With the emergence of a thriving carbon credit market in Australia, the banking and finance industry has seen a significant increase in funding being utilised towards the establishment of carbon farming and development projects. Much of this has been driven by a material increase in the market value of Australian Carbon Credit Units (ACCUs) which spiked earlier this year at over $55 per ACCU. Although the market value of ACCUs has dipped back to its Q3 2021 values ($28 per ACCU), the noticeable growth in the past 24 months and increased awareness of its carbon footprint by corporate Australia indicates that we will only see more carbon projects taking place in the coming years. This is likely to be bolstered by recent widespread investment in the carbon exchange from large corporations such as Mitsui E&P Australia, Shell and various private equity enterprises.
Our office has witnessed both lenders and borrowers taking the opportunity to become involved in these sustainability projects with a view of increasing their engagement in environmentally responsible corporate practices. Carbon farming also appears to have established itself as a viable commercial farming practice, and it may be appropriate to view the generation of ACCUs as another form of crop yield available to the Australian agriculture industry.
From a banking perspective, financing carbon farming projects is still a novel concept. This article is intended to serve as an introduction to the Australian carbon credit market for lenders. We also set out some of our recent experiences working on these transactions, with a particular focus on potential issues that may arise for financiers.
The generation and sale of ACCUs as a commodity is facilitated by the Carbon Credits (Carbon Farming Initiative) Act 2011 (Cth) (CFI Act) which provides a mechanism by which landowners can partake in carbon farming by way of an Emissions Reduction Fund Project. The scheme involves the provision of carbon credit units in exchange for carbon sequestration or carbon avoidance.
As a financier, it is important to understand the relationship of the major parties involved in a carbon farming project. In most situations the financier’s customer will be the landowner. In order to undertake carbon farming works, most landowners will then engage a Carbon Service Provider (CSP).
A CSP is an independent agent which provides carbon farming services to landowners. Generally, a CSP and a landowner will enter into a Carbon Service Agreement by which the CSP is engaged to provide carbon farming related services in consideration for a fee and, usually, the transfer of carbon rights. The benefit to the landowner in engaging a CSP is that typically the CSP will have the volume to tender for and obtain larger high worth government carbon abatement contracts. Access to these abatement contracts affords smaller landowners the chance to aggregate their carbon generation with other landowners to meet the supply requirements that they would, on their own, be unable to satisfy. To help protect landowners against unscrupulous CSPs, CSPs must meet the Clean Energy Regulator’s minimum performance criteria, which includes fair and appropriate contract terms and timely payments/transfer of carbon credits.
The terms of a Carbon Service Agreement are often the most controversial issue for a financier. The entry into such an agreement by the landowner may, depending on the terms, result in a financier’s security being diminished, or may require the financier to incur additional administrative obligations which may conflict with or fetter its usual legal rights. It is generally a requirement that a financier consent to the entry of a Carbon Service Agreement.
A Carbon Service Agreement will often provide for the transfer of all rights, title and interest in the carbon rights associated with the land from the landowner to the CSP. Such a transfer will be registered on title in the form required by the relevant jurisdiction. For a financier, this presents the most significant issue as the relinquishment of such rights may be contrary to the financier’s interests.
The carbon credit ownership structure is generally stipulated in a Carbon Service Agreement and will vary depending on service provider, jurisdiction and the overall nature of the carbon farming project. Interestingly, what appears most common in our review of Carbon Service Agreements within the industry, is for the CSP rather than the landowner to be granted legal ownership of the ACCUs. Depending on the relevant remuneration structure, there is a high risk to the landowner in granting valuable rights for nominal consideration which appears to have been the case in early Carbon Service Agreements entered into prior to the recent rise of ACCU values.
The Clean Energy Regulator requires specific carbon farming projects conducted under the Emissions Reduction Fund, including emissions avoidance projects and sequestration projects, to include Eligible Interest Holder Consent.
An Eligible Interest Holder is an individual or entity which has a legal interest in the land on which the project is being conducted. It follows that in circumstances where a lender holds an existing mortgage over the property, it will be required to consent to the project and in doing so, will be required to review and approve the relevant Carbon Service Agreement.
Our office has had the opportunity to be involved in a number of different carbon farming projects with a range of different CSPs. Although not exhaustive, some of the more common issues our team has navigated through are set out below.
Carbon Service Agreements often place strict legal responsibilities on the landowner. These include onerous obligations requiring a high level of expertise with regard to its complex responsibilities under the CFI Act, liability for the completion of services and meeting project targets, and a broad indemnity for the supply of carbon credits and any shortfalls. These obligations are placed on the landowner despite having engaged a professional third party CSP to manage the overall operations of carbon project. Such clauses when read together are strongly skewed in favour of the CSP and may amount to unfair contract terms. In our respectful opinion, the drafting of some of these Carbon Service Agreements are at odds with the minimum performance requirements of the Clean Energy Regulator, in particular with reference to the need for such terms to be ‘fair and appropriate.’ There appears to be a clear trend of some CSPs (and it is important note, not all) divesting material risk but seeking to still retain all rewards and benefits. Landowners and financiers should remain prudent and seek input on the legal terms of such agreements prior to entry.
In our experience, some early Carbon Service Agreements included a nominal consideration fee without sufficient clarity or explanation as to the reasoning behind the nominal fee. In such circumstances, it is unclear what the landowner received in exchange for giving up ownership of the carbon rights and carbon credits. It may have been the case where the landowner vastly undervalued the potential of ACCUs prior to their recent prominence. Financiers should be wary of securing land subject to existing Carbon Service Agreements, particularly if those agreements were entered into pre-2021 when ACCUs were markedly undervalued. At the very minimum, the relinquishment of the now profitable carbon rights should be weighted when considering land value.
Carbon Service Agreements often place restrictive assignment rights on the landowner requiring either novation of the agreement to the new landowner, or, that the new landowner enter into a new agreement with the CSP on substantially the same terms. For a lender and in an enforcement scenario, this is likely to be administratively cumbersome and somewhat restrictive, particularly if a purchaser intends to acquire the land for the purpose of utilising the ACCUs, rather than for the purpose of undertaking the project with the assistance of a CSP. We have not seen what impact the relinquishment of carbon rights will have on the valuation of land, and will be closely monitoring how the industry responds to this.
Gadens has been extremely fortunate to be involved in the financing of various carbon farming projects to date. We have been able to develop a deep understanding of the technical and often complex nature of Carbon Service Agreements and in turn have been able to assist our clients navigate these issues and protect their interests.
It will be interesting to see how the banking industry treats carbon farming projects in future. Presently, all carbon farming projects appear to be mostly secured by land. However, our office sees the opportunity for financing to be secured by future ACCU streams, based on portfolio of ACCUs aggregated from landowners or even secured by a future sale of the carbon farm, which would effectively result in ACCUs being treated as a separately bankable asset. This will understandably require some normalisation of ACCU values, but presently could certainly be considered by financiers willing to provide high leverage on somewhat speculative assets.
We hope to see further growth in the carbon farming lending space and look forward to continued involvement in such environmentally focussed initiatives.
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Martin Nguyen, Partner
Grace Cunningham, Lawyer