CDM: OVERVIEW OF FINANCIAL MECHANISMS Climate Change Information Center Manila Observatory Ateneo de Manila University

Contents 1.Mechanics of CDM 2.Basics of CDM Financing 3.Risks in CDM Financing 4.State of the Carbon Market

1. Mechanics of CDM

Clean Development Mechanism Enables developed countries (known as Annex I countries) to meet their emission reduction commitments in a flexible and cost- effective manner Assists developing countries (non-Annex I countries) in meeting their sustainable development objectives Investors benefit by obtaining Certificates of Emissions Reductions (CERs) Host countries benefit in the form of investment, access to better technology, and local sustainable development

What are the Criteria for CDM Projects? Sustainable development –Host country criteria –Environmental Impact Assessment –Stakeholder consultations Greenhouse Gas (GHG) emission reductions –Environmental additionality Project additionality Project viability –Technologically proven –Financially sound Host country approval Project validation and registration

CDM Project Achieves Sustainable Development objectives for the host developing country Reduces GHG Emissions

Simplistic numerical example Provide electricity for a barangay “Business-as-usual” (baseline): Diesel generator sets –Cost of project $10 –Emissions 1 tC Cleaner project (CDM-eligible): Micro- hydro –Cost of project $13 –Zero Emissions

Simplistic numerical example CDM Investor (e.g. Japan) –Invests $3 ($13-$10, difference between cleaner and business-as-usual project) –Gains Certificate of Emissions Reduction of 1 tC, which it can meet some of its Kyoto Protocol commitments to reduce emissions

Simplistic numerical example WIN – WIN – WIN WIN for the host country –Sustainable development benefit: Cleaner energy production technology WIN for the Annex I country –Credits for emissions reduction WIN for the Global Environment –Emissions reduction

Kyoto Protocol: Flexibility Mechanisms Present day 2012 (BaU) Assigned Amounts Domestic Actions Joint Implementation Emission Trading Annex I Emission Trading Clean Development Mechanism Domestic Actions 2012 with KP - 5% 1990 level

Price of a Unit of Emissions Reductions: A Competitive Market Cost of Reducing in the Host Country (Developing) < Price of a Unit of Emissions Reductions by CDM Cost of Reducing in the Investor Country (Annex I) <

Preparation and review of the Project Baseline Study and Monitoring Plan (MP) Validation process Negotiation of Project Agreements Periodic verification & certification Construction and start up Project completion 3 months 2 months 3 months 1-3 years Up to 21 years Upstream Due Diligence, carbon risk assessment and documentation: $ 50K Baseline: $30 K Monitoring Plan: $25K External consultant: $25K Processing and documentation: $30k Consultation and Appraisal: $75K Negotiations and Legal documentation: $30K Carbon Asset Creation and Maintenance Costs The PCF Experience: Transactions Costs Total through Negotiations All expenses: $265 K Initial verification at start-up: $25K Verification: $10-25 K Supervision: $10-20K

2. Basics of CDM Financing

Starting Point: Viable Project A potential CDM Project is a feasible project  Technologically feasible  Financially sound A potential CDM Project is a project which has an Environmental Compliance Certificate (ECC)

Total Project Costs and Sources of Finance Total Project Cost Estimates Investment costs, including development costs, up to commissioning of project Sources of Finance to be Sought or Already Identified Critical to identify other debt and/or equity finance Typical sources of funding: international development banks, government funding, private financing, supplier credit CDM contribution = typically 5-15% of total project costs

Important Distinction Project Financing –Equity –Debt CDM Finance / CER Revenue

Financing Options in a CDM Project Equity Annex I Investor co-finances part of a CDM project in return for shared financial returns and CERs Local investors co-financing CDM projects in a host country may wish to share in CERs so that they have the opportunity to sell the credits at a later time

BanksInvestor DebtEquity Power Purchase Agreement $$ Electricity CDM Equity Financing CDM Investor Equity $$ CERs

Financing Options in a CDM Project Loan Annex I Investor provides loan or lease financing at concessional rates in return for CERs

BanksInvestor DebtEquity CDM Debt Financing CDM Investor CERs Electricity $$ Debt $$

Financing Options in a CDM Project Emission Reductions Purchase Agreement Annex I investor agrees to buy CERs as they are produced by the project

BanksInvestor DebtEquity Power Purchase Agreement $$ Electricity Emission Reductions Purchase Agreement CDM Investor $$ CERs Emission Reduction Purchase Agreement

Financing Options in a CDM Project Carbon Funds Annex I investors contribute to a mutual fund Mutual fund agrees to buy CERs as they are produced by the project Examples –WB Prototype Carbon Fund –Netherland’s CERUPT

How Carbon Funds Work.. Industrialized Governments and Companies Developing Countries and Communities Carbon Fund $ $ Technology Finance $ $ Technology Finance CO Equivalent 2 Emission Reductions CO Equivalent 2 Emission Reductions

Carbon Fund $ $ $ $ 22 Emission Reduction Purchase Agreement BanksInvestor DebtEquity Power Purchase Agreement $$ Electricity $$ Carbon Credits Nature of Carbon Financing Contract

Emission Reduction Purchase Agreement Will improve IRRs Forward contract –Payment upon delivery of verified ERs –Upfront payments are rare Will provide a hard currency revenue ($, €, £, ¥) Helps secure financing and reduce project risk –Future ER payments as collateral for project loans –Can be paid into an escrow account, protecting lenders from currency convertibility and transfer risks

How CDM can matter Without CERs implemented With CERs not implemented No CDM Without CERs not implemented; with CERs implemented CDM FIRR CER income 0

Technology  IRR Hydro, Wind, Geothermal Methane Kick Crop/Forest Residues3-7 Municipal Solid Waste5-10+ Impact of Carbon Finance on Project Financial Rate of Return Revolution in Solid Waste Management Important impact on small-holder crop- processors and animal production

BanksInvestor DebtEquity Power Purchase Agreement $$ Electricity CDM Equity Financing CDM Investor Equity $$ CERs ODA Non-ODA

BanksInvestor DebtEquity CDM Debt Financing CDM Investor CERs Electricity $$ Debt $$ ODA Non-ODA

Carbon Fund $ $ $ $ 22 Emission Reduction Purchase Agreement BanksInvestor DebtEquity Power Purchase Agreement $$ Electricity $$ Carbon Credits Emission Reduction Purchase Agreement ODA Non-ODA

3. Risks in CDM Financing

Risks in CDM Financing Renewable energy projects are considered risky by financing institutions Multitude of risks could reduce the value of the project to zero Measures are needed to mitigate risks at different stages of the project

“Normal” Project Risks Political/Country Risks Sponsor Risks Construction Risks Technical Risks Fuel Risks Environmental Risks Financial Risks Legal Risks Operation Risks

CDM-Specific Risks Market/Price Risk –Will there be a market for project-based ERs? –Will contract price exceed market price? Policy/Compliance Risk –What if no Kyoto Protocol? –What if host country does not ratify or comply? –What if host country does not approve project?  Market and Policy Risk are closely linked

Baseline Risks –Eligibility--will ERs be Kyoto-compliant? –Will project be validated and registered? –Will ERs be verified and certified? –Baseline design--is the baseline robust? Will its assumptions remain valid over time? –Performance--actual performance will determine level of ERs generated CDM-Specific Risks

4. Emerging Trends in the Carbon Market

Summary of carbon markets currently in operation Project-based Emission Reduction purchases Allowance Trading Within National trading systems Intra-Firm trading Retail UK DK Shell BP “Pre-Compliance” From voluntary To Kyoto Pre-Compliance

Market Intelligence: “Few Countries Benefiting, Little Private Sector Buying” Market: cumulative 200 million tonnes CO 2 traded ($500 million) since 1996 Five-fold increase between 2001 and 2002 Only 43% of all carbon transactions made in CDM/JI ( ), dominated by Dutch and PCF Only 13% of the private sector’s purchases were in CDM ( ) African countries, smaller countries and small- scale projects are largely bypassed

Carbon Market Volume has increased Source: Authors’ own calculation, as above, volume projection by PointCarbon

Who is buying ER Credits? Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon

Balance in Asset Classes Emerging Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon

Carbon Finance flows Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon USA Canada Australia Latin America Asia Africa

Who’s buying where? ( ) Source: Authors’ own calculation, based on transaction database assembled with Natsource, Co2e.com and PointCarbon In , private companies acting alone have purchased only 13% of their reductions in developing countries.

World Bank Carbon Finance Vehicles BioCarbon Fund Netherlands CDM Facility Italian Carbon Fund

World Bank’s Carbon Finance Business - at a Glance Carbon Purchases agreed and under negotiation: ~40, ~US$250 million Number/Value of PCF and Netherlands Projects approved for carbon purchase: 64, US$ 440 million Carbon Asset portfolio: ~50 million tCO 2 e Underlying CDM/JI project finance: ~$3.0 bn

Sample Projects Latvia: $2.5 million PCF Purchase –anaerobic decomposition of about 20,000 tons of garbage a year –ERs from the existing landfill site gas recovery began June 2002 Uganda: $3.9 million PCF purchase –a 5.1 MW and 1.5 MW small hydro generating facilities in the West Nile region –Displaces >200 small and few large public diesel gensets Chile: $6 m PCF Purchase –26MW run-of-river hydro generating 175 GWh to replace coal/gas Brazil: $5 mm of PCF Purchase –Substituting coal/coke by sustainably produced charcoal in pig iron production, plus afforestation and ecosystem restoration, biodiversity and health benefits

Lessons from PCF: Carbon Prices Uganda small hydro (5&1.5 MW) remote area$3.00 Chile: 25 MW hydro run-of-river$3.50 [ +option] Brazil sustainable charcoal replacing coal/coke$3.50 Poland District Heating Fuel Switch – Coal to Geothermal and Biomass $3.50 C. America small wind/hydro$3.50 Romania Afforestation$3.60 [+option] Colombia wind farm$ South Africa Durban waste management$ Czech small-scale energy efficiency$4.00

Carbon Funds in Asia Asian Development Bank CDM Facility Development Bank of Japan Carbon Fund of Japan JBIC Carbon Fund

Carbon Prices Source: PCF estimates, based on database assembled with Natsource,Co2e.com and PointCarbon

Pricing of Emission Reductions Price range offered depends on the –Legal jurisdiction of the ER Kyoto Protocol, EU trading system, domestic trading systems such as those in UK or Denmark or the voluntary market –Price signal in the market for the jurisdiction –Willingness to pay of the buyers Price outcome in a project depends on risk sharing in the contracts including –Regulatory risk (e.g. Kyoto Protocol entry into force, eligibility of project, verification and certification) –Project performance and delivery risk

Price Differentials b/w CER & AAU Different Carbon Markets Legal Status of Asset  AAU has more secure status than CER  CER has Kyoto Risks Different Trading Regimes  AAU: Cap-and-trade  CER: Baseline-and-credit Each reduction has to be certified – higher transaction costs Baseline risks Compartmentalized Carbon Markets –At present, not allowed to trade CER in EU Trading Schemes

Estimated and Contracted ERs Contract default value 510 Year Estimated emission reductions Minimum contracted emission reduction Additional emission reductions

Actual performance and contract volume 510 Year Expected ERs

Actual performance and contract volume 510 Year Expected ERs “Swept” amount ERs freed due to sweeping Minimum contracted amount

Historical Emissions Low Surplus (High Demand, Low Supply) High Surplus (Low Demand, High Supply) % change Carbon Balance % change Carbon Balance GROSS DEMAND EU Carbon %120-3%30 Japan Carbon %58-3%17 Canada Carbon %610%37 + Net other GHGs (+5, -5%) Managed forest allowance -30 Buyers of Carbon Credits [MtCe/yr] (Source: Grubb, March 2003)

Historical Emissions Low Surplus (High Demand, Low Supply) High Surplus (Low Demand, High Supply) % change Carbon Balance % change Carbon Balance SUPPLY Russia Carbon %1060%196 Ukraine Carbon %670%87 Accession 10 Carbon %455%75 Other EITs %240%36 Other GHGs (10, 20%) Managed forest allowance 40 CDM Sellers of Carbon Credits [MtCeq/yr] (Grubb, March 2003)

Probable prices for CERs (£/tCO 2 e) (Grubb, March 2003) Renewable energy and energy efficiency projects under CDM fast-track procedures for small scale projects  £10 – 25 per tCO 2 e Land use and other CDM projects  £ 5 – 15 per tCO 2 e

Key Factors in CDM Market Development Need 5 years+ for carbon finance to make a difference in a project at current prices; Buyers only want ERs delivered by They heavily discount ERs after 2012 If value of post 2012 ERs is not assured by 2006, CDM market activity will decline sharply

Lead Time and Uncertainty Constraints on Project-Based Mechanism (esp. CDM) Operating Wind, Efficiency, Waste to Energy Large Hydro, Geothermal, Coal to Gas Power CDM Investment Window: 3years IF NO Decision; No Incentive beyond 2012, No Investment, Market Development Stalled Operating = Start Construction

CDM: Challenges ahead

Roberto C. Yap, S.J., Ph.D. Environmental Economist Climate Change Information Center Manila Observatory Ateneo de Manila University Tel Fax