Credit Risk
Contracting procedures for emissions trades are surprisingly standardized and
simple. Liability concerns for emissions trades under the U.S. Acid Rain Program are
low. Nonetheless, there are liabilities you should consider.
The emissions trading system dictates that, while allowances are granted by the government, there is no guarantee provided by regulators as to the ability of the seller to provide these credits. Therefore, the onus is on the buyer to determine the credit worthiness of the seller. Credit worthiness can be measured by credit rating agencies, such as Standard & Poor's, DCR, or Fitch IBCA. Often this is determined before choosing a counterparty for a bilateral trade, and an emissions trading practitioner working through a broker can stipulate that bids and asks should only be considered for counterparties meeting its pre-established credit criteria. In any case, credit risk is directly addressed in the contracting phase of the transaction.
Standard Contracts
In the SO2 market, the contracting process is a relatively standard affair. In fact,
the contracts used in almost all emissions trades these days bear a striking resemblance
to each other. The Emissions Marketing Association (EMA) has even produced a
sample contract which is just a few pages long, which can be downloaded from its Web site
for use in transacting trades (http://www.emissions.org).
Despite the standard nature of the documentation, contracting parties must still keep an eye out for basic trading issues. Foremost is the ability of your counterparty to come through with their end of the deal, whether it be providing cash for your allowances or allowances for your cash.
In most cases, contracts will contain provisions protecting against the default of either counterparty. Their ability to pay is often measured by credit rating agencies. These independent assessments are often incorporated into the contracting process. Contracts commonly use protections, such as: setting up lines of credit (LOCs) to back the transaction; gathering guarantees from a counterparty's parent company; or securing recourse to the parent company.
Once the contract has been executed, it is time to let the allowances and the cash change hands. Typically the seller of allowances will deliver an Allowance Transfer Form (ATF) to the buyer. This is a standard EPA document that confirms the movement of allowances from one account to another. The buyer will then fill out the ATF and forward it to the EPA, which will input the information in its tracking system. Cash or other payment for an immediate settlement transaction is usually made within three business days of an electronic or written confirmation by the EPA that the contracted allowances have been transferred in the ATS. EPA is moving toward electronic transactions rather than paper transactions.
With regard to the administration requirements for an allowance trading system, the Handbook has focused on the mechanics of opening allowance accounts and transferring allowances. These requirements apply to everyone participating in the market, not just the regulated industry. Of course, companies with compliance obligations under the U.S. Acid Rain Program are also responsible for filing other forms and reports with EPA. For more information on these requirements, see the Acid Rain web site at: http://www.epa.gov/acidrain.
For more information check these Web addresses:
http://www.standardpoor.com/
http://www.dcrco.com/
http://www.ibca.com/
http://www.emissions.org/