Corresponding Adjustments and Political Risk and Insurance, Oh My!
With some similarities to Dorothy being dropped into the unfamiliar land of the Wizard of Oz, so too are the carbon markets entering the world of Political Risk Insurance (PRI).
The Kita team has spent significant time over the last year working collaboratively with both carbon market and insurance industry stakeholders to understand evolving requirements and build bridges between the two sides, with the aim of developing suitable carbon market-specific PRI policies.
Here we provide a high-level explainer of: (i) why PRI is currently a hot topic; (ii) what PRI traditionally is; and (iii) challenges and opportunities for where PRI can help the carbon markets.
We also highlight a potential concern – insurance companies in the PRI space may be unlikely to deploy capital at scale into insuring carbon projects unless they feel secure in the strength of the underlying contracts with the host government. We cover why this is and potential fixes.
Please do not hesitate to get in touch with our team if you would like to discuss this in more detail. Not only do we know carbon markets and insurance, but our team also has long-standing political risk expertise that is highly relevant here.
Why is PRI a hot topic?
Political risk itself is not newly identified to the carbon markets (e.g. see here), and as noted above, the Kita team has focused on this space for over a year. However, the increased levels of interest are due to a new development that more explicitly stipulates the requirement for insurance.
The abbreviated summary...
From 5 February to 4 March 2024, The Technical Advisory Body (TAB) of ICAO invited crediting programmes to apply for assessment against the CORSIA Emissions Unit Criteria to supply CORSIA Eligible Emissions Units for the 2024 – 2026 compliance period (first phase). Following the submissions, several crediting programmes were listed as “Conditionally approved”, leading to ICAO receiving eight material updates, submitted by April 30, 2024.
Aspects of the conditional approval related to the scenario in which a host country were to either revoke its Article 6 authorisation or fail to apply a corresponding adjustment, leading to a potential ‘double-claim’ scenario. Thus, the crediting programmes were asked to strengthen how they dealt with this risk, including providing evidence of how project owners could “legally commit” to replace double-claimed mitigation. In recognition that insurance is one aspect of how this could be done, the material updates – particularly those by Verra and Gold Standard – outlined insurance specifically as a form of solution (others do as well, e.g. ACR here).
For example, from Verra’s “VS Program Change Notification, April 30th, 2024” (full doc here; our emphasis in the below bold text):
“Section 4.2 of the CORSIA Labels Guidance, v1.0, sets out forms of assurance of compensation that Verra accepts in cases where the Article 6 authorization label has had to have been removed. The strongest assurance is given where it is demonstrated that the host country has already applied a corresponding adjustment covering the mitigation outcomes represented by the VCUs. However, it will take some time for the market to have a supply of VCUs that have already been correspondingly adjusted, as this requires countries to authorize VCUs with first transfer events specified as authorization or issuance, as well as sufficient time for countries to report the associated corresponding adjustments to the UNFCCC.
The second form of assurance is a CORSIA Accounting Representation which commits that VCUs used for CORSIA that are not correspondingly adjusted will be compensated. The representation may be provided by the project proponent, buyer, or another entity. Verra requires a certificate of insurance with a Verra-approved corresponding adjustment risk insurance product to underpin the representation.”
When faced with a requirement to provide legally secure and binding commitments to replace units, market stakeholders will look to reputable counterparties who have sufficient credit rating and financial resources to cover the costs.
This is the insurance industry.
What is PRI and what does it do?
PRI is a long-established insurance market, geared to help businesses mitigate and manage risks arising from the adverse actions—or inactions—of governments. The aim is to provide a more stable environment in which to do business, thus enabling greater investment and scale by cushioning the impact of unpredictable and potentially sizeable losses.
Examples of traditional PRI include:
Confiscation, expropriation and nationalisation: for example, a country taking ownership of the underlying assets without providing fair and adequate compensation or restricting a company’s ability to exercise its rights in respect of an asset.
Contract Frustration: for example, loss under a specified contract directly due to a political force majeure event (e.g., strikes, civil war or invasion) and/or an event resulting from the action of a supra-natural authority or government entity.
Forced abandonment: for example, being advised or forcibly required to evacuate from the country in which the asset is held.
License cancellation and breach of contract: for example, a country breaching its contractual commitment regarding the project, leading to a loss.
Political violence: for example, war, terror or civil unrest within the country that leads to cessation or disruption of operations.
Selective discrimination: for example, a tax applied only to specific projects or countries (NOTE: governments are free to legislate, thus PRI will not traditionally cover a government’s decision to implement a tax across all projects in a market)
For more information, please see here.
One important point to note is that PRI linked to breach of contract will often follow Arbitration Award Default – meaning that after the relevant state entity breaches its contractual commitment(s), this may lead to arbitration, where provided in the relevant contract. In cases where the applicable state entity loses the arbitration and still fails or refuses to honour the terms of the arbitration award, then the prevailing party (the Insured) may be entitled to receive an insurance claim payment from the PRI insurer covering the cost of the arbitration award (up to a pre-agreed limit of indemnity).
Opportunities and challenges for PRI within the carbon markets
PRI is well placed to: (i) help the carbon markets mitigate the risks associated with correspondingly adjusted credits; and (ii) protect anyone investing in/operating in politically-uncertain environments (interesting fact – this year, more than 70 countries, representing half of the global population and 55% of global GDP, are holding elections).
However, as with anything, there will be both opportunities and challenges as PRI is incorporated into carbon markets.
Opportunities:
Traditional PRI covers listed above are relevant to carbon markets and translate well to carbon projects.
Political risk insurers will already be comfortable with many of the countries in which carbon projects are based.
“Breach of contract” works well for the specific risk in question where carbon credits that are not correspondingly-adjusted will be compensated, as the underlying reason for this lack of corresponding adjustment is likely to stem from a host country’s failure to comply with the rules of the Letter of Authorisation (LoA) and wider terms of the investment agreement (the “Project Development Agreement”). “Contract Frustration” may also work well in this scenario when the LoA can be viewed as a formal contract. [NOTE – for the sake of brevity, in this blog we are using “breach of contract” as a catch-all for any form of contract revocation, however within the technical world of PRI these terms do carry defined meanings and uses. The Kita team would be happy to talk through the nuances with interested readers.]
Working with carbon insurance specialists such as Kita, it is possible to bridge the information and understanding gap between PRI and carbon markets.
Challenges:
In the near-term, insurance capacity will be constrained as this is a new and evolving space. For project developers and investors who wish to access this insurance, it will be first come first served at the outset.
To increase PRI capacity (i.e. the amount of insurance cover available to market participants), insurance companies will expect certain contractual prerequisites to be met, particularly in relation to the breach of contract (and thus, protection for the corresponding adjustment risk). Note that a contract cannot be “breached” if it wasn’t legally binding in the first place.
Insurance companies in the PRI space may be unlikely to deploy significant amounts of capital into insuring carbon projects unless they feel secure in the strength of the underlying contracts with the host government. This is such an important point that we provide further elaboration below.
Contractual prerequisites for PRI at scale:
As noted above under the “What is Political Risk Insurance” section, PRI linked to breach of contract generally follows Arbitration Award Default (AAD).
This means the standard expectation for PRI (i.e. the billions of insurance that is currently deployed for wider markets around the world) is, following a government breaching/revoking a legally binding contract, the insured party should have the option of resorting to arbitration against the relevant state entity.
When the arbitration award is in favour of the insured party, and the relevant state entity fails or refuses to honour such award, the insurance claim follows. Costs and expenses incurred during this process may be covered by the insurance, which in the instance of carbon credits could include the amounts contractually due under a pre-agreed forward contract, for example as required to source adequate replacement carbon credits.
Thus, to enable market stakeholders to benefit from AAD coverage, the Project Development Agreement should constitute a legally-valid, binding and enforceable agreement with the relevant state entity(ies) under the laws of the Host Country, and should encompass the terms of the applicable LoA. To emphasise the point made in the previous section, a contract cannot be breached if it is not legally binding in the first place.
Here is an example wish-list of a Project Development Agreement:
It constitutes a legally valid, binding and enforceable agreement with the contracting entity(ies) of the host government, under the laws of the host country. This may require legal opinion from local counsel as to the validity and enforceability of its terms;
It contains clear governing law and dispute resolution provisions, including rights of recourse against the host government via arbitration. It must also clearly set out each party’s obligations and specify the grounds for termination;
It refers directly to the LoA, and clearly outlines the circumstances under which the host government’s non-compliance with its terms constitutes a material breach of the Project Development Agreement; and
The LoA contains the appropriate provisions outlining the host country’s Authorisation with respect to the carbon credits generated by the relevant project.
Conclusion
In relation to carbon markets, PRI coverage can be considered as splitting into broadly two categories (both of which can be covered in the same insurance policy):
Risks that are not related to a LoA, e.g. Expropriation; Deprivation; Political Violence; Forced Abandonment; Forced Divestiture; Selective Discrimination. The risks under this category extend more broadly to actions taken by the host government specifically targeting the carbon project, causing the disruption or cessation of operations.
Risks that are related to the LoA and wider Project Development Agreement between the insured party and the host government, e.g. breach of contract and thus failing to deliver correspondingly adjusted credits.
We do not see significant challenges with Category 1 for today’s carbon markets.
However, Category 2 is a different story, and it is important as this is the category relevant to the corresponding adjustment risk.
We recognise the challenges inherent in building these forms of legally binding contracts in the market today, however we also believe it is essential if we are to bring in PRI policies at scale. We suggest project developers and investors work closely with experienced legal counsel as they move forward, with the aim of developing standardized LoA templates and wider Project Development Agreement frameworks that satisfy insurance requirements.
Are you ready to explore how Kita’s Carbon Political Risk Cover can help to protect against issues related to Host Country Authorisations?