and licences: Companies that are franchisors or otherwise exercising business brand influence at lower levels of the distribution chain (eg, certain fast food, car, and telecoms brand franchises/distributorships) will be responsible under the CRC for the emissions arsing from the energy use of their franchisees/distributors. This is the case even though the franchisee is not a group company or connected to the group other than by contract. Any such arrangement will therefore entail additional allowances, administration and, where possible, contractual changes to allow for effective arrangements to be implemented as between franchisor and franchisee.
- Joint ventures: Where a portfolio company has an interest in a joint venture (likewise PFI/PPP/BDFO arrangements), the stated policy of the government is that where there is a parent with a greater than 50% controlling stake the emissions of the joint venture will be aggregated with that parent. If no parent with a greater than 50% stake exists, the joint venture will participate as an individual CRC organisation (provided that it meets the qualification threshold). However, this policy does not appear to have been reflected in the draft Order. Indeed, the provisions in the draft Order which relate to multiple ownership appear to present additional and unintended complexities which cut across some of the key principles that underpin the CRC which are addressed in this bulletin.
- Exemptions: The draft Order provides exemptions for emissions arising from energy used for transport (but not energy used to move people around certain types of places and within premises in equipment such as lifts and escalators). There are also exemptions which may need to be considered for emissions regulated by the EU Emissions Trading Scheme or a Climate Change Agreement. These exemptions are addressed in more detailed in the general Herbert Smith bulletin on the CRC.
Preparation and next steps
The CRC is expected to commence in April 2010 yet it remains unclear what changes may be made to the draft Order before it is issued. For the time being, preparations for the CRC have to be made in the absence of definitive rules, with the risk of civil and criminal penalties in the event of non-compliance by the relevant deadlines.
- Step 1 – determine the extent of the CRC "organisation": Given the complexities described in this note, private equity organisations are advised to start early in terms of determining the extent of their "organisation" – first as at 31 December 2008, the base date for qualification purposes, and subsequently for on-going CRC compliance purposes. In particular, it will be necessary to ascertain whether CRC obligated organisations will be contained at individual portfolio company level or whether they will be combined with one or more portfolio companies or even other funds. The control rights in relation to the general partner for each fund/limited partnership and each portfolio company should be assessed to ascertain if there is (or might be) any parent/subsidiary undertaking relationships and at what level(s).
- Step 2 – collect energy use data and verify inclusion within the CRC: CRC qualification packs will be issued in September 2009 to the billing address for each organisation that uses half-hourly meters. Responses to these packs will need to be filed for registration purposes (see step 4) by September 2010. Organisations will need to identify all their individual half hourly meters and report energy consumption through these meters. In addition, the response to the pack will need to include structural records that define the scope of your organisation and records to support reliance on any exemptions. Although the draft Order contains a requirement on energy suppliers to provide annual statements to customers, on request, detailing annual energy consumption through every meter, this obligation will only apply from February 2011 and so may do little to assist current preparations. (Organisations should bear in mind that even if they do not meet the qualification threshold but consume some electricity through standard half-hourly meters, they will still be required to respond to the qualification packs or face a civil fine of £1,000.)
- Step 3 – pre-commencement planning: Organisations that are required to participate in the CRC will need to identify all sources of energy (not just electricity) covered by the CRC and levels of usage taking out any non-accountable emissions (such as those in relation to a leased property where the landlord is the counterparty to the energy supply contract). They should use this data to plan their compliance, and identify opportunities for energy savings and efficiencies taking future CRC league table performance into account, including the metrics by which performance will be measured. The cost of any emissions reduction measures planned should be carefully assessed against the carbon cost savings and other potential benefits.
- Step 4 – register: Organisations that are required to participate in the CRC will be required to register with the Environment Agency between 1 April and 30 September 2010.
- Step 5 – nominate "primary member": Organisations must also determine which entity should be nominated as the "primary member" for scheme administration as between the organisation and the Environment Agency. If an organisation does not nominate a primary member, the primary member will be the top UK-resident parent (the draft Order does not specify how and by when an organisation may nominate a primary member but we assume that this will comprise part of the registration process). Where the top parent company is not UK-resident, the group must nominate a UK-resident member. A group may nominate any member as its primary member subject to the Environment Agency's right to reject the nomination in favour of what it considers a more suitable alternative. Given that there is joint and several liability across the group (the group is treated as the person responsible for compliance) there ought to be no reason why the Environment Agency should not approve a SPV established for this purpose though prior discussion and approval on this point would be prudent. This is most likely to be a relevant consideration where there is consolidation of portfolio companies and/or funds for CRC purposes.
- Step 6 - post-commencement planning and compliance: The CRC will commence in April 2010. Organisations will need to monitor those energy sources covered by the CRC and levels of consumption from this date in order to ensure compliance with the requirement to purchase and surrender sufficient allowances. Consideration may need to be given as to the merits of contracting out data management, energy efficiency advisory services, and CRC data verification and other compliance functions to a third party service provider.
- Step 7 – intra-group arrangements: Issues such as recharging for group costs, and any redistribution of recycling payments (please see the general Herbert Smith note on the CRC), will need careful consideration, particularly if the private equity structure creates a complex CRC organisation. Changes may need to be made to investment agreements to ensure effective co-ordination of CRC obligations. Likewise contractual arrangements may need to be put in place between group companies and the primary member to deal with the financial and administrative obligations, intra-group liabilities and intra-group indemnifications. Tax and cash-flow implications of the structure will also need to be considered.
- Step 8 – purchase and surrender of allowances: The first sale of allowances will take place in April 2011 and is a one-off double sale year when participants will need to purchase allowances to cover their emissions during 2010 and their expected emissions during 2011. The sale or auction of allowances in April of each following year will be for allowances to cover expected emissions during that particular year and as such, organisations will need to be in a position to be able to forecast emissions (ideally at least 12 months in advance) and may need to develop systems to track actual and projected emissions. From April 2013, the overall amount of allowances will be capped and all allowances will be auctioned. By July 2011 and July each following year, participants must ensure that they hold and then surrender sufficient allowances to cover their actual emissions over the preceding year. In the event that an organisation reports emissions to the administrator incorrectly (which means when there is a margin of error greater than 5%) or fails to purchase and surrender allowances, a penalty of £40 for each tonne incorrectly reported or for each allowance that should have been purchased and surrendered is payable.
- Step 9 – monitor changes to organisation structure: Any changes to the organisation structure – including where there is an acquisition or divestment of a portfolio company – will need to be monitored and its CRC impact assessed:
- Qualification: Organisations that meet the qualification threshold are required to participate for the duration of a CRC phase (three years for the first phase, five years for each subsequent phase) irrespective of any changes in energy use during that phase. Prior to each subsequent phase, qualification will be re-assessed and any changes in energy consumption (whether they result from acquisitions, divestments, organic growth or changes in operations) will then be taken into account for new baselining purposes. Such reassessment may also bring an organisation above or below the 6,000 MWh qualification threshold and so into or out of the scheme.
- Acquisitions and divestments of principal subsidiaries: On the acquisition or divestment of a portfolio company that (together with its own subsidiaries) itself exceeds the qualification threshold (known as a "principal subsidiary") special rules apply. The responsibility for emissions will be assigned to the buyer organisation from the start of the compliance year in which the principal subsidiary was transferred. The Environment Agency must also be informed of the transfer and will then adjust both the seller's and the buyer’s baseline emissions against which CRC performance are calculated. If on the buy-side, you will wish to diligence matters such as the target's ability to comply or its actual compliance with the CRC, whether any non-performance could entail civil or criminal consequences for the rest of the organisation, what the CRC allowance cost implications are associated with the acquisition - whether the purchase should be conditional on the transfer of allowances (whose face value may be less than the cost of acquiring new allowances in the secondary market). As identified in the summary above, readjustment of the carbon baselines for seller and buyer organisations only occurs on the sale/purchase of a principal subsidiary. Acquisitions of a number of investments, for example each of 5000 MWh consumption, will not derive any benefit from this rule but will suffer league table performance (and thus cost consequences) for increased levels of carbon emissions to the extent not offset by the marginal growth weighting applied.
- Other acquisitions and divestments: No special rules for sales or purchases of assets or of non-principal subsidiaries are prescribed. Such sales will have the effect of decreasing the CRC emissions of the seller organisation and increasing the CRC emissions of the buyer organisation. As discussed above, some weighting in terms of league table performance is given to consequential growth in turnover, if any, (and likely related increased emissions) by means of the growth metric but this is of limited assistance.