OVERVIEW: CDM FINANCING DENR Training Course November 4-6, 2003 Climate Change Information Center Manila Observatory Ateneo de Manila University

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

1. 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

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

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

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

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

Financing Options in a CDM Project Full or partial equity Annex I Investor finances all or co- finances part of a CDM project in return for full or 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 ODA Non-ODA

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 $$ Debt $$ ODA Non-ODA

2. CDM Transaction Costs

Pre-implementation costs Search costs Negotiation costs Baseline determination costs Approval costs Validation costs Review costs Registration costs

Implementation costs Monitoring costs Verification costs Review costs Certification costs Enforcement costs

Trading costs Transfer costs Registration costs

Transaction costsRelation to project size Estimate (k€) Search costsFixed15 Negotiation costsDegressive25 – 400 Baseline determination costsFixed35 Approval costsFixed40 Validation costsFixed15 – 30 Registration costsFixed10 Monitoring costsFixed10 Verification costsDegressive8 per turn Certification costsDegressiveNA Enforcement costsProportional Transfer costsProportional1% Registry costsProportional0.03% Minimum fixed costs (k€)150 Source: Michaelowa et al (2003)

Project size, types & total transaction costs SizeTypeReduction (t CO 2 per yr) € / t CO 2 Very Large Large hydro, geothermal, landfill methane >200, LargeWind power, solar thermal, energy efficiency 20,000 – 200, – 1 SmallBoiler conversion, DSM, small hydro 2000 – 20,00010 MiniEnergy efficiency in housing & SME, mini- hydro 200 – MicroPV< Source: Michaelowa et al (2003)

Project size thresholds PCF considers any project with a volume below 3 million € greenhouse gas benefits would not be attractive due to transaction costs  Threshold of about 50,000 t CO 2 per year for a 20–year project Transaction costs should not be more than 25% of proceeds of CER sales to make a project viable (Shell, 2001) Cost threshold of about 1 € / t CO 2

Viability of CDM Projects Given CER market price estimates of 1 – 5 € pet t CO 2 (Jotzo and Michaelowa, 2001) Given PCF transactions priced at 3 – 4 € per t CO 2  Only projects classified as large and very large are viable  Many small-scale projects would not be viable

Ways to reduce transactions costs Bundle projects to jointly undertake each step of the project cycle

Ways to reduce transactions costs Do verification and certification not annually but at long intervals Exempt projects from one or more steps of the project cycle Streamline the information needs on each step of the project cycle Standardization of parameters Source: Michaelowa et al (2003)

Ways to reduce transactions costs Do unilateral CDM projects that reduce search and negotiation costs Registration and certification fees proportional to the size of the project Validation and verification fees proportional to the size of the project Source: Michaelowa et al (2003)

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

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)

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

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

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