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Emission permission

Notwithstanding the political wrangles in the US, the Kyoto Protocol now forms a major consideration...

Notwithstanding the political wrangles in the US, the Kyoto Protocol now forms a major consideration for anyone with interests in carbon producing facilities in Kyoto signatory states and this includes business interruption insurers.

Kyoto's purpose is to reduce global warming by cutting greenhouse gases in the atmosphere, caused by carbon dioxide emissions. The underlying strength of Kyoto is that it creates commercial incentives to reduce carbon emissions. It does this by limiting carbon emissions but also by creating financial rewards for those that actively reduce carbon levels in the atmosphere.

In the European Union, Kyoto is implemented by the Emissions Trading Scheme, which came into force on 1 January this year. Each member state is permitted to emit a specified volume of carbon. The permission is expressed as an allocation of carbon credits that are distributed first between relevant industries and then to specific carbon producing facilities. The UK's allocation plan allows the emission of 792 million tonnes of carbon between 2005 and 2007.

The requirements of carbon producers fluctuate, as does the demand for carbon credits. This new demand is catered for through a burgeoning industry led by specialist, mainly London-based, carbon traders.

Credits were valued at EUR6 (£4.08) per credit at the onset of trading in January. A surge in global natural gas prices and drought in southern Europe - which depleted hydroelectric capacity - resulted in a June peak of EUR29 per credit. Using the UK's national allocation plan, and the fluctuating carbon prices to date, the annual UK carbon market alone ranges between EUR1.6bn and EUR7.9bn.

Mitigation opportunities

Important, but perhaps overlooked, is the need for property insurers to develop the same levels of sophistication as their insureds, in respect of carbon credits, because outages for carbon burning installations may result in an opportunity to mitigate an income loss. Conversely, outages for renewable energy installations may result in a new kind of income loss.

There is, however, no agreement as to the proper accounting treatment of carbon credits. These are sometimes represented as a production cost and sometimes as an asset on the balance sheet. Where a facility buys credits to maintain production, the cost treatment may be appropriate. However, the government allocation of 'free' credits should be regarded as a capital asset. That said, it is a uniquely wasting asset. The value of a credit can be eroded or extinguished during the indemnity period of a BI policy. Its value can only be realised by production or transfer.

If an insured ceases production during an outage, it is suggested that the insurer, not the insured, should benefit from the value realised by the transfer of credits. This is because the value has only been realised because of the outage.

Applying some concrete numbers can help illustrate this argument. For example, if a power station in the Midlands that has an annual allocation of 5 930 225 carbon credits, and it suffers an outage that is indemnified by a relevant BI policy for 30 days, how could mitigation work? On average, 16 247 tonnes of carbon are burned every day at the installation. During a 30 day outage, this results in a theoretical surplus of 487 410 carbon credits. Where one credit is valued at EUR5, the installation has a surplus asset worth EUR2.44m; where carbon is valued at EUR30, however, the installation has a surplus asset of EUR14.62m.

Business interruption strategies

Without appropriate wording this may create a windfall profit for the insured. With appropriate wording, however, the values insured could be significantly reduced.

Consequently, insurers should consider formalising carbon mitigation strategies in BI policy wordings and endorsements. Carbon credit wording should be welcomed by both insurers and insureds, as it can provide clarity in an area of current uncertainty. However, the detailed expression of the mitigation formula presents interesting problems.

For example, there will be difficulties in identifying the number of credits applicable to an indemnity period. A pro rata system may best identify the number of credits for a given outage. There will also be difficulties in valuation. Experience already shows that values fluctuate significantly. Moreover, a major outage could itself affect the market price. A basis of valuation would have to be agreed.

Equally important under Kyoto is the generation of incentives for the producers of renewable energy. Renewable installations, such as wind farms, solar, waste-to-energy, and hybrid systems, all work in the Kyoto framework to acquire carbon credits.

Effective wording

An outage on such installations will involve the loss of a primary income stream from the energy produced but also a loss from the secondary credit income stream. This could result in substantial, perhaps unexpected claims. The problem may not be obvious for master policies where there is a mix of carbon burning and renewable installations.

Property insurers need not keep abreast of extremely detailed and expanding environmental legislation concerning carbon credits to operate an effective mitigation strategy. It is critical however, for insurers to ask if - and how - carbon credits may impact a loss on every policy.

The impact of carbon credits is a fundamental underwriting issue for BI insurers. Ideally, insurers should build carbon credits into their policy wordings so that the basis of adjustment is understood by all from the outset. Raising the issue with an insured this way should result in sufficient accounting for the value of surplus credits following an outage.

By introducing effective wording, business can be preserved, mitigation can be managed, and unexpected liability avoided. Carbon credit policy wording and general awareness of the area will, at the very minimum, satisfy reinsurers that an insurer has effectively limited losses.

- John Startin and Jason Reeves are solicitors with Clausen Miller and a full version of this article is available from [email protected]

THE POSSIBLE VALUE OF CARBON CREDITS DURING AN OUTAGEFacility Annual Pro rata 60 day 180 day allocation carbon use indemnity indemnity EUR20 per EUR20 per credit creditPower station 5,962,684 16,336 EUR19,603,200 EUR58,809,600Cement works 1,163,632 3188 EUR3,825,600 EUR11,476,800Power station 664,229 1819 EUR2,182,800 EUR6,548,400Power station 287,535 787 EUR944,400 EUR2,833,200Paper Mill 96,711 264 EUR316,800 EUR950,400Chemical plant 38,374 105 EUR126,000 EUR378,000University 2714 7 EUR8400 EUR25,200
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