How do carbon markets work? Part 2

In part two of this two-part article, Niamh Dennehy-Maher of Allen & Overy and Robert Lang-Anderson of Bank of America examine legal issues and challenges relating to taking security over emission allowances and voluntary carbon credits – noting that this is a relatively new and evolving area of finance law and that there is, as yet, no established market approach to the various issues involved.

Mandatory Carbon Markets - taking security over UKAs

This section focuses on English law aspects of taking security over UKAs.  It does not purport to address how security might be taken over EUAs or over allowances issued under any other mandatory carbon scheme.

1. Legal nature of UKAs 

Determining the legal nature of a UKA is necessary in order to establish whether (and how) security can be taken over it.  The possibilities are that it could be considered a chose in action / bundle of contractual rights or some other form of intangible property.   Although there has not been a direct authoritative statement from the English courts as to the legal nature of UKAs, the prevailing view is that the English courts would be likely to characterise them as a form of intangible property. A number of factors support this view:

In order to constitute a form of ‘property’ under English law, it is established that an asset should be “definable, identifiable by third parties, capable in its nature of assumption by third parties, and have some degree of permanence or stability” (National Provincial Bank v. Ainsworth [1965] AC 1175).  These requirements would appear to be met in the case of a UKA, which:

- confers a permission to emit one tonne of carbon dioxide equivalent;

- is identifiable by reference to records with respect to the account in which it is held kept by the UK ETS Registry;

- is tradeable; and 

- has a value.

• The English courts have historically been receptive to, and flexible in, recognising property rights in intangible assets. This characteristic expansive understanding of property was demonstrated in a 2001 case involving waste management licences (In re Celtic Extraction Ltd), where it was held that a statutory entitlement that is transferable and has value is ‘property’.
• EUAs have already been recognised by the English courts as a form of intangible property (Armstrong v Winnington [2012] EWHC 10, [2013] Ch 156).  Given that the UK ETS mirrors and is based on the EU ETS, and in the absence of anything further in the UK statutory framework that elaborates on the legal nature of UKAs, it is likely the English courts would adopt the same approach when considering the legal nature of UKAs.

2. Taking security over UKAs

As UKAs are instruments created by English statute and are held in accounts at the UK ETS Registry, the applicable governing law of the relevant security interest should be English law. The relevant form of security interest for intangible property is an English law charge. 

When security is being taken over UKAs, the parties should consider each of the following:

1. Segregated UK ETS Registry account: whether the UKAs that the lender is taking security over are to be held in a segregated UK ETS Registry account of the chargor or whether they are potentially going to be commingled with other UKAs.  As mentioned in part one of this article, UKAs are homogenous units which are not identified by number; rather, they are indistinguishable from one other and are fungible.  Other types of asset which are fungible, and might be considered comparable, are shares (other than bearer shares) and dematerialised securities.  If the UKAs that the lender has security over are mixed with other UKAs (which could be subject to security in favour of another creditor) then this commingling means consideration needs to be given to how to identify the relevant UKAs upon an enforcement.  Also, if the number of UKAs in the UK ETS Registry account at the point of enforcement is less than the number of UKAs which had been expressed as being subject to the lender’s security (which could be the case if the parties have contractually agreed that UKAs can be withdrawn and traded prior to enforcement), consideration should be given to how any shortfall should be dealt with e.g. an intercreditor or other priority arrangement. Structuring the security using a segregated account is a way of avoiding these kinds of issues.
2. Security over all UKAs: is the lender being granted a charge over all UKAs held in the UK ETS Registry account from time to time as opposed to only some of the UKAs in the account?  This is a corollary of point 1 above and is preferable from a lender’s perspective because of the homogenous and fungible nature of UKAs and consequent commingling considerations.
3. Ownership of the UKAs: is the chargor the legal and beneficial owner of all of the UKAs held in the UK ETS Registry account, or is it holding the UKAs for the benefit of any other group entity or person?   (It is sometimes the case that a particular entity within a corporate group is used for the purposes of holding UKAs in its UK ETS Registry account for the benefit of its affiliates, effectively acting as a settlement agent to trade the UKAs on behalf of the relevant affiliates.)  In those circumstances, it would be necessary to evaluate in what capacity the particular entity holds the UKAs for the benefit of those affiliates in order to tailor the security accordingly. For example, the arrangement might constitute a trust or custodian arrangement.
4. Security over the UK ETS Registry account itself: whether the lender is to be granted a charge over UK ETS Registry account in which the UKAs are held, as well as over the UKAs themselves.
5. Restrictions on chargor’s use of UK ETS Registry account: whether the security agreement will restrict the chargor’s ability to deal with the UKAs and the UK ETS Registry account.  This will be relevant to whether an effective fixed charge can be taken over the UKAs and the UK ETS Registry account. Whether or not such restrictions on dealing are acceptable to the chargor will be a point of commercial negotiation for the parties.  
6. Signing rights over the UK ETS Registry account are obtained: Even if the chargor agrees to restrictions on its ability to deal with the UKAs and the UK ETS Registry account, it is not clear how easy it would be in practice for a lender to effectively block and control a UK ETS Registry account. In this regard, the lender may require that it is granted sole signing rights over the UK ETS Registry account from the outset.  A trading account held at the UK ETS Registry (a Trading Account) requires a minimum of two authorised representatives – one initiator and one approver – to operate the account so the lender may wish to appoint two of its own authorised representatives (to act as initiator and approver) when the charge is entered into, with these authorised representatives replacing those of the chargor. The lender may also require that the chargor undertakes not to exercise its right to request the removal of the lender’s authorised representatives.  Whether or not these kinds of requirements are commercially acceptable to the chargor will of course be a point of negotiation. The process of adding authorised representatives to a Trading Account is not quick so this would need to be factored into transaction timings.
7. Perfection: if the chargor is an English company then the lender’s security interest should be registered at Companies House, otherwise it will be void as against the liquidator, the administrator and any creditor of the chargor. The fact that security has been granted will then be publicly available information.  This is helpful to the lender because the UK ETS Registry itself does not note or register security interests.
8. Notification of the UK ETS Registry: in addition to registration of any charge at Companies House and given that the UK ETS Registry itself does not note or register security interests, the lender may also require the chargor to notify the UK ETS Registry of the lender’s security interest at the outset in order to make the UK ETS Registry aware of the existence of the security.  In practice, it is unlikely that the UK ETS Registry would acknowledge a notice of a security interest.

 

3. Practical challenges in taking security 

From a practical and commercial perspective, meeting each of the above criteria may be challenging for a lender; meeting all of them simultaneously is likely to be even more so.  For example:

- As explained in part one of this article, there are different types of account that can be held at the UK ETS Registry. Operator Holding Accounts (OHAs) and Aircraft Operator Holding Accounts (AOHAs), held by entities subject to UK ETS compliance obligations, are less likely to be suitable as the subject of a security interest because free access to those accounts by the entities is needed in order to meet their compliance obligations and surrender UKAs each year. 

-Trading Accounts are therefore more likely to be used for financing and security arrangements and could be opened by a compliance entity that only holds an OHA/AHA and is looking to raise finance.  A chargor might not be prepared to accept restrictions on its ability to withdraw UKAs from and otherwise operate its Trading Account.  If that is the case, a separate segregated Trading Account for the purposes of the particular financing could be opened (noting that the account opening process would need to be factored into transaction timings). 

-If it is not possible or practicable to impose restrictions on the operation of the Trading Account and/or the parties have contractually agreed that the chargor is free to trade the UKAs prior to an enforcement, then it is unlikely the lender would be able to demonstrate sufficient factual control to achieve a fixed charge over the UKAs or the Trading Account.  This would mean that these charges would be floating in nature. The lender may still wish to be granted signing rights over the Trading Account from the outset by appointing two authorised representatives, one to act as an initiator and another to act as an approver.  The chargor would also have signing rights and the parties would agree in the security document that the lender’s authorised representatives are not permitted to take action to control the account until an enforcement event had occurred or the charge had otherwise crystallised.  Any notice of the lender’s security interest that is delivered to the UK ETS Registry would reflect this commercial agreement (but, in any event and as noted above, it is unlikely that the UK ETS Registry would in in practice acknowledge any notice of security interest). If a chargor does not agree to the lender being granted signing rights over the Trading Account from the outset then the lender would likely seek to at least have the right to appoint its own authorised representatives once the security has become enforceable.   However, it should be noted that:

 

a) adding an authorised representative to a Trading Account is not a quick process – it involves co-operation on the part of the chargor and various mandatory documents in respect of the authorised representative (for example, up to date criminal record checks) being delivered to and scrutinised by the UK ETS Registry.  Practically speaking, this process could take a number of weeks (or longer) at a point when the lender may need to take swift action; and

b) whilst the process of adding its own authorised representatives is ongoing, the lender will have to rely on contractual undertakings from the chargor to no longer withdraw UKAs or otherwise deal with the Trading Account and, to the extent the chargor is uncooperative and assuming the UK ETS Registry will give effect to it, on the security document’s power of attorney to remove the chargor’s authorised signatories / representatives. 

 

Custodian structure

Depending on how title to the UKAs is held, an alternative security structure could be utilised whereby the UKAs are held for the borrower by an independent third party custodian.  This structure is more commonly seen on capital markets transactions than secured loan financings and is typically accompanied by an agreement between the parties that the UK ETS Registry account is to be blocked at all times. The security taken by the lender would consist of an assignment of the borrower’s rights under the custody agreement.  From a financier’s perspective, the UKAs would ideally be held in a segregated Trading Account in the name of the custodian and the lender’s security would be over the borrower’s rights against the custodian, including the borrower’s right to require the custodian to deliver up the UKAs held for it in custody. In order to perfect the security assignment, notice should be given to the custodian.  Custodian security structures normally involve a tripartite agreement between the borrower, the security agent and the custodian whereby the parties agree that the custodian will only release UKAs from the Trading Account upon the instructions of the security agent. A custodian structure accompanied by a blocking of the Trading Account from the outset therefore may not be appropriate for a loan financing where it is commercially agreed that the UKAs can be freely traded by the borrower prior to a security enforcement.  (If freedom to trade the UKAs is needed, an alternative structure would need to be explored whereby the custodian only blocks the Trading Account / acts on the instructions of the security agent following the occurrence of a trigger event.)  A custodian structure does not confer any interest in the UKAs themselves and the lender would accordingly need to evaluate whether it is an acceptable alternative to taking a charge over the UKAs themselves.

 

Enforcement 

In practice, a lender would likely enforce its charge over UKAs and a UK ETS Registry account by appointing a receiver to control the account and sell the UKAs to a third party.   The UK ETS Registry should be notified when the lender’s security has become enforceable (or upon the occurrence of any earlier trigger event which has brought the borrower’s ability to make withdrawals without the lender’s consent to an end).

Voluntary Carbon Markets - taking security over VCCs

 1. Complexity

There is more complexity involved when it comes to taking security over VCCs than is the case for UKAs.  

The fact that the voluntary carbon markets are still developing, the divergent approaches of different jurisdictions to characterising the legal nature of VCCs, as well as other concerns based on the varied and non-homogenous nature of VCCs, are just some of the challenges that to date may haveimpeded financial intermediaries from entering this market to a greater extent but they are now reportedly ramping up their participation[4].  It is to be hoped that as the market scales up and as greater uniformity emerges amongst VCCs (with several initiatives in this regard already underway, including global standards emerging and beginning to be adopted), financiers will be more comfortable with this asset class and an established market practice for taking security over VCCs will start to emerge.

2. What is the applicable legal regime?

As outlined above, English law security would typically be taken over UKAs, given that these are instruments created by English statute and are held in trading accounts at the UK ETS Registry.  Determining the relevant governing law for a security interest to be taken over VCCs is less straightforward, however, because VCCs are not created by any statute or international treaty framework tying them primarily to any one jurisdiction and legal system; rather, they are issued by one of a number of distinct issuing bodies located around the world.  For example, taking two of the most active VCC registries: Verra is based in Washington DC and subject to the law of the District of Columbia, while Gold Standard is established in Switzerland, meaning Swiss law would be relevant. Moreover, the jurisdiction of the VCC registry is only one of several potential jurisdictions/laws that need to be considered to determine the applicable legal regime.  Each of the following may impact the analysis:

 

(i)           the jurisdiction of the register on which the VCCs are recorded;

(ii)          the jurisdiction of the account in which the VCCs are held;

(iii)         the jurisdiction of incorporation of the registrar;

(iv)         the governing law of the carbon standard rules and/or registry rules; and

(v)          the law of the location of the climate mitigation project that generated the VCCs.

In many cases, the jurisdictions (at least in the case of (i) – (iv) above) will be the same, but this is not necessarily always the case. The first challenge when it comes to taking security over VCCs therefore lies in working out the applicable legal regime and a detailed analysis will be required in each case to understand the position.

3. Legal nature of VCCs 

The possible legal nature of a VCC varies from jurisdiction to jurisdiction. In some jurisdictions, the view is that a VCC would be considered a form of intangible property whereas in others it is possible it could be characterised as a bundle of contractual rights. In the absence of an authoritative statement directly on this point, there may remain residual uncertainties in certain jurisdictions.

The prevailing view is that the laws of England should be capable of accommodating VCCs as a form of intangible property.  The reasoning is similar to that outlined above in relation to UKAs; namely, that the test for determining whether an asset would constitute intangible property is whether it is “definable, identifiable by third parties, capable in its nature of assumption by third parties, and have some degree of permanence or stability” (National Provincial Bank v. Ainsworth [1965] AC) and these requirements would seem to be met in the case of a VCC, which:

1. confers a credit representing the reduction or removal of one tonne of carbon dioxide equivalent;
2. is evidenced by register entries and a unique serial number allocated upon its issuance;
3. is tradeable; and 
4. has a value.

 

However, as with UKAs, it should be noted that there is no authoritative statement as to the legal nature of VCCs.  Furthermore, it should be borne in mind that  Armstrong v Winnington, one of the key cases supporting the view that UKAs would likely be considered a form of intangible property under English law, is a case that relates to EUAs.  Extrapolating from the Armstrong case in the case of UKAs is logical given the close analogy to be drawn between UKAs and EUAs. Extending this analogy to VCCs also makes sense, especially when looking at the requirements for property which have been set out by the court [in National Provincial Bank v. Ainsworth], but there are differences between VCCs and UKAs that could potentially impact how an English court would characterise the legal nature of VCCs.

 

4.       Taking security over VCCs

 

If:

• the register on which the VCCs are recorded and the account in which they are held are located in England;
• the registrar is incorporated in England; and 
• the governing law of the carbon standard / registry rules is English law, 

 

then it is likely that the security taken over the VCCs should be governed by English law.

If (as is a distinct possibility given that currently none of the major VCC registries are based in England) this is not the case, local law advice should be sought in the relevant jurisdictions.

If security is being taken over VCCs the parties should generally give consideration to similar matters as those outlined above in the context of taking security over UKAs, as well as any jurisdiction specific points. This is subject to some caveats based on certain differences between UKAs and VCCs.

 

a) Unlike UKAs, and as mentioned in part one of this article, VCCs are not at all homogenous: each VCC is linked to a specific climate mitigation project and a large number of factors inform its perceived quality and price.  VCCs are allocated unique serial numbers when they are issued by a carbon standard’s administrator.
 
b) Because of each VCC having its own quality and value, the parties should consider whether the chargor should be free to trade the VCCs prior to enforcement because there could be circumstances where the VCCs the lender has security over are replaced with others of a different / lesser quality.  Any freedom to trade the VCCs will impact the ability to demonstrate sufficient factual control over those VCCs, which may be relevant to the nature of the security interest (e.g. fixed versus floating charge). 

c) If the commercial agreement is that the chargor is free to trade the VCCs prior to enforcement or other trigger event, then the lender would likely take floating security over VCCs owned by the chargor from time to time.  The lender may also want to place an obligation on the chargor to ensure that only certain VCCs of a specific quality or characteristic are acceptable to be kept in the account.

d) Commingling of VCCs subject to the lender’s security with other VCCs is less of a concern because each VCC can be identified by reference to its serial number.

e) Whilst on the one hand the fact of VCCs not being fungible with one another might make it less important for the lender to also take security over the account in which the VCCs are held, taking security over the account is still likely to be required by the lender in order to ensure that the lender can take control of and block the account and prevent the secured assets from being sold. 

f) If the lender is taking security over the account itself, consideration needs to be given as to how the account can be blocked and controlled (whether from the outset or following an enforcement or other trigger event), including the issues of (ii) notifying the registry of the lender’s security interest, and (ii) the lender being granted signing rights from the outset.

g) The rules of each registry will be relevant and understanding those rules will be important in assessing how easily the lender would be able to enforce its security in practice.  

Custodian structure

A custodian structure (similar to that outlined above in the case of UKAs) should also be possible as an alternative way of taking security over VCCs, subject to anything in the relevant registry rules. As with UKAs, this structure would not confer an interest in the VCCs themselves; rather, the lender would be taking security over the borrower’s rights against the custodian in respect of the VCCs.

Conclusion

There are a number of factors lenders need to be aware of when seeking to take security over UKAs and, to an even greater extent, VCCs. The various considerations, which include (a) characterising the legal nature of these instruments under the relevant applicable law, (b) determining the method of taking effective security over them and (c) how to enforce that security in practice, may have an inhibiting effect on the use of UKAs and VCCs in secured financing transactions. Given the vital role the carbon markets have to play in helping countries and companies meet their net-zero and other climate targets, anything that can be done to remove or at least reduce some of these uncertainties is to be welcomed.   One legal development that could help is an express clarification (by means of a legislative amendment) that emission allowances and VCCs are “financial instruments” and therefore “financial collateral” for the purposes of the UK financial collateral regulations.  One of the key messages to come out of a 2021 European Commission consultation addressing the scope of the EU financial collateral directive was that, as commodities instruments which are financially traded, emission allowances should be brought within scope by extending the current definition of “financial instrument”. It remains to be seen whether legislation will be enacted at the EU level, whether it would extend to VCCs issued by a carbon standard (or recorded by a registry) located in an EU member state as well as emission allowances, and whether similar amendments would in due course be made to the UK financial collateral regulations.  In the meantime, as emission allowances and VCCs become increasingly prevalent in the trade finance space, we look forward to helping lenders and borrowers navigate the complex legal issues and challenges involved.