Tuesday, July 08, 2008

South Africa and African industries have been slow in taking advantage of the Kyoto Protocol’s potential economic and environmental benefits, particularly the Clean Development Mechanism (CDM) and Certified Emission Reductions (CER) trading.  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.
Under the CDM, developed nations with emission targets may invest in greenhouse gas (GHG) 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 CER regime
Regulations were published in December 2004 in South Africa, in terms of the National Environmental Management Act, to give effect to the Kyoto Protocol.  A Designated National Authority (DNA) was established, under the Department of Minerals and Energy, to consider and approve applications for CDM projects.  The DNA’s letter of approval contains authorisation for a project proponent to sell the title and rights to CERs generated by the CDM project.
54 CDM projects have presently been submitted to the DNA.  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.  Additionally, as CERs are legislated and specific penalties apply for failing to reduce carbon emissions, the value of CERs are readily ascertainable.
Due to the absence of targets and timetables for CERs, the South Africa government has no emission caps.  It also does not presently have a formal emission trading market and no “cap and trade” market therefore exists.  The Johannesburg Stock Exchange, however, announced in October 2007 that it is investigating commencing such trade.
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.  Internationally however a CER may have value for a party with its own targets and timetables.
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.
Carbon trading
The only carbon trading in South Africa has been through derivatives.  In 2005 Sterling Waterford Holdings released the world’s first carbon credit derivative and investment product listed on an exchange.  The carbon credit notes (“CCN”) were bought and sold as derivatives, with carbon credits as the underlying security.  The notes are a pre paid forward contract, being an obligation of the issuer to deliver either a carbon credit or the cash equivalent on the delivery date.  The carbon credits are obtained by contracting with various countries, through intermediaries, and the investor does not participate directly in a CDM.
The company subsequently released the first fixed-interest carbon credit linked instrument - Collateralised Enhanced Yield Certificate.  They are presently marketing a carbon note release to European investors and hedge funds and looking to diversify the market with hybrid products, such as high yield bonds.  There have however been no other such derivative listings by other investors
With no established CER emission trading or price discovery mechanism in South Africa, this brings both opportunity and risk.  The main risk in obtaining security over CER’s is that CERs only have value outside South Africa and within South Africa there value is indeterminable.
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.
South Africa, along with India and China, may in 2012 be categorized as a developed nation under the Kyoto Protocol.  South African industries would have to meet targets and timetables for emission reductions, with high costs involved.  Africa is predicted to be the most effected by climate change and the slow progress in taking advantage of CDMs may be an economic and environmental opportunity lost, with the proximity of the next stage of commitment.

Bowman Gilfillan has advised a number of foreign and South African entities, including the IFC on the tradability of carbon credits and on the finalisation of CER purchase agreements.
2 July 2008
Claire Tucker is a director and Sandra Gore an associate in the Environment, Natural Resources and Carbon Trading and Energy practice area at Bowman Gilfillan.