Risks in the Climate Finance Markets

by Michael Newman (Parhelion Underwriting Inc./Biofuels Digest) Risks often act as barriers to investment and trading in the climate finance market – the systems designed to reduce greenhouse gas emissions such as the Renewable Fuel Standard (RFS), California’s Cap & Trade and Low Carbon Fuel Standard (LCFS) – because Federal and State programs have created areas of uncertainty. The risk of invalidation of credits and the political pressures that threaten to repeal the legislation worry market participants – but insurance risk capital can be used to mitigate these concerns and in fact already works successfully in several markets. One example of this is in the California program, where “buyer liability” has created a price differential between carbon offsets depending on the level of risk associated with them. By removing this risk from both offset buyers (typically refineries and utilities) and sellers (project developers), insurance adds certainty to the market because it’s a guarantee with investment-grade A+ security.

Similar solutions are available in Federal RFS and State LCFS markets, allowing refiners, producers, marketers and other parties that assume RIN invalidation risk in sales contracts to offer clear title. For refiners incurring significant RFS compliance costs as regulated parties, RIN insurance reinforces their due diligence programs at relatively small additional expense. For biofuel producers, using insurance adds liquidity to the market, leveling the playing field and facilitating deals that might not otherwise be possible.

But the role of insurance in Climate Finance Market isn’t limited to the risk of invalidation and revocation. Buyers of long-term, fixed price offtake of RINs and LCFS credits often look for a “reg out” clause – they want to be able to cancel their purchases of RINs if the RFS2 or LCFS is repealed.

The revenue generating capability of many renewable fuel facilities would be negatively affected if one of these programs is eliminated, but if both happened to be eliminated at the same time it would mean certain death to the industry – so we have created a pool of insurance capital that underwrites the continued existence of the RFS and LCFS markets.

The EPA has prosecuted millions of US$ worth of fraudulent RIN transactions, yet fraud continues to be a significant risk – and it’s a risk that is not covered by standard property and liability insurance policies; neither are RINs considered “goods” under the Uniform Commercial Code (UCC), so the Code’s warranty provisions do not apply.

Only about 12% of all RINs are Q-RINs because the process is expensive and numerous administrative steps are required for any party replacing RINs, claiming an affirmative defense to an alleged civil violation, requesting corrective action, and notifying EPA of the existence of a potentially invalid RIN (PIR) – so market participants have relied on other risk management strategies: only purchasing RINs from parties who have long established and trusted trading relationships; implementing their own auditing processes or only purchasing ethanol-based RINs. This development hurt smaller renewable fuel producers and reduced the RIN market’s overall liquidity.