emission reduction purchase agreement (erpa) - buying and selling carbon credits (undp presentation)

© 2007 UNDP. All Rights Reserved Worldwide.Proprietary and Confidential. Not For Distribution Without Prior Written Permission.

UNDP MDG Carbon Facility

Bio Carbon Certification CoursePanama

October 15 through 20, 2007

Module 9a: Buying and Selling Carbon CreditsDay 2 (16 October 2007)

Prepared and Presented by Marina Olshanskaya and Robert Kelly

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MDG Carbon Facility: Bio Carbon Certification Course

Presentation Overview

1. Emission Reduction Purchase Agreement (ERPA): role and key issues, clauses and terms

2. Obligations of buyer and seller

3. Types of agreement, prices and delivery

4. Balancing risks, price and contractual terms

5. Special case of non-permanence: how do expiring CERs work and who bears the replacement risk?

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Emission Reduction Purchase Agreement (ERPA)

Contracts form the basis of the market. For a well-functioning

market, contracts should:• Define the product • Set out rights and responsibilities• Allocate risks

Buying carbon poses unique challenges and specific risks• The product does not physically exist • Purchased in immature markets• From people who do not know what/whether they can sell• Where the rules are constantly changing/do not exist

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Role of ERPA for the Seller

Define future value of CERs to integrate in project financial model

Use ERPA as collateral to obtain project finance

Receive upfront payment for CERs to cover start-up costs

Maximize future revenues from CERs

Minimize project financial risks (e.g. non-payment for main project deliverables)

Mitigate non-market project risks (e.g. DNA approval)

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ERPA: key clauses

Definitions: what is to be sold (VERs, CERs, ERUs)

Determining legal title to the CERs and modalities for its transfer

Key terms: volume, price and delivery

Appropriate warranties, conditionalities, force majeure

Miscellaneous:

Communication with Executive Board

Payment of share of proceeds, taxes, etc

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ERPA: obligations

Sellers’ Obligations Buyer’s Obligations

• Complete Validation and obtain Registration for the Project• Develop and Implement Monitoring Plan• Carry out Verification and Certification to ensure issuance of CERs and• Deliver CERs to the buyer

• Ensure they have an account ready to receive delivery of the CERs• Pay for the CERs• Replace tCERs and lCERs with CERs

• Communicate with the CDM Executive Board as the Focal point (can be Seller/Buyer or both)

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ERPA: type of agreement Type I: Spot Agreement (becoming popular)

Status of CERs: issued, ready for delivery

Payment: immediate, on delivery

Risk to buyer/seller: negligible

Type II: Future Delivery Agreement (most common) Status of CERs: non-issued, to be delivered in the future

Payment: future on delivery OR advanced

Risk to Buyer: Small → large (upfront payment)

Risk to Seller: Small → very large (guaranteed delivery)

Type III: Call/put Options Buyer/Seller has the right, but NO OBLIGATION to buy/sell CERs

at a certain point in the future for a fixed price

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ERPA: type of pricing Fixed price More confidence in ERPA values

Hedge against market downfalls

Good when Seller wishes to use the CER revenue to leverage project finance

Indexed price (EUA –X%) Reassures Seller that they have a

buyer while allow to retain upside potential in bull market

Difficult to calculate ERPA value

Combination of fixed and floating: Enable the Seller to secure

minimum price, but also share in any rises in the market value of CERs

Floating P

Fixed/Indexed P

Fixed P

Price (P)

Time

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ERPA: delivery Definition: CERs: receipts into a registry account nominated by the Buyer

VERs: submission of Verification report

ERUs: transfer of ERUs from a seller country’s to buyer country’s accounts

Time: Mostly annually, but shorter or longer periods are also possible

Normally before 30 April – compliance day in EU ETS

Delivery guarantee: Normal when upfront payment is provided by the Buyer

Appropriate for larger projects supported by financially stable companies

Otherwise can turn ERPA from an asset into a liability and undermine the usefulness of ERPA to secure debt financing

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Legal Agreements in CDM Project Cycle

(1) Identifying CDM

project (PIN) - PPs

(2) Preparing Project Design Document (PDD)

- PPs

(3) Getting approval from each Party involved - DNA

(4) Validation - DOE (5) Registration – CDM EB

(6) Monitoring - PPs

(7) Verification and Certification - DOE

(8) Issuance of CERs – CDM EB

(9) Distribution of CERs - PPs

PPs – project participants; DNA – Designated National Authority

DOE – Designated Operational Entity, CDM EB – CDM Executive Board

Exclusivity Agreement /

Letter of Intent

ERPA (Type II)**Conditional on DNA approval,

validation &registration

ERPA (Type II)**Conditional on validation

&registration

ERPA (Type II)**Conditional on registration

ERPA (Type I - CERs) ERPA (Type I - VERs)

ERPA (Type II)

Delivery risk

Price

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Balancing risks, price and contractual terms Assign risks to those parties which can manage them

better

Every risk that is passed on from Seller to Buyer has a cost implication: high risk = lower price

Country risk: Sovereign risk - borne by Buyer (price)

Non-approval by DNA – warranty by Seller

Currency fluctuation – borne by Seller

Project entity risk:

Financial credibility – provision of bank guarantees or demonstrating financial closure before ERPA signing

Non financial credibility - having in place internal risk management system, ISO certification, etc

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Legal disputes over CER ownership

ERPA require the seller to provide warranties as to the CER ownership to guarantee clear and undisputable legal title

Legal nature of CERs is still being discussed: whether CERs constitute a commodity, a security, a permit or another type of intangible right

Few national laws (no in non-annex I countries) contain definitions of CERs and rules for determining its legal title

In the absence of national legislation, legal title on CERs can also be fixed through the Letter of Approval by DNA

CDM/Carbon specific risks

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Balancing risks, price and contractual terms

Project performance risk:

Overcollateralization – purchase less than 100% of ERs

Legal seniority - 1st right to purchase ERs

Managing post-2012 CERs

Minimum delivery amount (guaranteed)

Firm commitment

Options

Outside agreement

0%

50%

100%

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Agenda

Expiring CERsExpiring CERs

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Sequestration under the CDM

• Sequestration – limited to afforestation / reforestation under the CDM

• The key characteristic of sequestration – subject to ‘reversibility risk’

• Also termed ‘non-permanence’

• Sequestration – carbon credits are awarded for greenhouse gases that are captured and stored

• As long as the GHGs remain in storage, the carbon credits have value

• But storage can be reversed – e.g. forest fires, pests, soil erosion, theft of trees

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Expiring CERs• Address the permanence problem

• Limited temporal validity – essentially carbon ‘leases’

• The buyer is essentially deferring his compliance to a future commitment period

• Lower market price than ‘normal’ CERs

• Conservative approach

• Many projects will lead to long-term climate benefits that extend well beyond the project crediting period, but the associated credits expire nonetheless

• 2 types:

– temporary CERs (tCERs)

– long-term CERs (lCERs)

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tCERs

tCERstCERs

• Valid for one commitment period only• Expire at the end of the subsequent

commitment period• With every successful re-verification,

new tCERs are issued for the entire quantity of carbon sequestered

• Valid for one commitment period only• Expire at the end of the subsequent

commitment period• With every successful re-verification,

new tCERs are issued for the entire quantity of carbon sequestered

Essentially, good for 5 years.

Buyer knows the time limit.

The interest of the seller is to maintain storage and sell new

tranches of tCERs.

Essentially, good for 5 years.

Buyer knows the time limit.

The interest of the seller is to maintain storage and sell new

tranches of tCERs.

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lCERs

lCERslCERs

• Only expire at the end of the project’s last crediting period – potential 60-year validity

• lCERs are issued every 5 years for the net increase in sequestered carbon

• Only expire at the end of the project’s last crediting period – potential 60-year validity

• lCERs are issued every 5 years for the net increase in sequestered carbon

Theoretically, good for up to 60 years.

But must be replaced within 1 month of a reversal being detected.

Buyer bears replacement risk.

Theoretically, good for up to 60 years.

But must be replaced within 1 month of a reversal being detected.

Buyer bears replacement risk.

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tCERs vs lCERs

• Theoretically, lCERs are more valuable

• lCERs need only be replaced at the end of the crediting period (potentially 60 years)

• tCERs are likely to have additional fees and taxes associated with their 5-yearly renewal

• BUT…the buyer bears replacement risk for lCERs – lCERs come with uncertainty

• Seller may not wish to be locked-in to a 60-year contract with a buyer

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Why buy expiring CERs?

• Lower cost than permanent CERs

• Buyer might believe that the cost of permanent CERs will fall in the future (i.e. future replacement is cheaper than purchase now)

• Buyer might believe that there won’t be any future commitment periods

• Stop-gap measure: buyer may be cash-constrained

• Buyer may not be interested in expiring CERs per se, but in the underlying project

• E.g. the buyer may be targeting the forestry sector for its sustainable development benefits

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THANK YOU FOR YOUR KIND ATTENTION

emission reduction purchase agreement (erpa) - buying and selling carbon credits (undp presentation)

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