Trinity Topics: Carbon Offsetting through Project Financing: The Mechanics of Pre-Purchasing Carbon Credits
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As part of the global effort to combat climate change, carbon offsetting has become a crucial tool for mitigating greenhouse gas emissions. One increasingly popular mechanism for supporting decarbonization initiatives is the pre-purchase of carbon credits — a model that allows organizations to finance emission reduction projects while securing offsets for their own emissions. This approach has gained traction as entities seek innovative ways to meet their sustainability targets while also contributing to global decarbonization efforts.
At Trinity, we are actively engaged in carbon market transactions, including structuring projects where the pre-purchase of expected carbon credits plays a key role in project financing. We have been involved in many such transactions, advising both sponsors and financiers.
Decarbonization initiatives cover various types of mechanisms aiming at the removal, limitation, reduction, avoidance or mitigation of
greenhouse gas emissions, including for instance renewable energy installations, forestry projects (reforestation and afforestation), enhanced fuel-burning solutions (such as improved cookstoves) or soil- or earth-based solutions (biochar being an example). These initiatives, when structured in a certain manner, are eligible for carbon credits issued by recognized bodies (such as VERRA, Gold Standard or Puro.earth), who verify and certify the projects. The carbon credits issuance process involves rigorous validation and monitoring to ensure the credits are based on measurable and additional reductions beyond a business-as-usual scenario. Each of these bodies also organize trading markets for the carbon credits.
In this article, we explore the mechanics of pre-purchasing carbon credits, detailing its role in structuring financing solutions and examining the Verified Emission Reduction Purchase Agreement (VERPA), the fundamental legal instrument governing these transactions. The developments herein are limited to credits eligible to the voluntary carbon markets (as opposed to the regulatory market).
Structuring Project Financing through Carbon Credit Pre-Purchases
How does the pre-purchase of Carbon Credits differ from typical Project Financing?
The pre-purchase of carbon credits differs significantly from traditional project finance. Conventional project financing typically relies on the operational revenues of the project itself, with lenders evaluating cash flows, revenue projections, and debt repayment structures. In contrast, pre-purchase transactions hinge on the anticipated future value of carbon credits, making them more speculative in nature. Investors engaging in these transactions are often motivated not by direct financial returns but by the ownership of carbon credits, which investors can use for compliance, voluntary offsetting, or future resale.
This model introduces unique legal, tax, and regulatory considerations. Unlike traditional loans, pre-purchases do not involve repayment with interest but instead require the delivery of carbon credits upon issuance.
Consequently, such transactions are by their nature more complex, requiring careful evaluation of risks associated with project development, regulatory compliance, and market fluctuations in carbon credit pricing.
Tax and Regulatory Considerations
The tax treatment of carbon credit transactions varies by jurisdiction and can include value-added tax (VAT), income tax, and other levies. Some jurisdictions impose specific financial contributions on carbon credit revenues, necessitating thorough tax planning when structuring these transactions.
Given the cross-border nature of many decarbonization projects, tax treaties and transfer pricing regulations must also be considered to ensure compliance and ensure tax efficiency.
Regulatory frameworks governing carbon credits differ widely. Some jurisdictions classify carbon credits as financial instruments, while others treat them as commodities or intangible assets. In certain cases, the legal status of carbon credits remains undefined, leading to uncertainties regarding ownership rights, enforceability of contracts, and transferability across markets.
Additionally, some countries impose restrictions on foreign ownership of carbon credits, particularly in forestry-based projects, or require government approvals for their transfer. Compliance with local environmental laws, permitting requirements, and land ownership regulations is another critical factor in ensuring project viability.
Getting legal and tax advice early is key. Leveraging on its expertise, Trinity is able to assist its clients in navigating these tax and regulatory hurdles.
Structuring for Control, Ownership and Security
A fundamental challenge in structuring carbon credit pre-purchase transactions is ensuring that credits are issued to the appropriate entity.
Carbon credit standards generally recognize the “project proponent” rather than the ultimate owner as the recipient of issued credits, which can create complications when project sponsors operate through locally incorporated special purpose vehicles (SPVs) and/or with the support of other players in connection with the physical implementation of project development actions. Indeed, the “project proponent” is generally understood as the person or entity responsible for and controlling the development of the project.
To establish effective control and ownership, sponsors often employ complex shareholding structures and contractual arrangements. These structures must be carefully designed to address tax implications, regulatory concerns, and risk management considerations while ensuring that carbon credits are appropriately allocated to the entity receiving the financing from financiers or other intended recipients.
Moreover, another structuring item to be taken into account is the ability of the financier to obtain security to guarantee the value of the disbursed sums, e.g. by taking security over the project’s underlying asset (e.g. land or plant), the SPV’s shares or certain cash flows, and/or ensuring that it may direct or control transfers of ownership of the carbon credits issued in connection with the project.
We have assisted our clients in ensuring structures are aligned with these principles in various jurisdictions and continents.
The Verified Emission Reduction Purchase Agreement (VERPA): A Key Legal Instrument
Legal nature and purpose of a VERPA
A VERPA is a contractual agreement governing the pre-purchase of carbon credits. Unlike a loan agreement, which requires repayment with interest, a VERPA is a purchase agreement under which the financier provides upfront funding in exchange for the future delivery of carbon credits. This distinction is crucial in determining the rights and obligations of each party.
For the seller, typically the project developer, the VERPA provides necessary capital to advance the project, secure certifications, and fulfil monitoring requirements.
For the buyer, the agreement ensures a committed supply of carbon credits, often at a preferential rate, allowing them to meet offsetting goals or capitalize on potential value appreciation in the carbon market.
Key Provisions of a VERPA
Trinity has been increasingly advising on the drafting and negotiation of VERPAs, thus sharing with clients its experience of the fundamental provisions of these agreements.
Qualitative and quantitative determination of the carbon credits to be transferred
One of the most critical components of a VERPA is the definition of the carbon credits being sold. The agreement specifies the standard from which credits must be issued, such as VERRA, Gold Standard, or Puro.earth.
Additionally, the VERPA outlines the quantity of credits to be delivered. This can be structured as a fixed amount or as a percentage of the project’s total generated credits (minus a buffer that is required to be delivered to the standard issuing the credits itself), with provisions for overperformance or underperformance scenarios. In addition, the VERPA may provide for thresholds or caps, to limit the variation (upwards or downwards) of carbon credits that may be delivered.
Pricing and payment structure
Pricing and payment structures in VERPAs differ from standard carbon credit purchase agreements. Instead of pricing credits per unit, a VERPA typically establishes a total purchase price in advance.
Payments may be structured as lump-sum disbursements or staggered instalments tied to project milestones, ensuring that funds are released in a manner that aligns with project development needs.
Undertakings of the seller
The seller’s obligations under a VERPA include securing necessary certifications, adhering to rigorous monitoring and reporting requirements, and implementing actions necessary for timely credit issuance. These commitments are essential to mitigating risks associated with project underperformance, regulatory non-compliance, or credit issuance delays.
Conclusion
Pre-purchasing carbon credits through VERPAs represents a sophisticated intersection of environmental, financial, and legal considerations. This model provides an innovative means of financing decarbonization initiatives while enabling investors and corporations to secure carbon offsets in advance.
The complexities associated with tax treatment, regulatory compliance, and contractual structuring necessitate careful planning and expertise. Trinity is equipped with the corporate, financing, regulatory and tax capabilities that allow us to provide our clients with a tailor-made assistance on these transactions.
At Trinity, we believe that by leveraging VERPAs effectively, organizations can align their financial strategies with sustainability objectives while facilitating the development of impactful emission reduction projects.
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