The recent election may well clear the way for new greenhouse gas emissions legislation. It is becoming increasingly likely that some type of “cap and trade” policy will be enacted. These regulations may also embolden efforts already underway to convince both biofuel producers and traditional “smokestack” industries to sign complex long-term contracts to trade their potential carbon credits. There are several important attributes of carbon credit contracts that should be studied before signing.

Cap and Trade. First, what is the cap and trade approach? At the center of the cap and trade is a regulatory scheme that puts caps on emissions and allows companies that are below the cap to sell their credit to companies that are above the cap. While the example that follows is an oversimplification that ignores the complexities of the trading market, it may help illustrate the point.

Assume that we have two different companies, Plant A, and Plant B. Both plants are faced with similar caps on their emissions. However, for some reason Plant A can more economically achieve emission reductions. Plant A goes ahead with the extra emission reduction effort confident that it will be able to sell that reduction in emissions as a tradable credit, also known as an “offset.” It does this even though the regulations do not require this level of reduction. Proving that the emissions reductions are real is vital to a successful cap and trade marketplace.

Plant B finds that it is less expensive to buy the credit on the market than it is to install the additional equipment necessary to achieve emission reduction caps. So, plant B purchases enough credits to offset its failure to achieve compliance. Essentially, Plant B “pays” Plant A to improve Plant A’s own emission reduction.

There is yet another “market based” control that will eventually kick in. As the cap is lowered each year, there will come a time when Plant A can no longer sell its credits. It needs those credits for its own use. Plant A will join an increasing number of buyers in a seller’s market. As the price increases for the credits, Plant A’s engineers may eventually reach the point where they decide that it will cost less to reduce the company’s emissions than it will cost to purchase offsets. In the meantime, advances in technology will lower the cost of reducing its emissions as well.

Carbon Negative Companies. There is a second kind of carbon credit. Agricultural operations and some biofuel companies may be able to demonstrate that they are actually “carbon negative.” If the company can prove that it is a carbon negative producer, then it can, in theory, sell that carbon reduction in the market. This sort of carbon credit could be quite lucrative and it is likely that a number of industries, biodiesel and ethanol in particular, will be heavily marketed to sell their prospective credits.

There are several potential roadblocks before this will happen, however. First, proving that a company is carbon negative is difficult and complex. Let’s examine the ethanol industry as an example.

The argument that ethanol is carbon negative is based on the fact that the fuel (itself a carbon “neutral” product) replaces fossil fuels that, when burned, would otherwise allow carbon dioxide to enter the atmosphere. In other words, an H3 Hummer generating 2 pounds of carbon dioxide per mile will use ethanol instead of a fossil fuel. The fossil fuel remains (theoretically) in the ground where it is sequestered. Instead of releasing sequestered carbon dioxide, the biofuel-burning vehicle “borrows” the carbon dioxide from air and puts it back when it is done. However, it is not yet certain that ethanol plants are carbon neutral. Scientists differ on the methods, but the argument by some is that the use of natural gas to power the boilers and fossil fuels associated with growing the corn (or whatever product is used) comes close to equaling the carbon dioxide emissions saved by not burning gasoline. What tips ethanol over the edge, according to these critics, is that with the increase in food costs more land will be converted from sequestering pasture and forest to ethanol. This debate will have to be solved by Congress or regulators before ethanol can sell itself as carbon negative industry.

The second possible roadblock is that it is not clear if biofuel companies will own their own carbon credit. Some carbon traders suggest that they are very unlikely to buy or sell a credit sold by an ethanol company based on its “carbon negative” status. They argue that it is not the refinery that generates the credit but the consumer or distributor who makes the decision to buy the product (and thereby replace the fossil fuel alternative) or the decision to sell the product. It is probably impossible to “reward” consumers for making a carbon negative decision because there are so many and the cost of tracking and rewarding consumers would exceed the value of the reward. Therefore, the carbon credit trading industry would likely focus on the oil companies, blenders, and distributors. This would be a blow for biofuel producers. It is possible that future legislation may clear up this uncertainty and that the use of computerized inventory tracking might offer a way for the ethanol companies to keep a share of their credits.

Carbon Credit Trading Contracts. In many ways, the companies seeking to broker carbon trading credits from industry have very little to lose. They usually pay nothing for the equipment needed to reduce the emissions and offer no expertise other than their access to a market. Yet they usually demand very high commissions for a successful sale. Care must be exercised before signing these contracts.

Carbon trading contracts offered to industries take very different approaches. Some of the contracts are modeled after conventional brokerage service agreements. After the credit is issued, the ethanol company and the trading company split the net revenues according to the agreed formula and depending on the type of credit sold. Other contracts take the “property” approach. Once the credit is converted into a tradable security it is owned by the carbon trading company. The producer is paid a portion of the proceeds when the security is sold. In the end, either approach can accomplish the same thing. However, if a party to the carbon trade fails, a producer may be in a better legal position as an owner of the credit if it is trying to get its credit back.
What is the Contract Term? Some of the carbon credit brokerage contracts have ten year terms. Given the uncertainty surrounding the coming legislative debate over how carbon emission will be regulated, most companies should avoid a decade-long contract.
How much is the Commission? The commissions in the contracts are much higher than what is usually encountered in a commodity business, sometimes as high as 50 percent. Because this is a fairly new and evolving market, it is important for companies to carefully review these rates, especially if the contract is long term. Be sure to shop around.
Carbon Reduction Technology. Most industries already have emission reduction technology in place. Some of this technology may also reduce carbon dioxide or other greenhouse gases. Note that carbon trading contracts can indeed capture any credits generated by an industry from the use of this equipment. Thus, the high commission may be unwarranted. Also, through poor contract language some contracts inadvertently may give the carbon credit trader an interest in certain pollution reduction equipment or give the trader the right to modify equipment. Avoid this language. Most manufacturers will not warrant the performance of equipment that is modified by third parties. Lenders may balk at the level of control the contract puts on their secured equipment.

Caution is Required. Carbon credit trading is an evolving market segment. Industries should investigate the opportunity but be aware of the unknowns. Not all of the contracts being offered to industry will offer the sort of flexibility needed to respond to a changing regualtory landscape.

— James L. Pray