The Legal 500

The recent Department of Environmental Affairs and Tourism Report on mitigation of South Africa's greenhouse gas emissions brings the era of South African carbon trading closer.  This is because the report proposes emissions reduction targets and internationally this has generally led to the creation of a market in emissions reductions.

By Claire Tucker and Sandra Gore

Bowman Gilfillan Environment, Natural Resources and Carbon Trading and Energy practice area

The recent Department of Environmental Affairs and Tourism Report on mitigation of South Africa's greenhouse gas emissions brings the era of South African carbon trading closer.  This is because the report proposes emissions reduction targets and internationally this has generally led to the creation of a market in emissions reductions.

As developing countries have not agreed to emissions reduction targets in the Kyoto Protocol they presently only participate in the international trade in carbon emission reductions through the Kyoto Protocol's Clean Development Mechanism (CDM).  This is likely to persist until 2012 when the first Kyoto round ends.

Under the CDM, developed nations with emission targets may invest in greenhouse gas reduction projects in developing nations.  Financiers of CDM projects can acquire CERs, which can then be sold to signatory countries with emission targets.  CERs are also tradable in the European Emissions Trading Scheme (EU- ETS).

The South African CDM market

Even in the CDM market South Africa and African industries have been slow in taking advantage of potential economic and environmental benefits, Africa has only 25 projects, compared with 581 Asian projects.  Ranked as one of the highest per capita carbon emitters in the world, South African industries could receive both substantial incomes and cleaner technology from CER trading and CDMs - at the expense of developed nations' industries.

The International Finance Corporation (the IFC) has however recently concluded a landmark transaction with a South African entity, Omnia Fertilizers Limited to purchase CERs.  The first CERs were also issued in South Africa in June 2008.  These events may signal the beginning of South African industries taking advantage of the Kyoto Protocol's benefits for developing nations.

South Africa ratified the Kyoto Protocol on 31 July 2002.  As a developing nation it is not required to meet targets and timetables for emission reductions in the first stage of commitment, which ends in 2012.

The South African CER regime

54 CDM projects have presently been submitted to the South African Designated Natioanl Agency established by the Department of Minerals and Energy to fulfil our international commitments under Kyoto and approve such projects. 

13 Project Design Documents are registered with the United Nations Framework Convention on Climate Change as CDM projects and 7 are at validation stage.  The projects cover bio-fuels, energy efficiency, waste management, cogeneration, fuel switching and hydro-power in the manufacturing, mining, agriculture, energy, and housing sectors.  CER buyers, as project developers or investors, are both local and international.  However, only three CDMs have had their CERS certified, with the first CERs recently being issued on the Lawley Switch Fuel CDM Project

In developed nations carbon is a new commodity form and an asset class in its own right.  Carbon has acquired a value as governments have artificially created scarcity by capping mandatory emissions levels industries are permitted to produce in terms of the nation's targets.  The assets are regulated through emission trading systems.  Pricing is market driven, determined by supply and demand.  As CERs are legislated and specific penalties apply for failing to reduce carbon emissions, the value of CERs are readily ascertainable. In the South African market a CER has no value.  This is due to the absence of a regulated cap and trade system; allowances; and penalties for failing to adhere to caps. 

CERs "Incorporeal assets"?

Without a regulatory regime there is less security in carbon trading; uncertainty on CER's legal nature; and whether security can be taken over them.  CERs, at best, would be an incorporeal movable asset - like a share - that is an identifiable, non monetary asset without physical substance.  The CDM regulations provide that a real/property right can be acquired to a CER and they are transferable.  Theoretically, once a CDM project is registered, the resultant CERs can be traded, transferred or delivered, even before a CDM project begins.

A basic form of monetising CERs are Emission Reduction Purchase Agreements (ERPA).  In South Africa, ERPAs would involve CDM projects.  ERPAs could include fixed prices for the volumes delivered and an indexed price for the remainder, linked to a European Union Allowance Price Index or a market spot price.

In the Omnia agreement, the IFC committed to purchase a minimum of 50% of Omnia's CERs for 5 years and sell these to international buyers.  The CER's were generated through the CDM.

Taking security over a CER

If CERs are incorporeal assets, as they are transferable, security can be taken over them, through, amongst other mechanisms, general notarial bonds and cessions in securitatem debiti.  The rights arising out of an ERPA could be held by a cessionary until the cedent/ CER owner has settled his or her debt.  

A general notarial bond, however, provides limited security upon insolvency unless the bond is "perfected" before the liquidation of the mortgagor, enabling the creditor/mortgagee to take possession of the movables on default by the mortgagor. If the bond is not perfected, the creditor is only entitled to the movable's proceeds after preferent creditors.

As CER's have an uncertain legal status in South Africa it would be preferable to only take security over a listed CER, to ensure it is transferable.   However, due to the lack of a formal emission trading market, CERs are not a financial instrument as they do not represent cash or an equity instrument; nor provide a contractual right to exchange or receive anything.

Investment directly in a CDM project

Currently, an investor must invest directly in a CDM project.  To realize profit from the CDM and sell CERs to the open market, the investor must wait until the project delivers CERs.  Technical knowledge and costs must be established before an investor can take ownership of the CERs and trade is onerous.  This is a risk for a party without substantial experience and knowledge of the market and industry, as most projects have no guarantee of funding, completion, and validation, with the result that CERs may not be created or registered.

Claire Tucker is a partner and Sandra Gore an associate at Bowman Gilfillan.

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