The Obama administration is committed to pursuing greenhouse gas (GHG) restrictions, a cap-and-trade system for carbon emissions allowances, and incentives for alternative energy. Twenty-seven states and the District of Columbia have already implemented mandatory Renewables Portfolio Standards (RPS) requiring utilities to generate a specified percentage of their supplies from renewable sources, or to comply with RPS by procuring renewable energy credits (RECs). Legislation already has been introduced proposing to implement a Renewable Electricity Standard (RES) that is mostly consistent with the President’s goals. The federal government is contemplating an RES framework that will create a standard currency for renewable energy applicable to various types of commercial use through the country. This in turn would necessitate a competitive federal market for the sale of RECs to renewable energy developers, market intermediaries, and end-users or their load-serving utility.

Creating an REC market

For RECs to be tradable commodities, the RES requirements must accommodate each state’s special RES circumstances while allowing for market liquidity. In one likely scenario, the new emissions allowances will be created under a federal cap-and-trade system for greenhouse gases modeled on the acid rain program launched following the 1990 amendments to the Clean Air Act. Under the acid rain program, most emissions allowances were distributed at little or no cost to regulated industries according to one of several formulas that considered, among other things, each facility’s historic emissions. Similarly, the American Clean Energy and Security Act of 2009 (Waxman-Markey Bill) under consideration by Congress at midyear proposes that a wide range of entities, including electric utilities, oil companies, and large industrial sources, will be allowed to emit GHG emissions subject to a specified cap. That cap will be determined by the number of allowances that an entity has obtained to permit emission of one ton of CO2 equivalent. Emissions allowances will be allocated free of charge as an incentive for covered entities to pursue their clean energy transition.

No market participant can ignore the possibility that political support for a mandatory alternative energy and greenhouse gas reduction program and REC market may vanish if it appears that the political and economic price of these programs warrants a sudden shift in policy. Such changes may not prevent performance or render an REC contract void but can nonetheless alter the parties’ economic expectations severely. It is prudent, therefore, to identify at the time of contract formation how the parties will allocate the burden of intervening regulatory change. Far too often parties entering energy contracts do not allocate who bears the burden of intervening regulatory change and instead devolve into disputes and litigation when confronted with change.

Collapsing an existing market

As an example of the market impact that unforeseen regulatory or legal developments can have, consider the US Court of Appeals for the District of Columbia Circuit’s mid-2008 ruling in State of North Carolina v. Environmental Protection Agency (EPA). That decision held that the EPA framework for limiting the emissions of sulfur dioxide and nitrogen oxide was deeply flawed and thus invalid. Under it, the Clean Air Interstate Rule (CAIR) required 28 eastern states and the District of Columbia to achieve specified emissions reduction requirements and provided states with the option of meeting the standards by requiring emitters (such as coal-fired power plants) in their states to participate in EPA’s cap-and-trade system.

It is common for standardized trading agreements to provide for termination in the event of illegality. An agreement may also be terminated through no fault of either party if it becomes unlawful under an applicable law to make delivery or payment of a product. However, North Carolina v. EPA did not render the sale of emissions allowances unlawful, nor did it render performance of agreements for such products impossible. The decision did, however, significantly impact the value of parties’ contractual expectations. In the year before the court’s decision, the price for the right to emit one ton of sulfur ranged between $600 and $800. After the decision invalidating CAIR, the price fell to as low as $100. In December 2008 the court stayed its termination of CAIR, but the market has not returned to its former valuations, and many contracts affected by the decision did not address how to deal with such an upheaval.

Contract survival mechanisms

The key to surviving regulatory instability and ensuring a durable agreement is to identify the regulatory construct on which contractual expectations rest and then to negotiate the cost of compliance with existing and future requirements. Common sense dictates including a “regulatory change” provision in contracts to prescribe remedies following legal, regulatory, or governmental action that (while not rendering a market illegal) eliminates or alters the value of the underlying product. A contract might expressly state which party bears the risk of regulatory change, or specify that the price fully contemplates compliance with future regulatory duties.

Just as volatile financial market conditions can have unanticipated impact on trading strategies, so too can unexpected regulatory upheavals. The speed and impact of regulatory change on the energy markets increasingly illustrates this fact. This is true for all forms of energy products and will be especially apt for emissions and REC contracts. In the case of RECs, for example, purchasers should ensure that a seller commits to deliver a product that complies at the time of delivery with all the applicable requirements. Another alternative is specifying mediation to agree on respective compliance responsibilities. Requiring good-faith negotiation to reach an agreement consistent with initial expectations before might enable the agreement to survive without the uncertainties and expense of litigation.

Kenneth W. Irvin is a partner in the Washington, DC, office of global law firm McDermott Will & Emery. A member of the firm’s Energy and Derivatives Markets and Global Renewable Energy, Emissions and New Products Practice Groups, he represents clients on federal and state commodity and energy matters, including hedging and credit risks; contract structuring and disputes; arbitrations; and regulatory issues involving energy and commodities trading, market regulation, and structured transactions.