Credit: U.S. Department of Energy Carbon Value in Transactions: A Legal Perspective Tessa Schwartz and William Sloan Morrison & Foerster* Abstract As market-based caps on greenhouse gas emissions have emerged as a primary policy response to climate change, carbon markets have become a critical component of the regulatory landscape. In this article, Tessa Schwartz and William Sloan consider the principal legal and practical issues that lawyers, investors and businesses should consider in the context of carbon-related business transactions, including the concept of “ownership” of the benefits and liabilities of carbon reductions. Schwartz and Sloan propose strategies for capturing the value of carbon reductions under different regulatory regimes and how to account for the risks and liabilities in transactions under those regulatory frameworks. Key Words: carbon reduction, carbon offsets, liability, transactions, cap-and-trade, Kyoto, UNFCCC, EU-ETS, valuation to simply as “carbon”) in transactions, it is 1. Introduction imperative to understand the current and proposed markets and regulations related to To appreciate the economic and legal carbon reductions and credits. As carbon significance of greenhouse gases (often referred emissions are increasingly regulated, carbon 59 Tessa Schwartz & William Sloan, Carbon Value in Transactions: A Legal Perspective, 1 Clean Tech Law & Business 59 (Spring 2009) markets in the United States will continue to other foreign markets, regulations already grow at an exponential pace and “carbon” will require certain emitters to measure, track and become a significant driver behind a myriad of report reductions in the emission of carbon business transactions. This article raises key dioxide or carbon dioxide equivalents. legal and practical considerations to take into Although a regulatory regime in the United account in the context of carbon-related business States will likely take the form of a “cap and transactions, including “ownership” of the trade” program, it may well include aspects of a benefits and liabilities of carbon reductions. “command and control” structure driven by government mandated reductions or even a “carbon tax” approach for excessive emissions. 2. Understanding Carbon and the Carbon In either case, which industries will be regulated Markets and to what degree will have a huge impact on the market for carbon “credits” and products and Given the potential size of the carbon services designed to reduce carbon emissions. market, investors, start-ups and established companies all need to consider the relevance of B. International Climate Change carbon in their business strategy.1 According to Regulation—Kyoto and the EU Lead the a report by the World Bank, the value of the Way global carbon market in 2007 was approximately $64 billion, up from approximately $31 billion In any case, the system that emerges will in 2006.2 According to the latest figures, the likely be influenced by the Kyoto Protocol and global carbon market doubled in size in 2008, the EU Emissions Trading Scheme as well as the with figures varying from $118 to $125 billion.3 existing structure created by regional players in Europe and Japan currently make up a dominant the United States. portion of the world market. In the event cap- Entering into force on March 21, 1994, the and-trade regulations are enacted in the U.S., United Nations Framework Convention on some analysts predict that the carbon emissions Climate Change (“UNFCCC”) became the 4 market will be valued at $1 trillion by 2020. world’s first treaty designed to address global warming by limiting greenhouse gas emissions. A. The Importance of Being Regulated A first step toward achieving this objective was the creation of a national greenhouse gas The inauguration of Barack Obama as inventory that requires signatory countries to President signals the likelihood that a federal submit annual inventories of all anthropogenic framework for carbon reductions (and, perhaps, greenhouse gas emissions from sources and trading) will be adopted in the near future. removals through carbon sequestration. President Obama’s plans include the institution of an economy-wide cap-and-trade system with On February 16, 2005, the Kyoto Protocol to investment of much of the funding from cap- the UNFCCC was adopted, creating an and-trade auctions in alternative energy research international greenhouse gas reduction scheme and efficiency improvements. In fact, the White that imposes caps on the emissions of Annex I House’s proposed budget calls for an economy- countries, with reductions to be achieved by 5 wide (i.e. not limited to only certain industries) 2012. Most countries target individual cap and trade system that relies on the auction of industrial entities, such as power plants, in order 100% of the permitted allowances. That budget to achieve their emissions reductions. The proposal anticipates that, starting in 2012, such United States is the only Annex I country that auctions will raise seventy to one-hundred has not ratified the Kyoto Protocol. billion dollars. The first commitment period for Kyoto ends Government regulation, whatever form it in 2012. While a successor agreement is due to takes, will drive the carbon markets in the be adopted in Copenhagen, Denmark in 6 United States. In Europe, Japan and certain December 2009, a number of geopolitically 60 Tessa Schwartz & William Sloan, Carbon Value in Transactions: A Legal Perspective, 1 Clean Tech Law & Business 59 (Spring 2009) charged disagreements (including whether E. Carbon Registries developed and developing countries should share the financial burden of addressing climate New registries for reporting emissions and change through the imposition of emissions trading emission reductions are also emerging caps) must first be reconciled. around the globe. In 2008, the Chicago Climate Exchange (“CCX”) announced the opening of In Europe, the European Union Emissions the Tianjin Climate Exchange offices in China Trading Scheme (“EU-ETS”) was enacted to and launched an initiative to establish a climate comply with EU obligations under the Kyoto exchange in India. In North America, the Protocol; it began operation in 2005. Under the Climate Registry already includes 39 U.S. states, EU-ETS, some 10,000 energy-intensive plants in addition to Canadian provinces and Mexican across the EU are able to buy and sell permits, states and is well positioned to become a de representing about 40% of the EU’s total facto national registry for emission reporting in greenhouse gas emissions. the United States. C. California Dreamin’—Efforts to Curb Emissions in the Golden State 3. Impact to Legal Practice: Advising On Carbon-Based Transactions1 In the absence of leadership from the Bush Administration and the failure of Congress to Given the global warming crisis, the growth enact federal legislation regulating greenhouse of carbon markets and the likelihood of stronger gases, states and regions stepped in to fill the regulation of green house gas emissions, carbon void. California emerged as one leader with its has become increasingly relevant to a wide enactment of a comprehensive program for range of transactions. Whether in connection greenhouse gas emission reductions. Assembly with the transfer of carbon credits themselves, Bill No. 32 (the California Global Warming the sale of a business, the license or assignment Solutions Act of 2006) sets emissions limits to of intellectual property, the building or financing cut California’s greenhouse gas emissions to of a project, the provision of services and 1990 levels by 2020.7 This legislation is serving products, or other transactions, carbon may be as a model for similar initiatives in other states critical to a deal and the way it is structured. such as Florida, New Mexico, Arizona and The second part of this article focuses on Illinois. specific issues to consider in the context of carbon-related transactions. D. Regional Initiatives A. Valuing Carbon Regional initiatives include the Western Climate Initiative, launched in 2007 by several In determining what kind of value can be western states; the Regional Greenhouse Gas extracted from transactions with a carbon Initiative (“RGGI”), formed in 2005 by a group component, the parties to a transaction should of northeastern states; and the Midwestern identify “positive” and “negative” value. On Greenhouse Gas Reduction Accord, established one hand, the positive value associated with in 2007 by Midwestern states. Typical of these carbon can take the form of, for example, credits initiatives is the setting of goals for emission which may be bought and sold, revenue share reductions by a given date and the from carbon reduction products and services, or recommendation for a cap-and-trade system. intellectual property rights for carbon reduction RGGI has already begun successful quarterly and carbon capture technologies. On the other credit auctions. 1 This article does not address the particularities of transactions traded through the Kyoto Protocol and, specifically, the Clean Development Mechanism, as a detailed set of existing regulations and guidelines apply to those transactions. 61 Tessa Schwartz & William Sloan, Carbon Value in Transactions: A Legal Perspective, 1 Clean Tech Law & Business 59 (Spring 2009) hand, there may be value gained from mitigation transactions other than for the sole purpose of or avoiding carbon-related risks, e.g., risks compliance with emissions regulations. associated with reductions in