US Congress Throws Tax Benefits At Project Finance Community

US Congress Throws Tax Benefits At Project Finance Community

January 01, 1999

The “Framework Convention on Climate Change,” adopted at the United Nations Earth Summit in 1992, envisions long-term solutions to a long-term problem. With the adoption of the “Kyoto Protocol” to the convention a year ago, and its signature by the United States in November, more specific deadlines and requirements are beginning to take shape. The Kyoto Protocol requires the so-called Annex I countries (basically, the OECD plus most of the Warsaw Pact) to reduce their greenhouse gas emissions by varying amounts, averaging 5.8%, below a 1990 baseline. Five-year average emissions in 2008-2012 are supposed to meet this target. While a 5.8% reduction may seem relatively insignificant, it will represent approximately 20-40% less than what those countries are projected to emit but for the Kyoto Protocol commitments.Anchor

This article highlights issues that anyone negotiating power purchase agreements or involved in financing projects or acquiring assets in the energy sector should keep in mind.

Although the United States has not yet ratified the Kyoto Protocol, many countries already have, and some have begun translating the commitments it contains into enforceable requirements. And regardless of whether the United States ever ratifies the Kyoto Protocol, at this point it is virtually certain that some measures to reduce greenhouse gas emissions will be required in the US.

1. Contracts being negotiated now should anticipate the likely increased costs associated with climate change mitigation measures

Power plant siting boards in the United States, New Zealand, and elsewhere have already demanded offsets for new projects (by reducing greenhouse gas emissions elsewhere or implementing greenhouse gas sequestration projects (mainly reforestation or forest preservation plans)). The countries that have agreed in the Kyoto Protocol to reduce greenhouse gas emissions over the next 10 years will have to impose emission reduction requirements on existing sources, in addition to requiring offsets for new sources.

A carbon tax is now being debated seriously in the European Union, is already imposed in a few countries, and has been discussed in the US. The tax could be on fuel consumed, gases emitted, or even fuel sold. The tax may be imposed on the person generating electricity, the person using electricity, or the person producing the fuel that is consumed. Some analysts have suggested it might be necessary to set the tax at somewhere in the $20-40 per ton of carbon range in order to get the reductions necessary to meet the Kyoto Protocol commitments for CO2 emission reductions from the United States and some other countries. For a 300 megawatt plant, this could mean as much as $20 million a year in increased taxes. All of these future costs need to be considered in drafting long-term contracts for fuel supply or power sales.

2. Existing emissions of greenhouse gases now have value that should be accounted for.

Most of the likely scenarios for compliance programs involve the potential for one source to get credit for reducing greenhouse gas emissions at another source, either within the country or in some cases abroad. This means that at some point someone may be willing to pay for a facility to reduce its emissions (for example, by shutting down or improving efficiency). Existing sources of methane, such as landfills and coal mines, also now have value. (Since methane is 25 times more effective at trapping heat in the atmosphere than CO2, capturing methane and burning it effects a reduction in greenhouse gases.)

The value of these existing emissions needs to be recognized and addressed in acquisitions, negotiations to sell power, and the like. Exiting emissions need to be documented, and reductions in emissions need to be documented, as do carbon sequestration projects. (In the United States, the Department of Energy has a mechanism for doing so under section 1605 of the Energy Policy Act of 1992.)

One example of how these issues may arise: If an independent power company contracts with a utility to supply electricity currently being generated by that utility, who gets the credit for the reduction in greenhouse gases emitted by the utility? Who gets the credit for the reduction in aggregate greenhouse gas emissions from both plants, achieved because the IPP is more efficient than the utility generator it replaced? Over the life of a power plant, resolution of these questions could involve hundreds of millions of dollars.

3. Companies in the power or fossil fuel business may want to begin developing hedging strategies, especially if they are relatively “long” on carbon compared with their competitors.

Due to differences in efficiency, fuel sources, raw materials, and processes, some companies will have much higher greenhouse gas emissions per unit of production than others. Such companies should be evaluating, and may want to begin executing, various types of hedging strategies, like purchasing options, swaps, bundling of fuel with carbon dioxide emissions credits, voluntary early action agreements with the government, and so forth. The cost of hedging will undoubtedly go up as the 2008-2012 compliance period approaches. Millions of tons of CO2 options have already been traded in private transactions.

4. Laws and procedures to implement the Kyoto Protocol greenhouse gas reduction commitments are beginning to be developed in many of the “Annex I countries” covered by those commitments.

The way those rules get written will have a big role in determining who are the winners and losers in the climate change “game.” In particular, the new rules could present substantial barriers to independent power companies, who have little or no existing emissions that can be offset against emissions from their new facilities. A company investing tens of millions of dollars in development of a power project might be wise to invest some time and effort in assuring that it will not be impeded by new climate change requirements that may be adopted.

5. Companies that are publicly held or that make offerings of securities need to examine the reporting and disclosure obligations associated with climate change.

SEC regulations in the US require that anticipated material expenditures for environmental protection be specifically called out in registration statements and prospectuses. While it may be appropriate to say nothing or only make a general statement about facilities using fossil fuel in the United States, since the Kyoto Protocol has not yet been presented to the Senate for ratification, many other countries have already ratified the Kyoto Protocol, and some have begun imposing new requirements to implement their commitments for greenhouse gas reductions, so disclosure of the impact of such requirements, at a minimum, might be necessary.

by Keith Martin, in Washington