Legal Briefing

CRC Energy Efficiency Scheme: issues for corporate lawyers

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Corporate and commercial | 01 June 2010

The Carbon reduction commitment Energy Efficiency Scheme (the CRC) became effective on 1 April 2010. A full review of this has already been included in IHL179. However, the CRC will have important consequences that need to be considered by corporate lawyers and, in particular, in relation to corporate transactions, such as M&A and private equity investments, as well as restructuring and group reorganisations. This article will provide a brief overview of the CRC, and consider some of the corporate issues and how these can be addressed in corporate transactions.

UK legislation and policy are increasingly setting a trajectory for transition to a low-carbon economy. In the future, a business’s energy performance and strategies may therefore increasingly become indicators of value, particularly if the cost or risk profile of fossil fuels increases and the CRC, and other mechanisms, reveal the extent of a business’s dependency on fossil fuel. Where companies qualify for the CRC, their compliance with and performance within the scheme will also be a matter of public record, and will therefore be open to public scrutiny. Reputational risk will be an important consideration.

CRC: An overview

The CRC applies UK-wide to create a cap and trade scheme for emissions allowances, which is designed to reduce non-domestic, non-transport energy consumption. Participation is mandatory for around 5,000 of the large, but non-energy-intensive, private and public sector organisations. Examples of likely participants include banks, retailers, institutional landlords, data centre owners, private equity funds, large joint ventures, private finance initiatives, public-private partnerships, franchises, government departments and local authorities. Private sector participation will be based on groupings determined by share ownership or control. Foreign entities with an operation in the UK could also be caught. Another 20,000 organisations who do not qualify for CRC participation will be required to make certain information disclosures.

CRC will operate in phases. 2010 to 2013 is the first and introductory phase. Subsequent phases, each of seven years, will run to 2043.

An organisation must participate in a phase if, in a phase’s qualifying year, the organisation:

  1. had half-hourly metered, UK electricity consumption of 6,000 MWh or more; and
  2. was supplied with electricity though a settled half-hourly meter.

The qualifying year for the first phase is 2008 and for the second phase the year commencing April 2010. There are also certain reporting-only requirements for organisations with usage of between 3,000 MWh and 6,000 MWh, although these organisations would not be required to participate in the CRC.

CRC will seek to drive down energy consumption by:

  • annual measuring and reporting obligations of each participant’s energy consumption (excluding energy for domestic or transport use);
  • financial drivers – participants will have to buy and surrender, for each year, allowances sufficient to cover their emissions (money collected on annual allowances sales by the government will be recycled to participants after each year, distributed according to performance, and poor performers will fund better performers (recycled payments)); and
  • reputational drivers – public annual league tables showing participants’ comparative performances in reducing emissions.

This is all backed by stiff civil and criminal penalties for non-compliance. Members of a CRC group will have joint and several liability for CRC compliance.

Investments (eg equities, assets, joint ventures) may bring investors within the CRC’s first or subsequent phases with all attendant obligations, risks and opportunities.

For landlords and tenants, where the tenant has the energy contracts for the building then it will be responsible for the building’s emissions. However, in multi-let buildings, the landlord often has the energy contracts and so will have the emissions responsibility. It will want to look to its tenants to contribute towards any costs, but mechanisms may not exist to allow recovery. The CRC (and other mechanisms focusing on energy and sustainability) will create new tensions in landlord and tenant relationships, as well as additional reasons to collaborate – and not just on a voluntary short-term basis (particularly as there are innumerable existing leases with years to run).

Those involved with developments may find that the energy consumed during construction affects their own or the landowner’s CRC qualification and/or performance. This may need consideration in the building and/or development contracts. The owner or investor and user will have their own concerns as to energy sources and consumption of the final product.

CRC: Corporate and company law considerations

The following paragraphs outline some of the issues that will already need to be considered in relation to company law and corporate transactions. However, as 2010/11 is the first year of the CRC, how these issues play out in practice and what additional issues become significant will only emerge over the first few years of the operation of the CRC.

Determining the CRC group (private sector)

It will be each organisation’s responsibility to assess whether they qualify for the CRC and which entities within that organisation’s group form the CRC group for the purposes of the scheme. It will be the relevant CRC group’s usage of qualifying electricity that will be aggregated, and will be the subject of the reporting and assessment requirements under the scheme.

For CRC purposes, a CRC group is defined by reference to the meanings of ‘parent undertaking’ and ‘subsidiary undertaking’ in s1162 of the Companies Act 2006 (the 2006 Act) (although note that the CRC Order includes unincorporated associations that carry on charitable activities within its definition of ‘undertaking’).

Each group will have a primary member (also known as the account holder) to act on behalf of the group. Commonly, the highest parent undertaking of a group (that is, the undertaking that is not a subsidiary undertaking of any other) will be the primary member of the group with whom the administrator of the scheme (in England and Wales, the Environment Agency (EA)), will liaise.

Where a group contains a significant group undertaking (SGU) that qualifies for the CRC on its own (including its subsidiaries), the SGU can be disaggregated from the rest of the group, provided that doing so does not cause the parent undertaking and the remainder of the group to fall below the 6,000 MWh qualification threshold. Furthermore, the SGU must consent to the disaggregation and register as a participant in the CRC in its own right. To disaggregate for CRC’s first phase, the whole group must register before 30 June 2010, identify the SGU(s) that consent to be disaggregated and obtain EA approval. The SGU(s) must then register as a CRC participant before 30 September 2010. Where an SGU has been disaggregated, it will be treated as a separate participant and will be required to comply with the same obligations as any other participant. This means that it will not be jointly and severally liable (see paragraph below headed ‘Joint and several liability’) with the remainder of the group, for the group’s liabilities under the CRC.

Therefore, when approaching corporate transactions that will involve acquiring or transferring certain subsidiaries out of a larger group, full investigation should be made into where those subsidiaries sit within a CRC group and, in particular, whether any of the subsidiaries are the primary member for any SGU. The buyer’s CRC status will also be relevant. There are also notification requirements when members of a CRC group leave the group or new members join. The notifications need to be made to the relevant administrator (the EA in England and Wales) within three months of completion of the transaction.

Joint and several liability

Under the CRC, each member of a CRC group will have joint and several liability for the obligations of the group under the CRC.

The EA has indicated that it intends to pursue the primary member first and foremost to recover any unpaid fines or other sums from that party, but has not discounted the possibility of pursuing other group members if this did not work.

As noted above, the CRC allows for SGUs to be disaggregated, which will enable commercially distinct divisions within larger organisations to be insulated from each other’s CRC liabilities. However, it should be noted that a head office function or holding company, which by itself does not meet the qualification criteria, will not be able to exclude itself completely from the scheme and will be included in the CRC group or have to aggregate itself with one of the SGUs within its group. This is a significant concern that the private equity industry has with the CRC scheme, as private equity funds would, as things stand, be aggregated with their investee companies for the purposes of the CRC.

Where participants are being acquired or split out from a group under a corporate transaction and these do not constitute distinct SGUs, the issue of joint and several liability will be an important one to address in the documentation relating to the transaction that is considered below.

Overseas companies

While CRC is unique to the UK and catches only energy supplies in the UK, overseas undertakings (even without direct UK energy consumption) may be caught due to grouping rules and so will be jointly and severally liable with the rest of its CRC group, forming the participant. Non-UK driven organisations with UK consumption or subsidiaries with UK consumption will need to investigate their CRC position.

If the highest parent undertaking is an overseas company of a CRC group, it must nominate a UK-based subsidiary undertaking to fulfil that role (or, where no such subsidiary undertaking exists, such as where the UK energy consumption takes place in a branch, it will have to nominate a third party UK-based representative).

Footprint and annual reporting requirements

CRC participants will have to produce a footprint report for each CRC phase. In summary, a footprint report identifies all non-transport, non-domestic sources of emissions (including those covered by the EU Emission Trading System and the Climate Change Agreements). April 2010 to March 2011 will be the subject year for this first phase of CRC.

Participants also have to produce an annual report, which must be submitted by the last working day of July in each year. The CRC annual report is a different and separate requirement to an entity’s existing annual reporting requirements (though there may be some overlap with the business review requirements under the 2006 Act), and is therefore not linked to a company’s annual accounting reference date.

The CRC annual report will be used to identify the extent that a participant has been reducing its emissions compared to previous years and will be the source of information for determining the participant’s position in the annual league table, showing how participants have performed in the CRC and so determining the amount of a participant’s recycled payments. The league table will be publicly available and will contain certain information from the reports submitted by participants (for example the total carbon dioxide emissions from the annual report).

Evidence pack

It should also be noted that, in addition to its reporting obligations, participants are obliged to keep records of the information on which the reports are based (an evidence pack). The evidence pack will need to be audited and certified by a person exercising management control of the participant. A participant will need to send the administrator its evidence pack if it is selected for an audit.

This reporting and record-keeping burden should be a significant focus of due diligence when assessing an undertaking for acquisition or, indeed, preparing it for sale.

Directors’ duties

The statutory directors’ duties, which were codified under the 2006 Act, include in s172(1)(d) the requirement for directors, in performing their duties, to have regard to (among other things) the impact of the company’s operations on the community and the environment.

The CRC also seeks to use reputation risk as a lever to drive down emissions by publishing the league tables showing the participants’ relative performance. Directors should therefore assess this reputational risk against their overriding duty under s172 of the 2006 Act to promote the success of the company.

As the CRC will give a clear indication, as published in the league table, of a company’s performance with regard to emissions, any failures, or even perceived failures in this area, will bring a much greater focus on the extent to which directors have discharged their statutory duties generally in this area and, in particular, under s172(1)(d) of the 2006 Act.

Impact on cash flow

The need to buy and annually surrender sufficient allowances to match a participant’s emissions for the year, coupled with the timing of the recycling of money collected on the government’s sale of allowances, will mean that there is a time gap between the time of buying allowances and receiving the ‘recycling repayment’. For poor performers (and/or possibly some good performers who bought high in the secondary market) there will also be the shortfall in the amount expended compared to the amount received back since the amount of recycling payment is determined by a participant’s position in the annual league table.

This requirement to buy, ability to trade on a secondary market and surrender allowances each year, will need to be co-ordinated for the members of the participant’s group. Corresponding budgets, costs and targets will be allocated to members. Participants will also need to check that there are no governance or finance restrictions affecting the allowance trading (for example floating charges may cover allowances).

CRC: addressing compliance issues in corporate transactions

There are several tools within the legal framework of corporate transactions that can be deployed to identify and remedy any deficiencies in this area. These will be familiar to those accustomed to M&A transactions but it will be useful to consider these briefly in the context of the CRC. The summary below relates to M&A transactions, but the concepts are equally applicable to investments where the purchaser is the investor and the vendor is the target company, management or shareholders.

Due diligence

Environmental due diligence has tended to be more relevant to industrial or manufacturing deals. The CRC cuts across all business sectors. In the future, any business acquisition will require an assessment by the purchaser of whether the CRC applies.

Where a purchaser believes the CRC may be applicable to a target company or group, it should commission a specific CRC due diligence report (that is in addition to an environmental due diligence report otherwise required).

From the vendor’s perspective, it will need to make sure that its evidence pack and other record-keeping is in order, as well as the group accounting in relation to the payments and receipts under the scheme. With regard to the latter, these are all administered at the level of the primary member, which will need to make the appropriate allocations to its group. A purchaser will be interested to make sure that the target has not been unfairly allocated. Consideration will also need to be given as to whether allowances (an asset) are also to be transferred and at what price.

Warranties and disclosure

While due diligence ought to identify the risk areas and provide recommendations on how these risks can be addressed, a purchaser will typically require, in addition to the due diligence, full warranty coverage under the sale and purchase agreement. The warranties can be supplemented to address specific risks identified in the due diligence report to provide additional coverage. So, as the CRC scheme begins to mature, warranties in respect of the CRC would be expected to underpin, inter alia, a participant’s reported carbon emissions and corresponding claims for allowances. If, after the sale, it emerges that a participant has under-reported its emissions, the purchaser may have a claim against the vendor for breach of warranty. As there is likely to be reputational damage suffered in addition to the direct financial loss due to the public nature of the scheme, claims for damages for loss of reputation are likely to be significant.

Warranties may also be used to flush out any information that the purchaser suspects has not been forthcoming during the due diligence phase. By targeting the warranties on certain aspects or by specific information requests in the warranties, the purchaser can seek formal disclosure in the transaction documentation on areas of concern.

Indemnities and undertakings

Where specific liabilities have been identified in the due diligence process, the purchaser will want to seek indemnities to ensure maximum recovery. Where remedial action is required by the vendor, this can be sought through undertakings contained in the sale and purchase agreement. Remedial undertakings on the target company will more likely be a feature of private equity investment transactions or joint ventures.

With regard to the issue of joint and several liability, where a participant is acquired out of a CRC group, the purchaser will want to seek an indemnity from the vendor (and arguably the primary member and all other entities) that may be liable with the target company, to ensure that the target company has a clean break from its previous CRC group.