carbon finance
TRANSCRIPT
Carbon Finance
MEMAE
Master in Economics and Management of Environment and Energy
Ricardo Scacchetti
Tutor Bocconi: Stefano Gatti
Tutor First Climate: Nikolaus Schultze
Università Luigi Bocconi
December 2009
1
Preface
This thesis was written during my internship at the Project Finance
department of First Climate, which is a carbon asset management company,
covering the entire carbon credit value chain. The Project Finance department is
responsible for securing funds for projects, either through dedicated funds or
partner institutions.
The internship gave me the opportunity to understand the Carbon Market by
inside. In addition, working in the Project Finance department I could know the
main mechanisms by which an emission reduction project can be financed and
also understand the project success drivers by assessing a number of projects in
Europe, Africa and Latin America within a wide variety of technologies. However,
the development of this thesis includes not only First Climate’s experiences, but
also a research on Project Finance, Carbon Market and Carbon Finance concepts.
2
Acknowledgements
I wish to thank First Climate, for giving me this tremendous opportunity to
know Carbon Market in such a wonderful work environment, and specially
Nikolaus Shultze, Linda Manieram and Stephanie La Hoz Theuer.
I also wish to thank Stefano Pogutz, Master’s Director, for motivating me to
enroll the course, and Stefano Gatti for being my tutor in this thesis.
On a personal level, I want to thank Louise Ferré for her affection, constant
good mood and patience, to all my colleagues from Bocconi for their friendship
and my family for their support.
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Index
Acronyms ........................................................................................................................5
1 Introduction ...........................................................................................................6
2 Carbon Market background ....................................................................................7
2.1 Kyoto Protocol................................................................................................7
2.2 CER the new commodity.................................................................................8
2.3 Barriers for the CDM project development ................................................... 15
3 Carbon Financing .................................................................................................. 16
3.1 Carbon Finance concept ............................................................................... 16
3.2 Early assessment .......................................................................................... 20
3.3 Carbon Finance models ................................................................................ 24
3.4 Risk identification and sharing ...................................................................... 28
4 Conclusions .......................................................................................................... 33
References .................................................................................................................... 35
Annexes ........................................................................................................................ 37
4
Figures
Figure 1: CER commercialization in different Emission Trading Schemes..........................9
Figure 2: Carbon Market values ..................................................................................... 11
Figure 3: Types of CDM project with CERs issued (% number of projects) ...................... 13
Figure 4: Expected growth of accumulated CERs by project type ................................... 14
Figure 5: Registered projects by host region (% number of projects) ............................. 14
Figure 6: Project Finance documentation ...................................................................... 18
Figure 7: Carbon Finance concept ................................................................................. 20
Figure 8: Ratio of investment to ERPA value .................................................................. 22
Figure 9: Emission reduction success rates (by technology) ........................................... 23
Figure 10: Carbon payments escrowed as debt service .................................................. 26
Figure 11: Pooling model ............................................................................................... 27
Figure 12: Local Bank guarantee model ......................................................................... 27
Figure 13: Project Risks profile per stage ....................................................................... 29
Figure 14: CDM project risk profile and its impact on Carbon Credit price ..................... 30
Figure 15: General project risks groups ......................................................................... 31
Figure 16 - Participants to the Kyoto Protocol ............................................................... 37
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Acronyms
CER Certified Emission Reduction
CDM Clean Development Mechanism
ERPA Emission Reduction Purchase Agreement
GHG Greenhouse gas
IRR Internal Return Rate
JI Joint Implementation
LDC Least Developed Country
LFG Landfill Gas Recovery and Flaring project
LoA Letter of Approval
NPV Net Present Value
PDD Project Design Document
PIN Project Idea Note
UNEP United Nations Environment Programme
UNFCCC United Nations Framework Convention on Climate Change
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1 Introduction
According to UNFCCC1, additional investment and financial flows of USD 200 –
210 billion will be necessary in 2030 to develop an effective and appropriate
International response to climate change. The largest share (86%) of this
investment and financial flow is constituted by private-sector investments. In this
light, the Carbon Market plays an important role in shifting private investment
flows to reach the necessary investments to mitigate climate change issues. In
order to do so, the Kyoto Protocol has developed mechanisms able to leverage
the necessary capital such as the Clean Development Mechanism (CDM).
Despite the success of the CDM Market with more than 500 fully developed
projects since 2004, the progress of CDM projects has been limited by some
barriers. According to UNEP2, the lack of access to financing is one of the key
reasons why numerous CDM projects have never materialized. In this sense,
“Carbon Finance” plays a significant role in the Carbon Market, acting as
facilitator for project financing. Nevertheless, access to financing is not the only
factor that will improve the CDM performance.
This dissertation explores the main activities carried out by Project Finance in
the Carbon Market such as the project assessment and the arrangement of
financial mechanisms related to Carbon Credits, giving the necessary background
to the reader. By way of background, the first Chapter introduces the Carbon
Market and the transformation of Carbon Credits in a valuable and liquid
commodity. Chapter 2 explains the mechanism of Carbon Finance, its different
instruments and how it influences Project Finance. Lastly, Chapter 3 summarises
the main concepts and concludes with lessons learned from real experiences.
1 United Nations Framework Convention on Climate Change (UNFCCC), Investment and financial
flows to address climate change, (2007).
2 United Nations Environment Programme (UNEP), Guidebook to Financing CDM projects
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2 Carbon Market background
This section provides a brief overview of the Carbon Market. Firstly, it
addresses the origin of the Kyoto Protocol and its Flexible Mechanisms, including
Carbon Credits. Secondly, it briefly describes the main Carbon Credit trading
schemes in existence, and the resulting adoption of the Carbon Credit as a new
commodity. Finally, it describes the CDM, its process in generating Carbon
Credits and its barriers for further development.
2.1 Kyoto Protocol
At the Rio 92 conference, there was a broad international recognition of the
need for a common effort to mitigate climate change. This resulted in an
unprecedented international legally binding agreement, aiming to curb
greenhouse gas emissions – the United Nations Framework Convention on
Climate Change (UNFCCC).
The need to establish concrete measures and targets for action on the
UNFCCC’s framework provisions resulted in the Kyoto Protocol, signed in 1997.
Under the Kyoto Protocol, industrialized countries and some developing
countries agreed to specific emission reduction targets. Based on the principle
that effect on the global environment is the same regardless of where GHG
(Greenhouse gases) emissions reductions are achieved, countries may meet their
targets through a combination of domestic activities and use of Kyoto Protocol
“Flexibility Mechanisms”, which are designed to allow industrialized countries to
meet their targets in a cost-effective manner and to assist developing countries
in particular to achieve sustainable development. There are three Kyoto Protocol
Flexibility Mechanisms:
Joint implementation - JI
Clean Development Mechanism - CDM
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International Emission Trading
Both JI and CDM are “project-based” mechanisms which involve developing
and implementing projects that reduce GHG emissions, by generating Carbon
Credits that can be sold on the Carbon Market. JI is a mechanism that allows the
generation of credits (known as Emission Reduction Units or ERUs) from projects
within Annex I countries, whereas the CDM allows the generation of credits
known as Certified Emission Reductions (CERs) from projects within non-Annex I
countries(i.e. developing countries). Finally, International Emissions Trading
allows trading directly between Annex I Parties in the units in which each
country’s target is denominated, known as Assigned Amount Units (AAUs). All of
these different units (ERUs, CERs and AAUs) are effectively permits allowing an
Annex I Party to emit one tonne of carbon dioxide equivalent.
The various categories of participants on the Kyoto Protocol are illustrated on
Annex 1.
2.2 CER the new commodity
As mentioned above, “project-based” mechanisms, namely CDM and JI can
generate different types of Carbon Credits, as CERs or ERUs respectively. The
CDM is the most important mechanism, representing 90% of the project-based
transactions. Thus, this mechanism will be further explored to show the current
barriers and challenges faced by CDM projects.
The CERs can be commercialised in different markets resulting in different
prices. The main current trading markets are illustrated below:
9
Figure 1: CER commercialization in different Emission Trading Schemes.
Emission Trading Schemes
The Carbon Market has doubled in value each year reaching about EUR 86
billion in 2008. The existing Carbon Markets can be divided between compliance
and voluntary markets. The terms compliance and voluntary Carbon Markets
refer to whether or not industries are obligated to hand in carbon allowances
and Carbon Credits to governmental institutions. The existing emission trading
schemes, are briefly described below:
European Union Emission Trading Scheme (EU ETS) is the largest
compliance market, representing three-quarters of market volume and
value, and it is the most significant in terms of generating demand for
CERs.
The start-up: on January 2005, with the participation of the 27 EU
Member States. The scheme covers five sectors, whose emissions
represent 45% of the EU’s emissions, namely power and heat generation,
iron and steel, mineral oil refineries, mineral industry and the pulp and
paper sectors.
The system: the Kyoto Protocol emission target is shared out between
EU Member State and each country is responsible for allocating their
individual emission allowances to the sectors covered by the EU ETS. The
EU ETS allows companies to trade surplus EUAs between themselves. In
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addition, companies are able to purchase CER from CDM projects in order
to achieve their target.
Keidanren voluntary action plan is a voluntary emission trading scheme
established in 1996 by the Japanese business federation. This scheme
involves 85% of the industrial emissions and these companies have the
option of using CERs. A compliance market is under development in
Japan.
Chicago Climate Exchange (CCX) is a voluntary scheme based in Chicago,
USA. Although the CCX allows the use of CERs, the volumes and prices
traded on the CCX market were comparatively low.
Regional Greenhouse Gases Initiative (RGGI) is a coordinated effort
between seven USA States (Connecticut, Delaware, Maine, New
Hampshire, New Jersey, New York and Vermont) to implement a cap and
trade program to limit GHG emissions in the region. It is currently of
limited interest to CER vendors as it will only allow the use of CERs when
the price of emissions reductions rises above US$10 per tonne.
Canadian Large Final Emitters (LFE) is currently on hold by the Canadian
government on its way forward. It is supposed that LFE will allow access
to CERs.
Australian Carbon Pollution Reduction Scheme (CPRS) the Australian
trading scheme is moving rapidly forward. This scheme involves 80% of
the Australian emissions and it is currently being decided which
conditions the use of CER for abatement would be permitted.
11
Figure 2: Carbon Market values
Source: World Bank
The Carbon Market rapidly reached an improved level of maturity, due to the
healthy exchange of in-depth information and know-how, reinforced by a
transparent regulatory system. The achieved market maturity resulted in
reduced margins and spreads as well as in a less volatile market.
CDM processes
The carbon credit generated by a CDM project is the CER; one unit of CER
means 1 tonne of CO2 equivalent (tCO2-e). The Kyoto Protocol recognises six
main greenhouse gases with different Global Warming Potentials (GWP). The
equivalences per tonne of each recognized gas are described below:
Carbon dioxide (1t CO2) = 1 tCO2-e
Methane (1t CH4) = 21 tCO2-e
Nitrous oxide (1t N20) = 310 tCO2-e
Hydro-fluorocarbons (1t HFCs) = 150−11,700 tCO2-e
Perfluorocarbons (1t PFCs) = 6,500−9,200 tCO2-e
Sulphur hexafluoride (1t SF6) = 23,900 tCO2-e
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CDM projects must overcome a rigorous process of documentation and
approval, called CDM project cycle, in order to generate CERs. This process is
regulated by UNFCCC and the main steps are: initial feasibility assessment,
development of a Project Design Document (PDD), host country approval,
project validation, registration, emission reduction verification and credit
issuance. Throughout, this process involves national and international
stakeholders.
In order to receive approval of the entities responsible for validation and
verification, CDM projects must meet the requirements described below:
Contribute to the host country’s sustainable development;
Provide real, measurable carbon emission reductions using an approved
baseline and monitoring methodology. The fact that the project must
quantify the emissions reduction potential before submitting for
validation is particularly important for project developers also, since this
information allow them to know the carbon revenue potential.
Reductions in emissions must be “additional” to any that would occur in
the absence of the certified project activity. In other words, a CDM
project should be something that would not have happened, in the
absence of the CDM. For instance, a CDM project with a high IRR does not
meet this “additionality” criteria, since it is commercially attractive
without the CER revenues.
Projects should not result in significant negative environmental impacts
and undertake public consultation.
Projects should not result in the diversion of official development
assistance (ODA).
CDM overview
There are more than 160 approved baseline and monitoring methodologies
available, however most of the completed projects have concentrated only on a
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relative few. Around 87% of the CDM projects are related to renewable energy,
methane reduction and energy efficiency, as illustrated on figure 3.
Figure 3: Types of CDM project with CERs issued (% number of projects) CERs issued in each sector
6%
60%
19%
8%
3%4%0%0% HFCs, PFCs & N2O reduction
Renewables
CH4 reduction & Cement & Coal mine/bed
Supply-side EE
Fuel switch
Demand-side EE
Afforestation & Reforestation
Transport
Source: UNFCCC
CDM has boosted renewable energy projects since last few years. According
to “State of the Carbon Market in 2009” of Word Bank:
“CDM leverage clean energy investments in 2008 through projects in renewable
energy, fuel switching and energy efficiency. Hydro, wind, biomass energy and
energy efficiency of power generation at large industrial facilities led the growth of
the CDM pipeline and accounted for 70% of the number of projects and 65% of the
volumes that entered the pipeline from January 2008 to March 2009. Hydro projects
alone accounted for over a quarter of all projects and volumes entering the pipeline
in this period.”
Renewable energy projects are expected to continue growing supported by
two main factors: First, a high opportunity for emission reduction in the energy
sector. Second, the energy sector, even in Developing Countries, is well
structured and presents a technical know-how, which facilitates the
implementation of such a sophisticated mechanism as the CDM.
The market is dominated by projects reducing hydroflurocarbons (HFCs),
nitrous oxide (N2O) and methane (CH4), which in total account for about two
thirds of all expected CERs. This is due to the high global warming potential of
these gases (around 11.700 x CO2-e). By contrast, the large number of renewable
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energy projects accounts for only 22% of all expected CERs (Figure 4). The
reasons are that renewable energy projects typically reduce emissions of CO2,
which has a global warming potential of 1, and are often small-scale applications.
Figure 4: Expected growth of accumulated CERs by project type (Million of CERs on pipeline)
Growth of total expected accumulated 2012 CERs
0
500
1.000
1.500
2.000
2.500
3.000
Dez 0
3
Jun 0
4
Dez 0
4
Jun 0
5
Dez 0
5
Jun 0
6
Dez 0
6
Jun 0
7
Dez 0
7
Jun 0
8
Dez 0
8
Jun 0
9
Millio
n C
ER
s
Afforestation &
Reforestation
Fuel switch
Energy Efficiency
CH4 reduction &
Cement & Coal
mine/bedRenewables
HFC & N2O reduction
Source: UNFCCC
China hosted around 84% of the CDM projects in 2008, followed by India with
4% and Brazil with 3%. Furthermore, there is a broad recognition that the CDM
must be spread farther afield to lesser developed countries, especially in Africa.
Changes on the CDM rules for the Post Kyoto period (2012-2020) are being
discussed, in order to facilitate CDM development in Least Developed Countries.
Figure 5: Registered projects by host region (% number of projects)
Asia /
Pacific
73.72%
Latin
America
23.89%
Africa
1.85%
Other
0.54%
Source: UNFCCC
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2.3 Barriers for the CDM project development
Although, CDM gives projects the opportunity to receive CER revenue, it does
changes the risk profile of the project, since CDM subjects the project to CDM
requirements and associated high transaction costs. Moreover, projects in
Developing Countries have an additional challenge related to the country risk
profile. The main barriers for the CDM projects development are:
CDM project cycle - inefficiencies and bottlenecks in the CDM regulatory
system. According to World Bank:
“Only one-third of the projects in the pipeline have been registered and by
some projections, only about half of the potential CDM supply is expected to
materialize by 2012. There is continuing frustration regarding the regulatory
process, not just from private project developers but also from state-owned
developers and developing country governments who have been waiting for their
expected revenue streams to flow. Delays and inefficiencies along the project
cycle have continued, leading to higher transaction costs, losses in CER volumes
and lower market values.”
Developing countries risks - CDM projects must be undertaken in
Developing Countries, as a result of that they generally face additional
challenges related to: political instability, high tax, weak regulatory
systems, lack of infrastructure, local know-how and access to financing.
As mentioned earlier, Post Kyoto agreement probably will facilitate and
promote the development of CDM projects in Least Developed Countries;
this will significantly increase the challenge.
Uncertainty about the future CER price and regulatory rules post Kyoto.
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3 Carbon Financing
This chapter describes how Carbon Credits can be used to finance CDM
projects. Firstly, it explains the Carbon Finance concepts. Secondly, it describes
the investor Project Finance approach of a CDM project, beginning with the
assessment of projects and illustrating the most common financial structures of
Carbon Finance. Lastly, it describes the identification and management of project
risks.
3.1 Carbon Finance concept
Carbon finance is based on the ability to monetise the sale of Carbon Credits
to finance project investment costs. Carbon Finance involves few specific parties
and documents that go beyond conventional Project Finance documentation.
Parties involved in Carbon Financing
Carbon Finance transactions normally involves Project owners, Carbon Credit
sellers, government and sources of finance. These parties and their respective
role in Carbon Finance are briefly described below:
Project owner – The entity which promotes a project, brings together the
various parties and obtains the necessary permits and consents in order
to get the project underway. Often they are involved in some particular
aspect of the project such as construction and/or operation. They are
invariably investors in the equity of the project company and may be debt
providers or guarantors of specific aspects of the project company’s
performance.
Carbon Credit buyer – The entities which purchases Carbon Credits
normally are Carbon Credit investment funds, Carbon intermediaries or
compliance companies.
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Banks – Generally banks involved in Carbon Finance are International
banks with experience in Carbon Market, often having dedicated
departments of specialists, or local banks (Developing Countries) with no
experience or knowledge in Carbon Market.
Host government – The host country is likely to be involved in the
issuance of consents, permits and licences. This party can also act in
sharing risks with the sponsor company.
Multilateral agencies – Multilateral agencies are able to enhance the
bankability of a project by covering risk levels that the project cannot
cover.
Third-party equity – These are investors in a project who invest alongside
the sponsors. Unlike the sponsors, however, these investors are looking
at the project purely in terms of a return on their investments for the
benefit of their own shareholders.
Project documentation
Contracts between the various project parties assume a huge significance in
project/ carbon finance and it is these documents that are the instruments by
which many of the project risks are shared amongst the project parties. Figure 6
below illustrates the most common documents for a project.
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Figure 6: Project Finance documentation (Source: A guide to project finance)
In addition to these documents usually found in Project Finance, CDM projects
also incorporate specific documents generated during the CDM cycle (2.2.2 CDM
processes) and Carbon Credit sales. These documents are described below.
Project Idea Note (PIN) - Preliminary CDM feasibility study; not a statutory
part of the CDM process but often produced to facilitate host country
approval and/or financing of a project.
Project Design Document (PDD) – Document contents include project
description, estimation of ex ante net anthropogenic GHG removals,
monitoring plan, environmental and social impacts. This document needs
to be prepared and submitted by the project developer in order to
register a CDM project.
Validation Report – Document that reports the result of the validation
process, which determines that the project is eligible to be registered as a
CDM project, confirming that the project meets the requirements of the
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CDM. This process is carried out by independent private entities, called
designated operational entities (DOE).
Letter of Approval (LoA) – The letter by which the designated national
authority (DNA) confirms that it approves the participation of the project
proponents in the project activity, and in the case of the host Party letter
of approval, that the project will contribute to sustainable development
in that country.
Monitoring Report – Reports the result of the measuring of emission
reductions. This report determines the amount of Carbon Credits to be
issued.
Emission Reduction Purchase Agreement (ERPA) – Contractual agreement
for the purchase of CERs. The ERPA is crucial to reduce uncertainties
about project future revenues, by determining the price and ensuring the
acquisition of the future Carbon Credits generated. The price may be
fixed or indexed on the current Carbon Credit market prices.
Function of Carbon Finance
The main purpose that leads to Carbon Finance is the emissions reduction
potential of the project. This projected emissions reduction is translated into
future cash flow by an ERPA signed between a Project Owner and a Carbon
Credit buyer. The ERPA may support the project financing in the following
manners:
Up-front payment for future delivery of Carbon Credits
Increase of collateral for debt
Improvement of the project attractiveness by ensuring future revenues
Figure 7 below illustrates the ERPA’s effect over Project Financing. During the
project development, from the planning phase until the financial closure,
different sources of finance must be sought in order to fulfil the necessary capital
20
for the construction. The ERPA can attract finance sources due to the
improvement of the project cash flow or the collateralization of debt. The
mechanisms by which the ERPA can be used to boost Project Finance will be
further explored on “3.3 Carbon Financing Models”.
Figure 7: Carbon Finance concept
3.2 Early assessment
The Early assessment is the first step conducted by an investor in order to
identify the main characteristics of a project. This analysis also permits investors
to check the project’s robustness, verifying some aspects where CDM projects
normally fail. Risks identification and mitigation instruments will be explored in
“3.4 Risk identification and sharing”.
Counterparty check
The counterparty check aims to identify the parties involved in the project, to
assess their experience and financial situation as well as to determine whether
there is any associated reputational risk. The variety of variables analysed in a
counterparty check are listed below:
Experience - projects realized, years acting in the market, clients portfolio
and partners;
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Financial situation or creditworthiness - Ratio Debt/Equity; liquidity
(current asset - current liability); operating profit; rating agencies
(Moody’s, Standard & Poor’s, Fitch Ratings)
Reputational risk - is widely defined as any negative comments with
respect to a company’s activities. The issue that is addressed here is
public perception. In order to assess public perception, an internet
research is done, testing associations between the counterparty name
and different issues such as corruption, environmental problems,
insolvency and social scandals.
Project development status
A CDM project can be thought as a conventional project with an additional
CDM-specific component. As the project status evolves, the uncertainty related
to the project outcomes decreases, and consequently the project risk profile also
diminishes. Since, financiers’ appetite for risk may not match the project risk
profile, different sources of finance must be sought according to each phase the
project is in. These finances are accumulated until the necessary capital for the
total investment is completed. (Figure 7)
Therefore, is important to identify the current development phase of the
project in order to identify sources of finance which match with the project risk
profile. The assessment of the CDM project development can be made by the
UNFCCC website, verifying the published documents of the specific project, if the
project is already registered. Otherwise the assessment can be done based on
the PIN sent by Project Owner.
Carbon Finance’s capacity of attracting finance sources
Depending on the ratio between Carbon Credit value and project total
investment, the capacity of leveraging finance sources by Carbon Finance can be
more or less significant. This ratio can change mostly based on the project
technology, for instance a Landfill Gas Recovery and Flaring project (LFG), has all
22
its revenue generated by Carbon Credits, so Carbon Finance will be essential
important in attracting finance. On the contrary, Carbon Finance will be less
important in the case of a Wind energy project, where the Carbon Credit revenue
represents a slight part of the total project investment. Figure 8 below shows the
ratio of investment to ERPA value for different projects technologies (for
instance, Hydro projects investment are 12 times bigger than the ERPA value).
Figure 8: Ratio of investment to ERPA value
0 2 4 6 8 10 12 14
HFC
Energy Efficiency
Landfill Gas
LULUCF
Biomass energy
Wind
Hydro
ERPA value = Investment
Source: World Bank
In addition, an important factor that determines the carbon finance’s capacity
of attracting finance sources is the effectiveness of certain project in issuing
CERs, in particular the issuance rate (Figure 9). In the case of non operating
projects, this factor depends basically on the precision of emission reduction
projections. The success rate can be analysed by type of technology, since
projects of the same technology use the same methodology to foresee emission
reductions. In the case of operating projects, the success rate can be assessed by
the Monitoring report, which shows the real emission reductions generated over
a given period.
23
Figure 9: Emission reduction success rates (by technology)
0% 20% 40% 60% 80% 100% 120%
HFC
Energy Efficiency
Landfill Gas
Transport
Biomass energy
Wind
Hydro
Source: UNEP RISØ –Issuance success
Therefore, the assessment of the capacity of Carbon Finance in leveraging
finance sources must take into account two factors: the ratio between value of
Carbon Credits and the sought capital; and the normal success rate of Carbon
Credit generation for the analysed project technology. A further analysis to
identify the real success rate of the project can be done during a Due Diligence;
however, at the Early assessment, the most important thing is to have a
indicative perception of risks.
Scale: Capital Investment and CER available
Although large scale projects are preferred by banks and funds due to their
economies of scale and reduced transaction costs, small scale projects represent
44% of all CDM projects3. One of the main reasons for such a result is that there
are several small-scale methane (CH4) reduction projects, where global warming
potential is 21 times bigger than CO2. Moreover, there are two additional reasons
for that: the lack of large-scale approved methodologies; emission reduction
success ratio does not depend statistically on the project scale.
Therefore, the assessment of project scale is important to match the project
scale with potential investor interest. Generally, small scale projects can be
3 Data of UNEP RISO - 2008
24
interesting for the voluntary market or they can be packaged into a big project
that is interesting for carbon funds or banks.
3.3 Carbon Finance models
As mentioned before, CDM projects have faced some barriers in accessing
finance due to some intrinsic aspects such as small size; clean technologies are
usually more capital intensive than conventional ones; lenders ask for higher
interest rates in Developing Countries; and local financial institutions do not
accept Carbon Credits as a valuable asset (security) or do not understand the
risks involved in the CDM cycle processes. Therefore, in front of these challenges
the Carbon Market has developed mechanisms to overcome these barriers. The
most common models are described below:
Advanced payment mechanism
Carbon Credit buyers may be willing to invest in CDM projects, since they are
also interested in the materialization of the project. This investment is usually
done as a form of upfront payment, applying a high discount rate to the future
value of the Carbon Credits. In this circumstance, the advanced payment
mechanism acts much like a loan provided by the Carbon Credit buyer.
This mechanism is simple and relatively quick to arrange, comparable to a
conventional loan, because Carbon Credit buyers are usually well informed about
CDM-specific risks and are able to conduct the necessary Due Diligence at a low
cost.
However, this mechanism suggests a risk allocation toward Carbon Credit
buyer, since they are exposed to all risks associated with the future delivery of
Carbon Credits. As a result of that, in order to mitigate risks, Carbon Credit
buyers usually offer a low price per carbon Credit and a high interest rate.
25
Another disadvantage is that buyers are willing to provide upfront payments
usually only at advanced stages (after registration on UNFCCC and completion of
construction). As result, this mechanism usually does not solve the financial
problem for early stage projects.
Carbon payments escrowed as debt service
World Bank has pioneered this mechanism that capture the “high quality” of
Carbon Credit revenues, and that is not only based on the additional revenues
that can be generated (Bishop, 2004). These extra values brought by the quality
of revenue are:
Carbon contracts are denominated in hard currency, usually dollar or
Euro;
Long-term contracts, for example, the Post 2012 carbon Credit Fund of
First Climate is able to buy Carbon Credits generated until 2020.
Counterparties are generally highly-rated, for example, the Post 2012
Carbon Credit Fund with 125 million Euro from Aaa credit rating banks.
The mechanism consists on using the backed ERPA to collateralize debt made
by a bank (Figure 10). An escrow account outside the host country is set up, in
order to safeguard the revenue stream for debt service and mitigate currency
risks, since the debt and revenues are usually from an OECD country. Once the
service debt payment is finished, the residual Carbon Credit revenue is directed
to Project Owner.
26
Debt
service
CER Buyer
(ERPA)
Partner Bank Project
CERs
Escrow
account
CER revenues remaining
Debt
CER revenues
Figure 10: Carbon payments escrowed as debt service
This mechanism is normally used by First Climate in partnership with a Bank,
who accepts Carbon Credits as collateral. Generally, “Partner Banks” require an
overcollateralization of around 50% of the Carbon Credit present value.
The “Carbon payments escrowed as debt service” model has a significant
potential in attracting financial sources and is growing its importance since the
recognition of Carbon Credit as a commodity is being established.
Less common practices are the Pooling model and the Local bank guarantee
model, described briefly below:
Pooling model
A successful structure pioneered by Standard Bank and Camco, capable to
capitalize € 15 million upfront by a pool of 5.8 million CERs from nine CDM
projects in China.
The model follows the structure of mezzanine finance, which is basically debt
capital that gives the lender the rights to convert it to an ownership or equity
interest in the company if the loan is not paid back in time and in full.
This mechanism aims to package a pool of projects and monetize their
emission reductions (or the whole cash flow) by tranches with different risk
27
profiles. The tranche are auctioned in tranches and the first one gets the first
credits, wherever they come from, the second a bit more risk, and so on (Figure
11). An advantage of this model is that it is able to secure upfront money without
tying it to CER delivery; however it has a low demand for this kind of investment
since the Subprime Mortgage crisis in USA.
Investors
CER Buyer
Project
pool
CERs
SPV
Debt
CER revenues
Subordinated
lenders
Senior lender
ERPA
Figure 11: Pooling model
Local Bank guarantee model
Similar to the Pooling mechanism, however instead of providing debt the
Investors provide a Letter of Guarantee for a Local Bank, which does not accept
Carbon Credits as collateral. With the Guarantee letter the Project owner is able
to access finance from a Local Bank. In case of a Project Owner defaults debt
service payment the Investors can access the Carbon Credits of the Project pool
(Figure 12).
Investors
Financial
Agreement
CER Buyer
Project
individual or
Project pool
CERs
Guarantee
CER revenues
Subordinated
lenders
Senior lender
ERPA
Local Bank
DebtDebt
Service
SPV Figure 12: Local Bank guarantee model
28
CDM project values beyond the cash flow
Beyond the valuation of the project cash flow, financial institutions have been
recognizing environmental and social aspects as a requirement for investment.
Since these aspects are an intrinsic part of CDM projects, the concern with
“sustainability” of the financial sector has indirectly favoured CDM projects
financing.
3.4 Risk identification and sharing
Project participants are particularly concerned with ensuring that they have
identified and understood all risks that they will be assuming in connection with
the project. The main risks of a CDM project can be divided between CDM-
specific risks and Generic project risks; both can affect the project causing
basically: Failure, Delay or Under-performance, depending on the project stage
(Figure 13).
The project risk profile affects the ability of a CDM project to attract finance in
two different ways: directly, by affecting the lender’s willingness to invest;
indirectly, by changing the Carbon Credit buyer perception of risk. This last will
impact the project financing when the Carbon Credit Buyer compensates its risk
on the Carbon Credit Price (as shown in Figure 14), offering a lower price for the
acquisition. Therefore, the lower value of Carbon Credits will affect the debt
collateral and the project cash flow.
29
CDM
Imple-
ment
Failure
Perform
Delay
PA start Validation
Working
mode
Registration Issuance
Construction CommissioningFinancial
close Purchase
Figure 13: Project Risks profile per stage (Source: First Climate analysis)
As figure 13 shows, after financial closure the risk of project failure falls. This
confirms that financial closure is an important challenge for CDM projects.
Moreover, the fact that the risk of under-performance persists high until the
Registration explains why advanced payment by Carbon Credit buyers is done
just after this phase.
This section shows briefly the most common CDM-specific risks and Generic
project risks, and lists instruments of management and mitigation that can be
used.
CDM-specific risks
The perception of risk by the Carbon Credit Buyer is transmitted on the
offered price for an ERPA, affecting the financial performance of the project as a
whole. The most common CDM-specific risks are illustrated in the figure 15
below.
30
Figure 14: CDM project risk profile and its impact on Carbon Credit price (Source: UNEP FI)
Sharing project risks
The key project risks encountered in different types of projects can be
grouped as: Financial Risks; Market risks; Legal and Regulatory Risks;
Construction and Operation Risks.
After the decision to implement a CDM project is taken, the CDM-specific risks
and Generic project risks are integrated into the project risk profile. For instance,
in the case of an energy project, its financial performance depends on the
projected energy and Carbon Credit revenues. In this sense, CDM-specific parties
may assume part of the project risks. For instance, part of Financial risks are
assumed by Carbon Finance mechanism, Market risks by Carbon Credit buyers
and so on. (Figure 15)
It is likely that most participants in projects will need to consider one or more
of these risks and decide by whom these risks are to be assumed and how. Once
these risks have been identified, it is through the various contractual
31
arrangements between the parties, and insurance, that these risks are, for the
most part, apportioned and assumed.
Special Purpose
Vehicle
Banks
Sponsors
Suppliers
Local Laws
Host
Government
Operator
Financial Risks Market Risks
Construction &
Operation Risks
Legal &
Regulatory Risks
Shareholder
Agreements
Credit Agreement/
Security Documents/
Carbon Finance Off take
Agreements
(PPA)
O & M
Agreements
EPC
Concession
Agreements
Consents
/Permits
Supply
Agreements
Carbon
buyer
ERPA
Off takers
CDM
cycle
ContractorConsulting
Figure 15: General project risks groups (Source: Guide to Project Finance)
Existing instruments to address risks
There are some instruments currently available that help CDM projects to
avoid market and technical threats. The existing instruments are listed below:
Country risk guarantee
Emission Reduction Purchase Agreement
Escrow accounts outside the host country - It permits deposit of
payments for Carbon Credits from a buyer outside the host country,
thereby safeguarding the revenue stream for debt service while also
mitigating currency risk;
32
Partial risk guarantees to insure against host country non-compliance - It
assurances that the government will not seek to ‘nationalise’ CERs or
attempt to re-negotiate prices agreed in ERPAs. Alternatively, a lender
might require a commitment from the government as to the price or
availability of key inputs to the project (e.g. waste to a landfill site), or
future electricity or heat tariff increases that are required to make the
project financially viable;
Carbon Delivery Guarantee - It is a credit enhancement product, which
guarantees delivery of Carbon Credits from quality projects in developing
countries to buyers in developed countries.
33
4 Conclusions
Carbon Markets play an important role in shifting private investment flows
toward climate change issues. This dissertation concludes reviewing the most
successful Project Carbon Finance instruments and giving recommendations for
the private sector development.
Best-practice in project financing
Intrinsic CDM related barriers4 to finance, must be overcome by the quality of
Carbon Credit revenues (Bishop, 2004):
Carbon contracts are denominated in hard currency - Dollar or Euro;
Long-term contracts, generally until 2020;
Counterparties are generally highly-rated.
The current Financial Models able to enhance the values above successfully
are:
Carbon payments escrowed as debt service - model which consists on
using the ERPA to collateralize debt to be issued by a bank. While, an
escrow account outside the host country is set up, in order to safeguard
the revenue stream for debt service and mitigate currency risks.
Advanced payment mechanism - upfront payment from Carbon Credit
Buyers, applying a high discount rate to the future value of the Carbon
Credits. This mechanism is simple and relatively rapid to arrange, relative
to a conventional loan, because Carbon Credit buyers are usually well
informed about CDM-specific risks and are able to conduct the necessary
Due Diligence at a low cost.
4 CDM project characteristics that difficult access of finance: small size; clean technologies are
usually more capital intensive than conventional ones; lenders ask for higher interest rates in
Developing Countries; and local financial institutions do not accept Carbon Credits as a valuable
asset or do not understand the risks involved in the CDM cycle processes.
34
Carbon Market know-how
CDM risks and underlying project risks are not disconnected. Since part of
company’s revenue and risks derives from CDM projects, the carbon aspect must
be a part integrated in the company’s core-business, developing internal know-
how on Carbon Market or constructing partnership with liable Carbon
companies. Limited knowledge on the business has resulted in project failure or
in losses of opportunities.
35
References
Books and papers:
Andrew, J. (2004) Climate Change Strategy: The Business Logic behind Voluntary Greenhouse Gas Reductions.
Bishop, V. (2004) Catalysing climate-friendly investment. Carbon Finance, March: 16-17.
Business for Social Responsibility (2008) Offsetting emissions: A Business Brief on the Voluntary Market.
Denton Wilde Sapte (2004) A guide to project finance. London: Denton Wilde Sapte.
Deodhar, V., Michaelowa, A. & Krey, M. (2005) Financing structures for CDM projects in India and capacity building options for EU-Indo collaboration.
Ecosecurities Ltd, UNEP (2007) Guidebook to Financing CDM Projects.
Environmental Finance Report (2009) Confronting Climate Risk.
Federal Environmental Agency from Germany (2007) Promoting Renewable Energy Technologies in Developing Countries through the CDM. Available at: http://www.umweltbundesamt.de
Green, Gavin A. (2008) Cost-effectiveness of CDM projects types. UNEP.
IETA, The World Bank (2009) State and Trends of the Carbon Market 2009.
Lash, J., Wellington, F. (2007) Competitive Advantage on a Warming Planet.
KPMG (2008) Climate Changes your Business – Review of the business risks and economic impacts at sector level.
McKinsey & Company (2009) Pathways to a Low-Carbon Economy.
New Energy Finance (2006) Global Clean Energy Investment Overview.
Swiss Re (1999) Project finance: The added value of insurance. Zurich: Swiss Re Publishing.
The UNEP FI African Task Force (2009) And yet it moves.
United Nations Framework Convention on Climate Change - UNFCCC (2008) Investment and financial flows to address climate change, Technical Paper.
36
United Nations Framework Convention on Climate Change - UNFCCC (2004) The First Ten Years.
UNEP (2008) Public Finance Mechanisms to Mobilise Investment in Climate Change Mitigation.
Websites:
http://cdmpipeline.org
http://carbon.newenergyfinance.com/
http://www.pointcarbon.com/
http://www.carbonfinanceinternational.com/
http://www.carbon-financeonline.com/
37
Annexes
1. Categories of participants on the Kyoto Protocol - (Source: Point carbon)
The various categories of participants on the Kyoto Protocol are illustrated
bellow distinguished by colour:
Figure 16 - Participants to the Kyoto Protocol (Source: Point Carbon)
Blue, the European Union (EU-15): All EU members are Annex I countries,
and the EU-15 has taken on a common commitment to reduce their
average greenhouse gas emissions by 8 % in the first Kyoto commitment
period (2008-2012) compared to 1990 level.
Yellow: Countries undergoing the process of transition to a market
economy: countries that have emission caps and are usually net sellers in
the Carbon Market. JI projects are hosted mostly in these countries.
Red: Annex II non-EU countries that ratified the Kyoto Protocol: these
countries have ratified the Kyoto Protocol, have compliance targets, but
are not part of the EU or are not economies in transition.
White: Annex I parties not ratified: among the Annex 1 countries that
signed the Kyoto Protocol in 1997, only the USA has not ratified it. In 1990,
the USA emitted 36.4 % of the total GHGs in the world.
38
Green: Non-Annex I countries having ratified the Kyoto Protocol: the non-
Annex countries do not have emission caps and are potential host
countries of CDM projects.