With companies and governments becoming increasingly concerned about climate change, the carbon emissions trading sector is experiencing significant growth. However, it is important for companies entering this market to understand and manage the risks and have appropriate dispute resolution mechanisms in place to protect their legal rights.
The fast-approaching United Nations Climate Change Conference, which takes place in December in Copenhagen, has once again thrust carbon emissions trading back into the spotlight. Since the Kyoto agreement was opened for signature in 1998 more than 333 million Certified Emission Reductions (CERs) have been issued under the United Nations Clean Development Mechanism.
The EU Emissions Trading Scheme will enter its third phase in 2013 and, with countries such as the US and Australia planning to introduce cap-and-trade schemes (under which a cap on emissions is set and tradable allowances, or rights to emit, are issued that emitters must hold for each tonne of carbon emitted) in the near future, this trend is likely to continue. Any agreement reached by world leaders on a replacement for the Kyoto protocol at the upcoming summit in Copenhagen is also likely to have a significant impact on the carbon emissions markets.
In addition to momentum at a political level, many companies are becoming increasingly concerned about climate change from a governance and corporate responsibility perspective and are entering the market for carbon credits to reduce their carbon footprint. However, as with any developing market, there are risks that need to be managed and the related uncertainty is curbing enthusiasm.
The carbon emissions markets are heavily reliant on new technology and changing regulatory environments, which can be sources of significant risk and lead to market volatility. Many projects for the generation of carbon credits forward-sell the credits to be produced to secure project financing. If a project does not generate carbon credits in line with forward-selling contracts this can lead to delivery shortfalls. Also, where the market has moved against a party to a forward contract for purchase of carbon credits, that party may have a commercial incentive to look for ways to renegotiate or get out of the contract.
As with any commercial agreement, it is important when entering into a transaction for purchasing carbon credits to manage risk through due diligence, clear and detailed documentation and, where appropriate, hedging of risk. However, it is also important to include in the transaction documents an effective dispute resolution mechanism to take account of any disputes that may arise in the future. Strong contractual rights will only benefit a party if they can be effectively enforced, and at present, this is something that is often lacking.
According to figures published on the United Nations Framework Convention on Climate Change UNFCCC) website (http://www.unfccc.org), approximately 75 per cent of the carbon credit generation projects under the United Nations Clean Development Mechanism (CDM) are located in China (35 per cent), followed by India (25 per cent), Brazil (9 per cent) and Mexico (6 per cent). The UNFCCC website also shows that more than 70 per cent of the investment in registered CDM projects comes from the UK (29 per cent), Switzerland (21 per cent), Japan (11 per cent) and the Netherlands (11 per cent).
Given the international nature of emissions trading, it follows that international arbitration is the natural means for resolving disputes. International arbitration enables parties from different states to choose a neutral venue for resolving their disputes. In addition, the convention on the Recognition and Enforcement of Foreign Arbitral Awards provides for the recognition and enforcement of arbitral awards between the 144 states that are parties to the convention, which includes China, India, Brazil and Mexico.
A further advantage of arbitration is that it enables parties to agree on the qualifications of the tribunal to be appointed to hear a dispute and the method of appointment. Accordingly, parties can at the outset agree that any dispute that arises from their carbon credit transaction will be resolved by an arbitrator who has experience in carbon credit transactions.
In selecting an arbitral tribunal, parties can effectively seek to obtain a balance between industry experience and experience with arbitration practice and procedure. For instance, in a three-person tribunal the parties may wish to provide in their contract for the appointment of two members of the tribunal with experience in carbon credit transactions and a chairman with arbitration experience.
Similarly, legal advisors need to have experience of both the carbon markets and arbitration. The importance of detailed knowledge and experience in these overlapping spheres cannot be underestimated.
When including an arbitration clause in their contracts, it is important for parties to select an appropriate set of arbitration rules.
The International Emissions Trading Association (IETA) in its model Emissions Reduction Purchase Agreement (ERPA) suggests that parties adopt one of the following sets of arbitration rules:
- the International Chamber of Commerce Arbitration Rules (ICC);
- the United Nations Commission on International Trade Law (Uncitral); or
- the Permanent Court of Arbitration Optional Rules for the Arbitration of Disputes Relating to Natural Resources and/or the Environment (PCoA).
The PCoA rules are based on the Uncitral rules but have been drafted specifically for environmental disputes. However, corporates should exercise caution before selecting these rules as they may not be able to recover their legal costs in the arbitration.
The PCoA, when drafting these rules, intended that they be used for disputes between state parties as well as disputes between non-state parties. Because it was contemplated that the rules would be used in disputes between state parties, the rules provide that each party shall bear its own costs of arbitration. The rules allow the arbitral tribunal to apportion the costs of the arbitration between the parties if it determines the apportionment is reasonable, but such costs do not include the parties’ legal costs.
Accordingly, commercial parties should be cautious about selecting the PCoA rules as the ordinary presumption that the successful party will be entitled to all its costs will not apply. It is recommended that commercial parties including an arbitration clause in contracts for carbon credit transactions select arbitration rules that are widely used in international trade and commercial transactions such as the ICC rules or Uncitral rules.
Nathan Searle is a senior associate at Lovells and a member of the firm’s carbon markets and renewable energy group