World of opportunity

The Kyoto Protocol and the European Union's Emissions Trading Scheme are having an immediate financial impact for businesses and their insurers around the world. Carbon emissions are no longer a theoretical problem - the ETS has led to a systemic change in the way carbon-emitting business operates in the EU. Significant changes have also taken place at commercial facilities in the developing world where green credits are generated.

The issue involves substantial sums of money, which present both mitigation opportunities and, conversely, new liabilities for insurers.

Kyoto expires in 2012 and negotiations for a replacement global agreement are underway. In any case, the ETS renews every five years after its expiry so EU carbon emission controls appear a permanent feature.

The ETS also anticipates the inclusion of additional industries - for example, airlines and road transport. And with significant increases in the value of carbon credits expected over the next two years, this underlines the need for insurers to create certainty in respect of carbon.

Carbon underwriting

Carbon mitigation opportunities and liabilities result in a range of claim scenarios. Insurers should consider how best to include these issues in underwriting and claims management and carbon wording should be included in every policy involving a carbon-emitting business in the EU. For new policies, carbon wording can be incorporated; for existing policies, carbon endorsements can be inserted.

Excluding carbon from policies will not necessarily eliminate new liabilities or allow mitigation opportunities and the key to effective wording is the transparent accounting treatment of carbon credits.

Ideally, carbon should be a standard issue raised in risk surveys and proposal forms. And the wording must be commercially viable but sufficiently flexible to accommodate legislative changes, the predicted increase in credit value, the possible inclusion of new industries in carbon capping and the incorporation of other carbon reduction schemes.

With no established market practice or legal precedent, resolution of carbon disputes may require arbitration or litigation. Specific wording will permit the various claim permutations to be taken into account when a policy is placed, so that risks are understood and correctly rated. While such wordings are as yet untested, they should put insurers in a better position to resolve any disputes.

Effective underwriting should specify the accounting treatment of carbon credits and whether these are a subject of indemnity. The wording should allocate and value credits to particular outages, which involves distinguishing freely allocated ones from those that have been purchased.

How to determine the number of credits not burned due to an outage should be clear and thought given to wordings, which assist in determining the value of outage credits in light of the fluctuating market.

Carbon audit

Insurers can limit their exposure by conducting a carbon audit. Every commercial property insurer in the EU should investigate whether they insure any of the 12,000 installations covered by the ETS. And those insuring risks outside the EU should confirm whether they generate green credits. Particular care should be given to global or master policy wordings, which concern a range of installations. For such policies, transparency should be sought concerning the transfer of both allocated and green carbon credits. Every claim and adjustment presented since 1 January 2005 should be reviewed for carbon issues.

US business and insurers involved with any carbon-emitting business outside the US are, knowingly or unknowingly, already involved with the Kyoto Protocol. Furthermore, the US political landscape appears to be shifting.

From mid-January, unprecedented support from big business and both major political parties has been seen for mandatory carbon reduction and the most popular draft bill mirrors the EU 'cap and trade' model.

For the first time, carbon reduction controls are seriously on the US agenda and are likely to feature as a shared position in the 2008 presidential elections. US inclusion in a global cap and trade scheme would make these issues a regular feature of most commercial insurance policies.

Every claim adjustment must look beyond what is submitted and investigate carbon mitigation possibilities. To assist in managing claims and writing new product lines, some insurers may acquire and build a pool of carbon credits. A carbon pool could address an insured's claim for a deficit of credits.

Such a claim could be presented on a carbon guarantee policy or where an installation is unable to stay below its cap due to an outage or other reasons. A carbon indemnity may take the form of a transfer of carbon credits rather than a payment of money for an equivalent amount. Taking an assignment of outage credits may present insurers with an opportunity to build such a pool. This may allow new carbon products, discussed below, to be partially self-funding through other business lines.

A carbon pool would allow insurers to profit by obtaining credits at more competitive prices than when a loss occurs and selling credits when the market is high. Carbon pools would also assist in managing exposure to the volatility of this market and will assist insurers with a range of indemnity, hedging and financial purposes.

Reinsurance implications

Carbon will likely be formally introduced to the global reinsurance industry in two ways but both will no doubt involve litigation. The first scenario concerns an attempt by a reinsured to mitigate an insured's loss using freely allocated carbon credits. An insured will probably argue these are not an issue relevant to their insurance.

The second, perhaps more realistic, scenario concerns a reinsurer's refusal to cover a reinsured's outwards claim concerning carbon. This may involve a direct insurer who is unaware of how carbon may impact a particular claim. Effective carbon wording can help limit the scope of such disputes.

For accuracy, inwards and outwards modelling should contemplate carbon. This is easy to suggest but made more difficult by the carbon market being new and volatile. However, losses at carbon-emitting installations from previous years can be reviewed to assist in forecasting future exposures.

New carbon products

The increased value of carbon credits is likely to create a demand for new insurance products exclusively catering for carbon. Its unique legal and accounting aspects have similarities to traditional soft commodities or shares. Therefore, policies concerning carbon, as well as carbon-specific ones, are likely to blend traditional property underwriting with a financial lines component. The idea of carbon guarantee policies may eventually be more than a niche growth area for insurers.

Carbon reduction schemes are now a fact of life and cannot be ignored; they are already impacting some businesses and their business interruption insurers.

As carbon schemes are widened, so will their impact. Substantial sums can be saved by mitigating losses with credits due to the substantial amount of money involved in carbon trading - but there are new liabilities, which insurers must anticipate.

John Startin and Jason Reeves are solicitors with Clausen Miller. For further information on this issue email: jreeves@clausen.com.