Carbon trades are on the increase.  By some accounts, publicly-disclosed deals in recent years have already totaled as many as 150 million metric tons of carbon dioxide, or CO2, equivalents.  Informal carbon exchanges have been developed in several countries and, perhaps most significantly, a number of investment funds potentially exceeding $2 billion in assets have been announced or formed to focus upon developing tradable carbon credits worldwide.

Much of this activity reflects a growing perception that out of the chaotic beginnings of the global warming regime substantial opportunities may be seized.

At the heart of most carbon trades are two carbon credit mechanisms that were present in the original Kyoto agreement on global warming.  The first involves an emissions trading approach that would use market forces to allow countries to achieve their emissions targets.  Countries with excess or surplus emissions assigned to them based on 1990 emission levels — Russia is in this category — can sell some of their allocated emissions to other countries.  The second approach involves a so-called “clean development mechanism,” or “CDM,” under which rich countries can earn credits by investing in emissions-reducing projects in developing countries.

These two programs — whose rules are still being developed at the international level — will provide the basis for most international carbon credit trades.  Despite news stories to the contrary, the renegotiation of the Kyoto agreement that took place in Bonn in late July did not substantially change the general outlines of these mechanisms, although the delegates to Bonn were still working on the details for implementing carbon trading as the NewsWire went to press.

Contract Terms

The absence of clearly defined criteria and authority supporting such transactions makes the contract the trading parties negotiate all the more important.  The terms of the contract must be not only clearly defined, but also sufficiently flexible to deal with a variety of potential outcomes and intervening factors.  A would-be purchaser also has the burden to ensure his carbon credits can be transferred.

Any contract for sale of carbon credits should be sure to address at least six issues.

• The contract should take into account the applicable elements of the Kyoto protocol, as amended in Bonn, and the applicable country-specific requirements, such as requirements for qualification as a “clean development mechanism” project, proof that the reductions would not have occurred without the CDM project, and any potential limitations on the use of the carbon credits.
• In situations where a carbon transaction involves only private parties, attention should still be paid to the host government.  If possible, the government should provide certification to the purchaser that the seller has ownership and clear title to the carbon credits.  It might be a good idea to give the host government an ongoing share of future emissions credits created by the seller to ensure that it will continue to support and enforce the emissions reductions that are crucial to creating the credits.
• The contract should indicate the source and basis for the carbon credits that are being sold.  With the first commitment period for Kyoto essentially ten years away — from 2008 to 2012 — the factual predicates for the carbon credits must be clearly established in order to stand the test of time.
• The contract should explain the scientific basis for measuring the credits, and it should also allow enough flexibility to make changes both in the business arrangements and the methodologies for measuring and recording the credits to the extent that the relevant rules in the Kyoto protocol and the relevant countries evolve or change in the future.
• The contract should explain whose risk it is if some of the data on which the credits were based proves faulty, or the calculations were wrong, or something else goes wrong.  In this regard, a number of insurance products are available or under development that might provide useful support for carbon trades.
• The contract should ensure, to the extent possible, that the relevant reductions have the necessary permanence and are binding not only on the seller but also any successors or other parties that might be in a position to undo the relevant reductions or attempt to sell them to a third party.

These are the main legal issues, but others will also have to be addressed in the contract.  The complexity of the applicable risks and, therefore, of the contract itself will be proportional to the degree of discount in the value of the carbon credits being purchased and the nature of the underlying project.  Certain types of CDM projects — such as coal-bed methane gas projects — can be structured more easily than others.  For this reason, carbon credits from such projects are already being actively traded, and their pricing is likely to increase with the increased demand that will accompany eventual ratification of the Kyoto treaty.

Outlook

In Bonn last month, 178 countries committed to take steps to reduce greenhouse gas emissions that contribute to global warming.  Nevertheless, development of a uniform and reliable market for carbon trading on the scale contemplated by the Kyoto agreement still faces many significant hurdles.  The Kyoto protocol must still be ratified by 55 industrialized countries representing more than half of global greenhouse emissions.

Some people question whether a viable market can exist without participation by the United States.  According to the International Energy Agency, a potential greenhouse gas market of roughly $42 billion a year would thrive with full US participation in Kyoto but might be worth as little as only $3 billion a year without US participation.

Even after ratification, Kyoto will need to be implemented by the individual countries.  That process has already started, especially in Europe, but it has produced and will likely continue to produce important variations in how each country chooses to implement the accord.  In some countries like Canada, implementation will even be left to provincial governments.  There is also the prospect of further amendments to the Kyoto agreement, possibly to gain US participation, that might change the scope and timing of the required reductions.