By Matt Egerton-Warburton, Partner

Mills Oakley is active in the Australian Carbon Market advising landholders, Carbon Service Providers (CSPs), financiers, traders and other participants.

Introduction – the Carbon Market

When you reduce carbon emissions on farm and sequester carbon in soils and vegetation this has significant benefits for both the landholder and the environment.

The Australian Government, through the Clean Energy Regulator (Regulator), has established a market to support these efforts and reward landholders for positive carbon stewardship by providing Australian Carbon Credit Units (ACCUs) to landholders who emit less carbon or sequester carbon in their land.  Each ACCU represents one tonne of carbon dioxide equivalent (tCO2-e) of emissions stored or avoided by a Carbon Project.

These ACCUs can either by used as farm “inset” credits (to offset a farm’s emissions) or they can be sold to governments and third parties as “offset” credits (to offset the third parties’ emissions) as Australia pushes towards Net Zero by 2050.

While there are potential environmental, productivity and financial benefits for landholders who establish carbon projects, these benefits can be squandered by landholders who agree sub-optimal contracts with Carbon Service Providers (CSPs).

In worse case scenarios, bad contracts can lead to disputes and litigation as landholders struggle to sell land burdened by bad carbon project agreements or change how they manage their properties.

Carbon Service Providers and Carbon Project Agreements

To establish a Carbon Project, landholders typically enter into legal agreements with CSPs (Carbon Project Agreements).  Under these agreements the CSP will typically:

• provide advice on which method to use (the Regulator accepts a broad range of methods to reduce or sequester carbon including soil carbon, cool burning, tree planting, etc);
• conduct a feasibility study to determine whether it is worthwhile conducting the project;
• conduct a baseline survey (a reference point against which net-emission levels will be assessed);
• provide a template or guidance on the Land Management Strategy the landholder must submit to the regulator (to establish how the landholder will manage their land differently – the “newness requirement”);
• submit the Land Management Strategy, baseline survey and other paperwork to the Regulator to establish a Carbon Project;
• monitor the Carbon Project for compliance with laws; and
• assist third party auditors to certify how much carbon has been sequestered or reduced once the project is established.

CSPs are typically paid for these services either in cash or ACCUs or a combination of both.

Some CSPs also seek additional exclusive marketing and trading rights over all ACCUs generated by the Carbon Project over the life of the project.

Carbon Projects and Permanence Obligations

Within the first five years (depending on the method chosen), Carbon Projects are audited.  When carbon is sequestered or less carbon is emitted over and above the baseline survey, the Regulator issues ACCUs.

When ACCUs are first issued, the Regulator places a “permanence obligation” on the land, which runs with the land. This obligation requires the landholder to store this amount of carbon on their land for either 25 or 100 years (depending on the length chosen for the project).

Prior to the placement of a permanence obligation on the land the landholder can cancel their Project with little regulatory consequences (although there may be contractual consequences under the Carbon Project Agreement).

After the permanence obligation has been placed on the land, a Carbon Project can only be cancelled if the same number of ACCUs issued by the Regulator for the Carbon Project are returned to the Regulator.

If a landholder has sold or given away their ACCUs and they want to cancel a Carbon Project at some stage in the future, they will need to go into the market and buy that same number of ACCUs (at whatever market price).

Different Business Models – Buyer Beware!

There are a wide range of CSPs (over 25 and counting), with significantly different business models and legal agreements (there is no standard contract).

To avoid signing a sub-optimal contract for 25 or 100 years, landholders need to carefully choose the right CSP with the right contractual terms.

There are three basic business models:

1. Fee for service – landholders pay CSPs cash to conduct the service and landholders receive all ACCUs generated by the Carbon Project (with no obligation to provide any ACCUs to CSPs);
2. ACCU income stream – where CSPs receive all the ACCUs and agree to provide the landholder with a conditional income stream when the CSPs sell the ACCUs (the income may be an agreed fixed price per ACCU or an amount linked to the market value of ACCUs); and
3. ACCU sharing – where CSPs and the landholder share the ACCUs generated. Typically CSPs seek between 5% to 30% of ACCUs.

Landholders should seek legal advice before entering these arrangements. Some CSPs operate complicated legal and financial models which seem designed to provide maximum financial benefit and legal protection to the CSPs and their financial sponsors.

Signing a sub-optimal Carbon Project Agreement may:

• lower the value of a property;
• provide restrictions on how landholders manage their land;
• prevent landholders from being able to use ACCUs as security for loans;
• make it difficult for landholders to prove they run a ‘carbon neutral’ operation;
• result in landholders having to buy ACCUs later for a much higher price; and
• lead to ACCU price upside going to a third party (and not the landowner who generated the ACCUs).

Carbon Project Agreements can and should be negotiated to ensure landholders are protected and receive the reward for their efforts to sequester or emit less carbon on their land.

Six Key Issues and Risks in Carbon Project Agreements:

1. Who is the Project Proponent?

The Project Proponent is the person (or company) that is responsible to the Regulator for carrying out the Carbon Project. The Project Proponent receives ACCUs in their name (in an Australian National Registry of Emissions Units (ANREU) account). The Project Proponent can be the landholder or the CSP.

Most Carbon Project Agreements drafted by CSPs seek to establish the CSP as the Project Proponent. It is argued this lessens the regulatory and legal risks for landholders.  While this is technically true, these obligations and liabilities are then reciprocated in the Carbon Project Agreements, so risk remains with the landholder.

There are significant legal benefits for landholders if they are the Project Proponent and receive ACCUs in their name. Landholders can then appoint CSPs as their agents to act on their behalf to manage their Carbon Project with the Regulator.

2. Ownership of ACCUs

Having legal ownership of ACCUs is important as an owner of ACCUs can:

• use these assets as security for loans; and/or
• choose:
  • whether they sell their ACCUs (they may need them for their business in the future – buyers of farm products may seek to buy from ‘carbon neutral’ farms);
  • to whom they sell their ACCUs (they may want to avoid selling their ACCUs to certain parties);
  • when they sell their ACCUs (to time the market or climatic conditions); and
  • at what price they sell their ACCUs.

Landholders should be cautious and conservative before they transfer any ACCUs to third parties (as this increases the complexity in managing and selling their land). If a landholder is the sole owner of ACCUs generated from their property they can:

• change how they manage their land without being answerable to a third party owner of ACCUs; and
• choose to cancel the Carbon Project – by handing back all their ACCUs to the Regulator.

3. Timing the Carbon Project commencement

Landholders should always seek to sequester carbon or emit less carbon but they can be strategic about when to conduct and submit their baseline survey.

Studies show a leading factor in carbon sequestration in soil is rainfall. It may be judicious for a landholder using the carbon soil method to wait until carbon levels naturally drop in their soil during dry periods before submitting a baseline survey.

4. Land management conflict and restrictions

If landholders provide a percentage of ACCUs to a CSP under a Carbon Project Agreement a conflict of interest develops between the landholder and the CSP.

The CSP is incentivised to encourage the landholder to manage their land to maximise the production of ACCUs whereas the landholder will want to manage their land for profit and long-term value (which may not prioritise ACCU generation).

In most Carbon Project Agreements drafted by CSPs, landholders are not allowed to change their land management techniques without express written approval from the CSP.  This restriction may well lead to substantial litigation in the future.

Landholders should negotiate their Carbon Project Agreements to maintain maximum choice and control over how they manage their land.  ACCUs should be a by-product of good land management, not the sole aim.

5. Selling Land and Novating the Carbon Project Agreement

The existence of a sub-optimal Carbon Project Agreement significantly detracts from the value of a property and may impact land saleability and value.

In most Carbon Project Agreements drafted by CSPs, landholders are barred from selling their land until the purchaser agrees to accept the novation of the Carbon Project Agreement – the new owner of the land must ‘step into the shoes’ of the selling landholder and accept all their obligations and liabilities under the contract.

In circumstances where a potential purchaser of land does not want to accept the novation of a Carbon Project Agreement either: (i) the buyer walks away; (ii) the seller attempts to renegotiate the Carbon Project Agreement with the CSP; or (iii) the seller has to buy ACCUs in the carbon market so they can cancel the Carbon Project. All of these scenarios create legal and financial difficulties at a difficult time.

We have provided advice to a land purchaser who bought land and accepted the novation of a particularly egregious Carbon Project Agreement without review or legal advice. The purchaser regretted that novation and sought our advice to rescind or amend the contract. Unfortunately the purchaser’s point of leverage was prior to accepting the novation of the contract and, as a result, they were unable to achieve a good outcome.

Landholders should negotiate their Carbon Project Agreements to incorporate options that allow future sales of the land without the need for a novation.

6. Who controls the sale of ACCUs?

When choosing CSPs, landholders often seek experienced soil scientists and ecologists.  However, many Carbon Project Agreements include additional clauses that grant CSPs exclusive sale and marketing rights for ACCUs produced by the Carbon Project.  These clauses provide CSPs with the exclusive right to sell ACCUs owned by the landholder at a price and time controlled by the CSPs over the life of the contract (which can be 25 or 100 years).

So while landholders believe they are contracting for scientific and ecological services they are often also contracting for commodity trading and brokerage services.

Since it is unlikely that persons who are good at establishing a carbon project (ecologists and engineers) are also expert in trading commodities (buying and selling ACCUs), landholders should consider deleting these additional sales and marketing clauses.

As it is unclear how the market for ACCUs will develop or who will be skilled at trading these assets, landholders should reserve the right to choose who is best placed to sell their ACCUs in the future (if they want to sell them).

Another risk with these clauses is that if a CSP has control over when it can sell ACCUs and to whom and at what price, they may conduct a sale that does not maximise value (potentially to a related party or as part of another transaction).

Seven Key Recommendations:

1. Assess project viability and introduce forecast accountability

Before committing to a Carbon Project, landholders should conduct a feasibility study (potentially by an independent fee-for-service entity not interested in being a CSP) to determine whether their land is suitable and likely ACCU generation.  Not all carbon projects are viable and some projects have been undertaken on the basis of inflated carbon sequestration projections.

Landholders can make CSPs accountable for their forecasts by making a portion of their payment dependent on these forecasts being reasonably accurate.

2. Flip the script – take control of the process

As there are over 25 CSPs in Australia, landholders have considerable leverage to choose the right CSP, at the right price and on reasonable terms.

There is no reason landholders need to be passive ‘price takers’ – they can flip the script and take control of the selection process by tendering out this service like any other normal service on land.

Landholders can conduct a processes in which their lawyers send out an “RFP” (request for proposal) and term sheet to eligible CSPs.  Under this process the parties contract using landholder friendly Carbon Project Agreements drafted by the landholder’s lawyers.  This process should result in better choice and terms and it will save landholders time and money in negotiating and amending CSP friendly contracts.

3. Pay in cash

If landholders want to establish a Carbon Project, and they have the finance available (or cheap “Green Loans”), they could choose to pay cash to CSPs so they retain all the ACCUs (like most service agreements), at least until they see how the project and the ACCU market develops.

If landholders want to pay using a mixture of cash and ACCUs, CSPs should only receive ACCUs if they perform their service to certain standards and hit certain benchmarks.

4. Own the ACCUs

When landholders own their ACCUs they have better flexibility to manage issues in the future. Owning ACCUs allows landholders to:

• maintain a certain amount of ACCUs to offset their carbon production – so the producer can be “Carbon Neutral” or “Net Zero”;
• use these assets as security for loans;
• pick and choose when to sell these units and how many to sell (at present, no one knows how many ACCUs a landholder will need to retain to be carbon neutral);
• cancel a Carbon Project in future without having to buy ACCUs in the market (if landholders want to manage their land differently or a future potential buyer does not want to receive the novation of a Carbon Project Agreement);
• receive the financial upside for improving their land – not grant that upside to some third party.

5. Minimise or eliminate land management and sale restrictions

While CSPs have a role in encouraging and assisting landholders to sequester carbon, these agreements should provide landholders with flexibility to:

• change how they manage their land; and
• selling their land in the future without having to novate the Carbon Project Agreement.

6. Consider separate contracts for separate tasks

There are a number of services landholders require for a Carbon Project:

• feasibility study (agricultural economists);
• baseline testing (scientist);
• assistance with the Land Management Strategy (to remediate the property) (consultant/engineer/ecologist);
• regulatory compliance (compliance officer); and
• trading ACCUs (commodities trader).

It is unlikely a CSP has all these skills – under most Carbon Project Agreements, CSPs typically reserve the right to sub-contract these skills to third parties.

Landholders may choose ‘horses for courses’ – and contract with different service providers for different tasks. There is no legal requirement for one “umbrella” arrangement.

7. Anticipate that some CSPs will not perform and may go out of business

As with any service provider you need to be able to replace non-performing persons.

Carbon Project Agreements with CSPs need to allow landholders to terminate non-performing CSPs with minimal consequences.

Carbon Project Agreements should also be amended so a landholder is protected if CSPs go out of business.

Matt Egerton-Warburton was interviewed by Jackson Hewett and James Wagstaff on The Australian Ag Podcast about these issues and risks, listen here.

Matt also conducted a webinar with the Carbon Farming Foundation on this issue, read more here.