Advancing Climate Action through Forward Financing
Author: Ieva Blazauskaite (Ivy Protocol, Marketing Lead)
We recently met with Ryan Covington and Michael Byrd, co-founders of Skylight Law, who offered their expertise on early-stage carbon credit projects and forward financing. As a leader in the dynamic world of climate tech and climate finance, Skylight Law is helping startups, project developers, and investors to find ways to manage and fund carbon projects more efficiently. Join us as we, guided by Ryan’s and Michael’s invaluable insights, explore the legal intricacies of streaming contracts — and their implications for project developers and investors. We also discuss the essential legal considerations for both parties, highlighting the importance of registries, the role of legal teams, and the potential for a standard model agreement. Finally, we examine the future of the voluntary carbon market, emphasizing the need for collaboration and continuous development of market mechanisms.
One of the biggest challenges that early-stage carbon projects face is limited access to upfront capital needed for implementation and certification. Consider a non-profit organization that is eager to undertake a mangrove restoration or reforestation project. The project developer may have a proven track record of successfully implementing similar projects, and the technical capability to see them through. However, the reality of limited funding can be a significant obstacle to entering the voluntary carbon market, especially for smaller project developers or non-profits that lack the assets to access traditional bank financing. Unfortunately, this means that many project developers find themselves at a standstill, despite their confidence in generating carbon credits through their activities. They have the capacity, passion, and potential to make a positive impact but are held back by the financial constraints that prevent their projects from taking off.
90% of project developers agree that forward products will be key to scaling the VCM.
Forward Financing: A Solution
Forward financing focuses on future, not yet generated carbon credits, setting them apart from traditional carbon credit transactions, which deal with existing, registered, and issued credits, such as offtake agreements. Under an offtake agreement, the project developer agrees to deliver to the investor(s) a certain quantity of carbon credits at a predetermined price by specific dates. For instance, the investor may come into a contract to purchase 10,000 carbon credits, with 5,000 delivered by the “x” date and 5,000 delivered upon the “y” date. The parties will agree upfront on the “z” price that will be paid per carbon credit. Assuming that no hiccups occur, this provides the parties with certainty that the carbon credits transaction will be completed smoothly. However, payment for the carbon credits is made on delivery and is therefore not available to forward finance project development.
In contrast to traditional transactions, forward financing agreements are more prescriptive. They outline specific requirements for project owners to ensure the delivery of the promised carbon credits in the future.
This more detailed approach results in greater complexity and variability in these arrangements, as the contracts must be tailored to accommodate the unique dynamics of each project. However, the benefits of forward financing, such as attractive returns on investment and portfolio diversification, make it an appealing choice for investors looking to support climate action initiatives.
The predominant form of forward financing in voluntary carbon markets (VCM) is a streaming contract. Fundamentally, a streaming contract entails an agreement where the purchaser, or investor, offers upfront capital to a project developer. In return for this initial investment, the investor gains the right to receive a specific percentage or volume of the carbon credits produced by the project over a predetermined period. This strategy enables investors to back early-stage carbon initiatives while securing a consistent revenue stream from the carbon credits. To illustrate this concept, consider an example where an investor provides $1 million upfront to a project developer, and in exchange, they are entitled to receive 30% of the carbon credits generated over the subsequent five years.
Streaming contracts have the advantage of providing upfront funding (or funding over multiple tranches based on the passage of time and(or) the completion of project milestones) at the earliest pre-development stage, enabling project owners to execute their activities. That becomes particularly important as it grants the project developers access to necessary funds in the pre-feasibility stage and helps them to undertake the necessary activities to reach the feasibility stage. In contrast, forward contracts are more likely to be implemented in the post-feasibility stage, as project developers need to be confident they can meet the specific quantity demands stated in the contracts. However, streaming contracts are considered riskier than forward contracts and spot purchases. That is due to uncertainty in the project’s carbon credit volume, the delivery timing, and the possibility that one or more project risks will materialize, diminishing or eliminating the value of the streaming contract.
Key Investor Considerations for Streaming Contracts
In streaming contracts, investors provide upfront capital and receive future compensation — in the form of carbon credits — rather than traditional currency. This structure exposes investors to two main risks. First, the project may fail to generate the anticipated volume of carbon credits or, in the worst case, any carbon credits at all. Second, the value of carbon credits generally or the project’s credits specifically may (at the time of delivery) fall short of expectations.
To navigate this landscape effectively, investors must familiarize themselves with the project development cycle, understand the basics of the specific carbon project, and stay informed about regulatory changes in the industry. Furthermore, they need to assess any potential reputational risks linked to the counterparties or the quality of the carbon credits involved. And lastly — a key concern for investors — is obtaining assurances that their upfront investment will be protected, if the project does not progress as the project developer initially proposed. By addressing critical points, investors can make well-informed decisions and successfully navigate the world of streaming contracts in the carbon credit market.
Three Key Legal Questions for Project Developers
When negotiating streaming contracts for early-stage carbon credit projects — project developers should consider three key legal aspects.
When negotiating streaming contracts for early-stage carbon credit projects — project developers should consider three key legal aspects.
First and foremost, project developers need to ask themselves a crucial question: Can I execute this project? To determine this, it’s essential to evaluate the commitments and responsibilities associated with the project activities. For example, if a developer is committing to restoring 10,000 hectares of mangroves, they should carefully consider their capacity to accomplish this goal. Assess the factors: such as technical capacity, necessary permits and concessions, and land rights. Temporarily setting aside all of the carbon credit considerations, it’s important to honestly evaluate one’s ability to bring the project to fruition.
Second, it’s essential to have the appropriate team and partnerships in place to effectively navigate the processes of project design, validation, registration, verification, and issuance of carbon credits within the required timeframes and guidelines. The project developers need to consider whether they have the right team and the right partnerships to undertake the carbon credit activities. This consideration is particularly relevant for new project developers who might not yet be aware of how many key relationships they need to be able to complete the carbon project.
Third, project developers must ensure they can meet their obligations to the stream purchaser. For example, (if the streaming contract obligates the project developer to deliver a minimum number of carbon credits to investors) — they should ask themselves whether they can deliver the carbon credits as promised and whether they can handle potential consequences if they fail to fulfill their commitments.
The Role of a Legal Team
A legal team can assist project developers by offering them upfront coaching before they even consider negotiating with stream purchasers. This guidance is crucial as it enables the project developers to comprehend the project risk throughout the project’s development and the expectations they will face in negotiations, helping them present a more mature opportunity to potential investors. Without this coaching, PDs may find themselves in a reactive position during negotiations, which is never an ideal situation.
In essence, a legal team can provide coaching and help project developers understand project risk throughout the project’s development. By navigating project risk proactively and staying informed, PDs can effectively manage their transactions and foster successful collaborations with investors.
The Importance of Registries
Project developers must understand the importance of registries. Stream purchasers and investors seek carbon credits issued by approved buyer registries, such as Verra. To meet these requirements, project owners must have a solid team and strong relationships in place, ready to adapt to the constantly changing rules and regulations set by registries. This necessitates that PDs assemble a proficient team and establish strong relationships, enabling them to adapt to ever-changing registry rules and regulations.
Forward financing is gaining traction in the carbon credit market, and it is essential to move towards a model agreement for carbon credit streaming. Currently, the lack of uniformity in investor and project developer expectations presents a significant barrier to these transactions. It is not about creating a one-size-fits-all template but rather, developing an agreement that addresses around 75% of the key structures and risks from both the investor and project developer perspectives, leaving room for negotiations on unique project risks.
Education and consensus in the space are essential to overcome barriers to adopting a model agreement. As institutional investors enter the market, their expectations will potentially push for a more uniform approach. In other industries, such as venture capital in the US and loan markets in the UK, model agreements have evolved based on best practices and transaction repetitions. The voluntary carbon market can learn from these industries by combining concepts from various sectors to create a clear, strong contract that facilitates transactions without unnecessary complexity.
The Future Predictions
Here at Ivy, we believe that the increasing awareness of the climate crisis and corporate sustainability goals will further drive the demand for carbon credits. Innovations in technology, such as blockchain and AI, could also play a vital role in enhancing transparency, reducing transaction costs, and improving the overall credibility of the market.
As the market matures and grows, Skylight Law envisions a future where the maturation triggers a surge in demand for early-stage projects. In other words, as the carbon market matures and becomes increasingly attractive to institutional investors, there will be a noticeable rise in activity on exchanges and marketplaces dealing with existing carbon credits. However, investors will naturally gravitate away from the fully matured and efficient areas of the market, seeking better returns on their investments. To achieve this, they’ll engage in higher-risk activities by providing upfront funding for projects that will issue carbon credits in the future.
However, to reach market maturity, it is crucial to increase collaboration between project developers, investors, startups, platforms, exchanges, and consultants. What is more, the key to success lies in the continuous development of registries, marketplaces, and exchanges that set clear expectations for early-stage projects, ensuring their carbon credits can be issued and traded. By enhancing the most straightforward and transparent mechanisms within marketplaces, the industry players will enable project developers to access capital earlier (as they gain a clearer understanding of the steps required to register their projects and issue carbon credits).
In conclusion, forward financing breathes new life into early-stage carbon credit projects seeking upfront capital. As investors and project developers navigate streaming contracts, it is crucial to consider key legal aspects, the role of registries, and the assistance of legal teams in ensuring successful transactions. The development of a standard model agreement is vital for reducing complexity, and promoting a more uniform approach in VCM forward financing space. By embracing streaming contracts and fostering cooperation, the voluntary carbon credit market can help propel climate action forward.
Overall, understanding each party’s role in the space and creating opportunities for collaboration among stakeholders like project developers, investors, startups, exchanges, and consultants will help move towards an efficient and integrity-driven industry.
🌱 Here at Ivy Protocol, we’re committed to cultivating a platform that assists pre-certified project developers in accessing funds through Streaming Contracts, simplifying the process, and promoting collaboration amongst key stakeholders. By entwining yourself with the Ivy ecosystem, you’ll remain informed on the latest developments in carbon credit solutions and have the chance to contribute to a thriving, regenerative future. Click here to unearth more about our mission and how you can become a vital root in advancing future climate action.
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