19 Mar 2013

Kyoto I is dead, Long live Kyoto II

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International arbitration alert

The first, five-year long commitment period of the Kyoto Protocol has just ended on 31 December 2012 following a last-minute agreement between the relevant state Parties that a second commitment period would start running immediately, until 2020. Carbon emissions trading will therefore continue for another eight years but, as prices of carbon credits have fallen dramatically (by up to 85 per cent in the course of 2012) and are unlikely to rise back to previous levels in the near future, the number of carbon trading disputes which have recently multiplied is likely to continue to rise, and the recent surge in carbon credit-related arbitrations may therefore turn into a permanent feature.

The Kyoto Protocol to the United Nations Framework Convention on Climate Change (UNFCCC) was signed in 1997 and entered into force in 2005. It created binding obligations for industrialised countries1 to reduce, over a first commitment period of five years (2008 to 2012), their greenhouse gas emissions (also called carbon emissions) to the level they were at in 1990. The protocol put in place three "flexible mechanisms" through which states (and relevant corporate entities) could meet their targets: International Emissions Trading (IET), which is a trading platform for carbon credits; Clean Development Mechanism (CDM) and Joint Implementation (JI), which are project-based mechanisms designed to produce emissions reduction units (see overview below).

The last minute agreement reached in Doha in the meeting held between 28 November to 7 December 2012 (the so-called "Doha Climate Gateway"), extended the use of the flexible mechanisms through the agreed second commitment period. This agreement has alleviated some of the concerns raised as end of the first commitment period approached, but the potential for disputes remains.

Overview of the Kyoto Regime
A Key feature of the Kyoto regime is often referred to as the "Cap and Trade" system, under which caps on Green House Gas emissions, or reduction targets, accepted by Member States may be supplemented by purchasing excess emissions capacity from other countries. The reduction targets are expressed as levels of allowed emissions, or "assigned amounts", which are divided into "assigned amount units" (AAUs). Thus States that have a surplus of AAUs can sell their excess capacity to countries that need them (because they have exceeded or wish to exceed their carbon emissions cap).

In turn, Kyoto regime countries, allocate their emissions allowances or caps to factories, construction projects and power producers operating within their territory. Such businesses that are unable to meet their cap obligations may also purchase or earn additional capacity, in the form of "Carbon Credits", from other businesses in their own country or elsewhere.

There are different types of Carbon credits that can be earned in a variety of ways. "Removal Units" (RMUs) are granted for reductions in emissions generated by land use, land use change and forestry. "Emission Reduction Units" (ERUs) are generated from Joint Implementation (JI) projects and are awarded to industrialised states for carrying out emissions reduction projects (such as the introduction of more efficient power plants or developing forestry projects) jointly. "Certified Emission Reductions" (CERs) are generated from Clean Development Mechanisms (CDMs), which allow industrialised States or businesses from such States, to earn CERs in return for investments in emissions-reducing projects in developing countries. Each type of certified emissions credit is equivalent to one tonne of CO(2).

A number of national and international trading schemes have been established for this purpose the best-known of which is perhaps the European Union Emissions Trading System ("EU ETS"),(2) which allow carbon credits (called "EUAs") to be traded in same way as any other commodity, including by parties who are not subject to any emissions trading caps at all. Trading on such exchanges is often conducted pursuant to Emission Trading Master Agreements ("ETMAs") and other individual trading instruments. Direct sales of credits are also common. For example, CERs issued to CDM projects are commonly sold directly to buyers under Emissions Reductions Purchase Agreements ("ERPAs") and the future income from such sales may be collateralised to support project finance or may simply generate additional profits for the project.

Typical of disputes arising under Kyoto Protocol transactions
A number of types of "typical" disputes arising from emissions trading are starting to emerge.

Ownership disputes
A number of disputes over the ownership or entitlement to CERs have arisen between promoters of flexible mechanisms projects. For instance, if a privately-run CDM reforestation project is implemented on State-owned land, a dispute may arise as to entitlement to the CERs generated by the project.

A recent and symptomatic example arose out of a tripartite project in Daegu, South Korea, initiated in 2004 that was designed to reuse methane gas from one of Korea's largest landfills. The project involved two private companies and the City of Daegu. The project gas-to-energy plant was registered as a CDM under the UNFCCC. In August 2007, when the first CERs were issued, a dispute arose between the parties as to the allocation of the project CERs between them. The parties agreed to settle the dispute through arbitration and, in February 2010, the Korean Commercial Arbitration Board (KCAB) ruled that the City of Daegu would receive 88.51 percent of the CERs, while the private parties got respectively 10.33 percent and 1.16 percent(3).

Fraud disputes
The case of Armstrong DLW GMBH v Winnington Networks Ltd [2012] 3 WLR 835(4) is a recent and important example of how issues of fraud in emissions trading can arise and how they are dealt with by courts. In this case, a significant number of EUAs owned by the Claimant (represented by Stephenson Harwood) were misappropriated through a phishing scam run by a fraudster, and then transferred to and re-sold by the Respondent to a third party. The High Court resolved the liability issue in favour of the Claimant by ruling that Winnington ought to bear the loss caused by the fraudster's actions, because its failure to carry out proper due diligence made the trade "unconscionable". More importantly, the case posed the issue of the legal nature of the emissions certificates, which had a bearing on the availability and applicability of proprietary claims. The court ruled that EUAs are classified as personal, intangible property, and can therefore be the subject of a trust under English law, which meant, in this case, that the fraudster was considered to hold the certificates on (constructive) trust for the victim.

Contractual disputes
Other disputes that have arisen in the course of flexible transactions or projects, have arisen in connection with failures to achieve agreed levels of certification, which may in turn lead to disputes under finance agreement and/or ERPAs.

Further, the first commitment period was reportedly oversupplied by 13 billion tonnes of CO(2), resulting in a slump in carbon market prices(5). The main reason for this oversupply appears to have been that the target levels set out in the Kyoto Protocol where easily achieved by some States, such as Russia or the Ukraine. The resulting volatility in the market value of traded CERs appears to have placed commercial pressure on parties to CFR sale and purchase agreements not to perform them, giving rise to numerous disputes under ERPAs, ETMAs and other trading instruments. The case of Deutsche Bank AG v Total Global Steel Ltd [2012] EWHC 1201 (Comm)(6) provides an interesting example of how the High Court ruled on the appropriate measure of damages for a breach of contract in relation to emissions certificates.

Dispute resolution
Due to the international nature of many carbon trading deals, emissions allowance trading agreements tend to contain international arbitration clauses referring any disputes to arbitration rather than to national courts. For instance, the World Bank's model ERPA, widely used as a model contract for carbon emissions trading, provides for arbitration governed by the UNCITRAL Arbitration Rules.

The Permanent Court of Arbitration (PCA) in the Hague has a special set of arbitration rules (Optional Rules for Arbitration of Disputes Relating to Natural Resources and/or the Environment) which it actively promotes to use in emissions trading arbitrations. The International Emissions Trading Association (IETA) refers to these Optional Rules in its model agreements and promotes the resolution of disputes through PCA arbitration. However, a relatively small number of cases arising out of carbon emissions reduction projects or transactions have so far been registered by the PCA.

Beside the PCA, the major commercial arbitration institutions such as the ICC or the LCIA are also hosting an increasing number of carbon trading-related disputes.

Conclusion
The last minute deal struck at the Doha Climate Gateway has eased some of the concerns over the surplus of emissions credits in the market. While the surplus of AAUs will be carried over into the second commitment period, the agreement reached in Doha provides that allowance purchases shall be limited to 2 per cent of the purchaser's national allocation. Moreover, Australia, the EU, Japan, Liechtenstein, Norway and Switzerland have declared that they will not carry over any surplus emissions trading credits from the first into the second commitment period, thereby ensuring that AAUs produced between 2013 and 2020 would retain some market value(7).

Nevertheless, as Cap and Trade systems become better established and more commonly used, so will the scope for disputes between contracting parties continue to grow. Parties to Kyoto-related transactions must therefore ensure that the contracts contain appropriate arbitration clauses, allowing for fair, impartial and enforceable resolution of cross-border disputes.

1 40+ industrialised or in industrial transition countries listed in Annex I to the UNFCCC and Annex B to the Protocol, including 15 member States of the European Union (EU) and the EU itself. The two annexes are virtually identical - only Turkey and Belarus are absent from the Annex B list.
2 Others regional emissions trading schemes have been established in New Zealand, Australia, United States, Japan.
3 www.biztechreport.com/story/480-carbon-arbitration-korea
4 Available at www.bailii.org/ew/cases/EWHC/Ch/2012/10.html
5 www.pointcarbon.com/aboutus/pressroom/pressreleases/1.1986577
6 Available at www.bailii.org/ew/cases/EWHC/Comm/2012/1201.html
7 www.unep.org/newscentre/default.aspx?DocumentID=2700&ArticleID=9353, although according to a senior analyst at Thomson Reuters Point Carbon, the failure of Annex I/Annex B countries to commit to deeper reductions means that global carbon markets will remain depressed for a while, www.pointcarbon.com/aboutus/pressroom/pressreleases/1.2096704

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