You gotta fight for your right to caaaaarbon!

Eversheds Sutherland (US) LLP

Growing environmental awareness by consumers and governments has led to the proliferation of carbon and environmental attribute markets. Businesses in virtually every industry now participate in government mandated markets, voluntary markets, or both. The various markets serve different purposes for different industries. For example, the EPA’s Renewable Fuel Standard (RFS) and state Renewable Energy Certificate (REC) markets set a standard for amounts of renewable fuel or electricity generated or used. Others, such as carbon offset markets or cap-and-trade programs, set emissions standards; while others, such as wetlands restoration credit programs, seek to create other environmental benefits incentives. As these programs expand—and become more lucrative and complex—so do the number of disputes. Typical disputes range from basic contract disputes to buyers being sued for making false environmental claims because of a lack of understanding as to what exactly what type of credit they purchased. The purpose of this article is to examine, as an overview, the emerging areas of litigation in these markets and to provide best practices for potential and actual litigation.

At base, nearly all of the programs operate by separating an environmental attribute of one activity and selling it to another entity that needs it, often to meet a government mandate or to advertise environmental benefits. The terminology varies across programs; for the purposes of this article we refer to all of these intangible environmental attributes as “Credits.”

Credits are bought and sold in different types of markets. Mandatory government programs tend to have well-defined rules for Credit trading and often have their own trading platforms. While well-defined rules can bring certainty to a transaction, the trading platforms can make it easy, and tempting, to trade without a contract in place. Voluntary trading markets set up for different industries each operate on their own sets of rules. These programs can be difficult to navigate and may require individually negotiated contracts to transfer Credits.

Another important distinction is the difference between bundled and unbundled transfers. Different contracting laws may apply depending on whether a Credit is sold on its own or bundled with the underlying product that generated the Credit, i.e., the renewable fuel. Different programs may also have their own rules for handling disputes and the actions that are allowed or required when a party fails to meet its obligations.

This article focuses on what happens when a Credit, which is subject to an agreement to transfer, has been invalidly generated or simply is not delivered. Specifically, we focus on three stages of the dispute process. First, we discuss how entities can protect themselves at the time of contracting. Second, we discuss what steps to take when a dispute arises. Lastly, we discuss options for entities once litigation has commenced.

I. At the time of contracting.

The best way to avoid disputes is through thorough pre-contract due diligence. Relatively early on, the RFS market was rocked by a fraud scandal in which several purported biodiesel producers sold tens of millions of fraudulent Renewable Identification Numbers (RINs) to market participants. The scandal took years to unwind, led to at least one bankruptcy, numerous lawsuits, and jail time for several of the perpetrators. Moreover, government regulators also pursued civil fines against the companies that used the fraudulent RINs for compliance, claiming that the regulated parties should have conducted due diligence on the fraudulent RIN generators. Since environmental credits secure compliance from government penalties, the cost of purchasing fraudulent credits is not merely the cost of the credits, but can also be government penalties and fines for noncompliance. To avoid these headaches, here are some practical tips for pre-contracting consideration:

Know your counterparty. Often, the counterparty is a known, reputable entity, which injects substantial certainty into the transaction. However, some markets allow for blind transactions through a broker or futures exchange. If you are conducting a blind transaction, ensure the broker or futures exchange has procedures in place to ensure credit validity and only allows first-in-class companies to transact. Investigate your broker’s history in the market, identify any prior disputes, and whether the broker makes any guarantees or assurances, or maintains any applicable insurance. As you buy and sell in the market, maintain a standard checklist for vetting and approving counterparties and brokers, and maintain a list of parties with whom you have had a successful transaction.

Know the product. In mandatory trading markets, there is usually a defined system for purchasing a defined product to satisfy a government standard. This is less predictable in voluntary markets. The key is ensuring that the Credit aligns with the desired outcome. If, for example, your company’s goal is to claim reliance on 100% renewable power, the proper Credit is a REC which corresponds to megawatts produced from renewable sources. If your company’s goal is to claim net-zero carbon emissions, the proper Credit is a carbon offset which corresponds to a metric ton of avoided emissions or carbon removed from the atmosphere. Though a renewable energy project may generate either type of credit, the credits are not interchangeable. Companies should be particularly wary of purchasing from facilities that sell both types of Credits, as this may violate the principle of additionality (that each Credit represents a contribution that would not have existed but for that Credit) and could lead purchasers making inaccurate claims.

Credits related to transportation fuels include RINs, which measure a volume of renewable fuel produced, and California Low Carbon Fuel Standard (LCFS) credits, which measure the carbon emissions of a fuel relative to standard gasoline or diesel. Other common types of Credits include CORSIA credits, which measure emissions reductions by the aviation industry, wetlands restoration credits, grassland restoration credits, reforestation and afforestation credits, and emissions allowances (for carbon and other gasses such sulfur oxide). Most Credits can be traded directly via an exchange or, more often, through bilateral contracts. Some exchanges trade in digital tokens that represent an actual Credit held in trust. A few, but a growing  number, have associated derivatives markets. Knowing the proper Credit for the proper situation is crucial to achieving business goals and maintaining legal compliance.

Define the risks. The law surrounding Credit transactions is still developing. It is important to understand what law will apply to any dispute that may arise. For example, it might be surprising to learn that the Uniform Commercial Code, which is generally applicable to transactions for goods and services, typically does not apply to disputes over separated RINs transactions, depriving a would-be plaintiff of a potential implied warranty claim.1 The same rationale would probably apply to any intangible Credit transaction. In this respect, it is critical that an agreement for a Credit transaction identify the applicable law, the applicable venue for the dispute to be resolved, and which party bears the risk of invalidly generated credits.

II. Once a dispute arises.

If the dispute arises in the context of a mandatory Credit market, the first order of business is to determine whether replacement Credits must be purchased immediately to restore compliance. Some programs hold parties to compliance requirements, without regard to fault for invalid Credits. This means that even if the company that purchased an invalid Credit had no reason to know that a Credit was bad, was not at fault that the promised Credit was not delivered, and the agreement placed the risk of an invalid Credit on the seller, none of these facts excuse a party’s compliance obligations. To avoid further liabilities in the form of penalties and fines, first make sure that you remain compliant by purchasing additional Credits if necessary.

Likewise, if the Credit is used to make marketing claims or comply with voluntary environmental programs (e.g., LEED, Carbonfree, and EPA’s Green Power Partnership), be sure to secure additional Credits to avoid accusations of false advertising or from being disqualified from the environmental status earned.

Second, notify your counterparty immediately. The agreement governing the transaction may have strict deadlines to give notice of a claim for invalid Credits and initiate disputes. It’s also possible that your counterparty may not be aware that the Credits were invalid. The counterparty may have purchased the Credits from a third-party who is responsible for the fraud. The sooner that the invalid Credits can be traced to the true bad actor, the sooner market fall-out can be mitigated.

Third, report the invalid Credits to the applicable governmental agency or industry market monitors. Credit markets operate successfully when they are transparent. When the bad actors are identified and penalized or removed promptly from market participation, the market functions better. The governing agency may be able to alert other impacted market participants of the invalid Credits and may be able to launch an investigation or prosecution of the wrongdoer, which may ultimately help any recovery sought.

Fourth, start building your record. Gather all documentation and determine whether the contract demonstrates who should bear the risk of an invalid Credit. Review whether there are any conditions precedent that must be satisfied before initiating suit—review whether the parties must engage in informal negotiations or a mediation process prior to initiating litigation. Collect and preserve all emails, instant messages, text messages and other correspondence with the counterparty about the transaction, as well as any internal discussions that your company may have had regarding the transaction.

Taking these steps quickly will position your company to recover as quickly as possible from a soured Credit transaction, and potentially resolve it before resorting to litigation.

III. Litigating credit disputes.

Sometimes Credit disputes cannot be resolved informally and require turning to the judicial system for resolution. Indeed, it is often wise for buyers of invalid Credit to file suit quickly, as a company that sold the invalid Credit is likely to be the target of multiple suits, and the first party to collect on a judgment may be the only party to collect on a judgment.

Similarly, companies that sell invalid Credits often end up in bankruptcy court. Treatment of Credits in bankruptcy varies by program and the law is not completely settled as many programs opt to settle for reduced obligations rather than take their chances in court. For example, when Philadelphia Energy Solutions filed for bankruptcy, EPA negotiated a reduced RIN obligation. Similarly, bankrupt facilities participating in the Regional Greenhouse Gas Initiative (RGGI) settled for lower obligations after filing in court to discharge their obligations. The California Cap and Trade program, on the other hand, requires successor companies to take on a bankrupt business’s obligations. RGGI states are currently exploring implementing a similar successor liability scheme.

The most notable example of a bankruptcy involving a company that had taken orders to deliver credits and then lacked the ability to do so is the case of AgCert. AgCert, an Irish company, was unable to meet its obligations to deliver offset credits to clients participating in various mandatory and voluntary programs around the world. After striking deals with some customers for reduced obligations, AgCert sold itself to its largest creditor, AES, which paid off other creditors before liquidating the company a few years later.

Additionally, it is important to keep in mind that parties frequently must wage multi-front battles—in many cases parties end up litigating against a counterparty while also having to handle an administrative proceeding or regulatory inquiry regarding the same transaction. Be sure to coordinate efforts on both fronts to maintain unified messaging and position in both proceedings.

It is also important to think through your damages model and evaluate your possible remedies early on in the case. Keep track of the actual costs incurred for the invalid Credits, as well as costs relating to legal counsel, regulatory fines, and other expenses associated with resolving the issues relating to the invalid Credits.

IV. Conclusion.

The Credit market contains many traps for the unwary, and, at times, can even cause difficulties for the most savvy market participants. However, using these tips you can mitigate your own risk and move quickly when a potential dispute arises. Our attorneys are well-versed in these matters, and are willing to assist or advise on any of these issues.


1 Cargill, Inc. v. Int’l Exch. Servs., LLC, 2013 US Dist. LEXIS 2809, at *13-15 (S.D.N.Y. 2013); GP & W, Inc., 2012 US Dist. LEXIS 142213, 2012 WL 4513851, at *4-6; George E. Warren Corp., 2012 US Dist. LEXIS 183977 (S.D. Fla. July 25, 2012); Lansing Trade Grp., LLC, 2012 US Dist. LEXIS 87952, 2012 WL 2449514, at *4-5.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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