Managing Risk and Uncertainty in Carbon Finance Training Workshop : Project Formulation for the Clean Development Mechanism Hanoi, Vietnam September 30 – October 2, 2002

Managing Risk in PCF Projects  Objective: Explain how to structure carbon finance deals to improve project viability  Key issue: managing risk Sources of risk in carbon deals Assessing and assigning risks Mitigating risk through financial structure Reducing project risk through carbon finance

Sources of Risk Project Risks –Construction risk (built/operated on schedule?) – Performance risk (e.g. resource risk) – Counterparty risk (will offtakers pay on time?) – Financial and business risk (is capital structure viable, debt serviceable? Is parent company sound? Will product sell?) Baseline Risk –Eligibility--will ERs be Kyoto-compliant? –Baseline design--is the baseline robust? Will its assumptions remain valid over time? –Performance—actual performance will determine level of ERs generated

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?  Market and Policy Risk are closely linked Sources of Risk II

Assigning Risk General Principle of Project Finance: allocate risks to the parties with the greatest ability and incentive to manage it. So: Sponsor bears: –most project risks PCF bears: –baseline risk –market/price risk –policy/compliance risk –limited project risk

Mitigating Risk Baseline risk: –baseline study, assessment of “carbon asset” risk –reasonable but conservative estimate of ERs –rigorous monitoring Market risk: –market intelligence –consultations with Participants –options Policy/compliance risk: –remedies under host country agreement (and ERPA) –assignment of AAUs (ECA countries)

Mitigating Risk II (residual) Project risk: –Letters of intent with sponsor –Overcollateralization –Payment on delivery -- Upfront payments only if: PCF comfortable with project risks Essential to closing deal PCF shares in upside –Remedies –Capitalization of costs Overall: –Pricing of ERs to reflect risk.

Mitigating Risk III: Overcollateralization PCF contracts to purchase a conservative level of ERs.

Improving Project Viability through Carbon Finance Carbon finance reduces Sponsors’ risk through high-quality revenue stream and credit enhancement –PCF Pays in US $, generally upon verification of ERs –Payments can be assigned

Project: Bank-financed sanitary landfill Problem: additional funds required to finance methane capture and power generation Solution: –PCF disburses in advance of emission generation, in exchange for a share of upside –Share depends on market price of ERs Results: –PCF funds enable Liepaja to tap $5m ODA –MP reports on additional environmental aspects of project –Latvia (not PCF) receives windfall if ER prices increase Latvia Liepaja SWM Project

Sponsor’s share of excess ERs increases with market price.

Project: new IDA-supported power concession Problem: Bidders need certainty about revenues Solution: IDA funds capital subsidy; PCF provides: –Payment in advance of ER delivery (early years) –“Guaranteed” US$ payment stream subject to operator performance –PCF gets share of later ERs at no cost Result: Reliable, low-risk revenue stream to sponsor may result in lower cost to Uganda, consumers Uganda West Nile Hydro Project

Project: Eucalyptus plantation; Charcoal-based pig iron production Problem: Inadequate cash flow to plant trees Solution: Use US$ ER payments to secure and repay loan; amortization schedule = ER payments. Results: –PCF eliminates country, currency, transfer risk by paying creditor directly –Loan tenor extended from 2 years to 6 years –Company only pays interest on loan –Critical to deal financing Brazil Biomass/Pig Iron Project

ER payments are used to amortize commercial loan.

Project: 26-MW plant to be built by private sponsor Problem: Is baseline coal or gas? Solution: PCF contracts firm to buy 1m ERs; buys option on additional ERs assuming coal baseline Results: –PCF pays out firm contract ($3.5m) by 2014 if gas turns out to be baseline; 2010 if coal is baseline –Sponsor gets small option premium for incremental ERs –PCF has right (but not obligation) to buy additional, likely ERs from solid project –PCF covers reinvestment risk from under-performers Chile ROR Hydro Project

PCF purchases 1 m tonnes (based on gas baseline)…

Chile ROR Hydro Project …and options for additional ERs.

Conclusions Carbon finance can: –Improve IRRs (at zero cost to project) –Help secure financing, reduce project risk PCF assumes most carbon-related risks in carbon purchase transactions Price depends on residual risk Building carbon finance into projects can make them bankable We are here to help, as part of your team. Risk Mitigation in PCF Transactions