Earlier in August 2022, the German chemicals giantBASF entered into a “virtual” contract for renewable energy totalling 250 megawatts across the United States. With the changing landscape of the energy sector, the instruments used for transactions in the sector have also transformed. While blockchain technology has permeated the financial sector at an exponential pace, its applications in the energy sector are gradually proving to be revolutionary as well. In recent times, legal contracts executed through computer codes, i.e., Smart Legal Contracts (SLCs) have gained popularity in the energy sector.
Through this article, the authors shall attempt to demystify the concept of SLCs, their application in the energy sector, and the legal facets of such contracts. Although the Indian jurisdiction does not have enough guidance on the topic, the authors analyse how SLCs could benefit the Indian energy sector and what may be done to integrate them into our existing system.
What are Smart Legal Contracts?
Smart Legal Contracts (SLCs) arelegally binding contracts wherein the defined contractual obligations between the parties are automatically performed by a computer program without any human intervention. As the name suggests, these “smart” contracts execute obligations in a smarter fashion than traditional contracts. Thus, SLCs are a cut above the rest because they do not require the contracting parties to per se trust each other; instead, the parties can rely on the computer program for the proper and timely completion of the contract.
The essential question for us is to understand how SLCs function.
Consider a situation where A delivers goods to B. The delivery triggers the payment of consideration by B to A. In other words, B becomes liable to pay A in the future. However, had the consideration amount been transferred by B to an escrow account specifically meant for the contract, then as soon as the delivery was concluded, A would have received an automatic payment. Discernibly, such a contractual mechanism would eliminate the risks of non-payment and delayed payments, and in turn, inculcate more trust in the contractual system. This is the entire premise behind the functioning of SLCs. SLCs also offer increased transparency since the actions of both parties are recorded infallibly. When SLCs are stored on the decentralised blockchain network, there is no involvement of intermediaries like banks and financial institutions, which makes the entire process efficacious. SLCs have the capability to usher in benefits on multiple fronts. For instance, dealing with cryptocurrency would also become easier through SLCs since the transaction would not require any intervention by financial institutions.
There has been a great deal of discussion at the global level about SLCs being synonymous withsmart contracts. While both concepts revolve around technology and code, SLCs have a legal angle to them, unlike smart contracts. This added feature makes SLCs an appropriate tool to be used in mega-deals across sectors like energy, finance, and infrastructure.
SLCs are already being used in the global market. Recently,6 law firms collaborated with Genesis B to make an SLC for a mergers and acquisition escrow agreement. Under the agreement, until the terms and conditions of the contract were satisfied by the parties, the money was held in an escrow account. These conditions are similar to the ‘conditions precedent’ clause of a contract, which may also include other conditions like obtaining regulatory approvals, or completing internal procedures.
Despite their numerous benefits, there may be hiccups in the implementation of SLCs. The foremost drawback of these digital contracts is that they continue to be unrecognised by law in most parts of the world. There is also insufficient infrastructure and awareness to use these blockchain-based contracts. Moreover, if we consider India, then one of the biggest limitations is that all forms of blockchain, from cryptocurrency to contracts, are highly unregulated. Nevertheless, it is an undeniable fact that the commercialisation of SLCs would revolutionise and restructure numerous sectors, including the very important energy sector.
Smart Legal Contracts in the Energy Sector
A cryptocurrency can be virtually transferred on a blockchain, whereas energy is only physically transferable. However, ‘energy trading’ can be accomplished virtually through automation and SLCs. Consider a basic example where the energy is supplied to the consumer as soon as the energy supplier receives the payment, or alternatively, the energy supply is disconnected as soon as there is a default on payment. In SLCs, the payment of consideration is entirely automated. This is different from traditional contracts in the energy sector, which require manual payments by consumers. With SLCs, the instant a consumer exhibits the intent to purchase energy; the amount would automatically be deducted from his account. Such a setup would also reduce documentation work for energy suppliers since they would be able to dispense with the task of data maintenance relating to payments. Moreover, due to the non-interference by any intermediary, there would be added transparency and efficiency in the system.
As the energy sector grows, consumers have now become “prosumers” who engage in the production, storage, usage, and sale of energy. For example, a prosumer may decide to sell the excess solar energy generated from its rooftop panels to other consumers. This sale might be contingent upon certain legal conditions which, if fulfilled, would consummate the transaction. The mechanism allows energy trading to become decentralised due to its use of blockchain-based transactions. Energy can be bought from neighbouring places or local sources, and this setup is known as “blockchain peer-to-peer energy trading”. SLCs possess immense potential to support such trading transactions, along with the decentralised mechanism; thus, they can facilitate the transition to renewable energy at the grassroots level.
Another real life instance where SLCs are being used in the energy sector is ‘Share&Charge’. Share and Charge is an Ethereum-based platform developed by a German company that connects electric car drivers and charging station owners. Through the platform, electric car drivers can find their nearest charging stations and make automatic payments using digital currency.
Issues under a Smart Legal Contract
A smart legal contract is not drafted in a manner akin to a traditional contract. It has to be coded by a software developer. Many companies like OpenLaw, Accord Project, and Clause are taking advantage of this new opportunity and building applications to help law firms draft smart legal contracts and incorporate them into blockchain-based applications. Therefore, in order to draft a smart legal contract, a lawyer would require a software expert too. While the smart legal contract makes the tasks of clients easy and automatic, it may increase the workload of a lawyer. Lawyers will have to be more cautious about how smart legal contracts are being drafted and ensure that the coding of these contracts is error-free. While introducing SLCs at a peer to peer level for energy trading, individuals might have to hire lawyers to draft the SLCs which can become costly for them and hinder the growth of SLCs. Additionally, SLCs are considered safe as only verified users can create transactions under it. Therefore, the user verifying authority will have to expand its role to ensure that no false users make it to the system.
Another disadvantage of a smart legal contract is that it is irreversible. In instances where the contract terms are unconscionable or fraudulent, it will be difficult to reverse the entire transaction. On top of that, there are many clauses or legal conditions which cannot be automated or enforced by smart legal contracts. These may include clauses that use ambiguous terms, such as parties may perform their functions using their ‘best efforts’ or in a bona fide manner. In such a situation, lawyers will have to use creative ways to explain the computer application as to what they are referring to exactly.
Application of SLCs may face several challenges in the Indian set up. Not many people in India are engaged in or acquainted with blockchain based transactions. So, penetration of SLCs can become difficult considering that it requires technical knowledge. As discussed above, it can also become financially taxing for individuals to hire lawyers and developers for drafting SLCs. Therefore, the role of government authorities and regulatory bodies come into picture to eradicate the concerns and make SLCs accessible.
Virtual Power Purchase Agreements
Virtual Power Purchase Agreements (VPPAs) have been the talk of the energy sector over the last few years, especially in the renewable energy context. At their core, VPPAs are financial contracts that allow buyers to meet their energy goals without incurring massive investments. Through a typical VPPA, an energy buyer contracts to pay a fixed price for another party’s renewable energy. In consideration, the energy buyer receives a Renewable Energy Certificate (REC). The major differentiating factor of VPPAs is that, firstly, the entire energy setup is offsite, and secondly, there is no physical transfer of energy, thus, making it all “virtual”.
VPPAs are particularly beneficial for organisations that have huge energy consumption since the contracts allow them to distribute their loads within, as well as across, geographies. Hence, VPPAs are a win-win for the environment as well as corporates. Another added advantage of VPPAs stems from their “virtual” characteristic insofar as the changing regulatory and statutory landscape does not affect the contract.
It is important to understand the basic functioning of a VPPA before we delve into some of the important contractual considerations. Suppose Company A (energy buyer) enters into a VPPA with another party B (energy developer), who has a massive wind energy farm. The first part of the VPPA is executed when Company A promises to pay B a fixed price for the energy generated by the latter (fixed price) without any exchange of physical energy between the two parties. For the second part of the contract, B sells the energy generated by its farm to other third parties. This sale is made based on the spot rates (variable price). The first and second parts of the VPPA culminate when B pays (or receives) the difference between the fixed price and variable price to (or from) Company A. In cases where the difference between the fixed price and the variable price is positive, Company B pays to Company A in the forms of RECs.
VPPAs are relevant in the context of SLCs as they involve the transaction of a price difference between the energy buyer and developer. A monetary amount can be put in an escrow account, and as soon as the code detects a profit or loss for the energy buyer, it can remit or deduct payments.
Essential Clauses in a VPPA
On the contractual front, there are some important considerations for VPPAs due to their peculiar character, and some of the considerations are discussed below.
1. Firstly, as part of the representations and warranties, energy buyers very often seek the guarantee that the energy project will remain live, generate, and supply energy for a specified minimum amount of time annually. This is also known as the “availability guarantee”. The clause further covers the buyer by giving the right to claim liquidated damages in case the availability guarantee is not fulfilled.
Using SLCs, the parties can feed the “availability guarantee” as a condition to the execution. As soon as the code notices non-adherence, it would notify the parties, and within a specified period, the buyer would receive the liquidated damages as agreed.
2. The second important lookout relates to delays on the buyer side. Most VPPAs are effectuated during the construction of the energy project, which increases the risk for buyers in case of delayed project completion. To protect themselves, buyers insert clauses requiring the energy developer or energy project owner to secure the buyer’s interest by providing a guarantee, surety, or any other form of security. In such an instance, the points of negotiation range from the amount of security to the penalty if the promised commercial operation milestone is not met.
In such instances, SLCs can be of aid by ensuring that the amount of negotiated security reaches the buyer without causing them any loss or distress in the event of a delay.
3. On the flip side, the assignment is a point of concern to energy developers. Typically, by way of an assignment clause, both parties are required to obtain prior written consent before assigning their rights to a third party. However, given the massive investment requirements by the developer, the developer may have to collaterally assign the VPPA to secure financing. To remedy the buyer’s apprehensiveness, it may be apt to negotiate a form of consent and incorporate it as a part of the VPPA contract. Additionally, developers seek to assign VPPAs to their affiliates, however, buyers always resist such assignments. In such a case, the buyer may negotiate to add qualifications that must be met by the party to which the developer wishes to assign the VPPA. In other words, the buyer can insert experience, net worth, or capital investment requirements from the potential assignees of the developer in the SLC. Only if the specified qualifications are met by the assignor, the assignment would be valid, else the buyer would be allowed to take remedial actions such as termination of the contract.
At present, there exists no standard VPPA document or model in India. The lack of a model document translates into parties missing out on certain inherent risks as well as their inability to identify and pre-resolve possible conflicts arising out of the contract.
SLCs in India
Are SLCs legally covered?
The holy grail for contracts in the Indian jurisdiction is the Contract Act of 1872 (hereinafter referred to as “the Act”). While the Act was formulated in an era where contracts were drafted, signed, and executed on physical paper, the legislation has not lost its relevance in the internet era. For any contract to be valid in India, it must have the four essential elements of offer, acceptance, intention, and consideration. At their core, SLCstick off all four elements. Thus, they are good on the contractual law front in India.
The issues arise on the “smart” part of SLCs. Firstly, SLCs are rendered invalid under the Information Technology Act, 2000 (IT Act). The IT Act recognises digital contracts insofar as they are electronically or digitally signed using authorised government technology. However, SLCs are decentralised and without the involvement of any external authority. Secondly, SLCs are also inadmissible in law. Though the Indian Evidence Act, 1872 (Evidence Act) allows electronic contracts as legally admissible, any party requiring such an admission is required to identify the related electronic record or give particulars of the device involved. The entire premise of blockchain is based on anonymity, and thus, the SLCs that are based on blockchain fall out of the purview of the Evidence Act as well.
SLCs and the Indian Energy Setup
As is the global case, SLCs possess the potential to make India’s transition to green energy a reality. The government has been persistently exploring more sources of procuring green energy, which will help reduce the load on distribution licensees and make the energy system more decentralised. In furtherance of the same, the Indian government launched the ‘Rooftop Solar Programme’ under which any household can install a rooftop solar panel by following simplified procedures laid down under the programme. The move is expected to make energy generation more decentralised. The households can also sell off the excess electricity to the grid network and earn credits from the government. However, households are not allowed to engage in ‘peer to peer’ trade of energy.
As another step, the Indian government should consider introducing a platform for households where they can sell their excess energy to others using the grid network. This will help fulfil the growing energy demands and will make green energy accessible. Moreover, using SLCs and blockchain-based peer-to-peer energy trading in the process will make it efficient and cost-effective
Indian government may also contemplate on recording REC dealings through SLCs. In the past, REC instrument has not seen great success due to possibilities of fraud. InitiatingREC transactions through SLC will allow only the authorized renewable energy generators to create a transaction and sell the REC to verified buyers. This will automate transactions, help in record keeping, prevent frauds and may even improve green financing.
It is quite clear that the energy market could revolutionize through automation and verification enabled by SLCs. While the energy sector evolves, the role of regulatory bodies will also undergo substantive changes and given that the existing Indian legal setup is not adequate for SLCs, it is imperative for the Indian government to regulate and introduce statutory guidelines to give impetus to SLCs in the energy sector. For instance, the role of power exchanges would highly increase in a peer to peer energy trading model. If peers start to trade, power exchanges will have to collect a greater number of financial data and bank guarantees from all these individuals so as to settle the transactions efficiently and build trust in the system. In such a case, government will have to come up with new regulations to organize this emerging sector and decentralize the functions of power exchanges in India.
SLCs combine the goodness of smart contracts and legal contracts; the intersection is unexplored territory, and the energy sector is ripe for the application of SLCs. While VPPAs are innovations toward a cleaner energy grid, SLCs possess the power to make energy trading efficient as well as automate energy contracts. They are packed with benefits like transparency, infallibility, and automation, which makes them harmonious with the energy market. Moreover, as energy becomes available at a more decentralized level, smart legal contracts could become a mode to avoid fragmentation of transactions. They hold the potential to bind, modernize and push the energy sector in India. With the current government’s policies completely aligned towards creating ‘Digital India’ and producing ‘Green Energy’, SLCs in the energy sector can become a helping hand to achieve both these goals. Unfortunately, India has not had the chance to implement SLCs, and for a successful implementation, legal and infrastructural development is the need of the hour.
The views and opinions expressed by the authors are personal.
About the Authors
Ms. Lavanya Gupta is working as a Legal Counsel at Wipro Limited.
Ms. Kopal Kesarwani is a 4th Year Law Student at Jindal Global University; and an Associate Editor at IJPIEL.
Managing Editor: Naman Anand
Editors-in-Chief: Muskaan Singh and Hamna Viriyam
Senior Editor: Hamna Viriyam
Associate Editor: Kopal Kesarwani
Junior Editor: Ria Goyal
Preferred Method of Citation
Lavanya Gupta and Kopal Kesarwani, “Smart Legal Contracts: A Road to Green Energy in India” (IJPIEL, 12 September 2022)