carbon financing structures accra final

CDM – Carbon Finance Workshop

Accra, June 24-26 2009

CDM – Carbon Finance Workshop

Session 6: Discussion of carbon

financing structures

Contents

• Introductory quiz

• Carbon financing explained

• Key terms covered

• Case study

10

30

2

• Case study

• Major concepts explained

• Some special cases

• Group work

• Report back and key learning

30

30

Introductory quiz

Carbon financing analogyQuestion

• Would you finance a power project which • Then why would you finance an emission

• Without any additional information, would

you buy shares in Afrocentric on the

Johannesburg Stock Exchange?

• Then why would you expose yourself to

carbon market price risk without a sufficient

understanding of the market

3

• Would you finance a power project which

has signed a power purchase agreement

with a new company with no assets?

• Then why would you finance an emission

reduction project which has signed a carbon

offtake agreement with a high counterparty

risk player?

• Would you invest in a project based on a

feasibility study conducted by a company

with absolutely no experience?

• Then why would you invest in a project

where all the carbon documentation has a

high chance of being incorrect to such an

extent that CDM registration fails

Contents




• Case study

10

30

4

• Case study



• Group work

• Report back and key learning

30

30

During this session you will learn about…

Key concept Definition

• ERPA • Emission reduction purchase agreement – the agreement

defining the terms of sale of carbon credits

• Fixed price ERPA • An ERPA in which a fixed price is paid for carbon credits,

irrespective of price fluctuations in the market

• Carbon share ERPA • An ERPA in which the price paid for carbon credits is linked to

some kind of market price metric

• Delivery guarantee • A guarantee provided by a project to a carbon credit buyer that

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• Delivery guarantee • A guarantee provided by a project to a carbon credit buyer that

a minimum number of carbon credits will be delivered by the

project

• Counterparty • The carbon credit buyer with which the project signs the ERPA

• Upfront CDM costs • The costs incurred to register a project under the CDM.

Includes development costs (e.g. PIN, PDD), validation costs

and registration costs

• Upfront payments • Payments made by a carbon credit buyer to a project for

carbon credits not yet delivered

• Carbon fund • A fund which makes equity or debt investments into a project

on the basis of securing carbon credits as one of its revenue

streams

Case study: Energy production and methane avoidance from groundnut husks

Project description

• Ghana Groundnut Growers Association (GGGA) currently leaves husks in

large piles which decompose anaerobically, releasing methane

• Under the project, the groundnut husks will be fired instead of coal in a

boiler to produce energy, thereby reducing emissions of carbon dioxide

from the burning of fossil fuels

• By not allowing the husks to decompose anaerobically, the release of

methane will also be avoided

98

6

Estimated emission reductions(‘000 tCO2e)

Other• By examining similar projects in the UNFCCC pipeline, you find that these

types of projects deliver only 60% of methane avoidance emission

reductions on average

50 50 50 50505050

85

15

48

98

2016

Methane

avoidance

Fuel switch

17

67

13

26

76

14

35

2010

5

55

11

1060

12

252

The major carbon financing concepts explained:Advantages of a Fixed Price ERPA

A fixed price ERPA is an ERPA in which a fixed price is paid for carbon credits, irrespective

of price fluctuations in the market

Advantage Case illustration

• Hedge away carbon

market price risk and so

benefit if market

underperforms

• GGGA entered fixed price contract for carbon credits in

September 2008 for EUR14

7

Secondary

CER

market

price

ERPA price

The major carbon financing concepts explained:Disadvantages of a Fixed Price ERPA



Disadvantage Case illustration

• Forgo potential price

• GGGA enters fixed price contract for carbon credits in Sept 08

for EUR14 with Lucky Traders Ltd, a private carbon trader with

an insignificant balance sheetSecondary

CER

8

• Forgo potential price

upside

CER

market

price

ERPA price

• Potentially high

counterparty risk

• When the first credits are delivered, the market price is at

EUR8. Lucky Traders Ltd was planning to resell credits on the

market but now cannot afford to and declares insolvency

• The contract falls away at GGGA is forced to sell credits at

EUR8 to the market

The major carbon financing concepts explained:Advantages & disadvantages of a Carbon Share ERPA

A carbon share ERPA is an ERPA in which the price paid for carbon credits is linked to


Case illustration

• GGGA entered carbon share agreement where they receive

80% of secondary CER market priceSecondary

CER

market

price

Advantage / disadvantage

9

price

ERPA price

• Share in performance • Share in price upside if market price increases, but also share

in downside if market price decreases

• Lower counterparty risk

• If price decreases, less financial strain is put on the carbon

credit buyer, reducing counterparty risk compared to a fixed

price agreement

The major carbon financing concepts explained:Which to choose: Fixed Price of Carbon Share?

A carbon share ERPA is an ERPA in which the price paid for carbon credits is linked to




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Recom-mendation

If:

• A fair fixed price can be secured, and

• Counterparty has a relative good credit rating

Then rather hedge away risk through a fixed price contract

Unless:

• You have studies the fundamentals of the market and are confident that

prices will increase, and

• You have the appetite and means to take on carbon market risk

The major carbon financing concepts explained:Advantages & disadvantages of a Delivery Guarantee

A delivery guarantee is a guarantee provided by a project to a carbon credit buyer that a

minimum number of carbon credits will be delivered by the project

Case illustration

• Lucky Traders Ltd realises that they cannot take on carbon

price risk and so decide to enter a back-to-back agreement to

sell GGGA’s credits on directly.

• However, in order to ensure that they can fulfill this contract,

Lucky Traders demands that GGGA provides a guarantee that


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Lucky Traders demands that GGGA provides a guarantee that

they deliver the estimated number of emission reductions.

• Potentially higher price • With a delivery guarantee, Primary CERs have similar risk to

Secondary CERs and should therefore fetch a similar price

• Multiplication of project risk

• If the project underperforms, GGGA will produce insufficient

ERs and will therefore have to spend cash to buy CERs on the

market when the performance from the project is worst.

• Potentially onerous non-delivery clauses

• Lucky Traders may insert a clause saying that ownership in

GGGA’s project cedes to Lucky Traders in the event of default.

We have seen this before – especially in cases like this where

the project is expected to underperform! Beware the sharks!

Recommendation Avoid delivery guarantees wherever possible!

The major carbon financing concepts explained:Advantages & disadvantages of various Counterparties

A counterparty is the carbon credit buyer with which the project signs the ERPA

Case illustration

• GGGA goes out into the market again and finds another

potential buyer: the Swiss Government

• GGGA checks with a credit rating agency and finds that the

Swiss Government has a rating of AAA and estimates that

Lucky Traders has a rating of D+


• Lower carbon market • The lower the counterparty risk, the less likely that the ERPA

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• Lower carbon market risk

• The lower the counterparty risk, the less likely that the ERPA

will fall through, and the less likely that the project will have to

go out into the market and be exposed to carbon market risk

• Higher value ERPA • Banks and other investors usually recognise the value of a

strong counterparty (as they do with power purchase

agreements) and so will be more likely to provide finance if

there is less counterparty risk

• Lower price • There is a misconception that stronger counterparties

recognise their value and offer lower prices as a result. This is

not the case – in fact all of South Pole’s buyers are AAA-rated

and offer above market prices

Recommendation Sign an ERPA with the strongest possible counterparty to

minimise risk

The major carbon financing concepts explained:Advantages & disadvantages of covering upfront costs

Upfront CDM costs are the costs incurred to register a project under the CDM. Includes

development costs (e.g. PIN, PDD), validation costs and registration costs

Case illustration

• GGGA is approached by Super Penguins Ltd, a carbon

developer which offers to cover all upfront costs and be paid a

commission on sale of credits on a no-cure-no-pay basis.


• No cash flow requirement upfront

• The average CDM project costs EUR60-90k to register. These

upfront cash requirements can therefore be minimized by the

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requirement upfront upfront cash requirements can therefore be minimized by the

project

• Reduced exposure to CDM risk

• If CDM registration fails, the project has not sunk upfront costs

which cannot be recovered

• Higher probability of CDM success

• The carbon developer is better incentivized to see the project

succeed. In fact, EB records show a strong trend that the

quality of projects developed under such an arrangement are

of far higher quality

Recom-mendation

Unless the project owner has a surplus of cash, if a fair carbon price is

offered, go for a contract in which upfront costs are covered

• Lower price • Carbon developers may discount price as a result of increased

risk covered

The major carbon financing concepts explained:Advantages & disadvantages of covering upfront costs

Upfront payments are payments made by a carbon credit buyer to a project for carbon

credits not yet delivered

Case illustration

• Big Bucks Ltd offers to pay GGGA 25% of pre-2012 carbon

credits upfront


• Early cash flow • Upfront payment serves as an early cash flow to the project

which can be used to cover initial capital costs, raise financing,

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which can be used to cover initial capital costs, raise financing,

etc

• Lower price • In order to compensate themselves for the additional risk, Big

Bucks Ltd is likely to offer a lower price than if credits were

sold on a regular fixed price contract

• Often onerous guarantees required

• Many buyers who are willing to provide upfront payments

require bank guarantees to do so. If a project is in a position to

get a bank guarantee, they can rather get a loan directly from

the bank

• To overcome this, South Pole and BP are aiming to provide

upfront payments secured by project assets

Recom-mendation

Upfront payments are often very useful for getting a project off the ground

if the terms for the security are realistic

The major carbon financing concepts explained:Advantages & disadvantages of carbon funds

A carbon fund is a fund which makes equity or debt investments into a project on the basis

of securing carbon credits as one of its revenue streams

Case illustration

• Platinum Carbon Capital offers to take a 25% equity stake in

GGGA’s project, in return for 25% of project returns (including

25% of carbon credits)


• Access to capital • The presence of carbon credits allows a project access to

15

• Access to capital • The presence of carbon credits allows a project access to

potential investors who may not have been interested

otherwise

• Potential strategic partner

• As carbon funds invest in many related projects, they may

bring networks or expertise which are very useful to a project

• Potentially lower price • In order to minimize carbon market risk, a carbon fund may

assume a conservative carbon price when performing a

valuation on the project

Recom-mendation

Explore potential carbon funds if there is a funding gap in the project, but

ensure you are satisfied with carbon price assumptions

Contents




• Case study

10

30

16

• Case study



• Group work

• Report back and key learnings

30

30

Case study: Mini-grid hydropower project in Ghana

Project description

• The Rural Hydro Company is in the process of developing a 10MW hydro

project to supply power to a mini-grid system in Ghana

• The project also involves the development of a mini-grid system, and will

supply power to homes, schools and hospitals in the region, reducing the

need for the diesel powered generators which are currently used

• The project is expected to commission in Sept 2010

• The project is eligible under methodology AMS.I.A under the CDM

17

Estimated emission reductions(‘000 tCO2e)

616161616161

15

201615141312112010


• Substantial interest has been shown in the project by the global community

and as a result the Rural Hydro Company has been approached by 2

buyers with the following terms and characteristics:

Buyer name Swiss Government Conco

Credit rating AAA C

Probability of default Low price = 0%

Medium price = 0%

Low price = 50%

Medium price = 20%

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Carbon financing terms offered

Medium price = 0%

High price = 0%

Medium price = 20%

High price = 10%

Fixed price offered

with no delivery

guarantee

EUR11 EUR12

Discount if upfront

costs covered

EUR1 None offered

Carbon share offered

no delivery guarantee

80% None offered


External research

• You have commissioned an external consultant to do some external

research and have determined the following:

Low price Medium price High price

Price level EUR 5 EUR 11 EUR 16

Probability 25% 50% 25%

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• If upfront costs are not covered, a CDM project has a 20% non-registration

risk

• If upfront costs are covered, this risk reduces to 5%

Questions to be answered

• What carbon financing structure would you recommend to the project? Be

specific in terms of:

• Buyer

• Fixed price or carbon share

• Upfront costs covered or not

Contents




• Case study

10

30

20

• Case study



• Group work

• Report back and key learnings

30

30

Case study feedback

If a fixed price

• Option A: Swiss government: Risk adjusted price of EUR11

Price offered EUR11 EUR11 EUR11


Market price EUR 5 EUR 11 EUR 16


21

price contract was chosen which buyer would you go for?

Chance of default 0% 0% 0%

Default risk adjusted price EUR11 EUR11 EUR11

• Option B: Conco: Risk adjusted price of EUR10.30

Price offered EUR12 EUR12 EUR12


Default risk adjusted price EUR5.50 EUR11.80 EUR12.4

80% x EUR12 + 20% x EUR11

25% x EUR5.50 +

50% x EUR11.80 +

25% x EUR12.40

Case study feedback

Is the

• Option A: Swiss government: Risk adjusted price of EUR8.60

Price offered EUR4 EUR8.80 EUR12.80


Market price EUR 5 EUR 11 EUR 16


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Is the carbon share offer more attractive?


Default risk adjusted price EUR4 EUR8.80 EUR12.80

EUR5 x 80% EUR4 x 25% +

EUR8.80 x 50% +

EUR12.80 x 25%

So far, the fixed price contract with the Swiss Government is the most attractive offer

Case study feedback

Should the upfront costs be covered in return for a EUR1 price discount?

• CDM risk adjusted price without upfront costs covered from the Swiss

Government is:

EUR11 x (1 – risk of non-registration) = EUR11 x 80% = EUR8.80

• CDM risk adjusted price with upfront costs covered from the Swiss

Government is:


23


Conclusion

• The project should enter into:

• Swiss Government

• Fixed price contract

• With upfront costs covered

Key learnings

Fixed price vs Carbon Share

If:

• A fair fixed price can be secured, and

• Counterparty has a relative good credit rating

Then rather hedge away risk through a fixed price contract

Unless:

• You have studies the fundamentals of the market and are confident that

prices will increase, and

• You have the appetite and means to take on carbon market risk

24

Delivery guarantee

Avoid delivery guarantees wherever possible!

Counter-party

Sign an ERPA with the strongest possible counterparty to minimise risk

Covering CDM costs

Unless the project owner has a surplus of cash, if a fair carbon price is

offered, go for a contract in which upfront costs are covered

Upfront payments

Upfront payments are often very useful for getting a project off the ground if

the terms for the security are realistic

Carbon funds

Explore potential carbon funds if there is a funding gap in the project, but

ensure you are satisfied with carbon price assumptions

carbon financing structures accra final

Technology

fixed price of carbon

carbon ggga

market carbon share

carbon fund

fixed price agreement

price decreases

carbon documentation

price upside