The Carbon Reduction Commitment Energy Efficiency Scheme (CRC) aims to assist in achieving reductions in CO2 emissions, targeting non-intensive energy users. The deadline for initial registration has now passed. This article reviews the current status of CRC and its implementation, as well as the private equity industry's concerns about the scheme, and considers the actions private equity firms should take to prepare themselves for the second phase of the scheme, commencing on 1 April 2011.
The Carbon Reduction Commitment Energy Efficiency Scheme (CRC) has been a thorn in the side of the private equity sector since it first became clear that CRC would be designed and implemented on a group-wide basis. The deadline for initial registration (30 September 2010) has now passed, but issues remain for private equity investors and others. This article looks at the current status of CRC and its implementation, as well as the private equity industry's concerns about the scheme, and considers the actions private equity funds should take to review their current position and prepare themselves for the second phase of the scheme, commencing on 1 April 2011.
CRC is intended to play an important role in achieving the government's goal of cutting CO2 emissions by 80% (from 1990 levels) by 2050. CRC targets non-intensive energy users (the threshold for qualification is an annual consumption of 6,000 MWh of electricity aggregated across a group) and it was originally estimated that 5,000 public and private non-energy intensive organisations would be obliged to register under the scheme. In the lead up to the registration deadline the estimate of qualifying participants was reduced to between 3,000 to 3,500, and as at mid-October 2010, the total of registered participants did not approach this number.
The shortfall in registered participants suggests either that more organisations are participating under an umbrella organisation than was originally expected (in other words, that CRC's use of the concept "group" has been interpreted and applied very broadly) or that businesses and public sector organisations are still unaware of their obligations under CRC.
Shortly before the registration deadline Greg Barker, the energy and climate change minister, encouraged the regulators to take a sympathetic view of those who had failed to register in time. It is not clear for how long the regulators will continue to take this approach and when they will start to grapple with the issues of defective and non-registration. Common sense suggests that any such enforcement efforts will be concentrated on non-registration. However, those who have registered will need to remain alert as practice becomes established and as better guidance emerges, to ensure that the analysis on which their original registrations were made remains correct in respect of the initial phase of CRC, and remains correct when it comes to registering for the next phase of CRC.
It was announced during 2010 that CRC would be subject to consultation, to see if it could be simplified. This announcement has since been supplemented by the more drastic brief announcement made by the Chancellor in the Spending Review of 20 October 2010 (see below).
CRC was designed to operate as a cap and trade system with participants purchasing sufficient emission allowances in advance to cover their predicted energy use and then selling surplus allowances or buying extra as necessary. As announced in the Spending Review, the sale of the first allowances (for the year 2011/12) has been postponed to 2012 "to reduce the burden on businesses". It is tempting to speculate that it is in fact to reduce the burden on the regulator and allow progress to be made in the meantime on the simplification of CRC.
It is currently unclear whether this will result in a system under which allowances are always purchased in arrears. This would be simpler for all, but is not how CRC is presently set up. Without clarification, the cautious approach is to assume that participants should budget for the possibility that in 2012 they will be required to purchase allowances for 2011/12 and the following year (2012/13). This aspect of the scheme may remain unsettled for some time following a report from the Committee of Climate Change recommending that the introduction of auctioning rather than fixed price allowances be delayed (it was originally intended to come into effect in April 2013).
More fundamentally, it has been announced that revenues from the scheme will be used to support the public finances rather than being recycled to participants. In consequence, CRC has in essence become a tax. This reverses the previous policy of establishing CRC as a revenue-neutral scheme that rewarded superior performance through recycled costs. The most obvious consequence of this is that CRC will be more costly for all, but a welcome side-effect would be that CRC costs will be significantly easier to break down and allocate fairly to group members and others who might have a contractual obligation to pay, such as tenants.
In the light of these brief announcements, it is not possible to say with certainty what CRC will look like in the medium-term. But the consensus view is that it is likely to remain in place as a tax, with costs probably increasing, but to be borne on a less complex and more predictable basis by participants.
A CO2 reduction programme must necessarily include measures tackling non-intensive energy users, and if such measures are to be workable, they must be relatively pragmatic and cannot be expected to take full account of all of the varied features of the mix of public and private organisations to be covered.
However, the question in the private equity context is whether CRC has gone too far in this direction, and by not recognising the unique nature of private equity investment, it has created a result that is unworkable.
The problems posed by CRC for the private equity sector stem from the broad definition of "group" that has been adopted and the top-down approach to liability under the scheme. The potential consequences of this are that:
The private equity fund at the top of the group structure bears the CRC compliance costs and has the task of recovering its costs from the underlying businesses.
CRC performance, and therefore penalties, are assessed across the group. Individual group members may find that their own performance benefits from or is prejudiced by the performance of others with whom they have no connection other than common ownership interests. Following the recent announcement that recycling of payments is to be removed, this is now primarily a reputational issue and does not translate directly into lost recycling payments.
CRC liability is joint and several. If there is a default, liability may be visited elsewhere within the group.
A concept of significant group undertakings (SGUs) was introduced to the CRC in response to these concerns and most public comment in response to these changes has been favourable. However, while the problems have been mitigated, a number of areas of difficulty and risk for private equity funds remain.
The private equity sector collectively spent considerable time and resources on analysing their structures for the purpose of registering for the initial phase of the CRC. It is not yet clear what proportion of private equity participants managed to register and of those that did, whether they managed to correctly analyse and record their group structures.
The same exercise will need to be carried out for the purposes of registering for the second phase of CRC, for which the deadline is 30 September 2011 and which will require an analysis of the group structure as at 31 March 2011. The good news for the private equity sector is that during the flurry of activity leading up to the registration deadline for the initial phase the Environment Agency provided further guidance on the application of CRC to private equity funds. This guidance, alongside that issued by the BVCA (although not endorsed by the Environment Agency), addresses some of the concerns raised across the sector during the consultation process and the run-up to initial registration.
CRC applies to an entire group, rather than applying at the level of individual group members. The primary CRC obligation is, on this basis, held by the ultimate parent at the top of the group structure.
The top-down approach is implemented through the broad definitions of "parent", "subsidiary" and "group". CRC adopts the broad definition of subsidiary under the Companies Act 2006. Therefore, an entity that holds a greater than 50% interest in an energy user is automatically deemed to be the parent of the energy user for CRC purposes and an entity is treated as a subsidiary and a group member for CRC purposes if any of the following tests for control apply:
A parent holds or controls (through a shareholders' agreement) more than 50% of the entity's voting rights or has a contractual right (for example, under the articles or a shareholder agreement) to exercise dominant influence over the entity.
The parent is a member of the entity and has a right to appoint or remove a majority of its directors.
The parent exercises or has a right to exercise dominant influence or control over the entity.
The parent and entity are managed on a unified basis.
This approach applies even if the parent entity has no involvement in the energy user's management and is acting on a fiduciary basis for a third party investor (as is often the case in the private equity context). In such a situation, the form of the investment (a single entity as majority owner) would prevail over its substance (a single entity owning an interest for a diversified base of investors).
Given the breadth of the concept of "undertaking" under the CRC, which encompasses companies (including those incorporated outside the UK), partnerships and limited liability partnerships (LLPs), it is necessary to consider whether the general partner, fund (the limited partnership) and limited partners are part of a group of undertakings for CRC purposes. The Environment Agency's guidance on the application of CRC to the most common type of private equity fund structure using an English limited partnership is summarised below:
Where a general partner or a nominee company holds the fund's investments and assets (including the portfolio companies) for the benefit of the fund, any rights attached to those investments or assets will be deemed to be held by the fund for the purposes of CRC. This has the effect of grouping the fund with the portfolio companies if one of the tests for control is met.
Where, as is common, the general partner is itself an undertaking it may be grouped with the fund (and any of the fund's subsidiary undertakings) if one of the tests for control is met. To assess whether this is the case requires a detailed analysis of the terms on which the general partner is appointed, in particular whether the general partner enjoys a temporary or permanent appointment. While all relevant control factors must be taken into account, one key factor is likely to be whether a "no fault divorce" clause is exercisable as at the qualification date (31 March 2011 for the second phase) by which the fund can unilaterally remove the general partner. Where the general partner cannot be removed in this way by the fund, then the general partner may be found to be the parent undertaking of the fund.
Where a fund is managed by an entity other than the general partner (such as by an LLP which acts as a dedicated fund manager), then the analysis of that fund manager will be the same as that described above for the general partner. This has the effect that potentially the fund manager, rather than the general partner, will be treated as the fund's parent undertaking.
As it is very unlikely that the limited partners will satisfy any of the tests for control in respect of the fund (since the nature of a fund structured as a limited partnership means that a limited partner is not entitled to take part in the management of the fund) it is unlikely that the limited partners will form a group with the fund. However, where a limited partner is an undertaking (rather than an individual investor) and has made a significant investment into the fund and has significant influence over the fund one of the tests for control may be met.
The top-down approach has the effect that, if the fund holds interests in a range of otherwise unrelated businesses for a base of diversified investors, there may be no common commercial purpose, no common management and potentially no (or few) common investors. In such a case, both the links between the businesses and the upward connection to the parent are wholly artificial and potentially result in the unnatural aggregation of businesses that differ in sphere of activity, business models and operational sizes.
A further consequence is that different results emerge under CRC depending on the particular distribution among private equity funds of investment interests held in a single underlying business that exceeds the 6,000 MWh threshold. For example, if one private equity fund owns 51% or more of the shares in a business, then the fund is a parent and forms a group under CRC together with the underlying business. However, if the investment interests are marginally different, so that no one fund owns over 50% of the shares, then all of the private equity fund investors fall outside CRC and the underlying business is within CRC in its own right.
An individual business is not subject to CRC if it falls below the 6,000 MWh inclusion threshold. However, if that business is part of a group that does, in aggregate, exceed the 6,000 MWh threshold, then all group members must participate in CRC. In the private equity context, there may well be businesses that are functionally unconnected with one another and which individually fall below the 6,000 MWh inclusion threshold, but that will potentially be caught by CRC solely because a majority interest is held in them by the same private equity fund.
For these reasons, participants in the private equity industry have been keen to establish whether the facts allow their organisation to comprise a number of separate groups, rather than a single group, for CRC purposes. However, this must be based on a balanced evaluation of the relevant structures and the facts surrounding them. It is good practice to document and retain the basis for this analysis as part of the participant's Evidence Pack.
Following the consultation process held in advance of CRC coming into effect, the private equity sector raised concerns in relation to the grouping of undertakings. In response, the CRC regime was modified to allow organisations to register larger subsidiaries separately. Under this registration process, including for the upcoming second phase, participants will be able to nominate any larger subsidiary as a SGU, which would then participate separately under the CRC regime. To qualify as an SGU, the subsidiary must by itself (or with its subsidiaries, if any) exceed the 6,000 MWh threshold. If the participant wishes to disaggregate the SGU for the purposes of the next phase of CRC they must register by the end of June 2011.
This is a very significant feature from the perspective of private equity funds as it allows an SGU to manage and finance its CRC participation without involving the parent private equity fund and without its energy consumption being aggregated with that of other subsidiaries in the group.
However, this newly introduced right to register SGUs separately has an important limitation. A parent cannot separately register an SGU if that would result in the parent and other subsidiaries falling below the 6,000 MWh threshold and therefore falling outside CRC.
This limitation greatly reduces the scope for a private equity parent to use SGUs to escape participation at parent level in CRC. In many cases, even if one of more SGUs can be nominated, there will be a residual CRC group with the private equity parent having responsibility on the top-down basis.
CRC is unusual in the climate change context in that it is confined to the UK rather than being part of an EU-wide or larger international reduction or trading scheme (although there are links with the EU-ETS in that auction prices under CRC are likely to be capped by reference to EU-ETS allowance prices). CRC applies to UK energy use only and an entity must declare its UK energy use whether or not it is established or located in the UK. If a majority private equity investor is established or located outside the UK and meets the relevant definition of parent, then that entity must participate in CRC. For example, an offshore investment holder with controlling interests in two UK businesses that qualify when taken together would be required to participate in the scheme as parent in respect of those businesses' energy usage.
Some of the practical difficulties this raises have been recognised and CRC requires an overseas parent to nominate an entity based in the UK as its primary member (terminology used in the CRC guidance) or account holder (terminology used in the legislation). It is important to recognise that this does not displace the liability of the overseas parent or the joint and several liability across the group.
It is also possible to nominate a person (not necessarily a group member) as an agent. This enables various functions under CRC to be performed by the identified entity (including the buying, selling and surrendering of allowances), but again does not displace the liability of the members of the group. Any non-group member accepting this role is likely to insist on an agreement setting out the terms of appointment and, potentially, an indemnity for any liabilities.
There has been some confusion as to the extent of the responsibilities of these nominated entities, exacerbated by the unclear on-line CRC Registry interface. It is hoped that this will be clarified before the next phase of the scheme.
T +44 20 7600 1200
F +44 20 7090 5000
E edward.keeble@slaughterandmay.com
W www.slaughterandmay.com
Qualified. England and Wales, 1988
Areas of practice. Environmental with emphasis on M&A, compliance, regulatory and liability issues.
Recent transactions
For more details of recent transactions, publications, and so on, see full PLC Which lawyer? profile here.
T +44 20 7600 1200
F +44 20 7090 5000
E samantha.brady@slaughterandmay.com
W www.slaughterandmay.com
Qualified. England and Wales, 2009
Areas of practice. Environmental with emphasis on M&A, compliance, regulatory and liability issues; commercial real estate.
Recent transactions
