The International Swaps and Derivatives Association, Inc. (“ISDA”) has been active in the voluntary carbon credit industry.
ISDA helped facilitate the secondary trading of VCCs by publishing two papers exploring the legal nature of these instruments under English, French, Japanese and Singapore law. In December 2022, ISDA published the 2022 Voluntary Carbon Credit Transactions Definitions (the “VCC Definitions”) and accompanying template confirmations. Although this iteration of the definitions is version 1.0, preliminary feedback has been positive with significant buy-in from the industry.
The VCC Definitions permit parties to enter into both spot and derivative (i.e. forwards and options) transactions. Crucially, the definitions only support physical transactions; that is, cash settlement is not contemplated.
Given the diversity of the VCC industry, ISDA has taken the astute approach of making the definitions Carbon Standard and Registry neutral. The parties can decide as wide or as narrow a pool of VCCs as they wish by specifying these details in the relevant trade confirmation together with other “Agreed VCC Specifications” (e.g. project, VCC type, methodology, co-benefit programme, Carbon Standard label) and level of representations and warranties in respect of the VCCs.
Under the VCC Definitions, the relevant VCC (referred to as “Required VCCs”) can either be physically delivered or retired. Regardless of the settlement approach, the receiving party will pay to the delivering party the “VCC Purchase Price” (in the case of a spot or a forward transaction) or the “VCC Strike Price” (in the case of an option transaction), in each case multiplied by the “Number of VCCs”. The VCC Purchase Price or the VCC Strike Price are specified in the relevant trade confirmation.
The VCC Definitions contemplate three situations where a transaction can go wrong:
- a “VCC Settlement Disruption Event”, which is akin to the Force Majeure Event under the 2002 ISDA Master Agreement;
- a “failure to Deliver”, which arises when the delivering party fails to transfer the Required VCCs on the to the receiving party’s registry account on the specified delivery date; and
- a “failure to receive” occurs when the delivering party is unable to deliver the Required VCCs due to a failure by the receiving party to take the requisite steps to enable delivery (e.g. notifying the relevant Registry of its consent to receive the Required VCCs).
A failure by the delivering party to retire Required VCCs in accordance with the VCC Definitions will be an Event of Default under the ISDA Master Agreement.
It is important to analyse these specific situations by reference to the ISDA-standard Events of Default and Termination Events, including the extent to which they override or supplement them.
Whilst the VCC Definitions go a long way in helping standardise spot and certain derivatives transactions, parties need to be cognisant of key issues, including the following:-
- Legal nature of VCCs. Do VCCs constitute property under English law and/or any other relevant jurisdiction? This is a key question and directly impacts contractual enforceability as well as concerns regarding fungibility, ownership, taking security and treatment in insolvency situations (including netting). Parties will find interesting parallels with digital assets and distributed ledger technology, given equivalent legal arguments that these asset classes constitute intangible property;
- Regulatory implications. Certain transactions contemplated by the VCC Definitions clearly constitute derivatives and so “financial instruments” under both EU and UK MiFID and “specified investments” under UK FSMA. Unless a party benefits from exemptions, this raise potential registration concerns. Other knock-on implications are financial promotions, regulatory capital, margining and trade reporting (under EMIR and potentially under MiFID); and
- Early Termination. We have summarised above three specific early situations contemplated by the VCC Definitions. Should these or the ISDA-standard Events of Default and Termination Events occur, it is important to be cognisant of how early termination would operate (including the netting of outstanding VCC transactions with one another and with non-VCC transactions) and, more fundamentally, whether such early termination would be enforceable. To date, the ISDA netting and collateral opinions have not been widened to include VCC transactions; and
- Documentation. The VCC Definitions assume that parties have entered into an ISDA Master Agreement, whether full-fledged or in long-form. Certain parties would also collateralise their transactions (including by potentially posting the Relevant VCCs as collateral). To date, the template ISDA Credit Support Annex / Deed has not been widened to specifically permit VCCs being delivered as eligible collateral.
These aforementioned issues are by no means insurmountable. Reed Smith would be delighted in helping you document your VCC transactions under the ISDA framework.