Will risk weightings ensure a Direct Action dud?

On the balance of risk, companies and banks are unlikely to reach easy agreement when it comes to participating in Greg Hunt's emissions reduction fund - especially for land sector abatement.

A dark cloud now hangs over the future of the Commonwealth Government's proposed emission reduction fund, the centrepiece of its Direct Action policy, after Clive Palmer's announcement that his party would not support it in the Senate.

But in the event that the government obtains the necessary numbers in the Senate from either Labor or the Greens, or identifies an alternative way of implementing it without legislation, there is another question mark over it. That is, whether there are any companies – especially in the land sector – that will be willing to take the risk of bidding for abatement contracts.

That question emerges out of a draft standard form Emissions Reduction Fund contract that was released by the Clean Energy Regulator late last Friday. It was in large part overshadowed by Palmer's announcement with former US vice-president Al Gore earlier in the week.

However, its terms may determine which companies will be willing to enter into them and, importantly also, whether they are bankable. In other words, will banks be prepared to lend companies money on the basis of the security provided by the contract?

The problem that emerges from the draft contract is that it places much of the risk upon companies bidding and very little upon the government.

Normally, that risk would be priced into the contract by the seller but the government has so far indicated that it expects companies to bid in emission reductions at a low price.

It is understandable that given the Commonwealth is spending taxpayer’s money on the ERF it should be prudent in what risk it is prepared to bear. However, the consequence of that decision is that project proponents may decide not to bid for contracts given the price that is expected to be paid.

Before explaining more about that, it is worth providing some background on the standard form contract.

To qualify to bid in the ERF reverse auction, a company will need to meet "eligibility and credibility" criteria. In relation to the "credibility" criteria the government has indicated that a company's previous record of delivering contracted emission reductions – or more particularly failure to deliver – will be considered, along with commercial readiness of the technology or practice and the capacity of the project proponent to carry out the project.

Proponents need to understand the terms of the contract and its implications before bidding – once a bidder is successful in the reverse auction it will enter into a contract and it will not be able to further negotiate its terms. Details provided by the bidder before the auction – quantity of units to be delivered, price and delivery schedule – will automatically become terms of the contract.

However, the substantive obligations of the contract – to deliver and purchase units – will only come into effect once certain conditions precedents have been met. These conditions precedents will include demonstrating evidence of the seller's capacity and authority to enter into the contract and availability of sufficient funds to operate the project.

The core of the contract is the obligation of the seller to deliver the contracted quantity of carbon units at the scheduled time and the obligation of the buyer (the Commonwealth) to accept delivery and to promptly purchase and pay for them.

The first point to highlight from the way in which the draft contract defines the core obligation of the seller to deliver units is that it is not linked to the seller’s project. In other words, the obligation is simply to deliver Australian Carbon Credit Units, regardless of origin.

One problem already evident with the standard form contract is the term – up to five years. Some companies have already indicated that a five-year term contract is a disincentive to bidding given it is likely to be insufficient to secure investment for long-life assets. In response, the Government is undertaking market consultation about alternate contract lengths.

The next issue for some project proponents may arise from the requirement to specify a delivery schedule in advance. For some proponents, particularly in the land sector, it may not be possible to know with exact precision the time at which they can generate and then deliver units. The contract provides some flexibility by allowing for the seller to deliver carbon units in advance of the scheduled date where notice is given 20 business days before the proposed delivery. However, the Commonwealth is under no obligation to accept advanced delivery. According to explanatory notes provided with the draft contract, this is necessary "to allow the Commonwealth to manage its spending commitments, particularly between financial years".

All proponents will also need to think carefully about the number of units they offer at auction and the proposed delivery schedule given the potential for the Commonwealth to terminate the contract for overly optimistic promises made before entering into the contract. Under the proposed contract, the Commonwealth can terminate the contract if a representation or warranty made by the seller is recklessly, wilfully or intentionally false or materially misleading at the time it was made. As already highlighted, a seller's record of delivery will also be something considered by the regulator at the qualification stage before bidding.

However, the most significant risk for contractors is the draft agreement's "force majeure" provision. Normally, such contractual provisions provide for both parties to be relieved from liability or obligation when an extraordinary event or circumstance beyond their reasonable control occurs, such as a natural disaster. However, the ERF contract provides for an extra requirement for the operation of the force majeure provision – that the proponent be unable to provide "make-good" units.

In other words, if a proponent is hit by, for example, a bush fire or flood and unable to generate the contracted units, they must attempt to buy replacement units from the secondary market before claiming force majeure.

The Clean Energy Regulator argues that proponents will be able to obtain insurance for business interruption, the cost of which will be moderate when compared to the cost of insuring for other risks.

However, this proposed provision has generated significant concern among lawyers. Effectively, proponents hit by natural disaster are doubly penalised – through the loss of their project and through the obligation to purchase make-good units, which must be domestic Australian Carbon Credit Units and not international permits. This is especially the case in a relatively immature and shallow secondary domestic carbon market, where permit scarcity will see higher carbon unit prices.

To alleviate such concerns, the proponent will have the opportunity to renegotiate the delivery schedule but not beyond the term of the contract and the Commonwealth may also agree to reduce the number of units it is contracted to buy.

Nevertheless, it is a risk that potential sellers should factor into their bid in the reverse auction and this risk position may give some sellers a potential price advantage over others in a reverse auction.

For some type of projects this risk may be less than others – for example, commercial energy efficiency providers won't face the same problems that land sector proponents face from the elements. State and territory governments proposing emission reduction projects also will not face the same risk and may yet emerge as the biggest beneficiary from the ERF.

Marcus Priest is a lawyer and Grant Parker a partner at Sparke Helmore.