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Carbon reduction efforts present liabilities, opportunities

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Any U.S. property or energy insurer that insures or reinsures risks outside the United States that concern the emission of greenhouse gases is already affected—knowingly or unknowingly—by mandatory carbon reduction legislation. The legislation arises in connection with the Kyoto Protocol and the European Union's Emissions Trading Scheme. For insurers and reinsurers, carbon presents new liabilities, opportunities to mitigate loss and business opportunities.

There are 15,000 installations in the European Union and 2,000 installations outside the European Union that are affected by carbon reduction legislation. Additionally, the Regional Greenhouse Gas Initiative is a mandatory carbon reduction plan in the United States, which commences in 2009 in several East Coast states. There are also draft carbon reduction bills currently before Congress that have bipartisan support and the support of big business.

Carbon reduction plans are premised on a mandatory "cap and trade" system. Cap and trade limits the amount of emissions an installation can produce by issuing emission "credits" that permit a specified amount of emissions. Credits are essentially a license to pollute. Emissions are measured and accounted for annually. If an installation exceeds its allocated credits, it must purchase additional credits from installations with excess credits. This creates a financial incentive to operate cleaner installations. Installations are normally given fewer credits than required to encourage reductions. The more scarce the credits, the greater the credit price and incentive to reduce emissions. The wider trading system for credits is similar to traditional commodities.

Installations are generally not required to pay for their credit allocations under Kyoto, RGGI or the draft congressional bills. However, the credits have a financial value upon receipt. Credit value is realized by accounting for production or by the sale/trade of the credit. The plans are silent about the status of allocations during temporary outages. The issue is further complicated by the absence of any suitable accounting standard for credits. Most installations include the notional cost of free allocated credits in their production costs, which directly impact business interruption claims.

Insurers should ask two main questions when considering the impact of carbon reduction legislation:

1. What opportunities are there to mitigate an insured's loss?

2. What new liabilities does carbon present?

Fundamentally, when an outage leads to a business interruption claim, should insurers or the policyholder benefit from the value realized by the transfer or saving of allocated credits? For example, a cement plant is allocated 5,000 credits per day. A breakdown results in the complete cessation of production for 40 days. The policyholder loses $10 million profit as a result of the outage. During the outage, credits that were allocated for no cost are valued at $20 each and the insured has the opportunity to sell 200,000 credits worth $4 million. Can insurers set this $4 million off against the $10 million loss?

Green technology outages

What new liabilities are associated with outages of an insured's green technology at capped installations? A steel plant has an allocation of 5,000 credits per day. It installs technology that reduces emissions to 4,000 credits per day but then increases output by 25%, staying below its daily allocation. The new technology breaks down and is out of operation for 35 days. The plant must buy 35,000 credits to maintain production at the new level. During the outage, the market price of one credit is $20. Can the policyholder present a claim to insurers for $700,000?

Outages at installations with carbon allocations should anticipate these and more complex adjustment scenarios. Carbon is not a theoretical or modeling concern. It is a current issue for all losses at carbon emitting installations in the European Union. The issues will be virtually identical to future losses under RGGI and other anticipated cap and trade carbon reduction plans.

Specifics to keep in mind

Fundamentally, carbon is an underwriting issue/opportunity rather than a claims/adjustment issue. Most of the uncertainty associated with carbon reduction plans can be managed with suitable wording. Many existing commercial policies could incorporate carbon endorsements. Carbon wording should specify the accounting treatment of credits and whether these are a subject of indemnity. It should also suggest how to allocate and value credits to particular outages, which will require distinguishing free allocated credits from those that have been purchased.

Carbon mitigation opportunities and liabilities result in a range of claim scenarios. The reinsurance of carbon emitting installations, particularly the reinsurance of installations outside the United States, will require careful scrutiny. Ideally, carbon should be a standard issue raised in risk surveys and proposal forms. Wording should be sufficiently flexible to accommodate legislative changes, market fluctuations, the inclusion of new industries in carbon plans and integration with other carbon plans.

The anticipated increased value of credits in the European Union is likely to create a demand for new carbon insurance products. General policies and carbon-specific policies will likely blend traditional property underwriting with a financial lines/credit risk component. The idea of carbon guarantee policies may eventually be more than a niche growth area for credit insurers. As carbon plans are widened, their impact will grow. Insurers must engage with the financial reality of existing carbon plans and anticipate the impact of developing plans.

Jason Reeves is an attorney at law firm Clausen Miller L.L.P. in London.