Navigating the Legal Terrain of Carbon Credit Transactions

Peter Mayer, Partner, Stairs Dillenbeck Finley Mayer in New York City, is a lawyer representing developers of renewal energy projects. He advises suppliers, technology providers, and marketplaces in the carbon removal industry. This discussion centres around the intricacies of Carbon Removal Credit Purchase Agreements, emphasizing the importance of comprehending contract types, undertaking due diligence, and crafting strong contracts to safeguard against project failures and adapt to the evolving carbon market.

CW: What is a Carbon Removal Credit Purchase Agreement and what should a first-time buyer know about it?

PETER: As the name suggests, a carbon removal credit purchase agreement is essentially a purchase contract. In essence, a buyer pays a specified price and receives a carbon removal credit in return. These credits could be generated through nature-based or technology-based applications.

As in any purchase contract, it’s fundamental that the buyer receives exactly what they paid for. The most straightforward scenario is a spot sale, where a buyer purchases credits that are readily available at a digital marketplace.

But there are nuances and more complex arrangements such as forward agreements, prepurchase, or offtake agreements. In these cases, a buyer might partly assume the role of a lender, providing financing for a project that is either under development or hasn’t begun yet. In this scenario, a contract might contain lending and financing components. The time from the initial investment to when the product is ready can vary significantly, and circumstances can change during this period.

Before entering into such agreements for the first time, a buyer needs to decide why they’re investing in these credits. Is the motivation operational, commercial, reputational, or something else? This decision often impacts the terms of the agreement and the kind of protection needed. First time buyers in the voluntary carbon market might also want to test the waters first, start with small volumes and keep their financial exposure limited.

Once the decision to purchase credits is made, several considerations come into play. What defines a credit vary depending on the jurisdiction. New York law and English law consider a credit to be an intangible property that can be sold and transferred with relative ease. Civil law jurisdictions may view a credit differently, perhaps as a bundle of rights being assigned and transferred. In my experience, it’s often preferable to have agreements governed by common law jurisdictions due to a more established understanding of a carbon credit’s legal character.

Then there are marketplaces where the credits are traded. These platforms facilitate transactions and often offer technology solutions for monitoring purposes to ensure the relevant credits meet certain standards.

The transfer process is usually done digitally by utilizing blockchain technology which simplifies the transaction. Once a buyer has received the credit, it represents a tangible contribution to carbon removal. However, there’s always the risk of leakage or reversal, where events related to the project could negate the carbon removal that the credit represents. This risk makes it important to handle such issues contractually, ensuring that the credits are solid, believable, and the project doesn’t harm the environment or local communities.

Continuous monitoring and protection mechanisms are vital. For instance, the contract can distinguish between avoidable and unavoidable reversals, offering different remedies for each. From a buyer’s perspective, a well-drafted agreement will provide security buffers for reversal or leakage events. These could include purchase price adjustments or the provision of additional credits.

Therefore, the buyer must ensure the contract clearly defines the exchange of money and delivery of credits. The credits must be validated or verified, with third-party contractors chosen carefully to consider aspects like reversal or leakage and to provide for remedies in those scenarios.

CW: What are the different kinds of contracts for carbon credits, and what should normally be the time limit on them?

PETER: From a buyer’s perspective, the types of contracts vary based on the volume of purchases and the nature of the transaction. For small volume purchases, buyers typically adhere to the terms and conditions laid out by the marketplace or exchange. These platforms often provide template agreements which the parties accept by participating in the marketplace transactions.

Marketplaces might also offer services such as monitoring and reporting to ensure the quality of credits sold on their platforms. However, they generally avoid involvement in disputes between buyers and sellers, viewing their role as providing a venue for transactions rather than mediating conflicts. Should disputes arise, it’s up to buyer and seller to resolve them, whether through the standard agreements provided by the marketplace or through bespoke agreements negotiated independently.

For larger volume purchases, it’s common to negotiate a direct agreement tailored to the specific needs of the buyer and seller. This could be a standard purchase agreement or a more complex framework agreement that allows for ongoing purchases under predefined terms. Framework agreements are beneficial when a buyer intends to establish a long-term purchasing relationship and issue individual purchase orders over time.

Regarding the timeframe, the term of a carbon credit contract can vary. While some might suggest a term of up to a hundred years, practical considerations will often shorten this period. It’s necessary to establish a reasonable period that considers potential changes such as the seller’s existence, mergers, or transfer of rights. Depending on the nature of the underlying project, a minimum term may be around ten years, which typically provides sufficient time for issues to arise and be addressed.

Basically, the choice of contract and its term depends on the buyer’s needs, the volume of credits being purchased, and the services offered by the marketplace. Regardless of the scenario, the agreements should clearly articulate the terms and conditions of the purchase and the obligations of both parties.

CW: Are there any standards or guidelines that govern contracts in the voluntary carbon market?

PETER: In the voluntary carbon market, there currently aren’t any binding regulations specifically governing the content of agreements. However, there are established best practices and various resources that offer guidance on what these practices should entail. For instance, the discussions of the Supervisory Board with respect to Article 6 of the Paris Agreement provide valuable insights. While they haven’t formalized anything in the last Conference of the Parties (COP) meeting, the information available on their thought process and what they consider as best practices is informative, particularly regarding matters like reversal and leakage.

When drafting an agreement, one should consider these international discussions and strive to align with the standards being debated at both national and international levels. In the United States, the Commodity Futures Trading Commission has been conducting public hearings to discuss the carbon credit markets and establish a standard that ensures transparency and the quality of credits.

These hearings offer guidance that can be instrumental in preparing agreements within the carbon market, suggesting a framework for what might be regarded as best practice. And there are, of course, basic principles of contract law, such as those pertaining to good faith.

I often find that in common law jurisdictions, there is more freedom in contract drafting compared to EU jurisdictions. The EU has rules applying to contract templates intended for multiple uses, particularly concerning warranties, indemnities, and limitations of liability. These rules are based on protecting good faith and balancing the interests of the parties involved, especially considering the dominant position of the party that prepares a standard template.

So, while the voluntary carbon market may lack specific rules and regulations, it is governed by a combination of emerging best practices formed by international discussions, general principles of contract law, and, in some jurisdictions, specific rules concerning contract templates.

CW: What happens when the project doesn’t deliver as per the contract or, worse still, is exposed by an external party?

PETER: To be honest, the response from individual buyers varies. Many might choose to not publicly address the failure, preferring instead to treat it as a learning experience. The general tendency is to move on rather than engage in litigation or public disputes, especially since the financial stakes may not justify the costs and potential harm to reputation.

Most buyers would reassess their processes to ensure better outcomes in future transactions. They tend to prioritize managing their public relations and reputation over seeking legal remedies. This approach is partly due to the fact that the amounts involved are often not substantial enough to warrant the expense and attention that litigation would attract.

In essence, while there isn’t a significant precedent for big litigation in these cases, buyers are motivated to improve their due diligence and contract management to avoid issues in the future.

CW: As the voluntary carbon markets evolve, what would be your legal advice to current and future buyers of carbon credits?

PETER: As the voluntary carbon markets evolve, my legal advice to current and future buyers of carbon credits is to prioritize extensive due diligence and create robust, forward-looking contracts. This proactive approach is essential for navigating the complexities and risks inherent in the rapidly expanding carbon credit market. Buyers should scrutinize the credibility and track record of project developers, seeking out those with a reliable history of delivering on their promises.

Contracts should be comprehensive and include clear representations, warranties, and indemnification clauses to protect buyers from potential failures or misrepresentations. They should be designed to evolve with the market, incorporating the latest best practices and legal standards to ensure they remain effective in safeguarding buyers’ investments and reputations. In essence, buyers must ensure that their contracts can adapt to future challenges and that they are working with partners who are not only credible but also have the capacity to meet the demands of an increasingly scrutinized market.