Carbon Credits and Insurance

Abstract

Greenhouse gas (GHG) emissions regulation is expanding worldwide with the implementation of new cap and trade systems and the development of existing ones.

The EU Emissions Trading Scheme (ETS) sets a cap on GHGs emitted by energy-intensive industries in the EU. Emissions beyond that cap must be compensated for either by paying penalties or by purchasing carbon credits in the form of EU Allowances or carbon “offsets” obtained from Kyoto Protocol-based Clean Development Mechanism (CDM) or Joint Implementation (JI) projects.

Until recently, companies have received more allowances than they needed. This will change with Phase 3 of the ETS (starting in 2013): fewer allowances (a majority of which will be auctioned rather than granted for free), fewer admissible types of offsets and new sectors involved. Carbon credit prices are expected to rise as a result.

Carbon-related costs are treated as production costs which companies typically retain and reflect in their business decisions. Volatility risk can be hedged through flexible price clauses in sales agreements and through financial products available from the carbon markets. Companies have therefore seldom sought to transfer any carbon risk to insurance.

Whilst increasing efforts and capital are dedicated to reducing energy costs, companies face new risks with more restricting compliance requirements.

Firstly, industries can suffer a Business Interruption loss following the failure of (or damage to) a production unit. Loss mitigation efforts may involve the temporary use of less energy efficient spare units (and the fuel they use) which may trigger the need to purchase carbon credits to make-up for the increased emissions so caused. Such additional costs are generally covered under the Increased Cost of Working section of conventional PD/BI policies.

Secondly, companies involved either as owners, developers, financiers or investors in a CDM/JI project all face the risk of non (or late) delivery of carbon offsets which can be due to a wide spectrum of risks such as climatic, technologic, political, credit, insolvency and/or regulatory.

Coverage for “non-delivery” risks can be found with several insurers however sales, if any, have been very limited to date. Insurers have also failed to attract the necessary levels of insurance capacity that such projects require. Sales are expected to improve, albeit a at a slow pace, with the economic recovery and more restrictive cap and trade rules.

Regulatory risks are a major area of uncertainty for CDM/JI stakeholders. Most insurers believe there is no meaningful data to assess them. In 2010, the UN Emissions Board postponed the delivery of more than half of the offsets generated by CDM projects worldwide. Price volatility is also a sensitive risk. It can be covered subject to a cap (as is the case in other risks involving commodities).

Current policy wordings must address the specificities of carbon credits (focusing particularly relating to loss valuation and mitigation) failing which contractual disputes will inevitably arise.

Key words

Business Interruption; Cap and Trade Scheme; Carbon Credit; Carbon Credit Non-Delivery Insurance; Clean Development Mechanism; Increased Cost of Working (ICW); European Union Emissions Trading Scheme (EU ETS); Greenhouse Gas Emissions (GHG emissions); Insurance; Kyoto Protocol; Regulatory risks; Volatility risk.