Looking Through the Prism of the World Bank's First GHG Emission Reductions Transaction

Jean-Philippe Brisson

In January 2000, the International Bank for Reconstruction and Development (World Bank) launched its Prototype Carbon Fund (PCF) after approximately three years of preparation and discussion with various country, environmental, and industry group representatives. With capital contributions amounting to $145 million, the PCF currently is the largest single source of financing for the purchase of greenhouse gas (GHG) emission reductions. This newsletter previously featured an article that described the operations of the PCF (E. Brenes, "The World Bank’s Prototype Carbon Fund," Climate Change and Committee Newsletter, Vol. 4, No. 2, p. 7), so this article looks at the first PCF transaction, which was concluded with the Republic of Latvia. The World Bank’s experience in Latvia provides significant insight into the legal agreements supporting GHG transactions at a time when the regulatory framework governing climate change is so uncertain, and when no clear pricing benchmark exists.

Background
The PCF is an international trust fund established by a resolution of the Executive Directors of the World Bank. It is governed by the general principles of international law and is administered by the World Bank as trustee for the fund (Trustee). Participation in the PCF is now closed to new participants. Existing PCF participants are six governments at U.S.$10 million each (Canada, Sweden, Finland, Norway, The Netherlands, and Japan), and 17 companies at $5 million each (including Deutsche Bank, Electrabel, Gaz de France, Mitsubishi, RWE, and Tokyo Electric Power Corporation). The PCF works like a mutual fund. It pools the capital contributions of each participant and purchases emission reductions from a portfolio of climate change projects in accordance with pre-defined project portfolio criteria. Each participant is entitled to a share in the emission reductions generated by each project, pro-rata to its investment in the fund. This approach reduces the risks associated with any single project, minimizes transaction costs, and enhances the know-how gained by the participants, each of which will be exposed to more than 20 GHG transactions.

For the first PCF transaction, the Trustee agreed to purchase emission reductions generated by a solid waste, methane recovery project in Liepaja, Latvia (Latvia Project or Project). The Project involves the upgrade of a solid waste landfill, which would otherwise comply with the standards enacted in Latvia’s National Solid Waste Management Strategy, to a solid landfill that captures methane generated by the enhanced decomposition of waste. GHG "emission reductions" are generated in two ways. First, the emissions of methane, a gas with a powerful climate change potential, are recovered from the landfill. Second, this methane is converted to power, which is sent to the local grid and displaces fossil fuel power generation that would have emitted GHGs "but for" the PCF Project.

Structure of the Latvia Project
In the Latvia Project, the Trustee negotiated with a delegation composed of representatives from the Government of Latvia and the City of Liepaja, the majority shareholder of the landfill. Ultimately, however, the Trustee concluded an agreement with the Republic of Latvia, which provides for a subsidiary agreement between the Republic of Latvia and the City of Liepaja. This structure is somewhat unique. In future transactions, the Trustee likely will contract with a private or quasi-governmental project entity acting as the sponsor or owner of the project and with the country for purposes of facilitating the transfer of Emission Reductions and obtaining the formal approval required by Kyoto Protocol.

In parallel to this legal agreement, the Trustee also prepared various documents intended to increase the likelihood that the emission reductions generated by the Latvia Project would be credited as Article 6 "Emission Reduction Units" under the Kyoto Protocol. These documents include a baseline study and a Monitoring and Verification Protocol completed by an independent certification company. These two documents are complemented by a legal opinion from the World Bank’s Legal Department confirming the additionality of the Project by concluding that the conversion to a sanitary landfill with methane recovery technology was not otherwise required under Latvian law. These documents are critical for ensuring the environmental credibility of PCF operations generally, and demonstrating the Project’s integrity to any domestic or international regulatory agency, should this become necessary.

The Latvia Project’s Emission Reductions Purchase Agreement
It is beyond the scope of this brief article to provide an analysis of all the innovative provisions incorporated into the agreement for the Latvia Project. The following paragraphs highlight, however, some features of the Latvia Project’s Emission Reductions Purchase Agreement (Purchase Agreement or Agreement), and examine how the Trustee and the Republic of Latvia allocated some of the transaction risks.

If the transaction had taken the form of a conventional international sales agreement providing only for payment on delivery of emission reductions, construction and project risks would remain solely with the Republic of Latvia. In the Purchase Agreement, however, the Trustee agreed to make a substantial advance payment to upgrade the landfill, and to make additional milestone payments before delivery of any emission reductions. From a financial perspective, these payments are similar to a form of financing in the Project itself, and exposes the PCF to the general construction and start-up risks associated with the Project. The Trustee nevertheless concluded that such payments were necessary because the Project owners did not have the resources to finance the additionality component of the landfill, i.e., the upgrade to a methane recovery landfill. The Purchase Agreement is thus a hybrid legal instrument which falls between an equity/debt investment and a sales transaction. This view is reinforced by the significant degree of control over the Project’s design and operation granted to the Trustee.

The pricing mechanism of the Latvia Project is the most innovative aspect of the Purchase Agreement. The Trustee was careful in negotiating the Agreement not to explicitly provide for a specific price per ton of carbon equivalent. A specific price figure would be difficult to negotiate when there are currently very few pricing benchmarks that allow accurate comparisons. In addition, any specific price figure chosen would have opened the World Bank simultaneously to claims from non-governmental organizations that the Bank was "taking advantage" of developing countries, and from Annex I industry groups that the Bank was "driving up the cost of compliance" of the Kyoto Protocol. Thus, the Purchase Agreement provides for the payment of specific amounts of money at specific periods or upon certain milestones; it does not fix, however, any specific aggregate amount of emission reductions to be delivered by the Republic of Latvia.

The Purchase Agreement establishes "minimum amounts" of emission reductions that must be delivered every year. Failure to make such delivery is an event of default under certain conditions, and specific payments are made by the Trustee upon delivery of some specific annual "minimum amounts." The Purchase Agreement also establishes a presumptive "total amount" of emission reductions. When the number of emission reductions delivered exceeds this "total amount," all subsequent emission reductions are shared between the Republic of Latvia and the PCF. The share of emission reductions (above the "total amount") that will go to the PCF is a function of the international price of emission reductions. This allocation mechanism provides an incentive for the Republic of Latvia to ensure the proper operation of the Project.

At a time when the climate change regulatory framework is in constant flux, regulatory risks associated with the form of "property" generated by climate change projects are a significant concern in GHG transactions. In the Purchase Agreement, an "emission reduction" is defined as a reduction of GHGs that can successfully undergo a Kyoto Protocol certification procedure, or, in the absence thereof, an independent party certification procedure. Thus, the PCF assumes the risk that the Kyoto Protocol does not enter into force. If this risk materializes, however, this definition allows the Trustee to deliver to the PCF participants, at a minimum, a form of "property" that could be used for public relations, voluntary commitment, or even possibly alternative international, regional, or domestic frameworks.

Conclusion
This cursory review demonstrates that it is difficult to categorize and analyze "project-based" GHG transactions as traditional forms of financing (equity, debt, or both), or as pure sales agreements. More likely, each transaction will reflect a mixed approach that addresses the financial resources, risk tolerance, and other circumstances of each party involved. Furthermore, the PCF’s experience in Latvia illustrates the necessity of supporting GHG transactions with well-crafted, comprehensive legal agreements that protect the interests of each party. To some, such agreements currently are not necessary because the Kyoto Protocol has not entered into force, or because there are few pricing benchmarks. To the contrary, the potential for assuming unexpected risks and liabilities, or for losing title to a valuable "property," is the greatest when the framework for a transaction is not clearly defined and is likely to change in the future.

Jean-Philippe Brisson is an associate at Hunton & Williams; previously he was a consultant at the World Bank where he worked on the establishment of the Prototype Carbon Fund. The author thanks Mmes. Hanneke Van Tilburg and Charlotte Streck, respectively senior counsel and counsel at the World Bank’s Legal Department, for their helpful comments on drafts of this article.